Words and terminology change, we accept that fact. And indeed, even some proponents of supply-side economics describe it—positively—as “trickle down.” Even Rush Limbaugh does.
But the label doesn’t explain how economy works. Thomas Sowell once wrote something to the effect that it can take 23 pages to refute a bumper sticker, and that’s how we feel about this topic. It’s complicated, with a rich history that goes far beyond the “trickle down” moniker.
What is Supply-Side Economics?
Supply-side economics is perhaps one of the most misunderstood, and mischaracterized, theories in recent times. In reality, it’s quite simple, and very logical. Basically, capitalism is propelled by supply, not demand. Each actor in the economy has a dual purpose—that is, of producer and consumer. Which comes first?
People don’t consume in order to produce, they produce in order to consume. You don’t write a book because you acquire a computer; rather, you acquire a computer in order to write a book. Everyone knows, however, that their ability to consume, on the whole, is no greater than their ability to supply. In real terms, then, demand is supply.
Any buyer of a book, automobile, haircut or stereo pays not in the currency of demand—i.e., money—but from his own provision of goods and services to others..
When you obtain a haircut, you are simply trading some of your services as a CPA for those of a barber. Money is simply a convenience; it takes away the need for a “coincidence of wants” necessary in a barter economy. Money allows the trade to commence, even though your barber may not need CPA services at the time of your haircut.
By focusing on money—that is, demand—we miss the real essence of what makes an economy work. The very idea of people as consumers is deceptive and patronizing, as people must supply first in order to demand later.
This is the reason supply-side models are unconcerned with spending and demand. Rather, they focus on the producer by removing obstacles to production and trade. Economist Jean Baptise Say coined Say’s Law of Markets: Supply of X creates demand for Y.
In other words, a society’s income can never exceed its output.
If you’d like more information on supply-side economics, as well as the logic and history behind it, Ed and I have found the following books most helpful. We’ll provide some of the main point from each below.
“Trickle Down” Theory and “Tax Cuts for the Rich”, Thomas Sowell, 2012
“No such theory has been found in even the most voluminous and learned histories of economic theories…”
In a syndicated column Sowell challenged anyone to name any economist who advocated a “trickle down” theory. Lots named someone who claimed someone else advocated it.
It’s a classic case of arguing against a caricature instead of confronting the argument actually made, very similar to the Strategic Defense Initiative vs. Star Wars.
President Franklin Roosevelt’s speech writer, Samuel Rosenman referred to:
“The philosophy that had prevailed in Washington since 1921, that the object of government was to provide prosperity for those who lived and worked at the top of the economic pyramid, in the belief that prosperity would trickle down to the bottom of the heap and benefit all.”
Much same argument was made by William Jennings Bryan’s famous “cross of gold” speech in 1896.
Economist John Kenneth Galbraith labeled supply-side economics by using “the-horse-and-sparrow” metaphor: The horse is fed oats, some will pass through to the road for the sparrows.
President Woodrow Wilson in a 1919 message to Congress actually understood the negative consequences of high tax rates:
The Congress might well consider whether the higher rates of income and profits taxes can in peace time be effectively productive of revenue, and whether they may not, on the contrary, be destructive of business activity…
There is a point at which in peace time high rates of income and profits taxes discourage energy, remove the incentive to new enterprise, encourage extravagant expenditures, and produce industrial stagnation with consequent unemployment and other attendant evils.
The idea that profits “trickle down” to workers depicts the actual economic sequence in the opposite order. In reality workers are hired and paid first, before any output, or indeed, profits.
The real effect of tax rate reductions: they make future prospects more favorable, leading to more current investments, more economic activity, more risk-taking, entrepreneurship, and jobs.
Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity, Brian Domitrovic, 2009
This is the first scholarly history of the supply-side movement based on primary sources.
The movement was enhanced by a bunch of renegade, mavericks, all under 40, such as Jude Wanniski (author of the fantastic book, The Way The World Works), George Gilder, Robert Bartley editor of the Wall Street Journal, Congressman Jack Kemp and his staffer Paul Craig Roberts, who did have a PhD in economics.
There were two academic economists: Art Laffer and Robert Mundell, the latter a Nobel Prize winner in 1999). Five other Nobel economists were also associated with Supply-Side economics: Robert Lucas, Edward Prescott; the pioneer in “public choice” theory, James Buchanan; and Milton Friedman.
Robert Mundell elaborated on tax cuts and stable money in 1971 at a talk in Italy. His Nobel address is a great statement of supply-side economics and its historical vision.
Mundell has a university in China named after him: Mundell International University of Entrepreneurship.
No one called it “supply-side economics” in the 1970s. Jude Wanniski referred to it as “The Mundell-Laffer Hypothesis.”
Herbert Stein, economist and father of Ben Stein (of Ferris Bueller’s Day Off fame) labeled the movement “Supply-Side fiscalists,” a term of mild derision. Wanniski liked it, and used supply-side economics instead.
In December 1974, at the Two Continents restaurant in Washington, D.C. Arthur Laffer drew his now famous curve on a cocktail napkin. Present were: Jude Wanniski, Donald Rumsfeld (President Ford’s Chief of Staff), and his deputy, Richard Cheney.
Paul Krugman in an article in the New York Times, “The Tax Cut Con,” Sept 14, 2003: “Supply-side economics was a political doctrine from Day 1; it emerged in the pages of political magazines, not professional economic journals.”
This is untrue. From Day one it emerged on the pages of the IMF Staff Papers. And with Mundell’s presentation of a paper in 1958 to a Stanford faculty seminar, including the editors of the American Economic Review.
The Laffer curve is nothing more than a common sense view of taxation that comports to reality—that is, there are two rates that will bring zero revenue to the government: 0% and 100%. The crucial rate, to the supply sider, is the marginal rate, not the effective rate—the rate that applies on the last dollar earned, since it affects the decision to invest.
If you subscribe to the logic that 0% and 100% will generate the same level of revenue, that logically leads you to conclude that the power to tax is, indeed, the power to destroy. Thus, every human undertaking, short of breathing, can be destroyed by taxation.
Britain, in the 1970s, had a top marginal rate of 98% on investment income. At a time when England was in economic decline, there were many Rolls Royces on London’s streets. This was mistaken as a sign of prosperity, when in fact it was a sign of confiscatory tax rates on investment income. It simply made more sense to consume than invest.
There are basically two effects from reductions in marginal tax rates (as opposed to tax revenues):
- Income Effect—people have more money, so they work less (a target income theory).
- Substitution Effect—work pays more relative to leisure, so people work more.
The argument is over which effect dominates. If it were true that people worked harder, in order to achieve a “target level” of income—even at tax rates approaching 90%--then we should tax the poor and lower-to-middle income workers at these rates in order to encourage them to work more.
This is nonsensical and is not consistent with human behavior—the way to get people to work harder is to raise their taxes! One wonders what workers would do if employers proposed the same work at reduced wages? Once you understand that additional effort often requires increasing rewards, then you have the basic logic behind supply-side economics.
This could explain why Americans work more than Europeans?
Unbelievably, this same argument is used for savings—that is, people have a “target level” of savings they want to achieve, and by lowering the tax rate they will achieve it faster, and therefore consume the excess. This also does not comport to human behavior.
Andrew W. Mellon, Taxation: The People’s Business, 1924
Incomes over $300,000
Year Rate Taxes paid at progressive rate Returns filed
1916 7% $81,404,194 1,296
1921 77% $84,797,344 246
In 1921, over 80% of those earning over $300,000 disappeared!
There were 206 millionaires in 1916; tax rates rose, then there were 21 in 1921! After rates dropped, they climbed back to 207 by 1925.
How did the rich avoid tax? Tax-exempt bonds, etc. Congress enacts the high tax rates, then creates the loopholes that allow the wealthy to avoid those high rates. Why?
So they can engage in class warfare rhetoric for votes, and continue to receive Donations from the wealthy.
Wealth and Poverty, George Gilder, 1981
The source of the gifts of capitalism is the supply side of the economy.
Even Marx knew enough not to stress control over the means of consumption! (or even the supply of money).
Every economy has unlimited demand, but there is no demand for new or unknown goods.
Say’s Law (supply creates demand) was not only refuted, it was implicitly reversed, with cause and effect hopelessly confused in the proposition that demand creates its own supply—“take and you will be given unto.”
Buying power does not essentially “trickle down” as wages or “flow up” and away as profits and savings. It originates with productive work at any level. Give and you will be given unto.
Consumption doesn’t need encouragement; production does:
“Even in the short run real aggregate demand is an effect of production, not of government policy. The only way tax policy can reliably influence real incomes is by changing the incentives of suppliers. By altering the pattern of rewards to favor work over leisure, investment over consumption, the sources of production over the sumps of wealth, taxable over untaxable activity, government can directly and powerfully foster the expansion of real demand and income. This is the supply-side mandate.”
Say’s Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way, Steven Kates, 1998
Kates is the Chief Economist at the Australian Chamber of Commerce and Industry.
John Maynard Keynes tried to refute Say’s Law, but misunderstood and misrepresented it.
Say’s Law: the proposition that failure of effective demand does not cause recession. Your demand power is determined by your supply power. Production is the cause of consumption, not its consequence.
Kates writes that even Sowell failed to understand the core meaning of Say’s Law in his book, Say’s Law: An Historical Analysis, 1972.
Say’s Law declared that demand would never fall short of properly proportioned supply.
Ron equates this using this example: Children are demand-side economists, while parents are supply-siders.
Jean-Baptise Say: “It is the aim of good government to stimulate production, of bad government to encourage consumption.”
Say was the French Adam Smith who coined the term entrepreneur (undertaker), loosely translated as “adventurer.”