Executive Summary: A clear distinction of the supply and demand models is critical to the economy and financial markets as policymakers look to one or the other for guidance. Demand-siders focus on the consumer's pocket; supply-siders focus on the producer's incentive. Today, this fundamental difference is being blurred as demand-side economists begin to package their ideas with supply-side words. The risk is that even with an electoral mandate to change the direction of economic policy in the U.S., politicians may inadvertently initiate seemingly different policies when, in fact, they are simply extending those very policies that have sapped much of the vitality from the U.S. economy. The opportunity cost of such an error is potentially huge. Not only would the resurgence of the U.S. economy be delayed, but the supply side model, itself, could be unfairly discredited, leaving policy makers only the option of austerity and contraction.
An Authentic Guide to Supply-Side Economics
In its haste "There is a rising tide of literature and talk about supply-side economics," Herbert Stein observed in The Wall Street Journal of March 19. The former chief economic adviser to Presidents Nixon and Ford, a conservative Keynesian, went on to write: "For the benefit of non-economists who may be wondering what this is all about, I will put down here my view of what are and are not 'supply-side' propositions and what the current state of the evidence is." Mr. Stein, one of the most ardent opponents of supply-side economics, proceeds to compose an unflattering portrait of the supply-sider, colored by gentle ridicule. A supply-sider, he more or less argues, is simply a tax-cutter and not really a serious economist.1
His opening guns suggest that supply-siders area group of high school sophomores playing at economics. "I remember learning about this in my high-school course in economics, which goes back almost 50 years,' he says of the idea that the supply of resources will be influenced by the tax system. As to the notion that "Supply is an important element in economic analysis," Professor Stein observes: 'The first parrot who got a Ph.D. in economics for learning to say 'supply and demand' knew that." Professor Stein then tackles what he says is the central belief of supply-siders, that "A tax reduction .... will raise the total revenue." Arithmetic calculations are presented that demonstrate the implausibility of a fall in tax revenues equaling a rise in tax revenues. Similar calculations are used to ridicule the idea that "the way to tackle the inflation problem is from the supply side, especially by cutting taxes," a notion which Mr. Stein presents as another central tenet of the supply-siders.2
In The Wall Street Journal of April 22, Lindley H. Clark, Jr., tried his hand at explaining supply-siders. Mr. Clark, the dean of monetarists in the financial press and the official biographer of Milton Friedman, reported from Rochester on the semiannual Carnegie-Rochester Public Policy Conference (sponsored by monetarists Karl Brunner and Allan Meltzer) to contemplate "what has come to be known as supply-side economics."3 Mr. Clark observes:
Supply-side economics means different things to different people. To some politicians and perhaps even to some economists it offers a way to cut taxes without losing revenue. The tax cuts, if properly planned, spur workers and companies into such a frenzy of productive activity that large new tax revenues quickly wipe out any losses from the original tax reduction.
There was no one here to support that particular view of supply-side economics. Michael J. Boskin of Stanford, in fact, said the whole debate has been misnamed — the important arguments are not between people who favor the "demand side" and people who favor the "supply side". It is instead between people who focus primarily on what happens next quarter or the quarter after that and people who worry deeply about 1985 and 1990.
The best supply-side economists, in other words, are really working at something that might better be called long-run economics.4
Thus, the best supply-siders are not those who want to debate demand-siders, but who rather want to ponder the long run. We can, presumably, all become supply-siders of this variety. Indeed, the Keynesians and the monetarists are arranging for everyone to be a supply-sider on these terms. It is becoming more and more difficult to find economists who haven't been supply-siders since their high-school days. What surely is happening in the marketplace is that the demand for demand-side economists has diminished, which means that the roughly 60,000 economists trained in demand-management are having to make difficult adjustments.
At this time, at least, the adjustment is more cosmetic than real. Demand-siders are dressing up as supply-siders. The New York Times Magazine of March 23, describing Harvard's Martin Feldstein as the "superstar of the new economists", shows us how this is done:
"Demand side" economists, who have long held sway, emphasize Federal budgetary and monetary policies as a means of manipulating demand for goods and services, and, thereby, spurring the production side of the economy. "Supply-side" economists emphasize the need for new tax incentives to encourage people to save and business to invest in new and more efficient factories and machinery.
Martin Feldstein definitely belongs in the supply-side camp, though he does not hold with those all-out supply-siders who feel the approach answers all the problems of stagflation. Thus, his basic solution for a lagging economy—though not for inflation —is to increase the funds that business has available for investment.5
This formulation most definitely is not supply-side. The idea of emphasizing "the need for new tax incentives to encourage people to save and business to invest" is one that would only occur to a Keynesian demand-sider. Indeed, by calling a demand-sider a supply-sider, the Times subverts the language sufficiently to transform none other than President Jimmy Carter into a supply-sider. Observe:
These measures to alter the tax system to increase savings and investment represent the major thrust of Martin Feldstein's proposals to improve the nation's sagging productivity and its potential for growth, but they would do little to affect inflation in the short term. For that ailment, Feldstein offers a standard prescription: slow economic growth, which would take some of the pressure off prices and wages by means of an increase in the unemployment of men and machines. And it is a notion that has come to be very much in the economic mainstream. President Carter, through his renewed commitment to balance the budget, has hopped upon the bandwagon.6
Such a blurring of the distinction between "demand-siders" and "supply-siders" is of more than academic interest. The emerging debate over the appropriate course of economic policy for the next decade hinges to a significant degree on keeping the differences between these two approaches crystalline. How can a national debate over economic policy occur if the demand-siders cloak the same old policy prescriptions in supply-side slogans? The danger is that large segments of the electorate will be left unable to tell the two sides apart. As it is, President Carter, and by implication his policies of fighting inflation by reducing economic growth (i.e. demand), have been identified with the "superstar" of the supply-siders. Moreover, as the distinction between the two models is blurred, the chances for a fundamental change in economic policy goes down, while the chances for economic policy mistakes go up. The economy and financial markets will suffer as a result.
The distinction between demand-siders and supply-siders can be characterized as follows: Demand-side models focus on the consumer. Central to a demand side analysis are changes in the amount of money in consumers' pockets and corporate coffers for use in buying goods and services or investing in plant and equipment, respectively. Supply-side models focus on the producer. Central to its analysis are changes in incentives for both capital and labor to participate in market activity.
Though straightforward, the distinction can be misplaced easily.
When President Nixon proclaimed in 1971 that "we are all Keynesians now" he was, in a way, almost literally correct. Virtually the same statement could be made today. The Keynesian framework has become so deeply embedded in the national consciousness during the past three decades that citizens who have never heard of Lord Keynes or "Keynesianism" are dominated by his influence. Because the Keynesian framework has been large enough to embrace liberals and conservatives, Democrats and Republicans, it has provided the foundation of all public discourse on economic policy. Whether they know it or not, all politicians, all bureaucrats, all journalists—including those who believe themselves to be hostile to Keynes—have been obliged to operate within his system and thereby have been conditioned by it.
The most important feature of the Keynesian framework is its focus on the consumer. For all practical purposes, the producer does not exist in the Keynesian model, except insofar as the producer is himself a consumer of capital goods. It is hardly an exaggeration to say that the model is constructed around the consumer's pocket. The economist serves the policymaker— the President or the member of Congress or banker or businessman—by advising on the condition of the consumer's pocket. If the economist detects unemployment and recession in the wind, he advises the politician to put money into the consumer's pocket. This is accomplished by borrowing it or taxing it away from those who are saving it and dealing it out either directly to consumers through transfer payments — food stamps, unemployment benefits, etc. — or indirectly through government contracts. The object is to increase the consumer's demand for goods and services. The Feldstein idea, which is popular among conservative Keynesians, is to encourage "savings and investment" instead of "consumption". The essence of the notion is to increase the funds available to corporations for spending on fixed investment. Increased savings is viewed as a source of these funds. And tax cuts are seen as a way to stimulate spending by increasing corporate cash flow. The focus is still on demand per se — in this case the demand for plant and equipment instead of refrigerators and vacations. The supply-siders sometimes agree with specific Feldstein proposals, but it nevertheless remains that the theory underpinning his policy prescriptions is Keynesian, concentrated on the consumer either as an individual or as a corporation, not the producer.
Similarly, Professor Feldstein's proposal to combat inflation through "unemployment of men and machines" in order to reduce pressure on wages and prices is straightforward demand management, taking money out of people's pockets. The usual problem for the Keynesian demand manager is to how to combat recession and inflation simultaneously, it being difficult to increase and decrease the amount of money in people's pockets simultaneously. The Feldstein "supply-side" solution is to have business tax cuts, increased savings and investment and productivity at the same time the economy is experiencing slow growth and unemployment.
The monetarists are also demand-siders, in the sense that the consumer's pocket is also at the center of their attention. A recession is caused by an insufficient quantity of money in the system; inflation is caused by an excess quantity of money in the system. When a surplus of goods appears in the economy (a recession or depression) the monetarists would print more money instead of having the government tax money away from savers and give it to spenders. The producer is not a participant in the monetarist model, except as a recipient of the consumer's money.
To the supply-sider, the producer is the active participant. The producer—individual capital and individual labor—produces in order to consume. Producers come together in the marketplace in order to exchange their production. The government, in providing, securing and maintaining the marketplace, charges a fee (a tax), which represents a share of production. It regulates the marketplace in the interests of all producers, providing standard weights and measures, standards of health and safety, and conservation of natural resources. It provides a currency that serves as a medium of exchange and a store of value. Because the producer produces in order to consume both "present" goods and services and "future" goods and services—consumption and investment—production is discouraged when the store of value is not maintained, when the currency depreciates over time.
The supply-sider, then, is not concerned with the consumer's pocket but rather with the efficiency of the producer and his willingness to participate in market activity over time. The supply-sider is not, per se, a tax-cutter. If the supply-sider believes the efficiency of production will be enhanced over time by more public roads, bridges, waterworks, schools, security forces, he will urge that they be financed by borrowing or taxing away a greater share of the producer's production. Borrowing some of the production, which must be paid back through future taxation, permits the long-term benefits of public goods and services to be borne by future as well as present producers.
But, public finance is inefficient if individual labor and/or individual capital are taxed at rates that are beyond the point of diminishing returns. This is the essence of "the Laffer Curve". Lowering rates draws labor and capital back into the marketplace and increases the efficiency of production over time. In addition, the government bite of the producer's output that goes to sustain the needy and unemployed also is reduced over time as producers make use of these resources.
Government regulation of the marketplace also is urged by the supply-sider to maximize production over time. Cutting down all the forests this year increases current production but diminishes production over time. But regulations to protect forests from current exploitation reach a point of diminishing returns when a timber that should be culled rots instead under the government's protective cloak.
Monetary policy contributes to the maximization of production over time when it is devoted exclusively to maintaining a standard of value. Producers are willing to produce more for current consumption if they are provided a reliable medium of exchange. Money facilitates commerce. They are willing to produce more for future consumption if they are provided a reliable store of value. A stable value of money in terms of goods minimizes windfall gains and losses inherent in monetary disturbances, thereby facilitating accumulation of capital. Supply-siders tend to favor a "gold standard" of value because of the reliability of such a standard over time to the producer. Demand-siders—Keynesians and monetarists—joined in applauding President Nixon's closing of the gold window in 1971 because the dollar-gold link was preventing devaluation of the currency. The idea was that U.S. consumers would be able to buy fewer imports with the devalued dollar and foreign consumers would be able to buy more U.S. exports at the devalued dollar price, and the U.S. economy would expand. To the supply-siders, the result was doubly destructive to production. There suddenly was no fixed standard of value and the inflation that followed increased real rates of taxation.
Demand-siders tend to be political elitists because only an elite would pretend to know how much money should be in the consumer's pocket at any moment. Supply-siders tend to be populists, because supply-side policies do not pretend to manipulate the masses. A gold standard removes the ability of an economic elite to manipulate the quantity of money. Tax rates are set not for egalitarian purposes, and not to favor capital over labor, but to finance an efficient marketplace in which people can decide for themselves the level of their production.
To the demand-siders, an across-the-board reduction in personal income tax rates a la Kemp-Roth suggests wild inflation (M.I.T.'s Paul McEvoy, a George Bush adviser, predicts 30 percent). There is a picture of enormous cash flow into the pockets of the masses. To the supply-siders, an across-the-board income tax cut is the most efficient because all production ultimately flows through the income tax; there is no bias against the fellow who wants to produce for current consumption and none against the fellow who wants to produce for future consumption.
The critical importance of distinguishing precisely among supply-side and demand-side economists is political. Economists don't implement policies suggested by economic theory. Politicians do. If the demand model remains dominant, and its practitioners wear supply-side uniforms and shout supply-side slogans, then politicians who are elected because of their call for improving the climate for producers may implement, inadvertently, economic policies based on the consumer's pocket.
In Britain last year, for example, Margaret Thatcher ran the Conservative Party on supply-side slogans, but once in power her policies were designed by demand-siders. The promise was to restore incentives to the lackluster British economy and encourage investment to replace its aging plant and equipment. Tax rates were cut on income and "investment". But tax rates were increased even more on "consumption". The average marginal tax rate facing the British citizen was higher. In addition to spurring investment, the Thatcher government was committed to reducing the budget deficit—hence the need for higher tax rates.
We have the picture of money being taken out of the pockets of the masses and put into the pockets of the elite, who presumably will spend it on enterprise. In the supply-side model, however, the concepts of "investment tax" and "consumption" tax do not exist. All individuals produce in order to consume, now or later. To tax consumption is the same as taxing production. The "disappointing" performance of the British economy in the aftermath of the Thatcher tax increase thus was expected.7
The possibility of flubbing the chance to change economic policy in the U. S. is certainly no less than it was in Britain a year ago. Supply-side supporters of the Kemp-Roth 30 percent tax cut point to the Kennedy-Johnson tax cut of 1963-64 as model fiscal policy in an environment of tax progressivity plus real or inflated growth. But Walter Heller, who was the Chairman of the Council of Economic Advisers in that period and who is called the "architect" of the Kennedy tax cuts, now rejects the comparison, opposes Kemp-Roth and argues that conditions are different.
It is clear from Mr. Heller's testimony in January 1963, before Senator Douglas of the Joint Economic Committee, that he was only concerned with consumer demand and would have taken a spending increase of equal size instead of a tax cut.
Douglas: Many people are saying that they would favor a tax cut only if it were compensated for by an equal cut in expenditures. The question I would like to ask is this: If this were done, would it not take away much of the stimulative effect upon which you count?
Heller: Senator, it would take away almost all of the stimulative effect. It is fair to say, however, that in talking about a tax cut, one looks at two aspects of the drag that taxes exert on the economy.
One is the drag on purchasing power, on income, on consumption, and investment demand. The other is the drag on incentives. It is perfectly true, if you had paired reductions in expenditures, and in taxes, you would still gain something on the incentive side, though you would more than offset it on the demand side.8
The "incentive" effect referred to by Heller was not any incentive to produce, but an incentive to spend out of income. In later testimony before the committee, Arthur Burns elaborated on the Heller view and took issue with it.
Let us say that the planned budget deficit is $10 billion. This deficit can be realized in different ways.
Plan A, let us say, involved increasing Federal expenditures by $10 billion. Plan B involves, let us say, increasing expenditures by $5 billion and also cutting taxes by $5 billion. Plan C involves, let us say, a cut in taxes of $10 billion. The theory which is now fashionable among economists is that the first of these plans would be most stimulative.9
Behind the theory, said Burns, is the idea that if the government spends the $10 billion it goes directly into purchasing power. But if taxes are cut, individuals and businesses will save a portion of the increased cash in their pockets. Burns, though, disagreed with this analysis and said Plan C would be most stimulative:
Under Plan C individuals and businessmen will begin thinking very differently about the future. They will be in a position not merely to use the larger cash income which is at their disposal, but they may well be in a mood also to dip into their accumulated assets and to use their credit. Now, the important objective of fiscal policy at a time like the present should be to stimulate individuals to use their brains, their energy, their disposable income, and also their assets and even their borrowing power in the interest of enlarging their economic activities and through that the Nation's economy.10
For Arthur Burns, although still in the demand model, there is at least a shadow of the supply model that influences him toward "Plan C."
Two monetarists were on hand to argue against tax cuts as the solution. George Terborgh and Allan Meltzer "claimed that the desired expansion of the economy could be obtained by increasing the rate of growth of the money supply with little if any increase in the budget deficit.11
Finally there was Chairman Wilbur Mills of the House Ways and Means Committee, in his speech introducing the tax cut bill to the House, coming closest to supply-side arguments:
Many believe we can spend our way to prosperity. On the other hand, I am firmly convinced that if Congress adopts a tax reduction and revision bill of the type which is before this body today, we can also achieve the more prosperous economy by loosening the constraints which the present Federal tax system imposes on our tree enterprise system. These tax reductions will bring about a higher level of economic activity, fuller use of our manpower, more intensive and prosperous use of our plant and equipment, and with the increases in wages, salaries, profits, consumption and investment, there will be increases in Federal tax revenues.12
This is at least an approximation of supply-side rationale for the tax legislation, with Mr. Mills verbally expressing the essence of the Laffer Curve: Lift constraining Federal tax rates and economic activity will expand sufficiently to bring about an increase in Federal tax revenues. Such a notion—that tax revenues may, in a relatively short amount of time, go up instead of down in the aftermath of a cut in tax rates—is rejected by virtually the entire old guard of the economics profession. The inability of the tax base to grow fast enough to maintain the expansion in government programs leaves the demand-siders in a quandary. Professor Stein, for example, endorses yet another increase in tax rates. Arguing in the March 1980 issue of the AEI Economist that the Federal government is starved for revenues, he advances the following recommendation:
I believe, therefore, that we should preserve our present revenue-raising capacity until we are fairly sure that we are not going to need it soon. The simplest way to do this is to keep all existing taxes in place and allow the tax burden to rise as the automatic consequence of economic growth and inflation .... We should be looking for revenue sources that can replace some of the revenue automatically yielded by inflation and generate still more revenue if needed. My preference would be for a large increase in the tax on gasoline made from petroleum.13
And here is Barry P. Bosworth, writing for The Brookings Institution's latest book on "Setting National Priorities: Agenda for the 1980s."
.... the arguments that the government must pay more attention to the supply-side implications of its actions seem compelling. The wide swings of demand-management policies in past years and the continued uncertainty of the regulatory environment seem to have had a serious destabilizing influence: investment is misdirected and expansion of capacity among related industries has gotten out of balance....14
So far so good, right? Barry Bosworth, advertised as the best and the brightest of the young, liberal Keynesians, undergoing a public conversion to supply-side in the official organ of Keynesian dogma. So what does Mr. Bosworth propose in his next breath?
A program of general wage and price controls, restrictions on housing and energy demand, and a continuation of slow demand growth are not easy measures to sell even on a temporary basis. Yet it may be that government today can only address its problems within such a crisis framework.15
The Stein and Bosworth observations demonstrates the breakdown of the demand model as a useful guide to policy makers. The political objective of the supply-side movement is not to cut tax rates or even to elect a President, but to have the supply model accepted as the framework for policymakers for at least the next generation or two. This is a necessary step to escape the economics of austerity and contraction bred by the demand-side model's inability to chart a path back to noninflationary growth.
* * * * *
1. Herbert Stein, "Some 'Supply-Side' Propositions", Wall Street Journal, March 19, 1980, p. 24.
3. Lindley H. Clark, Jr., "Long Term Economics", Wall Street Journal, April 22, 1980, p. 24.
5. Soma Golden, "Superstar of the New Economists", Neiv York Times Magazine, March 23, 1980, p. 33.
6. IBID, p. 91.
7. Arthur B. Laffer, "Margaret Thatcher's Tax Increase", Economic and Investment Observations. H.C. Wainwright & Co., Economics, August 6, 1979.
8. Herbert Stein, "The Fiscal Revolution in America", The University of Chicago Press, 1969, p. 443.
9. IBID, p. 446.
10. IBID, p. 446.
11. IBID, p. 447.
12. IBID, pp. 449-450.
13. Herbert Stein, "The Big Issues: Defense and Inflation", AEI Economist, March, 1980, p. 5.
14. Barry P. Bosworth, "Economic Policy", Setting National Priorities: Agenda for the 1980s, Joseph A. Pechman, Editor, Brookings Institution, Washington, D.C., March 24, 1980, p. 69.
15. IBID, p. 69.