Home > data science, finance > Supply side economics and human nature

Supply side economics and human nature

March 21, 2012

The original goal of my blog, or at least one of them, was to expose the inner workings of modeling, so that more people could use these powerful techniques for stuff other than trying to skim money off of pension funds.

Sometimes models are really complicated and seem almost like magic, so part of my blog is devoted to demystifying modeling, and explaining the underlying methods and reasoning. Even simple sounding models, like seasonal adjustments (see my posts here and here), can involve modeling choices that are tricky and can lead you to be mightily confused.

On the other hand, sometimes there are “models” which are actually fraudulent, in that they are not based on data or mathematics or statistics at all- they are pure politics. Supply-side economics is a good example of this.

First, the alleged model. Then, why I think it’s actually a poser model. Then, why I think it’s still alive. Finally, conclusions.

Supply-side economics

At its most basic level, supply-side economics is the theory that raising taxes will stifle growth so much that the tax hike will be counterproductive. To be fair, the underlying theory just says that, once tax rates are sufficiently high, the previous sentence is valid. But the people who actually refer to supply-side economics always assume we are already well withing this range.

To phrase it another way, the argument is that tax cuts will “pay for themselves” by freeing up money to go towards growth rather than the government. That extra growth will then result in more taxes taken in, albeit at the lower rate.

Now, as we’ve states this above, it does sound like a model. In other words, if we could model our tax system and economy well enough, and then change the tax rate by epsilon, we could see whether growth grows sufficiently that our tax revenue, i.e. the amount of money that the government takes in with the lower tax rate, is actually bigger. The problem is, both our tax system and economy are way too complicated to directly model.

Let’s talk abstractly, if it’s the best we can do. If tax rates (which are assumed flat, so not progressive) are at either 0% or at 100%, the government isn’t collecting any money: none at 0% because in that case the government isn’t even trying to collect money, and none at 100% because at that level nobody would bother to work (which is an assumption in itself).

On the other hand, at 35% we clearly do collect some money. Therefore, assuming continuity, there’s some point between 0% and 100% which maximizes revenue (note the reference to the Extreme Value Theorem from calculus). Let’s call this the critical point. This is illustrated using something called the Laffer Curve. Now assume we’re above that critical point. Then raising taxes actually decreases revenue, or conversely lowering taxes pays for itself.

Supply-side economics is not a model

Let me introduce some problems with this theory:

  1. We don’t have flat taxes. In fact our taxes are progressive. This is really important and the theory simply doesn’t address it.
  2. The idea of a 100% tax rate is mathematically flawed, because it may well be a singular point. We should instead consider how people would behave as we approach 100% taxation from below. For example, I can imagine that at 90% taxation, people would be perfectly happy to work hard, especially if their healthcare, education, housing, and food were taken care of for them. Same for 99% taxation. I do think people want some power over their money, so it makes more sense to think about taxation approaching 100% than it does to imagine it at 100%. Another way of saying this is that the critical point may be at 97%, and the just plummets after that or does something crazy.
  3. It of course does depend on what the government is doing with all that money. If it’s just a series of Congressional bickering sessions, then nobody wants to pay for that.
  4. The real problem is that we just don’t know where the critical point is, and it is essentially impossible to figure out given our progressive tax system and the enormous number of tax loopholes that exist and all the idiosyncratic economic noise going on everywhere all the time.
  5. The best we can do is try to figure out whether a given tax increase or decrease had a positive revenue effect or not on different subpopulations that for some reason are or are not left out, so what’s called a natural experiment. This New York Time article written by Christina Romer explains one such study and the conclusion is that raising taxes also raises revenue. From the article:

    Where does this leave us? I can’t say marginal rates don’t matter at all. They have some impact on reported income, and it’s possible they have other effects through subtle channels not captured in the studies I’ve described. But the strong conclusion from available evidence is that their effects are small. This means policy makers should spend a lot less time worrying about the incentive effects of marginal rates and a lot more worrying about other tax issues.

  6. There are plenty of ways that natural experiments are biased (namely the subpopulations that are left out of tax hikes are always chosen very carefully by politicians), so I wouldn’t necessarily take these studies at face value either.

Supply-side economics is a political model, not a statistical model

In this recent Economix blog in the New York Times, Bruce Bartlett explains the history of supply-side economics and the real reason this flawed model is so popular. He explains an old essay of Jude Wanniski’s entitled “Taxes and a Two-Santa Theory,” which if you read it is an political, idiosyncratic argument for supply-side economics. Bartlett describes Wanniski’s essay thus:

Instead of worrying about the deficit, he (Wanniski) said, Republicans should just cut taxes and push for faster growth, which would make the debt more bearable.

Mr. Kristol, who was very well connected to Republican leaders, quickly saw the political virtue in Mr. Wanniski’s theory. In the introduction to his 1995 book, “Neoconservatism: The Autobiography of an Idea,” Mr. Kristol explained how it affected his thinking:

I was not certain of its economic merits but quickly saw its political possibilities. To refocus Republican conservative thought on the economics of growth rather than simply on the economics of stability seemed to me very promising. Republican economics was then in truth a dismal science, explaining to the populace, parent-like, why the good things in life that they wanted were all too expensive.

The Kristol quoted above is Irving Kristol, the “godfather of neoconservatism”. So he went on record saying that whatever the statistical merits of the supply-side theory were, it was awesome politics.

Conclusions

First, my conclusion is that Christina Romer should be ahead of Larry Summers on the short list to be the head of the World Bank. I mean, at least she’s trying to use actual data to figure this stuff out.

Second, I think there’s some lessons here to be learned about how people think and how they want to be convinced things work. When confronted with something they don’t like, like taxes, they are happy to believe a secondary effect, namely stifled growth, actually dominates a primary effect, namely tax revenue. It’s wishful thinking but it’s human nature.

My first question is, can Democrats come up with something along those lines too, which uses wishful thinking and fuzzy math to get what they want done? How about they come up with an economic model for how getting rid of big banker bonuses and terrible corporate governance will improve the economy, with a reference to a calculus theorem thrown in for authentification purposes?

My second question is, can we get to the point where people can figure out they are being manipulated by wishful thinking and fuzzy math with unnecessary references to calculus theorems? I know, wishful thinking.

Categories: data science, finance
  1. March 21, 2012 at 9:10 am

    “How about they come up with an economic model for how getting rid of big banker bonuses and terrible corporate governance will improve the economy,”
    With banks with the connivance of congress

    http://online.wsj.com/article/SB10001424052702303812904577293924199972912.html?mod=rss_economy

    stifling laws already passed by congress, I don’t like the chances of getting anything up. And this is just one example.

    “can we get to the point where people can figure out they are being manipulated by wishful thinking and fuzzy math with unnecessary references to calculus theorems?”
    I work in government (in Australia) with engineers, economists & other mathematically literate people. Their eyes still often glaze over at the mention or sight of a formula.

    If logic/math/physics were part of people’s life (from early education) then there might be a chance, that people would see the bullshit for what it is.

  2. Wendy
    March 21, 2012 at 9:18 am

    You had me til the penultimate paragraph. The idea that Dems actually want something different than Reps is wishful thinking, a comforting illusion.
    There’s a reason they don’t challenge this economic mytholody: they either believe it, or like it just fine, too. No cavalry is coming, at least not from the Dems.

  3. March 21, 2012 at 10:22 am

    Economists have long discussed the optimal tax rates for the highest income taxpayers in a progressive tax scheme. There is good evidence that there is a great deal of room to increase the marginal tax rates applicable to the highest income taxpayers.

    The most careful and thorough recent work I know of by economists on this subject has been done by Thomas Piketty of University of Paris/CEPR, Emmanuel Saez of Berkeley, and Stephanie Stancheva of MIT:

    “Why the top tax rate could be over 80%” (Note that they do not argue that the top rate *should* be over 80%, but they make a case that it *could* be over 80% without adversely affecting tax revenues.)

    Here is a lay summary:

    http://www.voxeu.org/index.php?q=node/7402

    Here is the technical paper:

    http://www.voxeu.org/index.php?q=node/7394

    • Paul Jurczak
      March 23, 2012 at 9:55 pm

      The best evidence for practicality of high marginal tax rate is in our history. Top income tax rate in U.S. was 90% throughout 1950s and the first half of 1960s, economy was doing very well and not many CEOs resigned their positions and went fishing instead.

  4. Mel
    March 22, 2012 at 12:04 pm

    “none at 100% because at that level nobody would bother to work (which is an assumption in itself)”

    or nobody would have anything left to work with, which I think is just as viable, maybe even more. I suppose the practical result of 100% taxation would be that everybody worked for the government, and we’d have to have the whole tax-level debate all over again with different spelling: replace “society” by “government”, replace previous instances of “government” by … something else …

  5. Dimm
    March 22, 2012 at 1:53 pm

    And some input from the blogosphere:

    http://www.angrybearblog.com/2010/12/top-marginal-income-tax-rate-should-be.html

    Krugman also did some work on that.
    65-70% Top marginal tax rate seems to be the consensus of those that deduct from numbers vs ideology.

  6. GMPierce
    March 22, 2012 at 2:18 pm

    “We don’t have flat taxes. In fact our taxes are progressive. This is really important and the theory simply doesn’t address it.”

    The argument you state above is fraudulent. The model you accuse of being false does not depend on the shape of the income curve – it depends on continuity. A progressive tax rate does not magically alter the logic of a continuous curve, and waving your hands does not invalidate the idea behind the:Laffer Curve.

    How you calculate the amount of taxes doesn’t matter. What matters is how much money is actually taxed. If you tax away half of my discretionary income, I don’t care whether you use a progressive tax rate or you throw a dart at a board. The money is no longer in my hands, it is in government hands. If any additional income I chose to earn is going to be taxed and the same or a higher rate, I might simply decide to spend more time fishing.

    • March 22, 2012 at 2:32 pm

      I don’t think I expressed this well. What I meant to say is that, although for an individual there may be a Laffer curve in effect, when you have a progressive tax code in effect, there is no one Laffer curve to talk about- so in other words, you may see totally different tax revenue with the same “average” tax rate but a different progressive scheme. But you’d have to choose a single number to encode your current tax scheme (so I chose “average” but you could have chosen something else). In order to visualize this effectively it wouldn’t be a curve but rather a large dimensional hypersurface (where the dimensions is approximately equal to the number of tax brackets in your progressive scheme space).

      But if you used such a large dimensional hypersurface to visualize this issue, you’d need to admit a pretty complicated algorithm to find a global maximum. In fact I’d guess such an algorithm doesn’t exist.

  7. John Zelnicker
    March 22, 2012 at 7:14 pm

    It may not be just human nature wanting to believe the good secondary effect overcomes the bad primary. In fact, if you take money out of the economy through taxation, you will reduce aggregate demand. Stifle may be too strong, but there will be a negative effect. Anytime you reduce someone’s income, you reduce their spending. People most probably realize this on a personal level. If I give up some income to taxes, I won’t spend it on goods and services. Since my spending is someone else’s income, growth will be inhibited as economic activity decreases.

    • March 22, 2012 at 7:34 pm

      Totally agreed it’s an effect. The wishful thinking is that it’s bigger than it is.

    • Karen
      March 23, 2012 at 1:04 am

      “…if you take money out of the economy through taxation…”

      What, the government isn’t part of the economy? When it hires workers, pays doctors with Medicare money and sends seniors their Social Security payments, somehow that doesn’t contribute to aggregate demand?

      I strongly suspect that if the government were to get serious about collecting more tax revenue from those who have far more money than they need (so consequently hoard it – excuse me, “invest” it) and getting it into the hands of those who don’t have enough to meet their needs, that would have a strong POSITIVE effect on growth.

      Businesspeople have been saying that what they need is more customers, not more low-interest loans. We should listen to them, and work on creating more customers.

      I don’t think it’s rocket science.

      • John Zelnicker
        March 23, 2012 at 7:47 am

        Karen — Of course the government spending contributes to aggregate demand. However, the federal government does not need tax revenue to spend. It spends by electronically crediting bank accounts. Rather than getting into a long explanation here, I recommend you look into Modern Monetary Theory as developed by the economists at University of Missouri – Kansas City (New Economic Perspectives), Warren Mosler (moslereconomics.com), and Bill Mitchell in Australia (billy blog). If we can just break through the neoliberal economic bulls**t around deregulation and lowering taxes on the wealthy, we could make real, lasting economic progress for all of society. Mainstream economists do not understand how our monetary system actually works.

        Your second paragraph has the right idea, though. The concentration of wealth does nothing but concentrate power in the hands of those few. Taxing away some of that wealth would help level the playing field for the rest of us. Putting more money in the hands of the rest of us would definitely increase demand. It’s just that we don’t need the former in order to do the latter. Your third paragraph is also spot on. All the clamoring for more deregulation and cutting government spending so private enterprise can prosper is a bunch of neoliberal crap. We need more federal government spending. As you said, it’s the customers that business needs, and that means: “It’s the demand, stupid.” Not rocket science.

        • Karen
          March 23, 2012 at 6:33 pm

          A government that spends by creating money out of thin air is debasing the currency and loading up the inflation gun, if you will.

          It’s simple supply-and-demand.

          If you haven’t read it yet, consider reading “When Money Dies,” by Adam Ferguson, about the German hyperinflation that started during WWI and ended in 1923. My mother was too young to experience it herself, but she remembered the stories her parents’ generation told about it.

          If something sounds too good to be true, it probably is. The idea that the government can add to the economy by creating money with the click of a computer mouse definitely falls into that category.

        • John Zelnicker
          March 24, 2012 at 9:18 am

          Karen — The hyperinflation of the Weimar Republic was not caused by “money printing”; money printing was the result. The problem was the Treaty of Versailles that required Germany to pay war reparations in gold or dollars, instead of Deutschmarks. In order to do this, Germany had to buy foreign currency on the foreign exchange market. This might have been okay until the French took over the Ruhr Valley and confiscated about 80% of the industrial capacity of Germany, crippling the economy.

          The point is, Weimar (and Zimbabwe) have nothing in common with the United States. There is a point when creating more dollars can be inflationary. That is when we have reached full employment and full industrial capacity usage. Then it is necessary to pull back on government spending. However, right now we are a long, long way from full employment or full capacity. When the 16 million people who are unemployed or underemployed have decent jobs with which they can support their families and industrial production reaches over 95% of capacity, then we should worry about inflation, not before.

          Since we import more than we export sending dollars overseas and since the private sector is trying to get out of debt and is not spending all its income, the government is the only sector that has the ability to increase aggregate demand by injecting more money into the economy.

          Again, I recommend you read Professor L. Randall Wray’s Modern Money Primer series at New Economic Perspectives, or the “Required Reading” at moslereconomics.com for a better understanding of our monetary system.

  8. ScentOfViolets
    March 24, 2012 at 2:16 pm

    Even with the assumption – an unjustified one – that marginal collections drop to zero at a tax rate of 100%, you still can’t mathematically justify the Laffer curve. And there’s a very simple reason: you don’t have a continuous curve, just a set of disconnected points.

    Over the years I’ve been amazed at the number of people who sneer that “liberals” just don’t get mathematics and so have no standing to criticize economic policy and subsequently do an about-face when this simple fact is pointed out and whine that I’m being “pedantic”.

  1. March 22, 2012 at 8:37 am
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