Assume for simplicity that the 75 percent tax rate applies to all his income. Now the government cuts tax rates by one-third, from 75 percent to 50 percent. Now consider a taxpayer paying a tax rate of 15 percent on all his income. The same 33 percent rate reduction cuts his rate from 15 percent to 10 percent. Because cutting the 15 percent rate to 10 percent exerts only a small effect on the incentive to earn, the rate reduction has little impact on the amount earned.
Therefore, in contrast with the revenue effects in high tax brackets, tax revenue will decline by almost the same percentage as tax rates in the lowest tax brackets. The bottom line is that cutting all rates by a third will lead to small revenue losses or even revenue gains in high tax brackets and large revenue losses in the lowest brackets. As a result, the share of the income tax paid by high-income taxpayers will rise. As the Keynesian perspective triumphed following World War II, most economists believed tax reductions affect output through their impact on total demand.
The potential supply-side effects of taxes were ignored. However, in the s, as inflation pushed more and more Americans into high tax brackets, a handful of economists challenged the dominant Keynesian view. Led by Paul Craig Roberts, Norman Ture, and Arthur Laffer, they argued that high taxes were a major drag on the economy and that the top rates could be reduced without a significant loss in revenue.
They became known as supply-side economists. During the presidential campaign of , Ronald Reagan argued that high marginal tax rates were hurting economic output, but contrary to what many people think, neither Reagan nor his economic advisers believed that cuts in marginal tax rates would increase tax revenue. The — period was an era of great debate about the impact of supply-side policies. The supply siders highlighted the positive evidence from two earlier major tax cuts—the Coolidge-Mellon cuts of the s and the Kennedy tax cut of the s.
Between and , three major tax cuts reduced the top marginal rate from 73 percent to 25 percent. The Kennedy tax cut reduced rates across the board, and the top marginal rate was sliced from 91 percent to 70 percent. Both of these tax cuts were followed by strong growth and increasing prosperity. In contrast, the huge Hoover tax increase of —the top rate was increased from 25 percent to 63 percent in one year—helped keep the economy depressed.
As the economy grew slowly in the s and the unemployment rate rose, supply-side economists argued that these conditions were the result of high tax rates due to high inflation. Keynesian economists were not impressed with the supply-side argument. They continued to focus on the demand-side effects, charging that it was irresponsible to cut taxes at a time when inflation was already high.
They expected the rate cuts to lead to larger budget deficits, which they did, but also that these deficits would increase demand and push the inflation rate to still higher levels.
Contrary to the Keynesian view, the inflation rate declined substantially from 9 percent during the five years prior to the tax cut to 3. Economists continue to debate the precise effects of the s tax cuts. After extensive analysis of the rate reductions, both Lawrence Lindsey and Martin Feldstein concluded that for taxpayers previously facing marginal tax rates of 40 percent or more, the drop in tax rates caused such a large increase in taxable income that the government was collecting even more revenue from taxpayers in these top brackets.
This would mean that tax rates of 40 percent had had a highly destructive impact on economic activity. According to Slemrod, only a small portion of the increase in the tax base resulted from improvements in efficiency and expansion in the supply of labor and other resources.
Even though economists still disagree about the size and nature of taxpayer response to rate changes, most economists now believe that changes in marginal tax rates exert supply-side effects on the economy. It is also widely believed that high marginal tax rates—say, rates of 40 percent or more—are a drag on an economy.
The heated debates are now primarily about the distributional effects. Supply-side critics argue that the tax policy of the s was a bonanza for the rich. It is certainly true that taxable income in the upper tax brackets increased sharply during the s. But the taxes collected in these brackets also rose sharply.
The percentage increases in the real tax revenue collected from the top 1 and top 5 percent of taxpayers were even larger. Since , the top marginal personal income tax rate has been less than 40 percent, compared with 70 percent prior to Nonetheless, those with high incomes are now paying more.
For example, more than 25 percent of the personal income tax has been collected from the top 0. These findings confirm what the supply siders predicted: the lower rates, by increasing the tax base substantially in the upper tax brackets, would increase the share of taxes collected from these taxpayers.
Supply-side economics has exerted a major impact on tax policy throughout the world. During the last two decades of the twentieth century, there was a dramatic move away from high marginal tax rates. However, studies have shown that due to multiple economic variables, environments, and factors, it can be hard to pinpoint effects with a high level of confidence and to determine the exact outcome of any one theory or set of policies. The Laffer Curve helped formulate the concept of supply-side theory.
The curve, designed by economist Arthur Laffer in the s, argues that there is a direct relationship between tax receipts and federal spending—primarily that they substitute on a one-to-one basis. The theory argues that a loss in tax revenue is made up by an increase in growth; thus, tax cuts are a better fiscal policy choice. In the s, President Ronald Reagan used supply-side theory to combat stagflation that followed the recession in the early part of the decade. Bush R : 2.
This supply-side fiscal policy of tax cuts to boost economic growth remained popular among U. In and , President George W. Bush also instituted wide-ranging tax cuts. These applied to ordinary income as well as dividends and capital gains among others.
In , President Donald Trump enacted a tax bill that, in principle, is based on supply-side economics. Since then, the provisions have benefited high earners disproportionately and hurt some working- and middle-class taxpayers. During his presidential term, Trump also focused on supply-side fiscal policy through trade relations that raised tariffs on international producers with the aim of creating an opportunity for U.
Critics of these types of policies point to the growing trend among corporations to engage in stock buybacks. Buybacks occur when companies place the cash they may gain from lower taxes back into the pockets of their shareholders rather than investing in new plants, equipment, innovative ventures, or their workers.
Bartlett, B. Canto, V. Foundations of supply-side economics: Theory and evidence. Academic Press. Center for American Progress. Mazerov, M. Center on Budget and Policy Priorities, January , The Guardian. The World Bank. Congressional Research Service. Tax Policy Center. Income Tax. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content. Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile.
Select personalised ads. Apply market research to generate audience insights. Measure content performance. Good tax reform broadens tax bases and lowers marginal rates.
The revenue impact of a tax cut depends on how easily those affected can change behaviour. All these insights have improved policymaking. Yet many Republican politicians made precisely that claim when justifying their tax reform.
Some claim the additional 45p income tax rate, applying as it does to highly mobile people with sophisticated accountants, loses revenue too. Art Laffer has been too Panglossian about these growth and revenue impacts of tax cuts from lower levels in recent years. Critics have a point that this has filtered out into an incorrect view about what tax cuts can achieve among many conservatives. They generated a global tax revolution, and the concepts he and others popularised became the bedrock of good tax policy for practitioners.
Live Now. This article appeared on UK Telegraph on June 20,
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