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2004: A test of Supply Side economics

Posted By Barry Ritholtz On December 27, 2003 @ 11:17 am In Finance | Comments Disabled

What are the Economic & Theoretical Ramifications of the 2003 Holiday Shopping Season?

The holiday shopping season of 2003 provided a fascinating glimpse into the goings on beneath the surface of the macro economy. It also provides a fresh opportunity to examine the validity of a specific economic theory — Supply Side / Trickle Down Economics — and to lay a fresh challenge to the proponents of that school of thought.

Our inquiry begins with this simple question: Why did the luxury sector do so smashingly well this Christmas, while the low end of the market — in particular, the mass discounters — performed below expectations? Contrast the year over year revenue gains for high end retailers Tiffanys, Coach, Nordstrom and others, with the performance reported by Wal-Mart, Target, CostCo, and the rest.

The explanation reads like an overview of 2003: The wealth effect from a rising stock market, along with a relatively healthy bonus pool this year, contributed to the surge in luxury goods sales following several years of pent up demand. But the true key to the 2003 holiday sales performance is found in the Bush economic plan. For higher income families, a holy trinity of tax cuts put a healthy serving of dollars into their pockets: Tax brackets were cut, capital gains taxes decreased, and an entirely new class of much lower dividend taxes created. The results from the retailers of higher end goods suggests that much of that money was spent on luxury items.

For middle and lower income families, the bulk of the tax benefits — manifested in the form of $400 Treasury checks reflecting lessened federal witholding tax [1] (due to the lowered tax rates and the larger standard deduction for married couples) — were long spent prior to holiday shopping. This group may also have reined in their spending a bit, as they remain somewhat skittish about the employment situation. Bearing this out is the irregular gyrations of the monthly consumer confidence numbers. While middle income families will continue to see benefits from the Bush tax cut — they will be rather modest. They will certainly not pay for many purchases from Nieman Marcus.

Viewing this phenomena through the lens of economic theory, the contrast between the luxury and discount retailers raises curious theoretical issues: Might some economists explain this discrepancy as an example of “Supply Side” economics in action? If the economy continues to strengthen going forward, will this school of thought finally be validated?

Long disparaged by classical econ scholars as the bastard stepchild of economics, the “Supply Side, Trickle Down Thesis” has been out of favor — at least publicly — since Ronald Reagan left the White House. While dedicated Supply Side proponents remained active in think tanks and media, they were at most influencing, but not pulling, the levers of power. Today, however, the Supply Side school of thought dominates the Bush Administration’s economic policies as thoroughly as the NeoCons dominate its foreign policy.

In the 1980s, as Ronald Reagan’s “Trickle Down” policies were put into effect, the top tax bracket was slashed in half, from 70% to 35%. That’s the sort of meaningful change to the tax code which economists believe create significant changes in investor behavior. President Bush, on the other hand, made what many pundits (present company included) derided as an “incremental cut” — less than 10% for the highest tax bracket. The assumption was that “incremental tax cuts for tax cuts sake” would not have all that profound of an impact.

What may have been overlooked at first blush was the cumulative effect of all the tax cuts discussed above. Capital gains taxes were sliced 25% (from 20% to 15%), and the new dividend tax cut — at least for investors in the top bracket — was more than chopped in half, (from 38.6% to 15%). Collectively, these three changes to the tax code seem to be having a meaningful effect on high end consumption. Whether it will have a trickle down effect on employment and business spending is as of yet unknown.

But we shall soon enough find out. Thus, Supply Side school of thought — derided on the campaign trail by Bush the elder as “Voodoo economics [2]” — now has a golden opportunity to redeem itself. Failing to do so, however, may relegate it once and for all to the trash heap of economic theory.

The architects of President Bush’s economic plans are former National Economic Council head Larry Lindsey, and former Council of Economic Advisers director Glenn Hubbard. Hubbard is widely credited [3] as being the man behind the dividend tax cut — he first proposed it while working for Bush I. Both are known as “strong supply-siders with conservative think tank roots.” These advisers have since moved on. Lindsay resigned last December; Hubbard followed him out the door a few months later. These top bracket tax cutters were confident enough that their plan was irrevocably in motion that they retired to the worlds of think tanks and academia.

To us, here is where things get interesting: Harvard economics professor Gregory Mankiw replaced Hubbard at the Council of Economic Advisers. The Professor has been described as not a Supply Sider [4] — at least, according to Stephen Moore (Club for Growth President and NRO contributor).

Moore cites Mankiw’s “Principles of Macroeconomics [5]” textbook, where the professor disparingly refers to Ronald Reagan’s supply-side advisers as “charlatans and cranks.” The obligatory excerpt:

An example of fad economics occurred in 1980, when a small group of economists advised Presidential candidate, Ronald Reagan, that an across the-board cut in income tax rates would raise tax revenue. They argued that if people could keep a higher fraction of their income, people would work harder to earn more income. Even though tax rates would be lower, income would rise by so much, they claimed, that tax revenues would rise. Almost all professional economists, including most of those who supported Reagan’s proposal to cut taxes, viewed this outcome as far too optimistic. Lower tax rates might encourage people to work harder and this extra effort would offset the direct effects of lower tax rates to some extent, but there was no credible evidence that work effort would rise by enough to cause tax revenues to rise in the face of lower tax rates. . . .

However, prominent Supply Side commentators strongly dispute Moore’s cranky assessment; Mankiw, we are assured, has both feet solidly planted in the Supply Side camp.

So is there a split within the economic apparatchiks of the Administration? Bush continues to maintain prominent Supply Side/Trickle Down [6] theorists, the most prominent of which is VP Dick Cheney. This group remains extremely influential with the President.

The present team seems to have more fiscal conservatives — including budget balancers and otherwise traditional economists — and self-described “responsible adults.” Should the President win a second term, these budget balancers expect to be the “clean up team” — imposing fiscal discipline on a White House and Congress that has yet to meet a spending increase they didn’t love.

The rest of the President’s term may play out as a fascinating economics drama between two schools of thought. We will be witnesses to a trial of the trickle down school of thought. The large disparity between the two end points of the retail sector that materialized suggests a real time, live test of the Supply Side economics.

Indeed, the key to which wing of Bush’s economic team will win subsequent budget and tax battles is likely to be determined by how the economy behaves between now and Inauguration Day 2005.

Is Supply Side Already Working?
The recent economy has something for every school of economics: There’s been enough deficit spending too keep the Keynesians happy; Money supply increases (at least, up until recently) were sure to warm the hearts of Monetarists. Yet the economy seemed not to respond to either of these stimulants — not until the 2nd Quarter of 2003, when the second round of tax cuts kicked in. Indeed, supply siders might even argue that a test in 2004 is unnecessary, as the recovery in 2003 more than proves the case.

Perhaps that assessment is premature. As Ned Davis said, “give me a trillion dollars and I’ll throw you one hell of a party.” The proof of Supply Side success will come once the economy demonstrates it is on a self sustaining path – that includes robust job creation. That’s something notably absent in this post recession recovery cycle, and which the Supply Side team expects to occur in the first half of 2004.

If the economy is in full recovery by this time next year, that will go a long way towards rehabilitating the supply side school amongst traditional economists. If on the other hand, the economy slips back into a slow growth mode without much in the way of job creation, or (gasp!) a contraction, that may very well spell the death knell of trickle down as a credible economic thesis.

As an economic agnostic — I believe in the “smorgasbord approach” of taking a little of what works from each school of thought — I simply can’t wait until next year to see how this plays out.

Redemption or repudiation awaits . . .

Sources
Hail Hubbard [3]
by Bruce Bartlett
National Review, January 13, 2003, 8:00 a.m.

http://www.nationalreview.com/nrof_bartlett/bartlett011303.asp

Think Twice About Gregory Mankiw [4]
This Harvard economist does not belong on the Bush economic team.
By Stephen Moore
National Review, February 28, 2003 11:30 a.m.

http://www.nationalreview.com/moore/moore022803b.asp

Principles of Macroeconomics [5]
by N. Gregory Mankiw
International Thomson Publishing; 2nd edition (June 2000)

Cheney the Supply-Sider [6]
Cheney the Supply-Sider
Larry Kudlow,
National Review, 7/24/00 6:45 p.m.

http://www.nationalreview.com/kudlow/kudlow072400.html

David Stockman, The Triumph of Politics: Why the Reagan Revolution Failed [2]
(New York: Harper & Row, 1986), p. 56.

The Education of David Stockman [7]
William Greider
Atlantic Monthly, December 1981, pp. 46-47.

http://www.theatlantic.com/politics/budget/stockman.htm

Q&A Gregory Mankiw [8]
Top economic adviser to George Bush
By JYOTI THOTTAM;
Time, Monday, Oct. 06, 2003

http://www.time.com/time/insidebiz/article/0,9171,1101031013-493318,00.html

Secondary Resources:

Trickle-Down Economics: Four Reasons Why It Just Doesn’t Work [9]
By Mehrun Etebari
July 17, 2003

http://www.ufenet.org/research/TrickleDown.html

The Rise of Supply-Side Economics [10]
www.huppi.com/kangaroo/23More.htm

Trickle Down Economics and corporations: How corporate taxes cost jobs [11]
By Brad Wardell
Posted Wednesday, September 03, 2003

http://www.joeuser.com/articlecomments.asp?AID=89&s=1

Trickle down economics comes of age [12]
By: Tim Wood
Posted : 2002/06/14 Fri 04:00  | © Moneyweb 1997-2003

http://m1.mny.co.za/MNBTalk.nsf/0/C2256A2A002030FD42256BD60028F633?OpenDocument

Trickle-down Economics and Ronald Reagan [13]
Jim Blair

http://www.bigissueground.com/politics/blair-trickledownreagan.shtml

The “Trickle Down” Economics Straw Man [14]
by Thomas Sowell  
September 27, 2001, Capitalism Magazine

http://capmag.com/article.asp?ID=1115

Trickle Down Economics in Full Flow [15] (PDF)
Center for Impact Research, April 2003

http://www.impactresearch.org/documents/newsletterarticle403.pdf

Supply-side Economics has Supporters in Academia [16]
Monday, September 29, 2003
by Bruce Bartlett

http://www.ncpa.org/edo/bb/2003/bb092903.html

A Supply-Side History And The Road Ahead Part I [17]
By Wayne Jett, August 1, 2003 Part I

http://www.wanniski.com/showarticle.asp?articleid=2803

and Part II:
A Supply-Side History And The Road Ahead Part II [18]

http://www.wanniski.com/showarticle.asp?articleid=2821


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2003/12/2004-a-test-of-supply-side-economics/

URLs in this post:

[1] federal witholding tax: http://www.irs.gov/newsroom/article/0,,id=109816,00.html

[2] Voodoo economics: http://www.amazon.com/exec/obidos/ASIN/0380703114/ref=ase_thebigpictu09-20/103-3937756-4643047

[3] widely credited: http://www.nationalreview.com/nrof_bartlett/bartlett011303.asp

[4] not a Supply Sider: http://www.nationalreview.com/moore/moore022803b.asp

[5] Principles of Macroeconomics: http://www.amazon.com/exec/obidos/ASIN/0030293081/thebigpictu09 20/103-3937756-4643047

[6] Supply Side/Trickle Down: http://www.nationalreview.com/kudlow/kudlow072400.html

[7] The Education of David Stockman: http://www.theatlantic.com/politics/budget/stockman.htm

[8] Q&A Gregory Mankiw: http://www.time.com/time/insidebiz/article/0,9171,1101031013-493318,00.html

[9] Trickle-Down Economics: Four Reasons Why It Just Doesn’t Work: http://www.ufenet.org/research/TrickleDown.html

[10] The Rise of Supply-Side Economics : http://www.ritholtz.com/blogwww.huppi.com/kangaroo/23More.htm

[11] Trickle Down Economics and corporations: How corporate taxes cost jobs: http://www.joeuser.com/articlecomments.asp?AID=89&s=1

[12] Trickle down economics comes of age: http://m1.mny.co.za/MNBTalk.nsf/0/C2256A2A002030FD42256BD60028F633?OpenDocument

[13] Trickle-down Economics and Ronald Reagan : http://www.bigissueground.com/politics/blair trickledownreagan.shtml

[14] The “Trickle Down” Economics Straw Man : http://capmag.com/article.asp?ID=1115

[15] Trickle Down Economics in Full Flow: http://www.impactresearch.org/documents/newsletterarticle403.pdf

[16] Supply-side Economics has Supporters in Academia: http://www.ncpa.org/edo/bb/2003/bb092903.html

[17] A Supply-Side History And The Road Ahead Part I: http://www.wanniski.com/showarticle.asp?articleid=2803

[18] A Supply-Side History And The Road Ahead Part II: http://www.wanniski.com/showarticle.asp?articleid=2821

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