Robert Mundell And Supply Side Economics

Robert Mundell And Supply Side Economics

 The death of Nobel Prize winner Robert A. Mundell at age 88 has brought forth much discussion about his work and legacy.  Most of this discussion, such as several columns by Paul Krugman, have commented favorably on the work for which he was officially given the prize, several papers he wrote in the late 1950s and early 1960s while he was at the IMF.  These papers, drawing on the experience of his native Canada at the time as a nation with a floating exchange rate and open to capital flows with the neighboring and domineering US at a time when most major economies had fixed exchange rates, laid the foundation for the now textbook Mundell-Fleming model of international open macroeconomics, A crucial insight now universally accepted was of the “impossible trinity” that a nation cannot simultaneously have a fixed exchange rate, and independent monetary policy, and open capital flows. This certainly drew on Canada’s experience and explained why it went against the rest of the world to have floating exchange rates.

He also wrote presciently on optimal currency areas, also thinking about the curious dispersion of Canada’a population across contrasting geographical zones while mostly being very close to the US border. He emphsized the importance of free factor flows within an optimal currency area. His writings on this led him to be called “the father of the euro” and curiously he advocated a global currency based on a combination of the US dollar, euro, and Japanese yen.  He also called for the Chinese yuan/rmb to be included in the IMF SDR, which came to pass.  Various people have noted that he may have been overoptimistic about the euro simply based on his own analysis of what is involved in such areas.

However, the item in his history that most have said not much about, although he was reportedly proud of it up to the end, is his role as “guru” of supply side economics. This is a doctrine that is not viewed nearly as favorably by most economists as these other ideas, especially the Mundell-Fleming model.  Indeed, parts of it are viewed as ridiculous by most, notably the repeated forecasts by Arthur Laffer and some others every time we have seen a GOP president or governor cut taxes that this would lead to an increase in revenues so that “the tax cut will pay for itself.” From the 1981 tax cut of Ronald Reagan through the 2017 Trump tax cut, none of these delivered this outcome, with several states such as Kansas and Oklahoma suffering severe crises given their balanced budget rules requiring them to cut spending in the face of declining revenues after tax cuts. And Laffer has long claimed that Mundell was his inspiration.

Now as near as I can tell Mundell never participated in any of these specific forecasts that did not pan out.  What he seems to have done is lay out the “possibility” that if tax rates are high enough cutting them will raise revenues.  And it seems that he was the one who first posed this idea to Laffer when they were together at the University of Chicago in the early 1970s.  This would make him the father of the Laffer Curve, and indeed when the curve first made a public appearance in a Spring 1975 The Public Interest by Jude Wanniski labeled the argument the “Mundell-Laffer hypothesis.”

Former adviser of Jack Kemp and Ronald Reagan, now a non-Republican, Bruce Bartlett, has posted an account of Mundell’s ideas on this and how they developed since Mundell died, . 

Bartlett, who recognizes that some of Mundell’s optimism and enthusiasm about the ability of tax cuts to stimulate expansion of aggregate supply has not been supported by more recent events, does think that his arguments held for the initial 1981 Reaganomics, which Bartlett was part of supporting and implementing after working for Rep. Jack Kemp, who was also a fan of supply side economics, which had been heavily publicized by Jude Wanniski in columns in the Wall Street Journal after meeting Mundell at an anti-inflation conference in Washington in May, 1974 that had been organized by Laffer and former Milton Friedman acolyte, David Meiselman.  Mundell’s main recommendation was to combine tight monetary policy to combat inflation with tax cuts to offset the contractionary effects of that by stimulating aggregate supply, apparently ignoring the demand-side effects of such tax cuts.  This would be what Reagan would do early in his term, although on the monetary policy side he was inheriting the tight monetary policy started under Carter by Paul Volcker.  But Bartlett praises all that and is proud of his involvement with it and credits Mundell as the man ultimately behind it.  Apparently Mundell first proposed this policy combination in “The Dollar and the Policy Mix: 1971” Princeton University International Finance Discussion Paper #85, May 1971, which never appeared in a journal.

Which brings us to the matter of Mundell and the Laffer Curve. Apparently he got the idea from reading a paper that he got published in the Journal of Political Economcy in 1971 just before he stopped editing that journal, “Ibn Khaldun: A Fourteenth Century Economist,” Jean David C. Boulakia, JPE, 1971, 79, 1105-1118. Ibn Khaldun was a historian, geographer, and economist in whose main work, al Muqaddimah, appeared the following line that appeared in this English translation from the Arabic in the JPE paper:

“It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty taxation yields a small revenue from large assessments.”

According to Bartlett Mundell made Laffer aware of this argument and then also Wanniski.  Supposedly Reagan read an article in the WSJ in 1978 that Wanniski had put in that quoted this item from Ibn Khaldun, and again according to Bartlett Reagan would quote Ibn Khaldun 10 times during his presidency.  Again, while Laffer went out on a limb, and had done so repeatedly since despite repeated failures of them to come to pass, to forecast that tax cut after tax cut would increase revenues, I am unaware of Mundell having made the mistake to do so as well.

I would note that we have seen some limited examples of tax cuts leading to revenue increases.  Most discussion of the Laffer Curve has implicitly involved average tax rates, and recent studies have suggested that among the major high income nations the average tax rate that would maximize tax revenues might be around 70 percent, we have seen marginal tax rates higher than that.  There has been evidence that revenues raised from top income individuals may have risen when those rates were lowered.

I also note the peculiar case of Russia in the 1990s and the beginning of of the 2000s.  The standard Laffer Curve argument has been that one gets zero revenues at 0 percent and 100 percent.  But in certain locations in Russia in the 90s there were effective marginal tax rates when one added local to higher level taxes exceeding 100 percent. But in fact there were positive revenues collected.  In the real world things are more complicated, and people end up paying bribes not to pay their full taxes, not to mention some people actually paying 100 percent or more on certain parts of their income while making that up in other ways.  As it was this was a period when much of the Russian economy went into a barter mode, especially after the 1997 financial crisis.  It was a supply side success, and one of the few wise things that Vladimir Putin has done, that not long after he came to power in 2000 he simplified the tax code and imposed a flat rate of 20 percent.  Indeed this led to an increase in tax revenues. 

Barkley Rosser