Supply Side vs. Trickle Down Economics

Supply side economics is sometimes denigrated as "trickle down economics". This is a mistake. To see this, we need some definitions.

The term "supply side economics" was coined by Hebert Stein. He chose the name to distinguish it from Keynesian economics, which he called demand side economics. Its main components are reducing regulations and tax rates. The best known part is the Laffer curve, due to Arthur Laffer. It states that as marginal rates are reduced, taxable income increases.

To understand what that means, we first need to understand the difference between total taxes and marginal taxes.

Suppose a couple has a taxable income of $150,000. Their standard deduction would be $24,400. So their adjusted gross income would be $125,600. Then they apply the tax rates. In their bracket (22%), their tax would be $8,907 + .22 * ($125,600 - $77,400) which comes to $19,511. That would be 13% of their total income. However, if they earned $10,000 more (i.e. $160,000), then their tax would be $21,711. That would be $2,200 higher. So they would be paying 22% of each dollar of additional income. So their total tax would be 13% of their income but their marginal tax would be 22%.

Supply side economics says that what matters are the marginal tax rates, not the total taxes. In our example, the 22% mattered more than the 13%. The reason is that if the couple were considering making more money (e.g. a side hustle) they would only consider the 78% of the additional income that they would receive net of taxes. If they could make $10,000 more, they would have to weigh the effort required against the $7,800 that they would receive net of taxes, not $10,000 they would receive before taxes. Note that only the tax rates matter, not the total taxes. If the standard deduction were raised by $10,000, that would reduce their taxes by $2,200, but wouldn't change their incentives, because they would still be in the 22% tax bracket.

This could have a greater effect on investments rather than on additional work. If an investor is considering where to put his money, he looks at the after tax return. Some investments (e.g. municipal bonds) are exempt from taxes, but have a lower rate of return. The only reason people buy them is the tax advantage. What matters to the investor is the marginal tax rate, because that is what affects his return on investment. The higher the marginal tax rate, the more attractive tax advantaged investments become. So, as tax rates rise, more money moves into tax shelters.

Now, with an understanding of marginal taxes, we can examine supply side economics.

There are three problems with supply side economics.

1. The name. It's reasonable to call Keynesian economics demand side economics: its main thesis is that economic downturns are caused by insufficient demand. But supply side economics deals with a different question. Its thesis is that high tax rates discourage taxable activity. The idea is if you tax something, you get less of it, if you subsidize something, you get more of it. So, if we increase tax rates, then taxpayers will devote more time, effort, and money to avoiding taxes and less to productive activities. If the effect is large enough, a tax increase could result in reduced revenues. For example: if the rate is 50%, then each additional dollar earned leaves 50 cents in additional after tax income and each dollar transferred from taxable income to nontaxable income increases after tax income by 50 cents. If the rate is reduced from 50% to 40% then each additional dollar earned leaves 60 cents in additional after tax income and each dollar transferred from taxable income to nontaxable income increases after tax income by 40 cents. So at a 50% rate, to justify spending time and effort earning money rather then sheltering it, the the number of dollars earned by an hour of productive effort has to equal the number of dollars sheltered by an hour of effort (because both are 50% effective). So if an hour of effort could move $100 from taxable income to non-taxable income, then productive effort would have to make at least $100 per hour to be justified. At a tax rate of 40%, the number of dollars earned per hour of productive effort only has to be two thirds the number of dollars sheltered by an hour's effort (because 40% is 2/3 of 60%). In the previous example, where an hour of effort could shelter $100, now at a 40% tax rate, the return on productive effort only has to be $67. Sometimes increasing tax rates can result in lower tax collections.

A more accurate name for supply side economics would be incentive economics.

It's difficult to test this empirically, because when a tax changes, other things will change as well. That makes if difficult to sort out cause and effect. (This is a common problem in economics.) The Congressional Budget Office wrote a report analyzing the effects of the 1981 tax cut. They couldn't measure the supply side effect. They wrote: "These changes include increases in realized capital gains and earnings, shifts from tax-exempt or tax-deferred income to taxable income, and reductions in tax-deductible expenditures." So they allowed for supply side effects, but they added: "the question of the effect of the tax cuts on total economic growth is not addressed." They noted that the share of the taxes paid by the highest income group went up, but they couldn't prove why: "It is plausible that the higher incomes may have resulted from changes in behavior induced by the tax rate changes, which increased marginal after-tax income per dollar of pretax capital gains and wages by a greater percentage for people in this group than for other taxpayers." So, it's plausible that the supply side effects played a role, but they can't measure it.

Another problem with measuring its effects is that Keynesian and supply side effects could occur simultaneously. A tax cut could increase the deficit and reduce the unemployment rate. That would increase economic growth. But since the unemployment rate can't drop below zero, that increase wouldn't be sustainable. A better measure would be productivity (output per hour worked), but that in turn can be affected by unemployment rates.

A fairly clear cut example of a supply side effect is Maryland. Although there is some dispute, a detailed analysis by the state tax office showed what probably happened. According to Tax Foundation: "One-in-eight millionaires who filed a Maryland tax return in 2007 filed no return in 2008. Some died, but the others presumably changed their state of residence. (Hint to the class warfare crowd: A lot of rich people have two homes.)"

This could be ominous for America. According to Tax Policy Center, 1% of taxpayers paid about 45% of individual income taxes. If just half of them (0.5% of the total population) were to leave, the government would lose almost a quarter of its FIT revenue: it would be bankrupt.

2. It isn't really an alternative to Keynesian economics. Keynesianism is a theory of macro economics: it deals with unemployment, inflation, and the overall movement of the economy. Supply side economics deals with the decisions people make in response to different incentives. That makes it a theory of micro economics, an entirely different branch.

3. it is in no way original. Arthur Laffer himself pointed out that the idea goes back to the 14th century. Alexander Hamilton argued that there was no need for the Constitution to specify a limit for taxes (e.g. import tariffs) because if the rates were too high, people would buy less and total tax receipts would fall. He wrote in Federalist Papers #21: "It is a signal advantage of taxes on articles of consumption, that they contain in their own nature a security against excess. They prescribe their own limit; which cannot be exceeded without defeating the end proposed, that is, an extension of the revenue." That is the same argument as supply side economics. The argument wasn't original with Hamilton: Adam Smith made the same argument.

It's not even the case that the principle had been forgotten. The effect of taxes on demand is well known. It is frequently used to discourage activities the government doesn't like: e.g. cigarettes. These taxes are called Pigovian taxes. The idea is that if an activity (e.g. smoking cigarettes) causes costs to the larger society (e.g. medical bills partly paid for by the government), then a tax would be justified.

Next, we have to define trickle down economics. Since there is no group of economists calling themselves trickle down economists, we have to infer a definition. It's most commonly used to describe statements that rich people are a benefit to society. We can define trickle down economics as: if a lot of rich people move into a society, then those who were already there would be made better off.

It's not obvious a priori whether that is true or false. It's an empirical question. But it is clearly different from supply side economics. A good example is gentrification. If a bunch of higher income people move into a low income neighborhood, that will change things. Some will be bad for those already there: rents will go up. On the other hand, property owners would benefit. But there are other factors. Consider radio. Once someone has bought a radio, he can listen to it for free (except for the electricity). The reason is that other people (presumably richer) will also be listening and some will buy things advertised on the programs. So the people in the region benefit from having richer people also in the region. Another example is early adopters. When a new product comes out, the first people to buy it are rich or upper income people. After the product has been on the market for a while, the price will drop and more people will be able to afford it. The early adopters make new products possible. So, overall it's hard to say whether trickle down economics is true or false. But regardless, it's different from supply side economics.

But in a way it probably doesn't matter whether trickle down economics is true or false. Since the term was coined by Will Rogers, it has mainly been used as a term of abuse, without much attention to what it means.

Posted 2019/October/11