Excellent Defense of Supply-Side Economics

I recently posted favorable comments about a National Review article that made two important points about fiscal policy and supply-side economics. First, the article reminded "supply siders" that the burden of government spending is very important (and very worrisome). Second, the article correctly explained that not all tax cuts are created equal, and Republicans should be careful not to make silly claims about all tax cuts "paying for themselves" (particularly tax credits that have no positive effect on growth).

My Cato colleague Alan Reynolds has responded to the article, largely to remind everyone that the core premise of supply-side tax policy is 100 percent correct. Someone emailed me to ask what I thought about what they perceived to be a "big disagreement" on the right, but I don't think that Alan's points are inconsistent with the core premises of Williamson's article. Maybe I'm in a "can't-we-all-get-along" mood, so judge for yourself. Here's the key excerpt from Alan's article:

The trouble with what Williamson calls “the bottom-line question of balancing the budget” is the implication that it makes no difference whether the budget is balanced by curbing spending or increasing taxes. A 2002 study by Alberto Alesina of Harvard and three colleagues found that the surest way to make economies boom is through deep cuts in government spending. Higher tax rates had the opposite effect. Although “growth isn’t going to make the debt irrelevant,” as Williamson says, the ratio of debt to GDP can become much larger and more troublesome if GDP stagnates. ...The burden of government depends on spending, but the “excess burden” or “deadweight loss” of tax distortions depends on marginal tax rates. The size of this excess burden grows with the square of the tax rate, making a 40 percent tax rate 16 times more damaging than a 10 percent rate. Recent estimates find at least a dollar of damage to the private economy for each additional dollar raised through today’s progressive taxes. Supply-side tax policy is about raising tax revenues in ways that do the least damage to the private economy. Spending cuts are entirely consistent with supply-side theory because (1) transfer payments that phase out with rising income are a disincentive to work and (2) government purchases divert real resources into unproductive uses. ...Supply-side economists criticized the Bush tax cuts as wasteful, and the phasing-in of lower tax rates as positively harmful. University of Michigan economists Christopher House and Matthew Shapiro, in the American Economic Review of December 2006, “attribute the slow recovery from the 2001 recession, in part, to declines in labor supply stemming from the phased-in nature of the tax cuts. Additionally, the rebound in economic activity in mid-2003 coincides with the removal of the phase-ins enacted in the 2003 tax bill. A comparison of the simulated and actual time series over this time period shows that about half of the rebound in GDP in mid-2003 can be attributed to the elimination of the phase-in of the tax cuts.” Revenue from top-bracket taxpayers, dividends, and capital gains all soared after those tax rates came down in mid-2003. Offsetting the supply-side revenue gains, however, were big losses from reducing the lowest rate to 10 percent and adding various tax credits. ...Williamson says, “When the Reagan tax cuts were being designed, the original supply-side crew thought that subsequent growth might offset 30 percent of the revenue losses. That’s on the high side of the current consensus.” On the contrary, the current consensus is that the typical effect of lower marginal tax rates on revenues will offset at least 40 percent of the losses, and perhaps more than 100 percent at very high incomes.