Supply Side Economics Revisited

Supply Side Economics:  Rationalization For a Hefty Tax Cut

Supply Side Economics, also known as “trickle down” economics, has been around for a long time.  It asserts that the wealthy in the United States run the engines of productivity and are responsible for our financial well being; make them happy and the country is happy.  Make them richer by cutting their taxes and that money will oil the engines of productivity.  Profits will soar and the benefits will “trickle down” the socioeconomic chain to everyone and the whole society will prosper and be happy.  Implicit is the belief that tax are too high and by lowering them productivity will rise and by extension revenue.  And with this will come more money for everyone.  The economist Arthur Laffer is reported to have sketched his Laffer Curve over dinner to illustrate Supply Side Economics.  The curve is drawn below.

Laffer Curve

 

 

The axes of the above graph are: horizontal x-axis shows income tax rate  0% to 100%; the vertical y-axis shows increasing government revenue from taxes.  The “T” on the red function relating revenue to tax rate is that ideal, Goldilocks, point where there is maximum revenue.  To the right of “T” taxes are too high leading to a loss of motivation to work and therefore, less revenue.  To the wealthy, we are perpetually to the right of “T” and taxes need to be lowered.  Unfortunately, even Laffer does not defend the fact that we haven’t a clue where “T” falls in reality and numbers are never affixed to the Laffer Curve.

The Argument for a Tax Cut is Two Fold

A tax cut, assuming we are somewhere to the  right of “T”, will foster positive economic behavior.  People will be more motivated to become entrepreneurs, starting businesses that will hire more workers.  Businesses will be motivated to invest in research and development, and boost inventory.  Such spirited activity will not only result in hiring more workers but wages will increase.  Kevin Hassett, Trump’s economic advisor, claims a hefty tax cut will raise the middle class average wage $4,000,  realized over a span of ten years.

The second benefit would boost overall productivity or gross domestic product (GDP).  The Republicans claim this is how their tax cut will benefit everyone and at the same time help pay for the tax cut.  Unfortunately, historically there no reliable function between increases (or decreases) in tax rates and GDP.  While lowering taxes might have a positive effect, throughout recent history such an effect is not  apparent.  During the 1950’s tax  rates on the wealthy were as high as 80% yet GDP was roaring.  During the 1950s following WWII the US  was the dominant global economic power.  There was pent up demand for all of the goodies that either weren’t produced or weren’t affordable during the war.  Everyone could now afford a car and the returning servicemen and women needed housing.  the economy was booming.

The famous tax cut by Ronald Reagan in the early 1980’s did seem to boost GDP but this followed a dismal period of 12% inflation.  Reagan was forced however, to raise taxes again due to a serious dip in revenue.  George H. W. Bush and later Bill Clinton raised taxes with mixed effect on GDP.  After Clinton’s increase there followed, for the first time since the 1960’s, a budget surplus.  Finally, George W. Bush cut taxes in his first term followed in the second term by the disastrous recession.

So, the second rationale for a tax cut by the Republicans is not  supported.  Moreover, large tax cuts not only reduce revenue they add to the federal debt which is currently at 20 trillion dollars!  Republicans,  particularly fiscal conservatives, have for years decried any increase in national debt.  Now they must face a serious increase in the national debt if their tax cut is not paid for.  The Republican fantasy is that the tax cut will  boost production and GDP to at least 3 to 4 percent.  Viola, the tax cut adds nothing to the national debt!  If the debt from the tax cut, estimated to range from 1.4 to 2.2 trillion dollars over the next ten years, is not paid for then economists warn that the Republicans will in all likelihood seek justification to cut into Medicare and Medicaid and even perhaps Social Security.  So, guess who ends up paying for the big cuts proposed for corporations?

Even if Republicans  overlook a hit to the national debt, there remains a more immediate problem.  Even the most optimistic Republican expects few votes from Democrats.  Any tax cut will be based almost entirely on Republican support.  Having a majority in both the Senate and the House, Republicans should pass some final bill.   If the tax bill  adds no  more than 1.5 trillion dollars to the national debt, then the Republicans can get the bill through the Senate by a simple majority, i.e., 51 votes in favor and without a Democrat filibuster .  This is why both houses in Congress hurried to pass a budget resolution.  Otherwise, to get the bill passed there would need to be some Democrats in support.   Now, both the House and Senate are scrambling to find ways to pay for the massive cuts in tax revenue their respective bills will produce.  Wise people have argued that eschewing bipartisan support is a formula for disaster much like the struggle that has ensued for the Affordable Care Act passed exclusively by Democrats.

Middle Class Tax Cut

Of course the final version of the tax cut proposed by Congress is not yet finalized.  But it is certain that this tax cut proposal is not  primarily for the middle class.  The centerpiece of the proposal features a corporate tax rate reduction from 35%  to 20%.  Alone, this reduction adds 1  to 1.3 trillion to the debt.  Corporations get the lions share of the benefits!   The latest Senate version  delays the cut until 2019 to save some money and maybe look less disingenuous.

Pass Through Income

The majority of businesses in the US have their profits “pass through” to the owners and investors.  This means that profits are passed on as personal earnings to the owners/investors.  Normally, these earnings would be taxed at a rate appropriate to the income of the individual.   But the Senate version allows 17.4% of the pass through income to be deducted.  This would reduce the top rate for owners/investors from 38.4% to 31.8%.   This pass-through benefit would be capped at $200,000 for so called “service” organizations such as accountant or law firms. A second, non-pass through, type of corporation is often termed the “C” type.  Their profits would be taxed at 20% but capital gains and dividends passed on to owners and shareholders are taxed separately at a top rate of 23.8%.  So all things being equal, the pas through corporation comes out better.  Nothing is yet settled.

To add to the frustration,  in one version, employers are allowed the benefit to deduct state and local taxes but not employees!  This is supposed to somehow compensate small business owners?  There are some other rules concerning multinational corporations motivated to discourage moving their operations to lower tax countries and to be able to collect some revenue.

Senate Retains a Modified Seven Tax Bracket Scheme

In the current system, for a married couple the brackets are:

10 % (taxable income up to $18,650);

15% ($18,650 to $75,900);

25% ($75,900 to $153,100);

28% ($153,100 to $233,350);

33% ($233,350 to $416,700);

35% ($416,700 to $470,700);

39.6% (taxable income over $470,700)

Under the new Senate plan they would be:

10% (taxable income up to $19,050);

12% ($19,050 to $77,400);

22.5% ($77,400 to $120,000);

25% ($120,000 to $290,000);

32.5% ($290,000 to $390,000);

35% ($390,000 to $1 million);

38.5% (taxable income over $1 million)

The thresholds for brackets will be adjusted according to chained CPI, a slower-growing measure of inflation than normal CPI, which is used currently; this change raises revenue over time by gradually pushing more and more people into higher tax brackets.

Sundry Details

The standard deduction is doubled to $12,000 for a single filer to $24,000 for joint household filer.  A child tax credit increase will be phased in from $1,000 to $1,650.  Also it is capped at $1,000,000 instead of the current $110,000.  Thus, many more wealthy people will be eligible.  The personal exemption  of $4,050 has been eliminated.  In the Senate version mortgage interest is still deductible up to $1 million as well as interest on student loans and the adoption credit.  Also, unlike the House version, medical expense deduction is left untouched.  Finally charitable deductions and retirement accounts like 401k savings are not touched in either version.

Point of Contention

The Senate bill follows the lead of the House and does away with deductions of state and local taxes.  This is especially hurtful for those living in states with particularly high taxes which just happen to be the mostly “blue” states of California, New Jersey, Illinois, and New York.  Finally, the infamous  estate tax exemption is doubled from $5.5 million to $11 million, meaning an even smaller share of the ultrarich will pay the tax — and even those who do pay will pay substantially less than under current law.  Oh, and one quite absurd proposal- a 1.4 percent tax on university endowment income is added, just as in the House bill.  This tax makes no sense.  At a time when the United States seems to be falling behind in the global technology race and when the average US worker is unprepared to fill jobs in the new technological environment this tax on education is unwise.

Finally, last but certainly not least, the Alternative Minimum Tax (ALT) is eliminated.  Some believe this was a major focus all along for these tax cut proposals.  The wealthy will benefit because the ALT sets a minimum at which a household or individual could reduce their federal tax obligation using deduction/loopholes discovered by high-dollar tax lawyers.  The AMT is gone.

Well, there it is, the outline of a tax cut plan the Republicans and Donald Trump are desperate to pass.  It is completely disingenuous for Paul Ryan or anyone else to call this a tax cut plan aimed mainly at the middle class.  It favors the wealthy and big corporations.  Unfortunately, the average tax payer will pay little attention to these details and confusing numbers having little patiences for them.  Politicians will appear on TV  and tell every one that this policy will save them big money.  The financial movers and shakers want this tax cut.  The stock market has been riding high in anticipation and the Republicans are under the gun to pass a tax cut – or something…anything!

The Pew Research poll shows 70% of citizens in general and 53% of Republicans in particular do not want this tax cut.  It is reported that most corporations are doing great sitting on piles of liquid funds.  The distortion that the 35% tax rate on businesses make them uncompetitive in the global market is nonsense.  First of all most are pass through types as mentioned above.  Their profits are taxed generally at a lower rate.  Even the C-type corporations rarely end up paying the advertised 35%.  Some economists argue this rate could be s low as 18.5% after the tax lawyers and accountants work their magic.

Profits have never been better for most businesses and yet wages remain stagnate.  The driving force for most businesses today is short term profit that can be sent back to the shareholders.  Businesses complain that jobs go wanting for the lack of skilled labor to fill them.  This is a sad commentary but few businesses provide internships or job training.  The unemployment rate is around a low of 4% but inexplicably workers lay idle in so many places.  Often thesir jobs are taken over by machines that work faster and often more reliably.  Towns across the land decay from lack of good jobs and potential workers see no future and increasingly turn to drugs to fill a void.  Pythagoras argues that people were not meant to be idle but need the stimulation and self respect that comes with problem solving associated with a meaningful job.