But the evidence reveals two fundamental problems with this story. First, its primary prediction is wrong—giving tax cuts to the rich does not increase economic output or create new jobs. Instead, tax cuts for middle- and low-income taxpayers are much more effective at boosting macroeconomic activity. Second, supply-side theory misunderstands the actual mechanism by which tax rates influence macroeconomic activity.
These empirical findings carry an important lesson for our tax policy: Rather than increasing inequality by throwing away revenue on tax cuts for the rich, we should ensure that middle- and lower-income Americans have enough after-tax income to maintain strong consumption levels, especially during economic downturns.
Moreover, by perpetually fetishizing tax cuts for the top rates, conservatives have disregarded other policies that are more effective at spurring economic growth. Supply-side economics starts with a reasonable intuition: If you let people keep more of the income they earn, they will have an incentive to earn more income.
Based on this intuition, supply-siders predict that lowering tax rates will encourage people to work, save, and invest more by increasing the after-tax returns from these activities. And they conclude that all this additional working, saving, and investing will generate faster economic and job growth. One reason is that rich people can afford to work less when tax rates are high, whereas lower-income people need to work enough to make ends meet regardless of the tax rate.
Giving tax cuts to the rich therefore should generate a bigger uptick in work. According to that logic, incentivizing a CEO to work a few more hours a week is thought to be more economically beneficial than incentivizing a janitor to work the same number of extra hours. A third reason is that rich people can afford to save most of their tax cuts, which in turn will increase investment.
In contrast, lower-income people often need to spend the extra dollars. But the real question for policy-makers is whether modest shifts in the top marginal rates make much of a difference. But the evidence is in, and it shows no such thing. The best place to start this empirical inquiry is to look at what actually happens when top tax rates change.
Do growth and employment shoot up when high earners get a tax cut? Does the economy tumble when their taxes rise? At first glance, the historical record seems to offer little to support the supply-side story. Consider the last decade. In , President Bush cut the top rate on capital gains and dividend income down to 15 percent from 20 percent—a rate that had already been reduced from 28 percent by President Clinton four years earlier—and cut the top rate on normal income down to 35 percent from Contrary to the Keynesian view, the inflation rate declined substantially from 9 percent during the five years prior to the tax cut to 3.
Economists continue to debate the precise effects of the s tax cuts. After extensive analysis of the rate reductions, both Lawrence Lindsey and Martin Feldstein concluded that for taxpayers previously facing marginal tax rates of 40 percent or more, the drop in tax rates caused such a large increase in taxable income that the government was collecting even more revenue from taxpayers in these top brackets. This would mean that tax rates of 40 percent had had a highly destructive impact on economic activity.
According to Slemrod, only a small portion of the increase in the tax base resulted from improvements in efficiency and expansion in the supply of labor and other resources. Even though economists still disagree about the size and nature of taxpayer response to rate changes, most economists now believe that changes in marginal tax rates exert supply-side effects on the economy. It is also widely believed that high marginal tax rates—say, rates of 40 percent or more—are a drag on an economy.
The heated debates are now primarily about the distributional effects. Supply-side critics argue that the tax policy of the s was a bonanza for the rich. It is certainly true that taxable income in the upper tax brackets increased sharply during the s. But the taxes collected in these brackets also rose sharply. The percentage increases in the real tax revenue collected from the top 1 and top 5 percent of taxpayers were even larger.
Since , the top marginal personal income tax rate has been less than 40 percent, compared with 70 percent prior to Nonetheless, those with high incomes are now paying more. For example, more than 25 percent of the personal income tax has been collected from the top 0. These findings confirm what the supply siders predicted: the lower rates, by increasing the tax base substantially in the upper tax brackets, would increase the share of taxes collected from these taxpayers.
Supply-side economics has exerted a major impact on tax policy throughout the world. During the last two decades of the twentieth century, there was a dramatic move away from high marginal tax rates. In , the top marginal rate on personal income was 60 percent or more in forty-nine countries. By , only twenty countries had such a high top tax rate, and by , only three countries—Cameroon, Belgium, and the Democratic Republic of Congo—had a top rate of 60 percent or more.
In , only six countries levied a personal income tax with a top marginal rate of less than 40 percent. By , fifty-six countries had a top marginal income tax rate of less than 40 percent.
The former socialist economies have been at the forefront of those moving toward supply-side tax policies. Following the collapse of communism , most of these countries had a combination of personal income and payroll taxes that generated high marginal tax rates. As a result, the incentive to work was weak and tax evasion was massive. Russia was a typical case. If Russians with even modest earnings complied with the law, the tax collector took well over half of their incremental income.
Beginning in January , the newly elected Putin administration shifted to a 13 percent flat-rate income tax and also sharply reduced the payroll tax rate. The results were striking. Tax compliance increased and the inflation-adjusted revenues from the personal income tax rose more than 20 percent annually during the three years following the adoption of the flat-rate tax.
Further, the real growth rate of the Russian economy averaged 7 percent during —, up from less than 2 percent during the three years prior to the tax cut. Beginning in , the Slovak Republic imposed a flat-rate personal income tax of 19 percent.
Latvia and Estonia also have flat-rate personal income taxes. Supply-side economics provided the political and theoretical foundations for what became a remarkable change in the tax structure of the United States and other countries throughout the world. The view that changes in tax rates exert an impact on total output and that marginal rates in excess of 40 percent exert a destructive influence on the incentive of people to work and use resources wisely is now widely accepted by both economists and policymakers.
This change in thinking is the major legacy of supply-side economics. James D. Gwartney is a professor of economics and director of the Gus A. He was previously chief economist of the Joint Economic Committee of the U. Footnotes 1. By James D. He concluded: I find it remarkable that virtually all of the large difference in labor supply between France and the United States is due to differences in tax systems.
The supply-side theory and demand-side theory generally take two different approaches to economic stimulus. The demand-side theory was developed in the s by John Maynard Keynes and is also known as Keynesian theory.
The demand-side theory is built on the idea that economic growth is stimulated through demand. Therefore, practitioners of the theory seek to empower buyers. This can be done through government spending on education, unemployment benefits, and other areas that increase the spending power of individual buyers.
Critics of this theory argue that it can be more costly and more difficult to implement with less desirable results. Overall, multiple studies have been produced through the years that support both supply and demand-side fiscal policies.
However, studies have shown that due to multiple economic variables, environments, and factors, it can be hard to pinpoint effects with a high level of confidence and to determine the exact outcome of any one theory or set of policies.
The Laffer Curve helped formulate the concept of supply-side theory. The curve, designed by economist Arthur Laffer in the s, argues that there is a direct relationship between tax receipts and federal spending—primarily that they substitute on a one-to-one basis. The theory argues that a loss in tax revenue is made up by an increase in growth; thus, tax cuts are a better fiscal policy choice.
In the s, President Ronald Reagan used supply-side theory to combat stagflation that followed the recession in the early part of the decade. Bush R : 2. This supply-side fiscal policy of tax cuts to boost economic growth remained popular among U. In and , President George W. Bush also instituted wide-ranging tax cuts.
These applied to ordinary income as well as dividends and capital gains among others. In , President Donald Trump enacted a tax bill that, in principle, is based on supply-side economics. Since then, the provisions have benefited high earners disproportionately and hurt some working- and middle-class taxpayers. During his presidential term, Trump also focused on supply-side fiscal policy through trade relations that raised tariffs on international producers with the aim of creating an opportunity for U.
Critics of these types of policies point to the growing trend among corporations to engage in stock buybacks. Buybacks occur when companies place the cash they may gain from lower taxes back into the pockets of their shareholders rather than investing in new plants, equipment, innovative ventures, or their workers.
Bartlett, B. Canto, V. Foundations of supply-side economics: Theory and evidence. Academic Press. Center for American Progress. Mazerov, M. Center on Budget and Policy Priorities, January , The Guardian. The World Bank. Congressional Research Service. Tax Policy Center. Income Tax. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
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