Three Questions from the Class
Jude Wanniski
August 8, 1997


Supply-Side Summer School Economics Lesson #8

Memo To: Students of the Supply-Side University
From: Jude Wanniski
Re: Question Period

1. From Joe Armstrong of Hale Center, TX: “I was asked at lunch yesterday why the Bush tax increases supposedly created a recession while the Clinton tax increases did not cause a recession but a boom instead. The people I was conversing with are all statist liberals and never met a tax they didn’t like. I was hard-pressed to come up with an answer and they told me I could not have it both ways in contending that higher taxes stifled economic growth and lower taxes engendered growth, when the Clinton tax increases indicate the opposite. The answer to this would be a good Supply-Side University lesson.

A. It is a good question. The answer is quite complex, which is why it is not easy to win an argument at lunch when people expect simple answers. The term “ceteris paribus” should be employed to suggest to your adversaries that there are a lot of things going on at once in the political economy. The term means, “everything else being equal,” or “holding the rest of the world constant.” One has to do this when analyzing the economy or markets because when you change one variable, it impacts all other variables. A change in a tax rate will cause behavior to change in regard to the thing being taxed. That change in behavior will also have monetary effects, i.e., changes in the dollar price of the thing taxed and changes in the prices of all other things that are not taxed, but which are substitutes for the thing taxed. The complexity of the things that occur when the United States government changes a tax rate or alters monetary policy is so immense that it is beyond human ken. Imagine first that when you stamp your foot, the whole planet shakes a little bit, and you can begin to imagine the infinite intricacies of the global marketplace and how they respond to policy changes in Washington. This is why it is essential that all analysis begin with an understanding of “ceteris paribus,” which permits us to look at one event at a time, in isolation.

With this in mind, we can then understand that tax cuts do not always cause economic growth and tax increases do not always cause recessions. We can say that, ceteris paribus, all taxes have negative effects on commercial activity, which Alan Greenspan told the House Banking Committee earlier this year. But if we did not have taxes, we would not have government or civilization, so obviously “ceteris” is not “paribus.” What are the taxes going to be used for? If they are going to be used to prevent people from starving or being homeless or unclad, these are useful, civilizing purposes and will not necessarily subtract from commercial activity. If the taxes are used to discourage people from working, by giving them food, clothing and shelter when they could be fending for themselves, there is a net loss to economic efficiency. When tax rates are raised to finance public works, the net effect is positive if the public works are needed and completed without too much fraud.

When the government needs more revenue to meet its obligations and it has an array of tax options, it should only raise those tax rates that stand a good chance of producing revenue. In the supply-side model, any increase in the capital gains tax will lose revenue, any cut will raise revenue, all the way down to zero. This is because a direct tax on successful risk-taking is a direct tax on success. Alan Greenspan has repeatedly testified that a capital gains tax is the worst possible tax to try to raise revenue with and that its rate should in fact be zero. Marginal tax rates on ordinary income are not as counter-productive, at least when they are below 25% or so. Higher tax rates on ordinary “labor” income make it more difficult for people without capital to acquire it themselves as a foundation for self-employment or new enterprise. To get a grubstake as they called it in the Old West.

In a monetary inflation, it becomes harder to get a grubstake because the harder you work, the more the government taxes away from you. This is the result of the impact inflation has on tax progression. Tax progressions, after all, were not meant to make it hard for the poor to become rich, but to keep the rich from becoming richer. Nobody thought about inflation when tax progressions were designed early in the century, after a half century of DEFLATION. At least in the Reagan years, this kind of income was protected against further tax bracket creep by indexation, although it still left workers who were never intended to be taxed on income with liabilities.

Monetary inflation also causes the nominal value of wealth to increase, which is why the worst tax of all, the capital gains tax, causes such terrible things to happen in an inflationary environment. Instead of taxing a capital gain -- an increase in wealth -- it taxes the wealth itself. In all these years of inflation, wealth has never been protected from this kind of taxation by indexation. It continues to be taxed by those who are forced to sell, but because it is a transaction tax, it can be avoided by not selling. An estimated $7 trillion in unrealized capital gains that are pure inflation have accumulated.

In 1988, George Bush was elected on a promise not to raise taxes and to cut the capgains tax to 15% from 28% and index it against inflation. In 1989, he tried to get the Democratic Congress to give him the capgains cut, but was thwarted in the Senate that autumn. In 1990, he tried again, with a package of spending cuts and tax increases -- breaking his no-tax cut pledge. Again, he caved in to the Democratic argument against capital gains and wound up with a tax increase on income instead, the top rate rising to 33% from 28%. Expectations of increased rewards to investment were dashed as the marginal cost of labor increased. The Bush Treasury attempted to persuade the Federal Reserve to lower interest rates to advance the economy, but Greenspan refused. Gold hovered at $350. Recession followed.

In 1992, Bill Clinton was elected with 41% of the vote on a promise of middle-class tax cuts of an unspecified nature and amount. He also made peace with Alan Greenspan, which removed that threat of inflationary political pressure from the bond market. The stock market fell when he announced he would raise taxes instead of lowering them, but the bond market rose as the administration continued to signal its support for Greenspan’s Fed policy. Clinton was persuaded by his Cabinet that the bond market was more important than speculative stocks. The final tax bill, which passed without a single Republican vote, raised the top marginal income-tax rate to 39% from 33%, but it left alone the 28% capital gains tax. At the time it passed, we told our clients that it would not do much damage to the economy. Long-term interest rates had gotten as low as 5.87% in October of 1993, but began creeping up as Greenspan allowed the decreased demand for dollar liquidity to be absorbed by a 10% rise in the gold price, to $383.

There was no technical recession following the Clinton tax increase, but that is only because the recession that ended the Bush administration was not followed by rising expectations of rapid economic growth. When the economy dips below a projected expansion path for two successive quarters, we term this a recession. When it recovers from this dip, we say the recession is over even before the economy returns to the growth path from which it dipped. The administration’s support of Greenspan’s monetary policy was enough to offset the dampening effects of the tax increase. Between the end of 1992 when the recession ended and the fall of 1996, the economy grew at a glacial pace. There was no boom, except in the new industries that flourish around telecommunications and computer technology. Enactment of the telecommunications bill in early 1996, with broad bipartisan support, was in itself enough to explain the rosy glow in that sector of the economy.

It is hard to exaggerate the importance of Fed policy in this period, especially as it affects the formation of capital. As long as the Clinton tax increase of 1993 did not increase the nominal rate of capgains tax, leaving it at 28%, the ability of Greenspan to keep inflation under control meant that the capgains tax would not be artificially swollen to two or three times 28%. At $320 gold today, there is a lower inflation expectation today than there was in 1992 when Clinton took office, with gold at $350. Once the Republicans won control of Congress in 1994, there was no longer any market concern that taxes would be raised, every bias that they would be lowered. The financial markets began to capitalize these lower-tax expectations throughout 1996. Now, with the budget deal in hand, the nominal capital gains tax will be lower, at 20%, and eliminated entirely on most homes. The lowering of estate taxes also has immediate positive effects on the economy, as prospective tax liabilities have been slashed.

The future seems as promising as it does to the financial markets because we now see an end to discussion about the need to raise taxes, as the economic expansion generates tax revenues far in excess of those which had been projected just several months ago. We are entering an era where the political debates will be focused on how to divide the revenues flooding into the U.S. Treasury and into all the state and local treasuries.

Why did the Bush tax increases cause a recession and the Clinton tax increase create a boom? To summarize the above answer, Bush was still climbing the mountain when he added the weights to his ankles. Clinton was on the down slope, with markets seeing better times ahead as far as the eye could see.

2. From Scott Robinson, M.D., Mill Valley, CA: “This week’s Barron’s suggests that the collapse of Keynes’s theory was due to the global inflation that you so consistently refer to in many of your articles. Apparently, Keynes assumed stable prices regardless of the level of government money creation. Was this naive or simply wrong?

A. When you pose a question based on something you have read, please use direct quotes from the article or book. As you put the question, I don't have enough information to answer it. Keynes had a great many theories within what he called his general theory, with many important insights. What has broken down is the neo-Keynesian model, which was an edifice erected by his followers after his death. Where Keynes had seen "stagnant pools of capital" and a surplus of “savings” by the rich at the heart of the Great Depression, his followers posit a surplus of “consumption” by the rich and a shortage of savings by the overall economy. The tradeoff between inflation and unemployment, the so-called "Phillips Curve," was devised after Keynes' death in 1946, following the currency devaluations of the 1950s. The Keynesian world, like that of the monetarist world of Milton Friedman, has its problems with inflation because it does not give sufficient weight to the monetary role of gold as a unit of account. Keynes and Friedman both thought modern central banking could "manage the currency" in a way that could keep prices stable and optimize growth. Friedman's errors were far worse than Keynes, in that he assumed the dollar/gold link could be broken and the velocity of money would still remain constant. It was gold that kept it constant. Once the link was broken, the velocity of the paper money shot up. That is, as money is losing its purchasing power, people are more eager to exchange it for real things that will hold value, like gold, other commodities, real estate and durable goods.

3. A series of scattershot questions from "Muggeridge." Again, I’d like you to take greater care in formulating your questions, not just tossing them off the top of your head. You have sufficient time to think them through.

Q. With the recent decline in gold prices, and if we as a nation were on a gold standard, wouldn't we collectively be poorer?

A. I'm surprised you would ask such a question? By this time you should be able to answer it yourself. Would you rather have the price of gold rise to $1 million an ounce so that we would collectively be richer? Can any of you other students help “Muggeridge” with his question?

Q. Aren't the Australians by selling their gold saying, "Gold is less valuable than what it will bring after being sold?” Doesn't this in fact illustrate that gold is in the final analysis a commodity and not a standard or yardstick?

A. When someone sells, someone buys. The Australians thought their gold was going to fall in value, and they sold it to someone who thought it would rise in value. How do you propose to have a commodity standard for the marketplace that is not going to be subject to the law of supply and demand? Please try and answer your own questions before putting them to me.

Your questions about Friedman's book, "Money Mischief," are too scattershot. You need to formulate them better. I'm not here to answer trivia to save you a trip to the library. Are you sure Friedman said "bimetallism is as good as monometalism?” That's hard to believe. If it is, it would confirm my argument that he sees little value in money as a unit of account. Give me the exact quote and I will address it. Actually, I will get the book, published only a few years ago, and get the full context. This would be a good topic for a future lesson.