Thursday, September 10, 2009

Supply Side/Reaganomics/Trickle Down: Does it really work?

My friend Josh and I have a sort of perpetual debate going about the theory of "supply side" economics and whether or not it worked. Neither one of us specialized in Economics, but both of us work in the financial sector (he is an accountant, I am in banking). He contends that it works, and I argue that it did not, as we have been using supply side economics in roughly 20 of the last 30 years.

This post is my attempt at trying to understand supply-side economics.

Basically, supply-side economics supporters claimed that by cutting taxes on the top earners in our society that tax revenues would increase, as well as "trickle-down" to the general populace because the top earners are the ones that create jobs. In essence, supply-side economics cuts taxes to the top earners in order to increase supply, since our society runs on supply and demand.

Proponents used the Laffer Curve to theorize that in order to maximize federal revenue one couldn't go too low with tax rates, nor too high. This is true. But Reagan and his financial advisors (and every following Republican President that has used this since) misunderstood the Laffer Curve, thinking that every tax cut would increase revenue. But that is simply not true. If you decrease taxes too much, revenue goes down. Basically, tax rates were far higher during the Kennedy administration than they are now (50-60% vs. today's 35-40% for top-tier earners). They were cut, and revenues went up. But that was the maximization. It already happened in those days. Reaganomics worked for Reagan. But that was the highest part of the Laffer Curve. Continuing to cut, as Bush 43 did, led to our problems today. But this is just the Federal Revenue side of this.

On the public side of this, or the "trickle-down" side, which contends that increasing the revenues for the highest earners will trickle down into the pockets of even the poorest. The rich business owner will gain more in money, invest more of it into his company, hire more workers, raise wages, and the middle class will earn more, which goes to the Starbucks and McDonalds and to the companies that employ the lower class, and they too will get hired more and increased wages. Sounds great, doesn't it? But it doesn't work out that way in reality. Business owners have always looked for the bottom line. But unlike the '80s, when Reagan employed Reaganomics, when it was better for the bottom line to hire American workers and raise wages to keep them happier at your company rather than the competition's, now it has become cheaper to outsource. "Trickle-down" now longer works. It has become "trickle out."

Keynesian economics, however, advocate the laffer curve as well, but with a better understanding. They too advocate cutting taxes, but to the middle and lower class. This frees up more money in the classes that spend their money more freely. Money circulates more. The tax base increases, thereby increasing tax revenues. On the public side, Keynesian economics, a "mixed economy," is better described as "trickle-up." Sometimes, private enterprises screw it up for the macro-economics of a country, as we saw in last year's meltdown.

Keynesian economics utilizes the private sector pre-dominately, but realizes that once in awhile, the private sector needs guidance from the government and public sector. This is theory that saved us from the Great Depression and brought in the Golden Age of Capitalism (1945-1970). Keynesian economics is still capitalism, folks. It just uses the government to make sure that the economy "trickles-up" instead of down, which works better. It isn't the middle class that outsources. It is the upper-class. I'd take "trickle up" over "trickle out" any day.

Let me know if I missed anything. Again, this is just my non-economist's view of macro-economics.


bluepitbull said...

This is a quote from y'alls fav site, Wikipedia:

He also argued that to boost employment, real wages had to go down: nominal wages would have to fall more than prices. However, doing so would reduce consumer demand, so that the aggregate demand for goods would drop. This would in turn reduce business sales revenues and expected profits. Investment in new plants and equipment—perhaps already discouraged by previous excesses—would then become more risky, less likely. Instead of raising business expectations, wage cuts could make matters much worse.

So cut wages, consumer spending goes down, small businesses go out of business. Or did I miss something?

Dave Miller said...

You should check out former President Bush 1 and his critique of Reaganomics. He called the plan voodoo economics.

Reagan's former budget director David Stockman also had harsh words for Reaganomics after he left office too.

Does, or did it work? Check the results. Record debt and the seeds of our current mess were sown back then.

TAO said...

If you actually read the small print of supply side economics you will also note that it does ecknowledge that the potential for asset class bubbles to develop (too much money in the hands of too few chasing ever increasing returns in a market with finite investment options) and then you have the issue that consumers represent 70% of all economic activity, which in turn is what is called 'DEMAND' and no matter how you try to dice it in the long term supply without demand is no economic growth...

BPB also hit upon a central theme of most Reagan style conservative thinking that unions and workers create inflation by ever increasing wage increase demands which is why NAFTA was passed and since the passage of NAFTA we have seen wage stagnation and viola! we found that by easy credit we could keep profits growing and eliminate inflation caused by wage increases!

Then look where we find ourselves economy that needs to be propped up with government loans and a socialist President!

Supply Side Economics got Obama elected....

dmarks said...

Tax revenues kept going up. So the tax cuts on everyone weren't the problem. The problem was that Reagan, and Bush after him, could not be bothered to veto bad budgets with overspending in them.

Wage inflation does happen, but it is not just in the unions who control a mere 10% of the population. There are plenty of others who get raises for just sitting there, including a lot of private sector mid-level management and public-sector bureacrats. I would count the bonuses given to top level "Wage Earners" for doing a very bad job as an example of this (re: AIG).

TAO said...

Put dmarks to bed...

Look at union membership in 1980 and then in 2008.

Look at median household income in 1997 and again in 2008.

If you take his examples, which are valid, and the outsized bonuses, then you realize that overall household income is overstated and skewed in favor of the wealthiest; which means that the overall results are worse.

James' Muse said...

Dmarks, I forgot to put this in the original post. Tax revenues didn't really go up, if you take into effect inflation and population growth they are basically bringing in what they were bringing in before.

TAO said...

Gee, where did dmarks go? :)

Sandy said...

Very good post James - thank you. I wish there were a simple answer to the question.

TAO - you seem to know alot about this. I have always been curious about whether the lower income historical data excludes illegal aliens and includes all entitlements and tax credits. Do you know? To be fair, I think they should but my guess is that they don't. I would also guess that the trend would still be generally the same but the disparity wouldn't be quite as shocking.

Jerry said...

I am posting here because James's Muse's post is full of dubious claims. My response, by paragraph:

--The republican tax cuts applied to everyone not just the rich. In particular Bush II's tax cuts made the federal income tax *more* progressive than it was before.--

--This is entirely false! Reagan is known for his large tax cuts in the early 80s, but he also raised taxes. When tax receipts fell one year (1982 or 3 ?), he raised them the next. Bruce Bartlett, who was there, lashes Bush II for not doing the same when Bush's tax cuts lowered receipts for several years in a row in 2001 to 2004 or so.--

--Several studies have concluded that outsourcing is beneficial: more jobs, higher wages.--

--If cutting middle class taxes is Keynesian, then Bush II should be accounted a Keynesian. The recession was set off by nearly $150 a barrel oil. The housing bubble was caused by government interference in the housing "market". Tax cuts for the rich are more effective because the rich pay so much more in taxes. Really large tax "cuts" to the middle class would require negative tax rates, ie welfare, which discourages labor and production.--

--Keynes famously thought FDR was stupid. FDR's policies caused and lenghthened the depression. The depression lasted throughout the "New Deal". The middle class benefits from outsourcing- lower prices, better jobs.--

TAO said...


Household income is pretax and it includes unemployment insurance, and disabilty insurance. Tax credits and entitlements are determined based upon pretax wages and as such are just economic subsidies and thus NOT included because since both start from pretax income (which includes wages, child support, alimony, unemployment and disability payments) the fact that someone receives tax credits and or entitlements is because it is determined that their pretax income is below a certain level (poverty).

Illegal aliens would be counted if they filed taxes, thus you have to ask yourself if they are in fact then illegal.

Jerry, if the fact that outsourcing increases wages then that would be noted as an increase in median household income and median household income has not increased since fact it has fallen which basically means something is causing wages in the United States to drop..

Lower taxes do stimulate the economy as does government spending and when Bush II and Reagan cut taxes both of them gave the economy a double stimulus because they did not cut government spending...

Now we have an economy hungover and we are really stimulating the economy but only with government spending...

dmarks said...

James: More money is more money. Once we get past the need to try to cook tne numbers.

Tao: What is your point about union membership?

Shaw Kenawe said...

Tax cuts for the rich are more effective because the rich pay so much more in taxes.--Jerry

That's true only if the rich don't hide their money in offshore institutions and they don't pay any taxes at all.

James' Muse said...

Dmarks, more money isn't always more money. Inflation isn't "cooking the numbers." In actuality, not accounting for inflation, which is about 3% a year, would be cooking the numbers.

James' Muse said...

Blue, which "he" are you talking about?

(O)CT(O)PUS said...

"Trickle-down" now longer works."

Trickle-down never did work. It was more of a political slogan than an economic theory; its purpose was to provide a rationale for the plutocrats of industry to plunder the American economy.

About Keynes, his main contribution to economic theory was to provide a framework for using monetary policy to smooth out the highs and lows of the business cycle by dampening speculative bubbles. The Fed works on this principle.

Laffer is NOT the chief architect of the supply-side school. Milton Friedman of the University of Chicago is. And if you want learn about severe economic dislocations caused by this school of thought, I recommend Naomi Klein's The Shock Doctrine.

James, I will add a link to this article under my Bush Economic Legacy post. Please feel free to grab the table graphic in any follow-up posts (credit Octo for it).

TAO said...

Octy, what do you mean the trickle down theory doesn't work?

I feel as if I have been pissed on for years! :)

(O)CT(O)PUS said...

Hah! Then trickle down works quite well, I suppose. Of course, if you are a Palin, you'll spend a good part of your life trickling down on pregnancy test strips.

TRUTH 101 said...

Now that was uncalled for Octo.

is it me or is Bluepitbull starting to come over to TAO's side on this and other issues of the day?

And I do remember Reaganomics well. I remember having to work two part time jobs because full time work unless you enjoyed the benefit of union membership was eliminated by employers at that time.

I remember abuse and exploitation of employees by having them work ungodly long hours but not pay them 40 hours pay so employers could get out of paying full time benefits.

Reagan was no friend of working Americans.