Supply Side Economics: How Tax Cuts Defy Our Intuition and Why Reagan Was Right

 

If there is one thing liberals like to whine about it is “the rich.” What’s interesting, however, is that the definition of “rich” varies from person to person. For instance, people making 30k a year might define rich to be anyone making more than 50k a year. People making 50k a year might define the rich to be anyone making over 100k a year. People making 100k a year define the rich to be anyone making over 200k a year... and so forth. What I find particularly interesting is that liberals love to define “the rich” by one’s taxable income. At face value, it seems simple enough... after all, rich people are making lots of money right? Well, not necessarily.

Consider my favorite case study, John Kerry. As it turns out, in 2004 John Kerry paid a mere 13% of his income to the government. Is John Kerry “rich” by most definitions? Hell yes. So why does he pay so little in taxes? The reason is that John Kerry, like most ultra-rich people, places the majority of his money in tax free securities. Thus, he is able to live off of his personal endowment, without working a day in his life.

I am often dismayed at the level of economic understanding I observe in the political arena. I am by no means an economics expert, but I feel that I do have at least a basic understanding of economics. It seems that some liberals, however, have not given much thought to their economic reasoning. For instance, I often hear liberals refer to the national deficit as the “largest deficit ever.” The statement is ridiculous in the first place, but what I find more disturbing is the supposed solution. The knee jerk reaction of many liberals appears to be a significant increase in taxes. In some cases, it may be appropriate to raise taxes. Yet, what many do not seem to understand is that there is not a direct correlation between tax rates and tax receipts.

Last year, as I sat in the last PoliSci class I will ever take, one student referred conclusively to Bush’s tax cuts as “the tax cuts for the rich.” The “tax cuts for the rich” line from Democrats has been played out for years and years. Yet, they are able to continue to use it effectively, since many Americans have not taken the time to actually investigate what has happened when marginal rates have been reduced for the highest income brackets. As it turns out, jus a couple hours before my classmate displayed her grasp of left-wing talking points, we were looking at the data, directly from the IRS, that unambiguously, in plain black and white, said that income earners in the top bracket paid more in taxes after the Reagan tax cut. I guess this particular student wasn’t paying attention.

How is this phenomenon possible? How could lowering rates lead to more revenue, particularly from high income earners? Well, first of all, in strict percentage terms, Bush’s cuts in marginal rates went disproportionately to individuals with little income. Yet, Democrats argue that Bush’s cuts in other areas, dividends and capital gains, will favor “rich” business owners. In a sense, they are correct, yet not in the way that one would expect. Pretend you are John Kerry with millions of dollars sitting in the bank. There are two options on the table. First, you can invest your money in tax free municipal bonds that return 5%. Second, you can invest your money in a cutting edge tech company that desperately needs investment and will return 7%. Which one will you choose? Well, if the government were to tax capital gains and dividends heavily -- at say, 30%, then you would choose the bonds. If, however, the government were to cut taxes for “the rich” you might be more inclined to invest in the company, which is a lot better in the big picture economic view. So, in essence, these taxes might “benefit the rich,” but only in the sense that it encourages those who can afford it to invest their money more effectively. This is, in fact, the primary argument for “supply side” tax cuts – it provides incentives for people to invest.

On some level, it seems kind of hard to argue with the reality straight from the IRS. When I bounced this argument off a friend of mine, his response was a simple, yet strikingly conclusive “no s***.” Of course, this sort of logic is somewhat complicated for those who like intuitive solutions to problems. Yet, as it turns out, the evidence seems to support the supply-side argument, and exactly what I predicted a year ago (Vol XXXIII, Issue II) appears to have occurred. Deficit estimates for 2004 and 2005 have been revised significantly downwards (by as much as 100 billion dollars), largely on receipts from capital gains taxes. Investment was, indeed, spurred by Bush’s cuts for capital gains and dividends, and, despite lower marginal rates, the “rich” are paying a larger share of total government revenue now than ever before.