Supply-side Economics and Recent Real GDP Growth

The latest White House claims about the budget has made Kash one Angry Bear for good reason. Rather than looking at the recent modest increase in tax revenues (from a rather depressed level), let’s focus on real GDP (figures in 2000$ on an annualized basis) in 2005Q1 ($11096.2 billion) versus where it was in 2000Q4 ($9695.2 billion), that is, 17 quarters ago.

The White House and its free lunch supply-side supporters want us to believe 3 things: (1) that we have returned to full employment after falling below full employment just as Bush took office; (2) that potential GDP growth has increased since Bush took office; and (3) changes in the growth rate of potential GDP are primarily from changes in tax cuts ala the “work, save, and invest” mechanism.

The following chart suggests alternative values for potential real GDP based on different assumptions as to the growth rate as well as the (debatable) premise that we were at full employment in 2000Q4. While I suspect some economists might argue we were still above full employment then, President-elect George Bush was arguing in late 2000 that we were in a recession. Actually, a fairer read of the GOP claims as the new Administration entered office – as it argued to the 2001 tax cut (memo to the supply-siders: you supported this 2001 tax cut even as you try to deny its existence now) – might go something like this. We had gone beyond full employment in early 2000 but the weak aggregate demand growth during the latter half of the year brought us back to full employment – and unless aggregate demand growth was quickly restored to its average 3.5% per year, we would fall below full employment.

Suppose some non-supply-sider argued that the tax cut had no effect on potential GDP growth with the implication that sustainable growth would be 0.85% per quarter. In this case, potential GDP would be around $11,196 billion implying a GDP gap near 1%. With a modest supply-side benefit existed increasing the growth rate to 0.9%, the implication would be that potential GDP today would be $11,291 billion implying a GDP gap of 1.7%. In other words, it is hard to make both the first and the second claim above coming from the supporters of Bush’s economic policies.

To be fair, David Altig argued that we have experienced some negative real business cycle shocks. Other economists have argued that the declines in the employment-population rate and the average workweek as well as the decline in the investment/GDP ratio may be due to certain negative real business cycle shocks. In fact, Kash has often noted that the rising cost of providing health care insurance is a negative supply-side shock. So is it possible that potential real GDP has been growing at only 0.8% per quarter? Perhaps – but such an admission undermines the third leg of the argument from the supporters of Bush’s economic policies.