The curse of the “Free-lunch Bunch”

Supply side economists—a.k.a. the “free lunch bunch”—are cursed.  I’ve been observing the economics and the related politics for a quarter century, and that’s the only possible conclusion I can draw.  The curse, in a nutshell, is the ease with which the fundamental supply-side idea can be misrepresented by its opponents.  Shouting down the substituted straw man then becomes child’s play. 

A review of the “supply-side” idea:

First, let’s review an accurate version of the supply-side idea.  Here it is in its simplest, fundamental form:

People respond to incentives.

And here is a more-specific form, as it relates to taxation policy:

Lower marginal tax rates, by increasing the potential rewards, will increase private sector players’ incentives to work harder and risk innovation, and will decrease their incentive to shelter themselves from taxation. 

…and its converse:

Higher marginal tax rates, by decreasing the potential rewards, will decrease the incentives to work harder and risk innovation, and will increase the incentive to seek shelter from taxation. 

Notice what it does not say: “Tax cuts will pay for themselves before the next election.”  (More on that later.)  It also does not say: “Tax cuts will always generate more federal revenue, no matter how low the new rate.”  It merely says that tax rate cuts increase the private sector players’ incentives to work harder and innovate—i.e., to grow their own incomes, and thereby the whole economy. 

Not only is the fundamental supply-side idea simple and intuitive, it’s also impossible for anyone to dismiss it as “false”—and still maintain their credibility.  (Try thinking of a way to falsify the underlying hypothesis: “People respond to incentives.”  If you can think of a way, please go immediately to the comments section and tell me what it is.) 

I think a more descriptive name for supply-side economics is “growth-incentive” economics.  Who could possibly be against faster-growing incomes?  Never mind, that’s a trick question, because growth-incentive economics has plenty of enemies—but because they can’t refute the truism that “people respond to incentives,” they’ve had to redefine their enemy.  And I’ll be the first to admire the skill with which they’ve constructed several straw men.  Here’s a small sample:

• “There’s no such thing as a free lunch!”
• “The tax cuts didn’t pay for themselves; they just ballooned the dreaded deficit!”
• “It’s nothing but warmed-over ‘trickle-down economics’!”

I’ll show the flaws in those later, after taking a look at a few illustrations.  The first one is a graphic depicting the false impression conveyed by a common straw man used against tax cuts: the so-called “Static model”:

Looks bad, doesn’t it.  The pink area depicts all the “lost revenue”; of course it’s the “rich” who pocket most of the “giveaway.”  The spin continues: Just think how much the dreaded deficit was increased, just to make the rich richer!

But wait: Isn’t the “static” model ignoring something important?  Some of us think that “people respond to incentives.”  If lower marginal tax rates do in fact increase incentives to innovate, and decrease incentives to avoid taxes, that would translate into a higher growth rate for the economy as a whole (cet par).  Because “people respond to incentives,” a dynamic model would be a better representation of the growth-incentives idea:

Unfortunately for the dynamic model, it suffers from at least two defects:

1.    It doesn’t look much different from the static model in the years before the next election, and it undeniably caused revenue to drop immediately after the cuts;

2.    It’s too hard to figure out; the Static model is much easier for economists to calculate and for politicians to understand (...just as it's easier to look for lost car keys under the streetlamp at night, regardless of where they fell out of one's pocket).

Strike one and strike two: those two defects make the “free lunch bunch” extremely vulnerable to political attacks.  Fortunately, though, it’s not a strikeout yet; fortunately, at least some people are more concerned with long term economics than they are with the next political campaign.  Fortunately, some keep the following picture in mind:

In the long run, even an extra fraction of a point in growth makes a huge difference.  As Paul Romer said about innovation and growth:

We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding. Possibilities do not add up. They multiply.

The benefits are long-run, and that’s a problem when the political horizon is short run.  “Supply-side” economics is growth-incentive economics; because of that, it has a built-in, seasoned political enemy: those who favor the redistribution of existing wealth over the faster creation of new, aggregate wealth.  Politics is all about persuasion, and straw-man arguments are an effective persuasion tool.  Let’s revisit the straw men, with my reaction to each one:

Straw man #1: “There’s no such thing as a free lunch!”
Patently false; of course there is.  Innovation is the free lunch.  Growth in productivity and wealth are the free lunch.  Reducing the capital gains tax yields a free lunch.  And here’s a paper demonstrating the math behind the free lunch of innovation. 

Straw man #2: "The tax cuts didn’t pay for themselves!"
Yes, it’s arguable that the 2001 tax cuts didn’t pay for themselves before the upcoming 2008 election.  However, that’s a lot different from saying the tax cuts did not and never will pay for themselves.  For even a small bump in the growth rate, the mathematics of compound growth would doom that assertion.  (And as for the “ballooning” deficit: it’s been shrinking, not ballooning; moreover, as I’ve said before, there’s nothing wrong with running a measured deficit each and every year, forever and ever, such that the debt grows no faster or slower than the economy.)   

Straw man #3: "It’s warmed-over 'Trickle Down' economics!"
Sorry, there’s no such thing as “trickle down” economics—the conjured scenario of heaping undeserved wealth onto the already-rich, which generates subsequent table scraps for the non-rich. 

Unfortunately for the “trickle-down” straw man, real-world risk-taking just doesn’t work that way; in fact, it’s just the reverse: Innovators and entrepreneurs risk their money (and others’ money) up front—paying it out to vendors, workers, landlords, utilities, etc.—long before they ever become “enriched” by new customers who purchase their new product or service (or become impoverished by overestimating the size of the new-customer base).  Lower marginal tax rates not only create more capital to fund risk-taking, but also give more people an incentive to take a risk.  The (possibly non-rich) risk-taker’s money first flows out to the non-rich;  the subsequent profitable inflow of money to (or subsequent declaration of bankruptcy by) the risk-taker happens later.  The former situation—profitability instead of bankruptcy—is by far the better result for all concerned: risk-taker, workers, vendors, etc.  In any case, “Trickle Down” is a politically-inspired fictional reversal of the way the real world works for the innovators responsible for the growth of our economy. 

The fundamental idea that "people respond to incentives" is growth economics.  Its opponents are experts in politics.  In my experience, politics trumps economics.  That’s a bad omen.  Can enough people see past the short-term politics?  I hope so.   

Summary
Yes, there is a free lunch: it’s known more formally as “compound growth,” and it is enhanced by growth-incentive economics.  Although its opponents are politically formidable, former Republican Senator Fred Thompson has a very good question for them at the end of his April 14 article in the Wall Street Journal:

"Are you really interested in tax rates that benefit the economy and raise revenue--or are you interested in redistributing income for political reasons?"

Comments

[Bob]

Seems to me that innovation and risk taking has taken a dangerous back seat lately. And I don't mean just in the political arena.

[Jason]

I don't think critics of supply-side policies try to "refute the truism that 'people respond to incentives,'" they argue that tax cuts simply aren't the proper incentives. I believe they would say that targeted spending by Congress is more effective and fair. The assumption is that lower taxes will provide incentives only to buy larger jets, vacation houses and yachts. The results of this consumption then "trickle-down" to the hard-working American.

The more frightening point of view is that the "rich" should pay higher taxes regardless of the effect on growth. I believe Robert Reich alluded that would oppose any proposal where the wealthy would become wealthier even if the proposal made no one worse off (i.e. it was pareto efficient). The lose of potential wealth would not be worth the raise in inequality.

On a lighter note, your post reminded me of this video: http://youtube.com/watch?v=VVp8UGjECt4

[John Adams]

I think tax cuts are fine if done right and for the right reason, but the problem I have with many supply-side proponents is this: If we take its reasoning to its logical conclusion, we could reduce tax rates to zero, and this would send economic growth and tax receipts skyrocketing.

This, of course, is absurd: You cannot collect taxes at all if tax rates are zero! At some point there must be a line of diminishing returns where tax cuts really do start to reduce revenue even though economic growth might skyrocket.

Furthermore, it is not just tax rates which cause or stifle economic growth. It is rather simplistic to say that such-and-such tax cuts caused an economic expansion when you don't know what would have happened sans those cuts. I read this in WSJ editorials all the time and it annoys me: I can't tell you how many times I've read the WSJ trumpet Bush's tax cuts as the cause of the current expansion. Oh, really? Do they assume the recession would have dragged on forever without them? That too, is absurd. The main impetus for the current expansion could very well have been the Fed's reduction of interest rates to practically nothing, in which case Bush's tax cuts would have been largely irrelevant. Or, the expansion could have occurred without either - which seems most likely to me, to be honest. Perhaps the expansion was driven by China's growth and the growth of the world economy in general, in which case anything the US government did had no effect at all.

If the recovery would have occurred without Bush's tax cuts and even without the Fed's encouragement, then what can we say about tax revenue? If we assume that economic growth would have been about the same without the cuts, it's fair to conclude we'd have more tax revenue because, after all, rates would have been higher with about the same amount of growth. One can argue that Bush's tax cuts made the economy grow faster than it would have without them, but I see little compelling evidence for this. The only truly "fast" growth we've had since 2001 was a few quarters in 2003 and 2004. That period could just as well have been spurred on by the Fed's low rates rather than Bush's tax cuts. Or, once again, it might have occurred without either. There have been plenty of periods of fast economic growth in US history without tax cuts to spur them on. This could have been one of them, even if Bush had not cut taxes.

Economic growth is a complex phenomenon with a variety of inputs. Placing too much emphasis on one particular input risks ignoring all the others, which supply-siders seem to do too often in their fixation on tax rates.

[Steve]

John:
I don't know of any "supply-sider" who has advocated 0% tax rates; similarly, I know of no "redistributor" who has advocated 100% tax rates. The effect on growth in either case would be irrelevant; the former would render the currency worthless, and the latter would cause an overthrow of the government.

Your post is a good example of why I prefer "growth-incentive" economics to "supply side." It's more difficult to set up a straw man. Sure would be nice to hear some Democrats' ideas about growth incentives, but so far the only ones talking about it are the Republicans. The Democrats seem to think the "Two-Americas" class warfare theme is more important than the JFK message that "growth floats all boats." Too bad.

[muirgeo]

"It merely says that tax rate cuts increase the private sector players’ incentives to work harder and innovate—i.e., to grow their own incomes, and thereby the whole economy. "

http://www.bea.gov/bea/dn/nipaweb/TableView.asp#Mid

Gross domestic product
1994 4.0
1995 2.5
1996 3.7
1997 4.5
1998 4.2
1999 4.5
2000 3.7
2001 0.8
2002 1.6
2003 2.5
2004 3.9
2005 3.2
2006 3.3

So what were the tax incentives in the 90's and then after the millennium?

The theory and the data don't seem to correlate.

This would be like some one claiming CO2 is causing global warming while showing a graph with an inverse relationship between CO2 increases and temperature trends.

But of course with regards to global warming the data does fit the theory....so I wonder why so many believe what they do in spite of contrary data.

http://cdiac.esd.ornl.gov/trends/co2/graphics/lawdome.smooth20.gif

http://www.cru.uea.ac.uk/cru/info/warming/

[Steve]

Although tax rates are only one of many things that affect growth (such as monetary policy, business cycle, foreign trade, etc.), you need to be careful to isolate at least the business cycle effects from your time series. Here's an example that uses the first four years of three different business cycles, each one roughly timed with an environment of tax cuts or tax hikes. (We only have 4 years of data since the most recent trough, so 4 year periods are chosen for the other two.)

Real GDP growth in first 4 yrs of business cycle:

'83 thru '86,
after tax cuts:
1983 4.5%
1984 7.2%
1985 4.1%
1986 3.5%

'92 thru '95,
after tax hikes:
1992 3.3%
1993 2.7%
1994 4.0%
1995 2.5%

'03 thru '06,
after tax cuts:
2003 2.5%
2004 3.9%
2005 3.2%
2006 3.3%

Still imperfect, but at least it's not distorted by the business cycle.

The premise still stands: People respond to incentives—or, more specifically:
Taxpayers respond to changes in tax rates.

[Interested Party]

muirgeo isn't worth the time, Steve. Trust me on this one.