Another stake through the heart of the Supply Side zombie

An analysis of 27 years of data from the "supply side economics" era, shows there has been no positive effect on growth that can be attributed to tax cuts for the wealthy, according to this report released today by Center for American Progress and the Economic Policy Institute. Indeed, growth was stronger during the Clinton years when taxes on the wealthy were increased (but the report does not contend the increase caused the growth).

The core belief of supply siders is that if tax rates are lowered and kept low on high earners and on capital gains, the beneficiaries will save more and invest more and the increased investment will stimulate growth. As far as I know, nobody argues that that's crazy or that it could never work, but there are many reasons to believe that it would not work under all circumstances and that it would not be as stimulative as other government interventions. So to have CAP and EPI economists go back and see what actually happened is extremely useful.

The key findings of the study, that both investment and growth were stronger after taxes were increased in the Clinton Administration than when they were lower in the Reagan/Bush and Bush Administrations, are presented graphically here on Matt Yglesias' blog. Commenter fostert (#3) makes the point that the tax cuts were not stimulative because there actually was no shortage of capital that needed augmenting, but that there was instead a shortage of attractive domestic investment opportunities. I agree. Investment was starting to be steered offshore, especially since 2000. My comment (#12), reproduced below, argues that the tax cuts probably impaired US growth by distorting allocations of capital between the "real economy" and the "financial engineering economy."

Agreeing with and expanding on fostert's comment, too much liquidity can result in less investment in the real economy. As asset values get bid up, creating short-term trading gains and apparent momentum, additional cash that might have gone into plant and equipment or R&D is diverted into the asset plays, further inflating the bubbles. George Soros describes part of the process as it relates to commodities investments here. This shift in emphasis over about 3 decades from earning share price gains by organic growth and improving the income statement to "creating shareholder value" by balance sheet transactions has contributed, IMHO, to serial bubbles and rising inequality.

Unless there is a real shortage of liquidity, there will always be a strong pressure to invest in asset classes that seem likely to increase in price and to engage in capital transactions that yield overnight increases in perceptions of value. Add in excess liquidity and that pressure becomes manic and dangerous. Isn't excess liquidity what fueled the junk bond and portfolio insurance crazes of the 1980s, the dot-com bubble of the 1990s, and the CDO/housing bubble and commodities bubbles in this decade?

During this same time frame, compensation of executives and professionals has been largely cut adrift from managerial performance and the income statement and, instead, has been largely linked to deal-making, transaction size, and balance sheet enhancements. This has enabled households in the top 1 percent and especially the top 0.1 percent to enjoy rapidly growing incomes, while incomes for the bottom 80 percent or so—those whose incomes are derived from the real economy—have stagnated or declined.

Update on Friday, October 10, 2008 at 01:37PM by Skeptic

A tenet of supply side economics is that tax cuts boost growth by boosting investment by businesses.  However, actual data from the supply side era show that business investment has consistently moved in the opposite direction from that prediction.  The following graph is from this post in Mark Thoma's blog (actually from a post by Uwe Reinhardt quoted by Thoma. 

What may have happened is good old fashioned "crowding out."  When the Republicans were in charge, they did not just lower tax rates, they increased deficit spending and government debt.  Up until about the time the Bretton Woods agreement (requiring international settlements in gold) was abandoned, economists were concerned that there was fixed national borrowing capacity and that if government borrowed more, private borrowing would be "crowded out."  The end of Bretton Woods seemed to free up the creation of enough money to satisfy all borrowers, and crowding out is seldom discussed anymore.  But maybe the effect is still real.