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room to grow Keynesianism“Supply-side economics needs a 21st-century update,” went a post at the American Enterprise Institute’s blog the other day, challenging the assurance from the Cato Institute’s Dan Mitchell that no, it doesn’t. The point of contention in the rising, intra-Republican squabble over economic policy is whether it is best to solve the problem of the tax code through comprehensive rate cuts, or through credits for middle class families.

In the latter camp, Sen. Mike Lee of Utah and the contributors to the volume Room to Grow are suggesting a modest cut in rates, such that the income tax would have two levels, one for low to median income, at 15%, and another for high income, at 35%. (The bottom rate today is 10% and the top rate 39.6%, with five further ones in between.) In the former camp are the residual supply-siders of classical Reagan tinge, still including Rep. Paul Ryan, who emphasize rate cuts and the devaluation of all exemptions and loopholes that rate cuts automatically accomplish.

The argument of the Room to Grow contingent is that Reagan’s tax cut made sense in 1981, when the marginal rate was 70%. Today, with working people hurting so, more credits for having children and expanding a family should be the preferred Republican option. As it is even now, taxpayers of regular means get $1000 deducted from their taxes for every child at home.

The first thing that must be clarified about this square-off is that the Mike Lee/Room to Grow project has nothing to do with supply-side economics. Supply-siders from start to finish, from Robert L. Bartley to Jack Kemp to Jeff Bell (now putting the heat on Cory Booker in New Jersey), have always been opposed to tax expenditures/loopholes/preferences, whatever you want to call the innumerable carve-outs in the tax code.

Every one of the great supply-side tax cuts of the 20th century had the salient characteristic of striving to undermine tax preferences by making them less valuable.

One of the express objects of Andrew Mellon’s marginal rate cuts of the 1920s was getting John D. Rockefeller out of $42 million in tax-exempt municipal bonds by taking the marginal rate from 77% to 25% (success was achieved). John F. Kennedy’s rate cuts were devised in a Treasury department at war with loopholes that counted among its assistant secretaries Stanley Surrey, the man who coined the derisive term “tax expenditures.” And as Bartley (the Wall Street Journal editor) said of the Reagan era in 1992, when you cut rates, “you don’t have to launch a search-and-destroy mission for loopholes; they will dry up in any event.”

Jack Kemp was always ready to point out why tax preferences are particularly harmful when directed at lower earners. These things raise their marginal tax rates. Today, a family with children making just over $110,000 pays a marginal tax rate five points higher than the statutory rate of 25%. This is because the $1000 credit for having kids phases out at this level of income. Tax preferences for the average earner, Kemp always warned, get people stuck in their current economic class and dampen private initiative to take advantage of opportunities, locking up human capital.

As for contemporary relevance, Casey Mulligan has been showing us how Obamacare is jacking up effective marginal tax rates on those with lower incomes, in some cases taking them to 100%. If somehow you clear the Obamacare hurdle and reach median family income, and Room to Grow gets its way, there will be another round of higher effective rates waiting for any further increases in income. You can forget about ever improving your station.

Then there is the matter of the fiscal-monetary policy mix. Here again, the tax-preference idea remains alien to supply-side economics. As Robert Mundell made clear in his canonical definition of supply-side economics in 1971, “The correct policy mix is based on fiscal ease…, in combination with monetary restraint….The increased momentum of the economy provided by the tax cut will cause sufficient demand for credit to permit real monetary expansion at higher interest rates.”

The Federal Reserve has been shoving money into bondholders’ hands for years now, to no good effect. It has been “pushing on a string.” Tax cuts at the margin have all along been the missing element. Such tax cuts increase the real return of all work and enterprise and thus increase real monetary demand. Increases in real monetary demand justify Fed expansionism and permit the dollar-masters to watch more important things, such as the dollar price of gold, oil, foreign exchange, and commodities.

Tax cuts at the margin—and only at the margin, in that these correspond to new economic initiative—hold the key to making monetary policy effective. Tax preferences not only do nothing in this regard; in necessitating higher marginal rates on account of their revenue losses, they undercut this essential supply-side purpose.

People say that the world is different today—Reagan had to deal with a marginal rate at 70%, while ours is only around 40%. This is to misunderstand what Reagan did and did not accomplish. Tax cuts and tax reform were accomplished in the 1980s: their legacy should be consolidated and extended, not repudiated.

Not accomplished was any kind of formal reform of the monetary system. No reconstituted gold standard, no price rule, no nothing outside of the same old seat-of-the-pants Fed chair/Board of Governors best guess at monetary policy was the practice institutionalized in the 1980s. But then again monetary policy was easy in the 1980s. Marginal tax cuts produced phenomenal demand for the dollar.

The Room to Grow suggestion is Keynesianism by another name: non-marginal rate cuts so that people closer to the bottom can have more to spend. It is odd to hear that supply-side economics should be updated because it succeeded in the 1980s. The proposed update suggests a return to demand-side economics, whose record includes having failed spectacularly in the stagflation of the 1970s.

Books on the topic of this essay may be found in The Imaginative Conservative Bookstore. This essay first appeared on Forbes and is republished here by gracious permission of the author. 

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5 replies to this post
  1. I don’t think most supply siders would object to target credits to address problems. After all we’ve been advocating school vouchers for at least twenty years now. As you say in your openning, it’s a matter of updating supply side. Sen Lee as you quote is still to my knowledge a supply sider. I’m not an economist to know the definitions, but tax credts don’t seem like Keynsian economics to me. If they are, so be it. I support them. I know Paul Ryan supports school vouchers. Where I don’t support Keynsianism is in the belief that government spending stimulates the economy and that it provides a net gain. Part of the drag on the economy the last few years has been the Obama huge “stimulous” spending of 2009. It neither provided a stimulous and it proved to be a drag.

  2. I think the best point the author makes is that while some level of positive tax reform was achieved under Reagan, nothing was done with Monetary policy reform (not monetary policy itself, but the monetary system within which policy is conducted).

    Now, we are living in times reminiscent of the “Cross of Gold” era, when monetary policy might actually be able to gain political traction rather than be an up-in-the-clouds technical issue for Fed insiders.

    Personaly, I think the idea to simplify the tax code to two rates (15 and 35) in a situation where the bottom rate is 10% is going to be political suicide for the Republican party:

    I can hear the Democrats now: lowering the top marginal rate from 39 to 35% is a tax cut for the rich so they can buy two more mega-yachts, but raising the marginal rate from 10% to 15% is a kick in the stomach to the poor who will have to cut back on food for their children.

    And the Democrats would be right.

    The same kind of strategy was what failed to get a flat tax passed in Poland because the bunglers who advocated it were blind to the fact that advocating a 19% flat tax when, in the progressive tax scheme the lowest rate was 12% – and 99% of the public paid the lowest 12% rate – was effectively a massive tax increase on the majority of tax payers and a huge tax cut on the rich.

    The real question – when considering tax rates – is what percentage of the population pays what rate?

    In America, if we believe Romney and various conservative sources, 46% of Americans pay ZERO Federal taxes.

    Any attempt at creating a simplified tax code with two or one rate which will also close loopholes is going to enrage these people because they will go from 0% to >0% – a political looser.

    What to do then?

    The Republican party must campaign on the abolition of the Income Tax (perhaps even constitutional) and its’ replacement through a Federal Tarrif scheme of modest proportions (5% on all imported goods to the USA). Combine this with abolition of Corporate taxes that hinder investment.

    Any other tax scheme aimed at created two simplified rates will fail because for 46% of the population – it will mean going from paying 0 to paying >0%.

    As for monetary policy – the Republicans should become the party of Gold.

    I agree that the arguments against Reagan’s tax scheme are bad; it should not be rejected – but expanded. However: expansion does not mean ignoring political reality but being as bold as Reagan was for his time.

    Boldness in our time is no income tax + the Gold Standard + the Tarrif as the Republican Party Platform for the XXI century.

    The BIGGEST political and economic hurdle is the debt and government spending. But in my mind – the only way to have a POLITICAL chance at tackling spending is to first get the economy moving again – because when Americans have jobs, they will be more open to the idea of spending cuts – hopefully (although this might not work, since government spending and deficits don’t exactly help get the economy moving) – so…I don’t know how to tackle the problem of spending.

    We’d need a President willing to use the full power of the Executive office to kill spending bills with the same imperial force with which the current Presidents have been willing to kill people overseas.

  3. Sen. Lee’s argument is that the combination of the senior entitlement system and tax system effectively double-charge parents for SS and Medicare. Parents pay the payroll tax (like everyone else) but exclusievly bear the costs of raising children, who will grow up to fund the benefits of all seniors, parents and childless alike. Fixing that distortion is not a Keynesian tax cut, but a correction of an unfair distortion, like fixing the marriage penalty. Growth is a vital goal of economic policy, but it’s not the only one, and not the highest one. The highest goal is freedom, which Lee’s plan rightly prioritizes.

  4. Since we tripled the debt in the 1980’s–ran it up at a faster pace than anytime before or since other than wartime–should that be called “supply side” or “Keynesianism”? Or is “supply-side” just the Republican cover for Keynes?

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