Voodoo Economics (Well, It’s Complicated #3)

  • Feldstein (1986)
  • Feldstein and Elmendorf (1989)
  • Garrison and Lee (1992)
  • Engen and Skinner (1992)
  • Slemrod (1995)
  • Auerbach and Slemrod (1997)
  • Mendoza et al. (1997)
  • Padovano and Galli (2001)
  • Gale and Potter (2002)
  • Desai and Goolsbee (2004)
  • Gale and Orszag (2005)
  • Eissa (2008)
  • Mertens and Ravn (2010)
  • Huang (2012)
  • Favero and Giavazzi (2012)
  • Yagan (2015)
  • Mertens (2015)
  • Zidar (2015)
  • Gale and Samwick (2017)

All of these studies, meta-studies, and papers have one thing in common: they all look at the effect of tax cuts on supply-side economic growth, either in the US specifically or in developed countries in general, by assessing empirical data.  They look at both narrow framed cuts like the Bush cuts in 2001/2003, and at broad framed reforms like the Reagan cuts in 1981 and 1986.  And ALL of them find the empirical data shows effectively no statistically significant correlation between tax cuts and supply-side economic growth.  None.  Zip, zero, zilch, nada.

The theory of supply side economics, also known as top down economics, investment-side economics, trickle-down economics, or Reaganomics, is elegant.  It sounds good.  It fits the rational models of Chicago school neoclassical economists to a T. In short, it says tax cuts stimulate economic growth by freeing up capital for investment and spending.

The problem is that little to no evidence supports it actually working that way in the real world.  At all.  The closest we get is Romer and Romer (2010), which supports the idea that demand will increase in the short term in response to unexpected tax cuts, but stops short of any evidence demonstrating actual long term growth, especially on the supply side.

As Gale and Samwick (2017) puts it: “The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel.  However, theory, evidence, and simulation studies tell a different and more complicated story.  Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest.  But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.  In addition, tax cuts…not accompanied by spending cuts…will typically raise the federal budget deficit.  The increase in the deficit will reduce national saving…and raise interest rates, which will negatively affect investment.  The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

If you want to argue that taxes are a moral evil, fine.  I’m not going to delve into the philosophy of social choice theory here.  That’s your call.  But if you want to support your philosophical argument by saying the economics are on your side, that “basic economics” tell us tax cuts are always good for the economy by boosting growth, that I’ll refute all day every day, because it just ain’t true.

The simplistic story told by “supply side economics” advocates is pure political bullshit, unsupported by evidence or theory in a complex and nuanced reality, no matter how many Thomas Sowell books you’ve read.  In the face of the real world, it’s complicated.