Opinion Editorial | |
| Monday, February 26, 2001 | |
The Difference Between Keynesian Stimulus and Supply-Side Tax Cuts |
Many commentators, both for and against George W. Bush's
proposed tax cut, have compared his plan to Ronald Reagan's in
1981. While there is a similarity, in that both plans cut
marginal income tax rates across the board, the underlying
philosophy is different. Whereas the Reagan plan was based on
supply-side economics, the Bush plan owes much more to Keynesian
economics. There is danger in this that Bush and his
advisers so far appear to be unaware of.
In the Keynesian model, based on the work of British
economist John Maynard Keynes (1883-1946), consumption spending
by individuals and investment spending by businesses drive the
economy. Saving, therefore, is a drag on the economy because it
reduces spending. The government can add to total spending by
running a budget deficit, either through purchases of goods and
services or by reducing taxes. Thus, budget surpluses are like
saving and subtract from spending, causing growth to slow.
This Keynesian view of the economy was very dominant among
policymakers throughout most of the postwar era. Whenever the
economy entered a slowdown, Congress was usually quick to enact
some sort of countercyclical fiscal policy. Usually this took
the form of increased public works outlays, but occasionally
involved a cut in taxes. The former was preferred because it
added dollar-for-dollar to total spending, whereas some of a tax
cut would be saved, thus reducing its "bang for the buck." In
order to limit saving from a tax cut, Keynesians favored tax cuts
aimed at those with lower incomes, who were more likely to spend
all of their tax cut.
The supply-side view, which arose in the 1970s, found deep
fault with the Keynesian approach to economic policy. Supply-
siders observed a steady deterioration in growth and productivity
over the postwar era, the failure of Keynesian measures to
prevent or even moderate business cycles, rising inflation, and a
bias toward the public sector at the expense of the private
sector. The supply-siders, basing their analysis on pre-
Keynesian neoclassical economics, argued that the Keynesian focus
on spending was misplaced because it ignored the role of
incentives and production in the economy.
The Keynesians, in effect, argued that producers produced
and workers worked simply because there was demand for their
products and labor. Supply-siders said it was for profit. If a
worker cannot buy goods and services with his labor that are
worth more to him than the cost of that labor, he just won't
work. And a critical component of the rate of return is the
marginal tax rate--the tax on each additional hour worked or
dollar earned.
With inflation raising nominal incomes, workers were being
steadily pushed up into higher and higher tax brackets. By the
late 1970s, workers increasingly found that even though their
incomes rose, what they could actually consume out of each
additional dollar earned was going down. It became common to
hear about workers rejecting overtime because they believed they
would actually lose money on the deal. That may not have been
literally true, but the perception was widespread and there was
no question that taxes were rising faster than incomes.
Supply-siders said that the excessive focus on demand in the
Keynesian model was largely responsible for double-digit
inflation. It was essential, they said, to restore incentives to
work, produce and invest. Instead of being discouraged, saving
should be promoted, because that provides the resources needed
for investment. Investment, in turn, creates jobs and raises
real incomes by raising productivity.
Ronald Reagan embraced the supply-side view of the economy.
That is why he strongly defended tax rate cuts for the so-called
rich. It was not so much that he saw the rich as being
particularly productive, but because he saw the urge to become
wealthy as the driving force in the economy. If people couldn't
become rich or at least have the hope, then the economy's
entrepreneurial dynamism would wither.
Bush says he shares Reagan's vision, which is why he
is pressing hard to lower the top income tax rate from 39.6
percent to 33 percent. However, he seldom uses Reagan's
arguments. One almost never hears from Bush any talk about
entrepreneurship, risk-taking, investment or innovation in his
speeches supporting tax reduction. Rather, one hears primarily
about putting dollars into people's pockets, increasing
disposable income, and the need to counter an economic slowdown.
These arguments have far more in common with the old-fashioned
Keynesian model than supply-side economics.
Critics of supply-side economics and the few remaining
devotees of Keynesian economics have noticed. Sebastian Mallaby
of the Washington Post, one of the former, took note of
Bush's apparent apostasy in a February 19 article. " Bush is
in some respects the anti-Reagan," said Mallaby. "Instead of
pushing Reaganite supply-side arguments, the Bush team is
stressing the demand side."
Mallaby correctly notes that this sort of Keynesianism
is "goofy." Yet this has not discouraged some of the few
remaining hard-core Keynesians from one-upping Bush. For
example, the Jerome Levy Institute in New York, a redoubt of
Keynesian purists, believes Bush should triple the side of
his tax cut. It is too small to pump up demand enough to offset
a looming economic collapse, it believes. This collapse is due
largely to the budget surplus, which is depressing spending.
Thus the Levy economists favor abolition of surpluses and a
return to large budget deficits.
Bush would help himself by downplaying the Keynesian
countercyclical case for his tax cut, if only because the current
slowdown is likely to be over by the time a tax cut is signed
into law. And by stressing the supply-side argument about the
long-term benefits of lower marginal tax rates, Bush can help
defuse the concern that his plan will extinguish the surplus. He
should point out that faster growth will lower the budgetary cost
of his tax cut.
Harvard economist Martin Feldstein estimates that faster
growth will reduce the actual revenue loss from Bush's tax
plan from $1.6 trillion to $1.2 trillion over 10 years. A new
Heritage Foundation study finds even stronger feedback effects,
with faster growth recouping almost half the static revenue loss (see figure).
Bush does not need to stop talking about how his tax
plan will help average people and perhaps counter a recession.
But he should not neglect the supply-side argument as well.
Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, February 22, 2001.
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