Thoughts on Supply-Side Policy

I wanted to share some independent research that I have been doing on tax revenues following the Reagan tax cuts and Bush tax cuts.

tottaxrev
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This is a graph I created documenting the growth of total tax revenue from 1977 to 2008. I used 1977 as a starting point because it just pre-dates the Reagan era tax cuts and is also the first full year after a change to the start of the fiscal year.

Just by looking at this graph, we can see upswings in the growth of revenue following the tax legislation of 1981, 1986, and 2003. Notable declines are following the Bush tax cuts in 2001, and 1983, following the Tax Equity and Fiscal Responsibility Act of 1982, which raised tax rates.

Changetaxrev
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This graph provides a more complete picture of the stimulating effect of tax-cutting. After 1981, the rate of growth of tax revenue went down. This means one of two things: either the economy was on the downswing and tax revenue growth would have been lower without the effect of tax cuts, or the tax cuts reversed short term trends of increases in the rate of revenue growth.

Tax revenue actually decreased around the time of the tax hike passed by Congress in 1982, but it seems unlikely that this bill had an effect that quickly. The next big upswing in revenue came following the passage of the monumental Tax Reform Act of 1986, which sharply lowered tax rates while closing a significant amount of loopholes.

Interestingly, after 2001, tax revenue plummeted and experienced substantial negative growth. One cannot be certain from this data as to the effect of the Bush tax cuts, however, given the concurrent events of the dot-com bubble burst and the attacks of 9/11.

Miraculously, after 2003, the the rate of growth skyrocketed, and we experienced the fastest increase in tax revenues in our history. It is worth noting that this is around the same time as the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, which accelerated many of the tax-cutting provisions in the Economic Growth and Tax Reconciliation Act of 2001.

This was of course followed by a sharp decline in growth as we approached 2008. Could this be a sign of the latent economic crisis at that time?

taxrevaspropgdp
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My next thought was that a productive way to examine tax revenues would be to look at them as a proportion of the GDP that year, especially since the supply-side claim is that there is an intimate relationship between taxes and GDP. Thus, I compiled GDP data for the same period 1977-2008 and produced this graph.

Tax revenues as a proportion of GDP fell sharply following the 1982 tax increases. Following the major tax bill passed in 1986, revenues increased as a proportion of GDP. This is really intriguing. What this graph is telling us is that following a tax increase, taxes grew at a rate slower than GDP, and that following a tax decrease, taxes grew at a rate faster than GDP.

Of course, following 2001, revenue  fell to a very low proportion of GDP. Again, however, one must take into account the significant internal and external economic shocks that were occurring at that time as well. The distinct ability of the 9/11 attacks to sow uncertainty in the market likely had unique effects undermining growth. This should be taken into account when evaluating how much tax policy influenced this decline in revenue growth relative to GDP.

In any event, taxes grew again relative to GDP finishing out the Bush era, which saw the maintenance of that administration’s tax-cutting provisions enshrined in the Tax Increase Prevention and Reconciliation Act of 2005.

delttaxrevoverdeltgdp
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This graph more clearly articulates the point I was making above. It shows the proportion between change in tax revenue and change in GDP growth.

One can clearly see sharp growth of revenue against the GDP growth following the 1986 tax bill. Other notable growth occurred around the time of the tax increases in 1993, and the acceleration of the 2001 tax decreased passed in 2003. 2001 remains a notable period of substantial decline in revenues.

Conclusion

With these graphs I am clearly not able and not trying to establish any causation between the tax legislation passed over the past 30 years and the growth in tax revenues and the GDP. I am merely examining a perceived relationship that my personal research and data compilation has yielded.

The years 1981 and 1993 seems to stand as counter-examples to the notion that cutting taxes stimulates revenue growth and that raising taxes lowers it, since in those years taxes were cut and raised, respectively, and the opposite effects of what the supply-siders would have predicted actually occurred.

However, it seems that the massive growth in revenues following the recovery of the post-9/11 economy, in spite or because of tax cuts, is significant. Certainly it cannot be ignored. Furthermore, the overall decrease in taxation from the 1986 tax reform bill and corresponding growth in revenues is also a point of interest that lends credence to supply-side theory.

I think it is a logical assumption to say that cutting taxes provides more money for investment and can raise the GDP. The real question is whether it increases growth in tax revenues. 

States vs. National Government

There is a great case to be made that supply-side effects are more pronounced in states, where people have greater mobility to move or at least purchase goods across borders. Ironically, the people with the greatest mobility are the rich, those that the state taxes the most. This only pronounces supply-side effects from tax increases and, also ironically, results in a shifting of the tax burden to the poor. I think it is no coincidence that migration over the past 30 years has been from high-tax states in the Northeast to Sunbelt low-tax states.

But at the national level, I am not sure that supply-side effects are so pronounced. As Milton Friedman said, “If I do not like what Washington imposes, I have few alternatives in this world of jealous nations.” Rich Americans will grin and bear higher taxes much more often than flee to another country, most of which have higher tax rates anyway.

My overall recommendation would be to decrease taxes while cutting spending as well. I am convinced enough by the data I have seen and the analyses I have read that spending cuts do not have to be as large as the tax cuts. I do, however, think that spending cuts have a lot of efficacy as a hedge against other externalities that can cancel out supply-side effects (i.e. a terrorist attack).

Let me know any critiques of the analysis that you have. I am interested in dialogue.

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