Tax Cuts, Revenues, and Trends of the 1970s

During the 1980 Presidential campaign, we can say that it was the last time that we heard actual issues being discussed, as opposed to the slick media campaigns today complete with the hard-core negative attack ads (with black-and-white photos, etc.). (We don't have TV reception, and I have not watched political ads on a regular basis since 2000. I don't miss them, and I don't miss most television.)

One feature of the campaign was the debate between people who called themselves Supply Siders and what Robert Higgs would call Vulgar Keynesians. The Supply Siders claimed that cutting marginal tax rates (the highest rates then were at 70 percent) would generate so much new economic activity that the rate cuts would "pay for themselves."

Keynesians, on the other hand, said that tax cuts would increase the rate of inflation (I remember a Bill Maudin cartoon which had an evil-looking Ronald Reagan pouring gasoline on a fire, the gasoline labeled "tax cuts"). So, what happened?

Paul Krugman claims to know, and he gives us a revisionist view of the 70s and beyond with this diagram:

He explains his point:

A couple of points. First, the Carter years, contrary to legend, were not a period of economic stagnation and falling revenue because high tax rates were strangling the economy; there was a nasty recession starting in 1979, largely thanks to an oil shock, but overall growth was respectable and revenue growth reasonably high.

Second, the revenue track under Reagan looks a lot like the track under Bush: a drop in revenues, then a resumption of growth, but no return to the previous trend.

This is exactly what you would expect to see if supply-side economics were just plain wrong: revenues are permanently reduced relative to what they would otherwise have been.

As usual, one has to do some re-interpreting of Krugman's remarks. First, and most important, I believe that the issue of revenue is a red herring. After all, if the government wishes to raise more revenue today, all it has to do is to confiscate everything we have, and I suspect that the government budget would almost be balanced, at least for one year (but not beyond that).

Now, not even a Keynesian True Believer like Krugman would advocate such a thing, although there are plenty of people in Washington who probably think this move by the government would be great. Furthermore, I never have been comfortable with the contention by Supply Siders that we could have our cake and eat it, too. Many of them were trying to claim that all that was needed by politicians was to cut tax rates, and everything else would fall into place.

However, there is yet another problem that neither Krugman nor the Supply Siders have addressed, and that was the Recession of 1982. As you can see in Krugman's graph, he assumes that ALL of the fall in revenues around 1982 was due to the lowering of the top rate from 70 percent to 50 percent. In other words, according to Krugman, had there been no tax cuts, apparently there would have been no recession.

(Note to the Krugman groupies: No, he does not say it directly, but the red trend line he created certainly implies it.)

Krugman's explanation for the recession of 1979 was the "oil shock," but other "oil shocks" have not started recessions. Whenever Keynesians try to bring in oil shocks or bad crops as explanations for recessions, I think about the mutually-exclusive set of excuses Jake Blues gave the Carrie Fisher character (his fiance) in "The Blues Brothers."

Yet, why did the recession occur in the early 1980s? Krugman has claimed elsewhere that it simply was the result of the Fed under Paul Volcker putting the stop to inflation, and certainly the double-digit inflation that infected the economy through 1981 (that Krugman fails to mention in this post). The Austrians have noted that a decade of boom and bust and massive inflation was certain to end in a recession, which is what we had.

However, in reading Krugman's post, I guess I am to assume that had the old regime of 70 percent tax rates and inflation been permitted to go on, there would have been no recession, the economy would have been great, and the government would be balancing its budget. However, if the recession of 1982 was inevitable (and Austrians believe that it was), then revenues would have fallen drastically, even had the 70 percent rates been in place. Krugman fails to mention that point, but I think it is relevant.

I have no idea whether or not cuts in tax rates "pay for themselves;" I do believe that high tax rates will hamper entrepreneurs and economic growth. Since Krugman is a Keynesian, and in that world, capital and other assets are homogeneous, economic growth is the simple function of money spent, and it matters not whether it is spent by individual consumers or the government.

By the way, as I have noted before, when I asked Krugman at a session of the Southern Economic Association meetings in New Orleans on Sunday, November 21, 2004, if he favored going back to the old 70 percent rates, he exclaimed, "Oh, no! Those rates were insane." Guess he is redefining insanity these days.