A Taxing Proposition: Understanding Supply-Side Economics

Another long read (maybe 15 minutes), but hopefully a worthwhile one.

Having recognized the futility of trying to get a divided GOP to pass health care reform, President Trump has decided to leave that alone until Obamacare finally implodes, and move on to tax reform.

I'm not going to propose a tax plan here; there are a number of things that would improve the current tax code and structure, and I could live with anything from the streamlined set of income brackets and reduced rates proposed by the administration, to a flat tax.

Instead, I'm going to provide some much-needed education regarding supply-side economics, which has become known as "trickle-down economics," mostly by its detractors.

The idea is this: provide tax breaks for businesses and high-income individuals (who are often small business owners, and thus provide jobs for others, but don't incorporate and must therefore pay their business taxes at the top individual rate), and the benefits will "trickle down" to lower tax brackets.

The term "supply-side" comes from the idea that you're providing tax benefits to those that are net suppliers in the economy - businesses - and they'll create more jobs, both directly and indirectly from purchasing more of the items necessary to production, which in turn will benefit the companies that provide those items, etc., etc.

That lowering taxes on businesses both large and small is good for the economy overall is so basic a notion that it shouldn't bear further explanation.  If it does, I probably can't help you: I can explain it to you, but I can't understand it for you.  However, I will offer a fundamental primer.

Consider the case of a small manufacturer.  Let's assume it doesn't import or export anything, nor does it operate outside the U.S.  That will keep it simple.  Let's further assume it manufactures something everyone needs - say, widgets.

Our manufacturer has various cost inputs: labor, materials, plant and equipment.  It has to cover its costs and provide a return to its owners; after all, that's why they're in business.  It isn't evil, it's called making a living.  A business's primary responsibility is to maximize shareholders' returns.  For those who decry that concept, look at your 401k holdings.  Chances are, you're one of those shareholders.

Back to our manufacturer.  It divides its total costs by the number of widgets it produces to determine the unit cost, then it prices the widgets at a reasonable profit margin above that.

One of the cost inputs is taxes.  So if the corporate tax rate is 35%, that gets factored into unit costs, and the profit margin is added on top of that.  Thus, the price of a widget is higher than it would be if the corporate tax rate were 15%.

In other words, if the corporate tax rate is 35%, corporations don't ultimately pay that - consumers do.  You and me.

Further, if the cost of widgets is lower, maybe we'll buy more, meaning our manufacturer can sell more.  So it expands, and hires more workers.  That means more jobs.  Those workers buy groceries, etc., so the grocers and etc. providers hire more workers and create more jobs.  And on and on it goes.

In addition, the manufacturer pays more taxes, because it's selling more widgets, and making more money.  At some point, it might be paying more than if the tax rate were still 35%.  That's simple math: 35% of income at $1M per year is less than 15% of income at $2.5M per year.  Beyond that, the additional workers the manufacturer hires also pay taxes, so the individual tax burden is distributed across a wider swath of taxpayers, and all of us can enjoy lower tax rates as a result.  The grocers and etc. providers, and their employees, also pay taxes, so tax receipts may actually go up as tax rates go down.

But if the corporate tax rate remains at 35%, we all pay more for widgets, so we don't buy more.  The manufacturer doesn't hire any additional workers, and the grocers and etc. providers don't benefit.  Tax receipts don't increase, thus tax rates can't be cut because the overall tax burden is still shared by the same (relatively) small cohort of taxpayers.  Thus we have high taxes, low output growth, and anemic wage growth.  Sound familiar?  It should - that's been the status quo for the past several years.

To make matters worse, if Ireland comes along and offers our widget-maker a 20% corporate tax rate and a skilled labor pool, the company might fire its U.S. workers and set up shop on the Emerald Isle.  Thus employment in the U.S. shrinks, and you and I wind up paying more in taxes to make up for the lost tax revenue from the displaced workers.  Plus the U.S. gives up the corporate tax revenue altogether.

Now, let's move beyond that to the other piece of the supply-side equation: consumption.  This is where the "trickle-down" concept is most frequently misunderstood.

The argument against "trickle-down economics" in a consumption context goes like this:

"Give a poor man a dollar, and he'll spend it.  Give a rich man a dollar, and he'll save it."

Well, it's a theory.  I suppose its attractiveness is its simplicity, meaning that simple people with no understanding of economics can grasp it.

The problem is, it's wrong on so many counts that I hardly know where to begin debunking it.  But I'll take a shot.  Here's another annoying numbered list:

1.  It assumes what we hear all the time, that consumption is the true engine of economic growth.  People like to crow that "consumption has always represented 70% of GDP," without even knowing what makes up GDP.

GDP - gross domestic product - is a measure of a nation's economic output.  The equation is:

GDP = C + I + G + (Ex - Im), where C = spending by consumers, or consumption; I = business spending, or investment; G = government spending; Ex = exports; and Im = imports.  In other words, output is the sum of consumption, business and government spending, and net exports.

A simple google search of "consumption as a percentage of GDP" produces an article from Policy.Mic as the first hit.  The article begins thus:

"It seems most people understand, personal consumption drives the American economy.  Personal consumption historically represents 70% of our nation's GDP" (italics added).

Wrong.  The truth is, personal consumption expenditures have never reached 70% of GDP.  Currently, the figure is 68.9%.  The peak was 69.1%, in Q1 2011.  Ah, you say, you're nitpicking - just round up.

Okay, let's look at the "historically" part of the assertion.  The economy was rocking from 1983-1990, and consumption averaged about 63% of GDP.  After the '90-91 recession, the economy again took off until the dot-com bubble burst in 2000, and consumption averaged about 65% of GDP during that period.  Consumption never even hit two-thirds of GDP until 2001.  So the dependence of output growth on consumption is a fairly recent phenomenon (consumption averaged less than 60% of GDP during the 1961-1970 expansion).

Now, I'll grant you that consumption has always been the dominant piece of the equation - after all, there are four components of GDP, and consumption has indeed historically represented more than half of output.

However, if you study the history of the stock market, which correlates with economic growth, here's what you'll find.  Market performance since the Crash of 1929 can be broken down into roughly 15 to 20-year "supercycles," with the market trending generally either up or sideways.  To be sure, the market had its ups and downs within each of those cycles.  But endpoint-to-endpoint, the market was significantly higher at the end of the up cycles, while it was flat at the end of the sideways cycles - in other words, during the sideways cycles, you'd have been as well off keeping your money under your mattress as in the markets.

The drivers of those cycles vary:  WWII, the energy crisis of the '70s, the credit-driven recession of '90-91, the dot-com bubble, the housing bubble.  There will always be asset price disruptions within one asset class or another.

However, we can find one common denominator that corresponds to the beginnings of each up supercycle:  the savings rate was near or above 10%.

Thus savings, boys and girls, is the true engine of growth.  That only stands to reason: savings provides banks with money to lend to individuals and businesses, which provides capital for business expansion, etc.  Consumption only fuels today's purchases.

(If you doubt the veracity of this research, please know that I used it as the basis of a prediction I made at an economic conference in 2000:  that the stock market would trade sideways for the next 13 years or so.  Then compare the S&P 500 at its 2000 peak vs. 2013.)

So, back to our adage that a rich man, given a dollar, will save it.  Even if that were true - which it's not - it would be a good thing in terms of long-term, sustainable economic growth, the engine of which is savings, not spending.

2.  There's no evidence to suggest that a rich man, given a windfall of a dollar, will save it rather than spend it.  The notion is conjured up from hate-the-rich images of Ebenezer Scrooge, pinching every last penny while leading a miserly life.  Most rich folks don't behave that way.

Real conventional wisdom would tell us that most rich folk got that way by saving what they needed before they were rich (or by inheriting wealth, in which case their forebears did the saving for them), and are now free to spend their discretionary dollars gained through windfalls like tax cuts.  And they spend a heck of a lot more than us peons do.

The rich buy yachts.  They buy jets.  (Just watch "Selling Yachts" or "Selling Jets" on AWE.)  They vacation abroad.  They buy expensive jewelry and clothing.  They eat at fancy restaurants.  They buy Mercedes and BMWs.  (Note that this applies to the "rich" in a broad swath from the uber-rich to many among us; after all, an income of $135,000 for a 35-year-old would put him or her in "the 1%," and there are plenty of 35-year-olds earning that income level driving Beemers and vacationing in St. Thomas.)

To wit, the stock price of Tiffany (the high-end jewelry retailer) is often used by market observers as an indicator of a strong economy, while Wal-Mart's stock price can be indicative of a relatively weak one.  Here's the idea: when incomes and wealth are rising, for whatever reason, people who shop at Tiffany spend more there.  Conversely, when incomes and wealth are falling, everyone is shopping at Wal-Mart, so that stock does well.

The last meaningful attempt at tax reform was the Tax Reform Act of 1986, which included a supply-side tax cut for the top brackets and corporations.  Tiffany went public a few months after the TRA was signed into law, and by the onset of recession in 1990, its stock price had more than doubled.  Granted, other things were going on at the time besides lower taxes.  But again, we can draw no inference to suggest that the tax savings of those in the top brackets were saved and not spent.

See, the poor typically don't shop at Tiffany (I sure don't, and I'm not poor).  So it had to be "the rich man" driving Tiffany's stock performance after the TRA, putting the lie to the notion that the rich man saves his tax windfalls, while the poor man spends it.  (Folks of lesser means do spend their windfalls, but they spend them on less expensive items - it just adds up more at the top brackets.)

So what good does that do the rest of us?  Well, the sales clerk at Tiffany probably isn't rich, so he benefits when the company does well.  Tiffany sells online, so it will hire more warehouse workers when sales are strong.  Those workers buy groceries and modest cars and take vacations, however inexpensive, so the grocers and auto workers and motel employees make more money.

In other words, the benefits trickle down.

Consider a more direct and recent example.  When gas prices fell precipitously in 2014, it was like a tax cut for nearly all Americans (at least, those employed outside the energy sector).  Many observers moaned, however, that consumer spending didn't increase, and thus inferred that people were saving, rather than spending, their gas price windfall.

But they were wrong.  Consumer spending did indeed remain flat.  However, spending is like a pie.  The overall pie didn't get bigger, but one slice - spending on gasoline - got considerably smaller.  That means other pieces had to get bigger.  Thus discretionary spending did increase.

I dug a little deeper into the spending data a couple of years ago to see which pieces of the pie grew the most.  And the two categories that showed the largest increases in spending were dining out and entertainment, and leisure travel, especially foreign travel.

So both rich and poor spent some of their windfall - all of it, in fact, as the overall pie remained the same size and the savings rate didn't increase.  Both rich and poor dine out, and they take vacations.

But the poor may dine out at fast food outlets, while the relatively well-to-do will dine out at higher-end restaurants.  The poor take vacations, but typically not abroad.  The fact that these discretionary spending categories increased to the extent they did - especially foreign leisure travel - clearly indicates that the rich were spending, and not saving, their "gas tax cut."  It takes a lot of additional McDonald's diners to equate to one additional dinner out at Chez Foo-Foo.  So a big increase in spending has to reflect spending at the highest income levels, not just the lowest.

So the rich man/poor man myth is just that - a myth.

Detractors of supply-side economics further say "it has never worked."  First, it worked okay in the late '80s.  And second, the only reason it has never worked long-term is because the populists who don't understand it but see it as a regressive policy won't let it alone.

Putting any economic theory into practice is an experiment, and like any other experiment, in order to determine whether it proved the hypothesis, we have to control the other variables.  So when an administration has to bargain with the supply-side detractors, throwing them bones in exchange for supply-side tax cuts, it muddies the waters.  President Reagan, for example, had to hand the Democrats huge increases in spending to get the TRA passed.  That, coupled with the defense spending build-up that was necessary to end the Cold War, resulted in huge deficits.

So the Democrats concluded that trickle-down economics causes deficits.  No, it doesn't.  Excessive government spending causes deficits, unless you tax everybody to the moon and back to pay for the spending.  Reasonable tax policy has to be coupled with reasonable spending.  In other words, control the spending variable, and supply-side tax policy works.

Don't believe me?  Let's try it.  Let's really give it a chance to work.  If you're not willing to do that, please show me where I'm wrong.

But you'll have to do better than come up with some simplistic and wrong-headed platitude of a theory like the rich man/poor man myth.  Shooting that nonsense down is like hunting for squirrels with a howitzer.