Sunday, December 05, 2004

Living on the Supply-Side of the Tracks

One of the largest questions that politicians and policymakers must address is that of taxes. In fact, tax policy may be the most generally distinguishing factor between Republican and Democratic platforms. Of course, no one wants high taxes, but Democrats are generally willing to endorse higher taxes in order to fund the government programs they support. Conversely, Republicans despise nearly all taxation with a hatred that often borders on the pathological. I say this because support for tax cuts endures even when it will indisputably create revenue shortfalls. For a party that claims to be the guardians of fiscal discipline, that's more than a little strange.

Now, in reality Republican tax cutters fall into two categories: "supply-siders" and "starve the beast"-ers. Regular readers of Paul Krugman will recognize this distinction. For those who haven't caught his New York Times op-ed for the last five years or have not read The Great Unraveling, I'll provide a brief description. Basically, "starve the beast" is a philosophy of reducing taxation in order to create dangerously large deficits. It is believed that eventually the deficits will create an economic crisis that will force politicians to dismantle large and otherwise untouchable government programs, such as Social Security, which these individuals dislike for a host of reasons. However, this rationale is rarely if ever explicitly revealed. It is, after all, a strategy to eliminate popular government services that would never succeed through direct democratic action.

"Supply-siders" are a horse of a different color. They claim, somewhat counterintuitively, that lowering taxes raises revenue overall. Needless to say, this claim is rather controversial. Despite this, nearly every public voice clamoring for lower taxes will trot out this rationale. And why not? It's another way of saying tax cuts are free. Keep more of your money, without sacrificing the government services we've all come to know and love.

The question I have is this: how authentic are "supply-siders"? I mean, do they really believe it?

Short answer: no.

OK, here's the long answer. Supply-side tax policy is in essence a claim that taxes are a drag on the economy and that by removing them you create more business activity, more taxable events, and ultimately more revenue. I'm sure that an economist would have an awful lot to say about the validity of these statements, but for the time being let's assume that the general premise is correct. Let's say reducing taxes creates more taxable events. With this as a given, how does revenue go up (or at least stay neutral)? It does so as long as taxable events increase at a rate high enough to offset the revenue loss on previously existing taxable events.

But, even if everything we have just discussed is incontrovertibly true, does this trend extend forever? In other words, will the increase in taxable events forever outpace revenue loss due to lower tax rates? Well, obviously no. For example, if we reduce taxes as much as is possible, by eliminating them, it wouldn't matter if there were an infinite number of taxable events. Infinity (the number of taxable events) times zero (the aggregate tax rate after eliminating taxes) is zero. Therefore, no one can rationally argue that reducing taxes inevitably leads to higher revenue. There is a point where the tax rate is going to be simply too low relative to the number of tax events to keep revenue rising or neutral.

Where is that point? That is an excellent question. And the answer to it should be incredibly important to any supply-sider because that point is where they should want the aggregate tax rate set. Moving away from it, either by raising or lowering taxes, reduces revenue, something they are ostensibly trying to avoid.

Now, have you ever heard any supply-sider discuss the existence of this magical tax point? Me neither. And frankly, if you're not talking about it, you're not serious.
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