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  • Abiye Alamina

Tax Reform and the Supply Side Promise (Tax Reform Part III)

The US House of Representatives passed in November the “Tax Cuts and Jobs Act” bill and the Senate followed with its own version shortly after Thanksgiving. Both bills intend to provide comprehensive tax reform and are premised on meeting three objectives:

  1. Reduce Taxes on Americans and American businesses in general.

  2. Simplify the tax code simple so that most filers can file it as easily as on a postcard.

  3. Grow the economy through the underlying economics of job growth through supply side incentives.

These three objectives jointly lead me to address three burning questions, each of which is some combination of the three objectives stated above:

  • What is the true cost of tax reform?

  • Do the bills in their current form achieve the intended objective on face value?

  • What exactly does economics project will be the impacts of either bill ultimately becoming law?

This blog post addresses the third question and here, in the context of the current economy and the proposed bills, I mull the prospects of the supply side economic theory, implicit in both bills' job and output growth pitch, playing out as promised.

Some Preliminary Theory

One of the basic lessons in a principles coverage in economics is that the incidence of a tax (who ultimately pays the tax) is not dependent on where the tax is placed. A part of understanding why this this is the case lies in realizing that a tax serves the same purpose whether to the buyer or seller, and that is to discourage the activity. So if a tax discourages the activity, it stands to reason that removing the tax should encourage the activity.

Individuals facing income taxes believed to be high may have incentives not to work as hard or work longer hours as they do not get to retain all or more of the reward from working. With reduced tax liabilities they might be more motivated to work harder and longer hours. Similarly, businesses facing higher business taxes would have reduced their output production and trimmed their workforce or employee hours, but facing a reduction in these taxes should be expected to expand output and hire more workers, or raise wages for existing workers to incentivize them to work harder or overtime in order to produce more output.

This is the basic idea behind Supply Side Economics. Reducing unnecessary and burdensome government regulation including taxes would generate output growth from the supply side of markets. Further, the nature of the relationship between taxes and government revenues suggests that if taxes are believed to be high then the tax base has to have shrunk such that lowering taxes could actually be revenue neutral or even revenue increasing through an expansion of the tax base from incentivizing work and production effort. The graphical depiction of this is known in Economics as the Laffer Curve, after the economist Arthur Laffer who has been attributed with this proposition and was in part behind the Supply Side policies of President Ronald Reagan in the 1980s.

From Theory to Tax Reform

The bills that have passed the House and the Senate call for a wide variety of tax reduction measures for individuals and for businesses. Further, businesses are incentivized to repatriate foreign profits back to the US and to invest domestically through a move to a territorial tax system. Republican Congressmen and women all tout these changes as necessarily going to bring about faster economic growth, jobs and wage growth, as predicted by the theory discussed above.

This expected growth in output and in revenues shows up in most economic analysis on the impact of the GOP bills and can be seen in the analysis from the Tax Foundation where the key predicted growth drivers are from the reduction in the corporation tax and from the lower marginal tax rates on households.

What could be problematic about this theory though? While not exactly the same, an example of a divergence from traditional modeling that is maintained in mainstream economics is that while we might for the most part assume that prices are generally flexible in most markets, they tend to be downward inflexible in labor markets. Similarly, there might be reason to believe that businesses will not just respond to tax cuts and the tax free return of profits from abroad by expanding output and raising wages. There are at least four arguments that could support why they may not.

First, if businesses are currently paying workers what is the value of their marginal contribution on the job, then there is no reason why any windfall they get would go toward raising worker's wages. It is difficult to argue that the presence of taxes keeps businesses from paying workers what they genuinely contribute on the job and the elimination of those taxes now allows them to pay workers what they are worth.

Second, the market structure in which these corporations operate is more accurately characterized by imperfect competition and it could be argued that the demand for their products is more than likely to be fairly inelastic. These companies perhaps spend a whole lot on advertising to convince consumers of the uniqueness of their products or they may be operating in oligopoly like markets, either of which would lead to the demand for their products being inelastic. In which case they will not have any reason to expand output and see their product price fall in order to clear the market as their total revenues, and resulting profits, will be lower than otherwise.

Third, the presumption of job growth occurring faster than otherwise when unemployment in the economy as of today is already below full employment is suspect. The only pressures that can arise should businesses want to expand production would be inflationary, as they simply would have to bid workers away from other productive industries by offering higher wages, and in turn they would raise prices so that any wage growth would largely be inflationary. Indexing the tax code to adjust for inflation would only generate a wage-price spiral and continued cost push inflation.

Fourth, considering an even perhaps more realistic political economy framework: Politicians caring about reelection have provided corporations with a benefit and expect in return valuable financial contributions to advance their reelection bids and to maintain the policies that continue to provide these benefits. Corporations themselves wishing to retain these advantageous policies will therefore rather split the windfall between themselves and the campaign contributions they will have to make later on and leave workers out in the cold. So income and job growth do not materialize as hoped.

The Reagan era Tax Cuts

It is necessary to comment on the application of the same theory in the 1980s. For those conversant with history you would know that the economic environment was different then from now. At the time the US was reeling from the impact of high inflation and high unemployment, the result of oil shocks that contracted the economy from the supply side. Statutory tax rates were also so much higher than what we have today. Supply side policies make the most sense in that setting, yet even at that it is still arguable what the long run impacts of the economic policies were on the economy as deficits still rose significantly over that period and the economy also contracted again. Others though credit those policies with having laid the foundation for the later Clinton era surpluses. This is a debate that is unresolved yet one thing is clear, the environment at the time differs markedly from the current environment, and if supply side theory does work, that environment not the current one best suits it.

My Verdict

Here I have to whip out my stereotypical two-handed analysis. On the one hand I would expect that these policies do hold some promise of stimulating growth through the predictions from supply side economics but perhaps not through supply side changes but changes in spending growth - the demand side, however on the other hand I think that this growth would not be enough to overcome the huge tax reform costs in such a way as to curb the growth of the deficits in the long run, without specific plans to rein in government spending.

It is instructive to note that the reactions from major corporations are that while some are promising jobs (which is not necessarily binding), others have clearly indicated that these savings will be paid out as dividends to shareholders. This is not necessarily job creating as what the shareholders do with the dividends is uncertain.

I would suggest rather that the 20% corporation tax reduction be implemented as a tax credit retroactively for corporations having met specific job and wage growth goals. Further, I would suggest that professional service businesses are not penalized through creating an unfair competitive advantage for corporations by lowering their taxes while having these businesses face potentially much higher taxes. These would provide the economic incentives for both greater competition and for alignment of societal objectives with business profit maximizing pursuits that would more readily achieve long run faster output growth thus mitigating and ultimately covering the cost of tax reform.


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