Supply-Side Economics in Reverse: Why America Needs a Conservative Macroeconomic Policy

June 24, 2022

During this period of considerable uncertainty that is being felt everywhere in the United States, Americans are eagerly demanding solutions to our economic problems. High rates of inflation, rising gas prices, increasing interest rates, and legitimate fears that a recession is quickly approaching, have all undermined confidence in the Biden administration’s ability to tackle these problems. More broadly, voters are becoming increasingly doubtful as to the competence of Democratic leaders in the realm of macroeconomic policy. To begin to reverse this situation, America needs to embrace a conservative macroeconomic policy agenda, and the sooner it does, the better will be the prospects for its long-term economic health.

As complex as the U.S. economy is, its path during the past half century is comprehensible to a person who is willing to devote the time and effort to understanding it. In this brief article, I will emphasize a few key macroeconomic occurrences that shed light on the reason America should embrace a conservative macroeconomic policy agenda, concentrating especially on tax policy and monetary policy.

As our ability to produce goods and services fundamentally depends on our available resources and technological capabilities, logically these elements should play a role in any government economic policy that is designed to promote economic vitality and economic growth. Perhaps surprisingly, this issue has been a significant source of debate within the field of macroeconomics. Conservative economists have tended to emphasize society’s resource stocks, including land, labor services, physical capital, and human capital when advising policymakers regarding the best way they might address output fluctuations, low rates of economic growth, high unemployment rates, and/or rising or falling price levels, among other concerns. Liberal economists, on the other hand, have tended to concentrate on how the government might influence components of aggregate spending in the economy to reduce macroeconomic instability, unemployment, declining production, and price instability.

The Rise of Reaganomics and the Resistance to Liberal Economic Policies

Liberal economic policies became dominant during the Great Depression and World War II and persisted in popularity among policymakers through the 1960s. Economic policy missteps during the period leading up to the Great Depression, including excessive lending by the central bank, led to overinvestment in key sectors of the economy. When such miscalculations became apparent, asset values crashed, and the economy suffered a depression with soaring unemployment and plummeting production. Such dreadful macroeconomic conditions created the conditions for the rise of statist or liberal macroeconomic policies that were intended to steer the economy–as if a small group of elected officials could successfully direct something so complex.

Due to a variety of advantageous conditions during and after World War II, the largely free market American economy enjoyed such strong resource growth and technological improvement that rising levels of government expenditure and money supply growth did not produce high rates of inflation. By the 1970s, however, this situation had changed. Rising oil prices and excessive growth of the money supply produced high inflation rates even as the economy experienced recessions. This combination of high inflation rates and declining production was dubbed “stagflation.” When a resource as fundamental as oil became less available due to changing conditions in the global oil market, the disadvantages became all too clear of a liberal economic ideology that neglected supply side factors in its explanations of economic phenomena.

As supplies became tighter and government spending and money supply growth accelerated, prices continued to rise, and inflation rates remained high during the decade. A lack of attention to supply-side factors in the dominant liberal economic theory prevented policymakers from recognizing that the high capital gains taxes that persisted throughout the decade were contributing to the nation’s economic problems. High capital gains taxes reduce after-tax rates of return on new investment. Furthermore, high inflation rates reduce real rates of return on investment because real returns decline as prices rise, other factors the same. As Vigilante (2022) explains, the “combination of high capital-gains taxes and inflation had devastated real rates of return on investment for a decade.” Declining real returns on investment discouraged investment in new capital, which is an essential input for promoting economic growth.

Recognizing the flaws in the liberal economic ideology, Congress acted. “In 1978 a bipartisan group in Congress turned President Carter’s proposed increase in capital-gains tax rates into nearly a 50% reduction, down to 28%. Reagan won a further cut in 1981, down to 20%” (Vigilante 2022). The reduction in the capital gains tax contributed to an increase in real rates of return on new investment. Supply-side economists understood that tax policy should be used to create incentives for self-interested economic actors to voluntarily contribute to capital creation. President Reagan and his economic advisers knew that working with the American people rather than against them would place the country on the path to prosperity. The time had thus come to give renewed emphasis to supply side factors in the debate over macroeconomic policy.

There is a sharp contrast between the supply-side economics of the Reagan administration and the liberal economic theory of the earlier Democratic administrations. As Vigilante (2022) points out, “the impact of the Reagan reforms played out for decades because their effect wasn’t a temporary boost in “aggregate demand”—the widely despised “sugar high”—but an accumulating shift of capital to people who repeatedly demonstrated they could use it productively.” This policy insight helped usher in a new period of low inflation, low unemployment, and rapid economic growth.

The Reagan administration’s focus on tax incentives and the creation of capital encouraged the American people to invest in the productive side of the economy rather than lock up their wealth in unproductive real assets. As Vigilante (2022) explains, before the Reagan years, “[o]ver a decade, Americans cumulatively dumped dollars to acquire some $7 trillion in mostly unproductive stuff, always oddly described as ‘real assets’” (Vigilante 2022). In other words, Americans bought up unproductive assets to protect themselves from inflation. Although these asset values rose at the rate of inflation or even faster, serving to protect the real wealth of their owners, the assets could not be used to expand the nation’s production of goods and services. During the Reagan years, the increase in real rates of return on new investment led to a massive reallocation of financial assets from unproductive to productive uses.

Tax policy, of course, is only one part of macroeconomic policy. To the extent that the Reagan administration’s tax cuts incentivized capital creation, it increased the nation’s capacity for production. Over the long-term, the increase in production puts downward pressure on prices. However, in a period of rising inflation rates, more must be done to bring down the rate of inflation quickly. Recognizing this necessity, the Federal Reserve adopted a conservative approach to monetary policy referred to as monetarism.

Monetarists emphasize that changes in the money supply are the primary determinant of the price level. Furthermore, money supply growth is the primary determinant of the rate of inflation. Milton Friedman, the most famous proponent of the monetarist perspective, consequently favored money supply targets to address inflation during this period. As Ip (2022) explains, in “the 1970s and 1980s, Mr. Friedman helped inspire the Fed and other central banks to adopt money-supply targets to tame double-digit inflation.” The ultimate objective was to lower the rate of inflation and stabilize the general level of prices.

In the years since the monetary contraction of the 1980s, the monetarist perspective has fallen out of favor. As Ip (2022) explains, monetarist theory encountered problems related to the most appropriate money supply measure to use when predicting inflation and the background assumption pertaining to the average number of times a unit of currency is spent during a year. These complications made it difficult to predict inflation using changes in the growth rate of the money supply. Therefore, “[w]orking economists have since largely ignored the money supply” (Ip 2022). Although it was an imperfect tool, the monetary contraction of the 1980s brought the inflation rate down and raised the real return on new investment, thereby incentivizing the expansion of the nation’s stock of capital–a primary driver of economic growth. ???

President Trump as an Adherent of Supply-Side Economics

In the years since the monetary contraction of the 1980s and the Reagan tax cuts, Democratic administrations and the Fed have enjoyed success to the extent that they have adopted this strategy of incentivizing productive effort in an environment of stable prices. To the extent that they have departed from this path, it has cost them politically and the American people dearly.

In a sense, we are now observing the reverse chronology of the Carter and Reagan years in terms of macroeconomic policy. Whereas the Reagan administration adopted supply-side economic policies in an inflationary environment that was penalizing productive activity, the Biden administration has adopted liberal economic policies in an environment, inherited from President Trump, that aimed to maximize the incentives to be productive while keeping inflation in check.

Indeed, President Trump’s economic policies were generating economic outcomes reminiscent of the Reagan era. The Tax Cuts and Jobs Act (TCJA) of 2017 reduced the federal corporate tax rate from 35% to 21%. As Goodspeed and Hassett (2022) explain, they predicted that the corporate tax cut combined with the introduction of “full expensing of new-equipment investment would boost productivity-enhancing business investment.” These changes to the tax code did cause a sharp increase in business investment such that “[b]y the end of 2019 [the growth in business investment] was 9.4% above its pre-2017 trend” (Goodspeed and Hassett 2022). Goodspeed and Hassett (2022) also note that corporate businesses, especially, increased their levels of real investment “by as much as 14.2% over the pre-2017 trend,” and S&P 500 companies increased their “total capital expenditures in the two years after tax reform [to levels that] were 20% higher than in the two years prior.” As during the Reagan administration, business tax cuts increased the after-tax real return on investment, creating a powerful incentive for the creation of new capital.

The Trump tax reform measures also had an impact in the international sphere. As Goodspeed and Hassett (2022) explain, “the 2017 tax law effectively created an incentive for multinational enterprises to move their profits home.” And move profits home, they did. For the entire year 2018, the first full year during which the tax law was in effect, multinational enterprises repatriated more than half a trillion dollars of foreign profits (Saros 2021). See Saros (2021) where I have explored these consequences of the 2017 tax law in detail. Furthermore, just as American corporations have repatriated foreign profits, many have chosen not to invest domestic profits abroad. According to Goodspeed and Hassett (2022), for example, “firms were repatriating only 36% of prior-year foreign earnings, and reinvesting 70% abroad, in the years leading up to 2017. Since 2019 they have on average repatriated 57%, and reinvested only 47% abroad.” The repatriation of foreign profits means more production in the United States and more employment. President Trump’s achievement in this realm stems from his adherence to the view that empowering people to produce more and allowing them to keep more of what they earn generates the best economic results.

A welcome benefit of the reduction in the corporate tax rate is a noticeable increase in corporate tax revenues. Supply-side economists in the 1980s argued that tax rate cuts could increase total tax revenues because the tax cuts would incentivize more production and more work, thereby generating more tax dollars. In addition to the impact that the 2017 tax law has had domestically, the Trump administration was able to generate a rise in corporate tax revenues by altering the after-tax real return on investment in the U.S. relative to the rest of the world. Indeed, “[c]ommentators have recently noticed that in the 2021 fiscal year, not only did federal corporate tax revenues come in at a record high, but corporate tax revenue as a share of the U.S. economy rose to its highest level since 2015” (Goodspeed and Hassett 2022). This supply-side economic policy has thus had a positive impact on capital investment, economic growth, and employment, but also on the federal budget.

President Biden as a Supporter of the Liberal Economic Ideology

The Biden administration is sending America back to the days of punishing capital with high rates of taxation and inflationary increases in government spending. In terms of taxation overall, the Tax Foundation reports that with the “’BBBA [the Build Back Better Act] and the FY 2023 Budget, the Administration proposes roughly $3.5 trillion of new revenues on a net basis after tax credits’” (Freedman 2022). If enacted, the tax plan would reverse much of the positive impact that the 2017 tax cut had on domestic investment. The Tax Foundation has summarized the projected supply-side impact of the Biden administration’s tax increases:

The tax increases in BBBA alone would reduce long-run GDP by 0.5 percent, and the tax increases in the budget, including a higher corporate tax rate of 28 percent (up from the current 21 percent) and international tax changes, would further discourage domestic investment and reduce the productive capacity of the United States. For example, raising the corporate tax rate to 28 percent would reduce long-run GDP by 0.7 percent and eliminate 138,000 jobs. (Freeman 2022)

Such changes to the tax code would revive the practice of punishing American corporations at home and incentivizing them to export capital and profits, thereby conferring benefits on foreign nations at the expense of the United States. According to the Tax Foundation, “when combined with state taxes, the combined U.S. rate would be nearly 10 percentage points above the average found in other industrialized economies” (Freeman 2022). Such penalties on capital ownership would have a direct negative impact on the U.S. economy.

At this stage, Republicans in Congress will likely prevent the passage of the BBBA. According to GovTrack (2022), the proposed BBBA bill that passed the U.S. House of Representatives on November 19, 2021, only has a 4% chance of being enacted. Nevertheless, voters should not become complacent as political power may shift in unexpected ways.

Furthermore, even if federal legislation does not restore the extreme penalization of capital investment, high inflation rates will impose their own penalty on capital ownership by reducing the real rate of return on investment as it did prior to the tightening of monetary policy in the 1980s. According to Henderson and Mulligan (2022), “[h]igh inflation . . . is increasing taxation of capital without any action by Congress. [Additionally,] Mr. Biden is almost certain to let temporary capital-taxation provisions in the 2017 tax cut law expire. The effect will be to reduce growth of real GDP by about 0.4 percentage point a year.”

As supply-side economists understand well, incentives to invest promote capital creation, and the creation of new capital boosts worker productivity by enabling workers to produce more with the same labor input. The growth of worker productivity thus makes possible higher rates of economic growth.

One might say that President Biden is pursuing a supply-side economic policy but one that is the exact opposite of what supply-side economists recommend. As Henderson and Mulligan (2022) note, there are “factors on the supply side of the economy that may tip the U.S. economy into a recession. Among them are the tax and regulatory policies of the Biden administration.” With supply-side economic policies implemented in reverse, one would anticipate the macroeconomic consequences to be the reverse. That is, imposing penalties on capital will discourage capital formation, thereby slowing productivity growth and overall economic growth.

Henderson and Mulligan (2022) describe the benefits of productivity growth under normal conditions and how the Biden taxation scheme will likely erase those benefits.

In normal years, workers’ productivity rises by about 1%. That alone is a strong economic tailwind causing GDP growth, making recession by the reduced GDP definition less likely than otherwise. Unfortunately, Mr. Biden’s economic policies will likely cause productivity growth to fall. (Henderson and Mulligan 2022)

Henderson and Mulligan (2022) recognize how the Biden administration is turning supply-side economic policy on its head and with disastrous consequences. Henderson and Mulligan (2022) state that “increased regulation and increased taxation of capital—two Biden administration policy priorities—are supply-side headwinds that make recession more likely” (Henderson and Mulligan 2022). The Biden administration’s effort to upend a well-established macroeconomic policy approach should be expected to cancel its demonstrated benefits if it becomes a reality.

Another Element of the Biden Tax Plan: Pour gasoline on a fire

In addition to raising the corporate income tax rate to punishing levels, since early 2022, the Biden administration has been subjecting many American corporations to another layer of taxation. As Nix (2022) explains, “the Treasury [has] limited the ability of companies to claim Section 901 foreign tax credits for income taxes paid in foreign countries. Some businesses will have to pay domestic corporate income taxes on top of the foreign taxes they already pay” (Nix 2022). As “a dollar-for-dollar credit available to corporations and individuals who pay income taxes in a foreign country[,]” Section 901 allowed American companies to avoid this scenario in which they are taxed once by a foreign government and again by the U.S. Government. Nix (2022) describes it as “double taxation” for this reason.

Interestingly, this policy of double taxation may have conflicting results in terms of whether American corporations choose to operate in the U.S. or abroad. As Nix (2022) puts it, “[t]axing income twice will disrupt business operations and discourage foreign investments and acquisitions. [On the other hand, s]ome businesses operating in foreign countries might move their headquarters out of the U.S. to avoid the tax.” By contrast, President Trump’s 2017 tax reform unambiguously encouraged the repatriation of capital to the United States where it will promote the employment of American workers, thus putting America first.

This Biden tax reform measure also reverses the traditional chain of events that supply-side economists encourage economic policymakers to initiate using changes in tax laws. As Nix (2022) recognizes, “[d]ouble taxation . . . leads to less investment, fewer jobs, lower wages and off-shoring.” To the extent that some American corporations transfer operations entirely to foreign countries, the imposition of double taxation reduces real returns and discourages productive investment in the United States with predictable consequences for employment. To the extent that some American corporations, not yet operating abroad, might decide against shifting some operations to foreign nations, the policy achieves this result by threatening to penalize the companies for letting efficiency considerations drive their decisions about where to locate operations. Such threats disrupt investment decisions and are particularly disruptive when corporations are in the process of transferring operations.

In a letter signed by Chief Financial Officers (CFOs) of twenty-eight major American corporations and sent to Treasury Secretary Janet Yellen, the corporations have registered their objections to this departure from traditional tax policy. As Williams-Alvarez (2022) explains, “In a letter dated June 3, CFOs from companies including Coca-Cola Co., General Electric Co., Walt Disney Co. and Verizon Communications Inc. said the new regulations, which restrict when U.S. companies can claim tax credits for payments made to foreign countries, have created a competitive disadvantage and will result in double taxation.” As fears of an impending recession continue to spread, the Biden administration’s policy of double taxation pours gasoline on a fire that is already threatening to engulf domestic business investment as inflation erodes real returns on new investment.

What about monetary policy?

Given the difficulties surrounding money supply measurement and other theoretical challenges to the monetarist perspective, predicting inflation rates based on changes in the growth rate of the money supply has proven difficult. Nevertheless, the options before monetary policymakers do not include tweaking the money supply growth rate to make what would constitute, based on recent historical experience, minor changes to the rate of inflation.

As Ip (2022) explains, Jason Furman, a Harvard University economist, has proposed using changes in nominal income for inflation forecasts. However, Furman argues that “using the gap between nominal demand and the economy’s supply-side capacity to forecast inflation only works at times like last year when the gap is so large. [He adds that the] same might be true of big increases in the money supply” (Ip 2022). Since minor tweaks in the inflation rate are not what is needed, the country needs a major tightening to tame inflation. Admittedly, a significant tightening of the money supply is a blunt policy instrument, but market economies are not controlled entities where policies can be applied with absolute precision. Furthermore, this process may already be underway. As Ip (2022) has noted, “money-supply growth this year has plunged. If the monetarists are right, perhaps that means inflation will, too.” Until that inflation reduction materializes, however, a monetary contraction, which is essential to price stabilization and an elevation of the real return on capital, may be our best chance of achieving these important macroeconomic objectives.

Sources

Freeman, James. “Biden Tax Hike: $3.5 Trillion.” The Wall Street Journal. June 7, 2022. Web.

Goodspeed, Tyler, and Kevin Hassett. “The 2017 Tax Reform Delivered as Promised.” The Wall Street Journal. May 8, 2022. Web.

Henderson, David R., and Casey B. Mulligan. “Biden is Practically Engineering a Recession.” The Wall Street Journal. June 22, 2022. Web.

“H.R. 5376 — 117th Congress: Build Back Better Act.” www.GovTrack.us. 2021. June 24, 2022. https://www.govtrack.us/congress/bills/117/hr5376

Ip, Greg. “Inflation Surge Earns Monetarism Another Look.” The Wall Street Journal. June 22, 2022. Web.

Nix, Travis. “Treasury Threatens to Double-Tax Some Businesses.” The Wall Street Journal. June 22, 2022. Web.

Saros, Daniel. “We Need Members of Congress Who Have Supported Pres. Trump’s Efforts to Promote Production and Job Growth in the United States.” Linkedin. January 2, 2021. Web.

Vigilante, Richard. “We Need to Remember What Reagan Knew About Economics.” The Wall Street Journal. June 16, 2022. Web.

Williams-Alvarez, Jennifer. “CFOs Express ‘Serious Concerns’ About Changes to Foreign Tax Credits In Letter to Yellen.” The Wall Street Journal. June 6, 2022. Web.

Photo: mccauleys-corner. “Trump.Reagan.” Uploaded on January 21, 2017. Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). flickr.com.

Link to Photo: Trump.Reagan | mccauleys-corner | Flickr

License for Photo: Creative Commons — Attribution-ShareAlike 4.0 International — CC BY-SA 4.0