“Supply Side Lite” and the Psychology of the New Normal

Over at Underbelly, Buce, in commenting on Bruce Bartlett’s new book, makes a point about what he calls “supply side lite” that I’m inclined to agree with:

First, supply side lite. How much extra income will we garner if we tax all incomes over $200,000 at 100 percent? The answer is none: no one will work for nothing. Taxes are incentives, and incentives change behavior. As Bartlett correctly argues, this is really nothing new. Taxes on heroin, shotguns, human trafficking, are designed not for revenue: they are designed to discourage disfavored behavior.

But the devil is in the details. Suppose we have a gross domestic product of 100 and a tax rate of 25 percent; we collect 25 in taxes.* Suppose we cut the rate to 20 percent. How much revenue will we lose? You can’t say in the abstract, but the answer is almost certainly not five. Some people, incentivized by the new, lower taxes, will work harder and make more money. So in the end, we may lose only three or four. It’s an empirical question and it is not easy to answer precisely in the abstract, but the general principle is inarguable.
It works the same the other way around. Suppose we have GDP of 100 and a tax of 20 percent, so we collect 20. How much extra income will we get if we raise the rate to 25? Again, the answer is unknowable, but it is almost certainly not five. At the margin, some people will lighten up on work, and we may get only three or four.
By now this ought to be axiomatic although it is amazing to recall that the government just didn’t do this kind of accounting until about 30 years ago. It’s tricky: it is hard to get right and easy to get wrong (and, therefore, vulnerable to corruption). But the principle is beyond dispute.

Like I said, I agree. But consider Buce’s example. In the first case, the higher rate is ‘normal’, and the tax cut is not as effective as one would predict. In the second case, the lower rate is ‘normal’, and the tax increase is less effective. I realize that this is a ‘toy’ example, but why is one rate optimized, but the new rate suffers from a psychological effect? To clarify, a nominal 25% rate doesn’t have to actually yield 25%, it could yield less, but the point is that cuts and increases are never as effective at least initially as one might think. So at what point, if any, does the psychology adjust, and the amount of taxes captured change?
Somebody might want to study that.

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15 Responses to “Supply Side Lite” and the Psychology of the New Normal

  1. justawriter says:

    The weakness of the theo…, no, it’s not well thought out enough to be a theory. The weakness of the hypothesis is that people don’t work for money so much as to maintain a certain standard of living. If taxes decline and I don’t have to work as hard to maintain my preferred standard of living, I won’t. I’ll go read books in the park instead. If taxes go up and I need more money to maintain that standard of living, I will work harder, just like I have to work harder because gas, food or any other expense goes up. It is the conceit of the conservative mindset that taxes are functionally different than every other expense people in the real world deal with every day.

  2. John says:

    This is called the “Laffer Curve”. For example, see http://en.wikipedia.org/wiki/Laffer_curve

  3. We are looking for a function z = f(x, y) where x is the tax rate and y is the psychological resistance to economic activity. It is defined by the differential equation:
    part(f)/part(x) + (K * part(f)/part(y)) = 0
    Where K is a constant of proportionality. I eagerly await notice of my Nobel Prize in economics. 😛

  4. Dunc says:

    So the spending of the money raised by taxation has absolutely no effect on GDP, right? Doesn’t matter a damn whether the roads are serviceable, or the courts work, or the population is literate, the only variable in play is people’s motivation to work, as modulated by the marginal rate of income tax?
    Seems just a tad simplistic if you ask me… I suspect that there may be multiple variables involved and several different feedback effects at work.

  5. Robert says:

    Along with the standard of living argument about taxation…
    Higher taxes are no necessarily an incentive to work less – just to cheat more: http://www.imf.org/external/pubs/ft/wp/2008/wp0807.pdf
    Lower taxes do not necessarily lead to higher final disposable income: lower taxes lead to a higher deficit, higher interest rates, and higher consumer debt service costs. If services are cut to offset the reduced tax revenues, then tax savings to the individual may be diverted to replace local centralized services.
    The cut taxes argument and lose less incremental revenue that the tax cut would directly indicate implies: a non-zero tax revenue stream even at zero tax rates. Even Laffer knew that wasn’t right.
    The supply side argument has so many problems there was a good reason it was called Voodoo economics… Let’s not even get into running the numbers on the Reagan tax cuts – but they certainly don’t support what most Republicans claim they do economically.

  6. sikiş izle says:

    A controversial teaching program linked to an alleged cult leader managed to slip into 44 New York City public schools because it didn’t cost enough to trigger detailed background checks, school officials said yesterday.

  7. HP says:

    Do people really believe that the amount of money you earn correlates with how hard you work?

  8. NewEnglandBob says:

    Supply side economics is nonsense.

  9. Jim Thomerson says:

    It is really very simple. Tax the wealthy as much as you can, but not up to the point where you discourage them from wanting to be more wealthy.
    Isn’t it odd how many people think tax money just vanishes from the economy?

  10. william e emba says:

    Bartlett is as ignorant of history as he is of economics. These supply side arguments were made against the original income tax.
    The main effect of taxes is to shift economic activity, not stop it. When weighing a potential job change across the state border, I don’t just look at the salaries, I look at the comparative tax rates. Companies in high tax states do have to offer a higher gross, but in the end, it’s the net, or more accurately, net/prices that actually matters to me.
    In other words, income taxes are really taxes on employers. The employee is working for his net. What on earth does he really care that his gross is just a bragging point?
    Only an idiot goes around whining that the government is stealing his money with taxes. Really, after Reagan’s big tax cuts, how many pay raises were there?
    The real question is what do high personal income taxes do to companies.
    Meanwhile, the whole Laffer curve argument is pointless. It relies on the ludicrous notion that the economic role of government is revenue maximization. People try to maximize their utility, companies their net profits. Governments? They are trying to correct for externalities, building freeway systems or encouraging scientific research on the one hand, because the free market undersupplies them, or taxing pollution and regulating misbehavior because the free market oversupplies them.
    Any other thinking is crackpot nonsense.

  11. D. C. Sessions says:

    Do people really believe that the amount of money you earn correlates with how hard you work?

    The rhetorical question’s implied answer is “no.” Which runs straight into lovely counterexamples such as commission sales, hourly contracting, and my neighbor who is semi-retired but still does custom home remodeling so good that people cheerfully pay him premium rates.
    Me, I’m halfway along the curve: I’ve pretty much always been exempt, but I’ve also made mid-five figures from patent bonuses etc. The same goes for the faculty among us who draw both a salary and a cut of grant money.

  12. The Laffer Curve argument completely ignores the existence of people who’s work and effort are not motivated by net income. How many fewer songs will singers sing, touchdowns athletes score, or prayers priests pray, if their tax rates go up?

  13. Paul Murray says:

    The rhetorical question’s implied answer is “no.” Which runs straight into lovely counterexamples such as commission sales,
    Riiiight … so if someone on commission sales were getting 5% less per sale, he’d work 5% less so as to get more mon …. no, wait – that doesn’t figure.

  14. sikiş izle says:

    It’s Wednesday morning. I don’t see his corporate backers fleeing him just yet, but the people who voted for him are turning away in disappointment.

  15. eNeMeE says:

    The Laffer curve is idiotic because it assumes revenue varies as a curve, not some strange hyperdimensional surface which is more likely to be the case.
    And I doubt people who work will work less or work harder if their taxes increase. Or the reverse. Most will just keep working since 75% of any extra income is still more than a 0% increase…

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