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Why Supply Side Economics Won’t Solve the Current Economic Malaise

Posted By Guest Author On September 16, 2011 @ 8:30 pm In Economy,Taxes and Policy | Comments Disabled

Prior to law school, Hale Stewart was a bond broker with Vining Sparks, where his clients were comprised of mutual funds, insurance companies and money managers. He returned to law school in 2001, graduating from the South Texas School of Law in 2003. After law school, he opened his law practice focusing on transactional work. He continued his education at the Thomas Jefferson School of Law in 2007 where he obtained an LLM in domestic and international taxation, graduating Magna Cum Laude. He has three certifications from the American Academy of Financial Management: Chartered Trust and Estate Planner, Chartered Wealth Manager and Chartered Asset Manager. Mr. Stewart is also a member of the AAFM’s Board of Standards. He is the author of the book U.S. Captive Insurance Law and is currently working on his Ph.D..

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There is currently a debate regarding the appropriate policy response to the current economic situation.  The arguments can be broken down along two lines — supply side and Keynesian.  While supply side economics may be appropriate in some situations, they are completely inappropriate for the current problems we face.

In general, supply side economics can be described thusly: [1]

Supply-side economics is a school of macroeconomic [2] thought that argues that economic growth can be most effectively created by lowering barriers for people to produce (supply) goods and services, such as lowering income tax [3] and capital gains tax [4] rates, and by allowing greater flexibility by reducing regulation. According to supply-side economics, consumers will then benefit from a greater supply of goods and services at lower prices. Typical policy recommendations of supply-side economics are lower marginal tax rates [5] and less regulation

In thinking about the preceding, consider this simple chart of supply and demand: [6]

[7]

What supply side policies are attempting to do is increase the supply of goods and services.  The underlying idea is that an increase in supply will satisfy more consumers wants thereby lowering prices for the economy as a whole and increasing overall growth.

Let’s consider some of the general policies advocated.

Perhaps the most important policy advocated by supply side advocates is a reduction in overall taxes.  Now, let’s think about what this would do by looking at the standard corporate income statement: [8]

[9]

Notice the general orientation of the deductions (which apply both to individuals and companies).  First, the income statement lists a host of expenses to arrive at “net income before taxes” after which taxes are deducted.  So, the central idea of a cut in marginal tax rates is this will lead to an increase in income for the business and individual.  As to what is done with this increased income, little to no incentive is given.  Perhaps it will be spent in the economy, reinvested in the business or distributed to investors.  However, the central idea behind a reduction in tax rates is to increase the bottom line income thereby spurring the creation of business start-ups or increasing investment in ongoing businesses.  It’s exceedingly important to remember that national income is the flip side to GDP — and is considered by some economists to be a better measure of national growth.

However, as the following data indicates, the above results are not needed in the current economy.

First, corporations have more than enough money on their respective balance sheets right now, as evidenced by the following chart:

[10]

Above is a chart from the St. Louis Reserve’s FRED data system of total checkable deposits and currency assets on the balance sheet of non-farm, non-financial corporate business.  As the chart demonstrates, corporations have move than enough cash — in fact, they have the highest amount of cash in the last 50 years.

Also consider that people are in fact saving again:

[11]

The above chart shows the savings rate has increased over the last 5 years.  As such, individuals need to start spending the money to get some velocity going (more on that below).

Secondly, tax rates are near their lowest in 50 years:

[12]

As explained by Reuters: [13]

  • Federal taxes are the lowest in 60 years, which gives you a pretty good idea of why America’s long-term debt ratios are a big problem. If the taxes reverted to somewhere near their historical mean, the problem would be solved at a stroke.
  • Income taxes, in particular, both personal and corporate [14], are low and falling. That trend is not sustainable.
  • Employment taxes, by contrast—the regressive bit of the fiscal structure—are bearing a large and increasing share of the brunt. Any time that somebody starts complaining about how the poor don’t pay income tax, point them to this chart. Income taxes are just one part of the pie, and everybody with a job pays employment taxes.
  • There aren’t any wealth taxes, but the closest thing we’ve got—estate and gift taxes—have shrunk to zero, after contributing a non-negligible amount to the public fisc in earlier decades.

Put another way — the country is not over-taxed.

Third, remember that the central idea of supply side tax cuts is to increase income.  It does nothing to increase spending.  As a result, there would be no increase in monetary velocity as a result of the policy — meaning nothing would happen to the pace of transactions in the economy.  As the charts below indicate, this is a central problem with the current economic malaise — things simply aren’t moving in the economy:

[15]
[16]
[17]

As the three charts above indicate, the pace of transactions in the economy is very slow and dropping.  The reason is people and businesses are hoarding cash — meaning that once they make a profit, they are banking that profit and not spending it.  While there is nothing inherently wrong with savings, the economy also needs transactions which the above data indicates are occurring at a snails pace.  In short, we need policies that encourage people to spend their money — not hoard it.  And cutting taxes is not the answer to that problem.

And finally, consider this fact: taxes are already incredibly low and companies have ample cash.  Yet they are not creating jobs in any meaningful way.  As such, it’s difficult to conclude that the current rate of low taxation needs to be lowered in any way to create jobs.

As for the regulation argument, consider this: [18]

McClatchy reached out to owners of small businesses, many of them mom-and-pop operations, to find out whether they indeed were being choked by regulation, whether uncertainty over taxes affected their hiring plans and whether the health care overhaul was helping or hurting their business.

Their response was surprising.

None of the business owners complained about regulation in their particular industries, and most seemed to welcome it. Some pointed to the lack of regulation in mortgage lending as a principal cause of the financial crisis that brought about the Great Recession of 2007-09 and its grim aftermath.

Also consider this post from Mark Thoma [19].  Additionally, consider that lack of regulation — in other words massive deregulation — was a primary cause of the recent financial crisis.  Finally, the incredibly low monetary velocity numbers indicate there is a dearth of transactions in the economy — meaning people and businesses are not spending money.  In short, the excessive regulation argument fails to provide an adequate answer for our current problems.

As the above data indicate, supply side policies are not needed in the current environment.  Businesses have ample cash on their balance sheets and yet are still not hiring people.  Neither businesses nor individuals are overtaxed; in fact, taxes as a percent of GDP are near their lowest in over 60 years.  And finally, there is no evidence that regulation is in fact the job killer many tout it to be.

There may be a time when supply side economics will be an appropriate policy response.  But now is not such a time.


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

URL to article: http://www.ritholtz.com/blog/2011/09/why-supply-side-economics-wont-solve-the-current-economic-malaise/

URLs in this post:

[1] described thusly:: http://en.wikipedia.org/wiki/Supply-side_economics

[2] macroeconomic: http://en.wikipedia.org/wiki/Macroeconomic

[3] income tax: http://en.wikipedia.org/wiki/Income_tax

[4] capital gains tax: http://en.wikipedia.org/wiki/Capital_gains_tax

[5] marginal tax rates: http://en.wikipedia.org/wiki/Marginal_tax_rate

[6] simple chart of supply and demand:: http://www.netmba.com/econ/micro/supply-demand/

[7] Image: http://1.bp.blogspot.com/-nKsyLQ9SEKI/Tm4vMff6j5I/AAAAAAAANKE/jfSaJgaguBA/s1600/supplydemand.gif

[8] standard corporate income statement:: http://www.vertex42.com/ExcelTemplates/income-statement.html

[9] Image: http://3.bp.blogspot.com/-m2Wg3RGLc-M/Tm4xGt1D2fI/AAAAAAAANKI/xWH5bm9XcHg/s1600/income-statement_screenshot.gif

[10] Image: http://4.bp.blogspot.com/-D-WoWctM-1U/TnCQOpts38I/AAAAAAAANKw/lA-m_QDP_lo/s1600/CDCABSNNCB_Max_630_378.png

[11] Image: http://2.bp.blogspot.com/-fTlaP5AY46k/TnCWyuVI0xI/AAAAAAAANLE/1UcefwJvH4s/s1600/PSAVERT_Max_630_378.png

[12] Image: http://2.bp.blogspot.com/-x4AAsumJCzM/TnCRTFJjEfI/AAAAAAAANK0/5tGRQcbTML4/s1600/US_TAXGDP1210.gif

[13] As explained by Reuters:: http://blogs.reuters.com/felix-salmon/2010/12/06/chart-of-the-day-u-s-taxes/

[14] corporate: http://blogs.reuters.com/felix-salmon/2010/12/03/chart-of-the-day-u-s-corporate-tax-revenues/

[15] Image: http://1.bp.blogspot.com/-WeXIpvhc8zo/TnCSNttRX2I/AAAAAAAANK4/R6h5PUlpCnI/s1600/M1V_Max_630_378.png

[16] Image: http://4.bp.blogspot.com/-WLPh2kVMB54/TnCSN238PbI/AAAAAAAANK8/PLzzrEkGnI4/s1600/M2V_Max_630_378.png

[17] Image: http://3.bp.blogspot.com/-PVk-Qn0bCN8/TnCSOEHH7BI/AAAAAAAANLA/1rRzfTmH-Xc/s1600/MZMV_Max_630_378.png

[18] consider this:: http://www.blogger.com/McClatchy%20reached%20out%20to%20owners%20of%20small%20businesses,%20many%20of%20them%20mom-and-pop%20operations,%20to%20find%20out%20whether%20they%20indeed%20were%20being%20choked%20by%20regulation,%20whether%20uncertainty%20over%20taxes%20affected%20their%20hiring%20plans%20and%20whether%20the%20health%20care%20overhaul%20was%20helping%20or%20hurting%20their%20business.%20%20Their%20response%20was%20surprising.%20%20None%20of%20the%20business%20owners%20complained%20about%20regulation%20in%20their%20particular%20industries,%20and%20most%20seemed%20to%20welcome%20it.%20Some%20pointed%20to%20the%20lack%20of%20regulation%20in%20mortgage%20lending%20as%20a%20principal%20cause%20of%20the%20financial%20crisis%20that%20brought%20about%20the%20Great%20Recession%20of%202007-09%20and%20its%20grim%20aftermath.%20%20Read%20more:%20http://www.mcclatchydc.com/2011/09/01/122865/regulations-taxes-arent-killing.html#ixzz1XvWDd2Ox

[19] from Mark Thoma: http://economistsview.typepad.com/economistsview/2011/09/its-not-regulatory-and-tax-uncertainty.html

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