Monday, October 22, 2012

Bruce Bartlett's The New American Economy 4: Tax Cuts, Supply, and Inflation

In my latest reading of The New American Economy: The Failure of Reaganomics and a New Way Forward, Bruce Bartlett discusses the rise of supply-side economics.

Probably the clearest definition of supply-side economics that I've encountered is from David Stockman's July 14, 1978 testimony before the Senate Finance Committee.  Bartlett quotes from it on page 116:

"We are not merely advocating a simple tax cut, an election-year gimmick.  Instead, we view this measure as just one policy step in a whole, new fiscal policy program based on the supply side of the economy; based on the idea of getting more labor, capital, innovation, risk-taking, and productivity into the economy by removing government barriers and deterrents, the most important of which, I would suggest to the committee today, is the rapidly rising marginal tax rates that Congressman Kemp has just discussed..."

I'll admit that I have long misunderstood the definition of supply-side economics----and I especially communicated that misunderstanding when I was blogging through Henry Hazlitt's Economics in One Lesson.  I won't go back and correct those posts, since that would take a lot of work, and I have other things to do.  Plus, I never claimed that every post that I ever wrote was perfect!  But back to supply-side economics.  The way that I understood it was as follows: the government cuts taxes, and people are thereby left with more money that they can spend.  They spend that money, and that stimulates the economy.

The thing is, that focuses on demand rather than supply.  Demand deals with people spending their money.  Supply pertains to companies producing products.  And supply-side economics is about supply.  How so?  It goes back to what Stockman said: You cut taxes to remove "government barriers and deterrents" to such things as investment and productivity, with the result that there is more investment, productivity, risk-taking, etc.

Tax cuts have been viewed by a number of detractors as inflationary.  This was especially the case during the 1970's, which was when supply-siders were promoting tax cuts as a means to economic growth.  If you read or watch the Presidential debates from 1980, you'll see that this was an issue: inflation was rampant at the time, and Reagan was promoting tax cuts, and so he had to interact with the argument that tax cuts were inflationary.

How would tax cuts be inflationary?  I can think of at least two ways.  First, tax cuts increase consumer demand.  People now have money to spend, and that means that there are more customers demanding things.  When demand exceeds supply, prices go up.  Second, tax cuts put more money into the economy.  When there is more money in the economy, there is inflation, as companies raise prices with the realization that there is now more money in the economy.

But one could also argue that tax cuts can counter inflation.  How so?  It goes back to what Stockman was talking about, and other factors.  First of all, when you remove the tax barriers on investment and productivity, then the result is that companies produce more.  There is now a greater supply of products.  And, when supply exceeds demand, prices come down.  Second, companies pass on the cost of taxes to their consumers in the form of higher prices.  Cut those taxes, and the prices will come down (one would hope!).

The thing is, from what I read in Bartlett, supply-siders tended to focus on monetary policy in terms of fighting inflation.  They did not focus on the role of (say) deficits and massive employment on inflation, but rather on monetary policy----how much money is in circulation.  Their approach to bringing down inflation was to have a tighter monetary policy.  They were rather revolutionary in the sense that they supported both tax cuts and also a tight monetary policy.

In the following chapter, Bartlett goes into the fall of supply-side economics.

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