American Enterprise Institute Economists Redux

by Mike Kimel

American Enterprise Institute Economists Redux

The other day I wrote a post about economists at the American Enterprise Institute (AEI), a prominent conservative think-tank. The post began with this paragraph from a story in the NY Times

Politicians sometimes say that lower tax rates lead to higher economic growth, which in turn leads to higher overall tax revenue. This may have been true in the early 1960s, when the top tax rate was 91 percent, but the top tax rate today is 35 percent. For decades, lower tax rates have led to lower government revenues, says Alan Viard, an economist at the American Enterprise Institute, a conservative policy group. “The Reagan tax cuts, on the whole, reduced revenue,” he explains. “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.”

I noted that while Viard is right about tax cuts reducing federal revenue, he is wrong about “There is no dispute among economists about that.” As evidence, I pointed to a piece by his sometime co-author, Kevin Hassett and another by Glenn Hubbard, the first Chair of the Council of Economic Advisors under GW Bush. Both, I might add, are with the AEI (Hubbard as a visiting scholar). It wouldn’t take long to point to other quotes by other AEI economists disputing what Viard said is not disputable (and which, not incidentally, shouldn’t be disputable given the data.) At the AEI’s blog, James Pethokoukis responded to my post. There is no polite way to say this, so I’ll just state it as it is: his post is riddled with errors. Let me cover several of them. Of my post, Pethokoukis says this:

I have read it several times but I am not exactly sure of its Big Point other than to say nasty things about economists who either work at AEI or are affiliated with AEI. What I think author Ken Houghton is trying to say, maybe, is that supply-side economics doesn’t work.

There are three errors here, all of them concentrated in the last sentence:

1. The author of the piece is not Ken Houghton. It is Mike Kimel. As it says, “Posted by Ken Houghton” but “by Mike Kimel.”

2. The piece is not trying to say that supply-side economics doesn’t work. Alan Viard of the AEI is quoted as saying something which translates as follows: at least since Reagan took office, the tax cuts we have seen have led to lower revenues. I don’t know if Viard is willing to go further and endorse the implication of his statement about taxes and revenues, which is this: since the top marginal tax rate was at 70% before Reagan took office, and tax cuts from that 70% level and below have led to reduced revenues, if the Laffer curve is more than just a theoretical construct, unless we have a reason to believe that the last thirty two years of US history are an aberration, it turns out that we will not get an increase from revenue from a tax cut unless the top marginal tax rate is somewhere in excess of 70%. Like I said, that’s an implication of Viard’s statement.

That is not a point of the post, although in the post I did note that it seems Viard had seen data and was being honest about what the data stated. But that is only a point of the post in the sense that stating “the New York Times quoted AEI Economist Alan Viard” is a point of the post, which is to say, it isn’t a point of the post at all.

3. The point of the post is that while one AEI economist is willing to state the obvious about tax cuts, and though he may state that no economist disputes the obvious, his more prominent colleagues at the AEI do dispute what the data so obviously shows. I went further, and noted that Viard had to know that his own institute is a big part of the problem. Pethokoukis’ next sentence:

 “Supply-side economics is simply a school of economic thought that believes a) incentives matter, b) high tax rates are bad for growth, and b) inflation is fundamentally a monetary phenomenon.”

4. I’ll ignore the grammatical error toward the end of the sentence – there are enough substantive issues in the post – and merely point out: “incentives matter” is not something that defines supply-side economics any more than having two arms and two legs is a defining property of people of Swedish extraction.

I have yet to meet an economist of any stripe who doesn’t believe incentives matter, just as I cannot think of any country whose citizens don’t typically come equipped with four limbs. Its just that typically different schools of thought think incentives matter in different ways.

Let’s take Marxism as an example. I’m no Marxist, nor do I personally know any Marxists, but Marx can be summarized as: “those with capital have an incentive to exploit the workers to increase their profits, and the workers have an incentive to throw off their shackles, leading to a revolution. As long as there as a division of people due to ownership, those incentives persist. Peace, happiness, and prosperity can only exist by getting rid of those incentives, but only a revolution followed by a dictatorship of the proletariat can achieve that.” Now, whether Pethokoukis or I agree with this story (for the record, I don’t, and I’m pretty sure Pethokoukis doesn’t either), there is no question that incentives are part of the story. And I think I can show very clearly that supply siders treat certain incentives as egregiously as the Marxists do, but that’s for another post.

 “Back in the 1970s, Keynesian economists really didn’t believe any of that stuff and they dominated the economics profession.”

4a. This is kind of a continuation of the previous error, and it indicates Pethokoukis doesn’t understand the basic point that Keynes was trying to get across. I would assume that it isn’t controversy to say that Keynes General Theory, which is the basis for everything one can call “Keynesianism” can be summarized as follows: “When the economy slows, people buy less stuff, so manufacturers hire fewer people, pushing up unemployment and decreasing wages. This in turn slows the economy even more, leading to even more even pressure on employment and wages. But if the government were to start buying stuff, counteracting the reduction in demand from the private sector, it will decrease the pain companies feel, and thus decrease the layoffs and the downward pressure on wages, preventing the economy from getting worse and ending the recession sooner.”

If someone can tell that story in a way that doesn’t require both companies and workers to have incentives, I’d love to hear it. Alternatively, if someone can define Keynesian philosophy of any stripe in a way that doesn’t involve some variation of the story I just told, I’d love to hear that. FWIW, here’s Paul Krugman’s summary of the General Theory:

Stripped down, the conclusions of The General Theory might be expressed as four bullet points: • Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment • The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates slowly and painfully • Government policies to increase demand, by contrast, can reduce unemployment quickly • Sometimes increasing the money supply won’t be enough to persuade the private sector to spend more, and government spending must step into the breach

Even if you prefer this formulation, its hard to say there aren’t incentives in the General Theory.

5. Most Keynesians do think higher tax rates slow economic growth. In fact, back to Keyenes…. the flip side of having the government step in and spend money when the economy is slow is that, according to Keynes, when the economy is running full speed, the government should cut back on spending raise taxes. One reason for raising taxes is to pay down the debt resulting from the deficit spending when the economy was in recession, but the other is to slow the economy to prevent it from overheating, thus prolonging the expansion. For what its worth, I personally don’t think slowing the economy to prevent overheating fits what data we have, but Pethokoukis wasn’ talking about me, he was talking about Keynesian economists in the 1970s.

 “Today, pretty much everybody believes incentives matter, high taxes rates hurt growth and inflation is a monetary phenomenon. ”

6. As I noted before, you could find that incentives matter in Marx and you could find it in Keynes’ General Theory, the sources of two schools of thought to which most supply-siders will agree they are in opposition, both of which predate supply-side economics. So the fact that pretty much everyone believes it today is a meaningless statement unless you can show that Marx and Keynes were exceptions – they just happened to believe something that the supply-siders would later believe, but virtually nobody else other than Marx and Keynes held that supply-sider belief prior to the supply-siders. Otherwise, we’re once again oohing and aahing over the fact that the overwhelming majority of Swedes have two arms and two legs.

7. I’m not sure what Pethokoukis is saying when he says that everyone agrees that inflation is a monetary phenomenon, or that it is a big deal that everyone believes it now, except that he is slightly misquoting Milton Friedman. That’s all very nice, but the belief that money affects inflation goes back a very long way. Lenin, for instance, talked about debauching the currency. Here’s Keynes, straight from the General Theory:

The view that any increase in the quantity of money is inflationary (unless we mean by inflationary merely that prices are rising) is bound up with the underlying assumption of the classical theory that we are always in a condition where a reduction in the real rewards of the factors of production will lead to a curtailment in their supply.

This doesn’t sound like someone who doesn’t believe that the quantity of money is unrelated to inflation. Its merely someone who believes that the quantity of money alone isn’t the only determinant of whether there is inflation – you aren’t going to have to fear inflation as much if there’s slack in the system. To provide an obvious example of what Keynes was talking about almost eighty years ago: I’m sure Pethokoukis knows how much the money supply has increased in this country since December 2007 and how little inflation we have had in that time.

 “Supply-side economics is just economics, really. We’re all supply-siders now.”

8. Oh, really? Well, as I noted above, Keynes agreed with the three beliefs that Pethokoukis ascribes to supply siders (incentives matter, higher tax rates slow growth, and inflation is a monetary phenomenon). Yes, he had a different view of incentives than Pethokoukis, and he had some caveats on when money doesn’t affect inflation as much, but for the most part, by Pethokoukis’ definition, Keynes was a supply sider, as are most of the folks he influenced. (I note that I personally would not qualify as a supply sider by Pethokoukis’ definition, which is to say, I don’t agree with Keynes on a key piece of that definition but that’s not the subject of this post.)

 “Oh, and the Laffer Curve? Just common sense.”

9. True. But common sense is often wrong. See, the dirty little secret of modern economics as practiced in the US these days is that if you apply the Laffer curve to US data, and by that, I mean, no cherry picking. Use the entire series of US government data going back to 1929, the first year for which official data exists, estimate revenues = f(top marginal tax rate, top marginal tax rate squared) you get a quadratic function as Laffer said. The only problem is – its upside down. Results are not different from what Laffer claimed, they are absolutely and precisely the opposite. Don’t take my word for it. Do it yourself. Anyone who took an intermediate level undergraduate econometrics course and has access to a spreadsheet can do it. “

Economic historian Bruce Bartlett calls the Laffer Curve “a generally accepted analytical device … [that is] a widely discussed subject in respected academic journals.” ”

10. Show me a group of physicists discussing phlogiston and I’ll show you a group of physicists who should be extremely embarrassed. As I said above, anyone who took an intermediate level undergraduate econometrics course and has access to a spreadsheet can fit a Laffer curve. It takes a bit more effort than that to check into whether phlogiston theory has anything to it.

 “In 1980, the top U.S. marginal income tax rate was 70 percent; today it is 35 percent. Yet the share of total income taxes paid by wealthier taxpayers has risen sharply. That is powerful evidence that the United States was on the wrong side of the Laffer Curve back in 1980. ”

11. What do the first two sentences have to do with the last sentence? The Laffer curve is not about the share of taxes paid by the wealthier taxpayers. As Pethokoukis himself wrote a few paragraphs earlier:

There are two tax rates that generate zero tax revenue, 0 percent and 100 percent. And in between, there is some tax rate which generates a maximum, non-zero amount of tax revenue. As tax rates rise from 0 percent toward that level, tax revenues increase both through higher economic growth and greater tax compliance. Once beyond that inflection point, higher tax rates generate less tax revenue.

Now, powerful evidence against the Laffer curve is, in fact, is provided by Pethokoukis’ colleague Alan Viard of the AEI:

For decades, lower tax rates have led to lower government revenues, says Alan Viard, an economist at the American Enterprise Institute, a conservative policy group. “The Reagan tax cuts, on the whole, reduced revenue,” he explains. “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.”

Well, for me this is just a hobby – I don’t get paid for this. I’ve already spent too much time at this and I have to get to work.