Gary Cohn had, it seemed, drawn the easy assignment. In the all-hands-on-deck push for passage of the Tax Cuts and Jobs Act, the Director of the National Economic Council was making the pitch to the Wall Street Journal’s annual CEO Council meeting at the Four Seasons in Washington. “We want companies to invest back in the economy, not give money back [to shareholders], or sit on money because they don’t think there’s anything to do with it,” he explained.
But journalist John Bussey turned to the gathered CEOs and asked, “If the tax reform bill goes through, do you plan to increase investment, your companies’ investment, capital investment? Just a show of hands, if tax reform goes through, okay?” One or two raised their hands.
With the same confusion that afflicts so many policymakers who insist tax cuts hold the key to generating investment and economic growth, even though they keep failing to deliver it, Cohn was left to ask: “Why aren’t the other hands up?”
For more than 40 years, GOP orthodoxy has proclaimed that high marginal tax rates are a major barrier to a thriving economy, and that rate reductions are the vital response. This focus is a central feature of what became known as “supply-side economics,” so named because it emphasizes the interests of producers (and their ability and willingness to increase supply) rather than stabilizing or increasing demand as the older Keynesian orthodoxy recommended.
Perhaps high marginal tax rates were at one time the primary barrier to American investment, but they have not been for quite some time. Instead, tax rates and investment rates have declined together.
The central supply-side insight—that producer incentives matter—is certainly correct. But the market fundamentalist misinterpretation of this truth embraced on the American right-of-center, that, to quote Ambassador Nikki Haley, “as we are dealing with changes in our economy, tax cuts are always a good idea,” does not follow. Perhaps high marginal tax rates were at one time the primary barrier to American investment, but they have not been for quite some time. Instead, tax rates and investment rates have declined together. Economic performance has consistently been as good, or better, when tax rates are higher.
The question for policymakers is why investment has weakened, and what is to be done. A supply-side economics for the 21st century would worry far less about the difference between a 39% and 37% top marginal tax rate and more about how the incentives created by forces like globalization and financialization have made investing in the American economy an unattractive use of talent and capital. If conservatives can put down their 1980s playbook long enough to look at the world around them, they will find their principles are uniquely suited to leading a new supply-side revolution that addresses the challenges of today.
Supplying Some Supply-Side Theory
The ideological power of supply-side economics resides in its appeal to common sense: remove the impediments to businesses investing and growing, and they will do more of it. As presented by Ronald Reagan, the Great Communicator, this line of thinking entrenched itself deeply in the American psyche and in the messages of politicians across the ideological spectrum. Its ubiquity makes it hard to recall what a significant revolution it once represented.
The insights gleaned by British economist John Maynard Keynes from the Great Depression dominated policymaking in the middle of the 20th century. Prior to the 1930s, classical economics held that economic downturns self-correct. When demand drops, production does too, leading to declines in prices and wages. Lower costs then create an opportunity for producers to increase investment, thus stimulating renewed growth. But in the Great Depression, Keynes saw that this process had clearly broken down.
Keynes realized that an economic downturn, rather than encouraging new capital investment, can prompt low confidence. As businesses hesitate to invest in production for which they perceive no forthcoming demand, the pessimism becomes a self-fulfilling prophecy. Wages, meanwhile, are “sticky” and slow to change—in practice, workers are reluctant to accept declining wages no matter what the economy is doing, thereby short-circuiting the process by which costs should supposedly fall and investment become more attractive. What matters, in Keynesian economics, is raising aggregate demand to restore confidence and induce investment. Government spending is the way to do it.
The challenges of the 1970s fractured the prevailing Keynesian confidence. Inflation was high, but so was unemployment, in defiance of the expectation that higher prices would induce investment and employment. Neither high deficits nor low interest rates seemed to help. The combination of inflation and stagnation produced a gloomy and restless political mood; “stagflation” entered the national lexicon. The moment was ripe for a new argument.
Like Keynesianism, supply-side theory described a way that an economy could get stuck far below its optimal performance and proposed that policy intervention could unstick it.
Economists including Milton Friedman, Friedrich Hayek, and Arthur Laffer championed the idea that supply, not demand, could be the key driver of growth. Like Keynesianism, supply-side theory described a way that an economy could get stuck far below its optimal performance and proposed that policy intervention could unstick it. But instead of boosting demand to prime supply, it focused on increasing supply to employ wage earners and lower prices, and thus induce demand. Policymakers should seek to move the supply curve first, and so need to address the factors that influence decisions to invest and produce.
Reagan took this theory, combined it with Hayek and Friedman’s arguments that free markets produce a spontaneous efficiency that government never can, and turned it into a political pitch: get the government out of the way and leave businesses to pursue their own interests. High marginal tax rates and heavy regulation made economic activity more costly and returns less attractive. Cut the rates and the red tape, he argued, and the economy would boom.
His message not only earned the support of the business community, but also persuaded American workers that cutting taxes on business and top earners was good for them, too. In 1980, President Reagan won 44 states. The following year, he signed the Economic Recovery Tax Act, which reduced the top income marginal income tax rate from 70% to 50% and the capital gains rate from 28% to 20%. His 1986 tax reform dropped the top income tax rate to 33% and the corporate rate from 46% to 34%. As described by the Reagan Foundation, “reducing tax rates restored the incentive to produce and create jobs, and getting government out of the way allowed people to be entrepreneurs. From there, the free marketplace operated as it was supposed to.” This has been the heart of the Republican economic agenda ever since.
What Would Reagan Do?
The basic claim of supply-side theory is that policy should seek to induce greater productive investment. In Reagan’s time, high marginal tax rates and sclerotic regulatory regimes were obvious culprits to target. But you only get to reduce tax rates from 70% once. Subsequent efforts at repeating the trick have brought diminishing returns and rising costs.
In fact, over the past few decades, the economy’s performance has been at least as strong in the periods after tax increases as in the periods after tax cuts.
Unfortunately, the Republican Party confused the principle of supply-side economics for the policy tool of tax cuts, dogmatically embracing a permanent, ossified diagnosis of tax rates as the primary obstacle to investment and growth, and tax cuts as the answer. Supply-side economics does not support this in theory, and repeated rounds of tax cuts have failed in fact. As Oren Cass explains in “The Curse of Voodoo Economics,” neither the Bush tax cuts of the early 2000s nor the Tax Cuts and Jobs Act of 2017 (TCJA) yielded the hoped-for gains. In fact, over the past few decades, the economy’s performance has been at least as strong in the periods after tax increases as in the periods after tax cuts.
An explanation of America’s supply-side problems, and a supply-side policy response, must look beyond tax policy. A good place to start would be the economy’s financialization and the increasing tendency of firms to maximize short-term shareholder returns and disgorge profits back to financial markets rather than pursuing investment at all. In the 1970s, publicly traded companies returned roughly 50% of their profits to shareholders each year. From 2008–17 that rate averaged 100%, and in four of those years exceeded 100%.
The Brookings Institution’s William Gale and Claire Haldeman provide an illustration of how this trend stymied TCJA. The law’s provision permitting U.S. corporations to repatriate profits without a U.S. tax penalty worked, insofar as annual repatriated funds increased by $470 billion in 2018 and 2019 relative to the 2010–17 average. But “rather than boosting investment or wages,” the increase “generated a wave of corporate stock repurchases.” And what was true of this one-time provision has been true of TCJA in general. In 2018, the S&P 500 bought back about $800 billion of its own stock. Annual stock buybacks reached $950 billion in 2021 and $1.2 trillion in 2022. A lower corporate tax rate will not generate higher investment if its result is merely higher after-tax profits to pay out. A lower cost of capital will not make much difference if firms are already ignoring their cost of capital in setting the internal hurdle rate that any new investments must clear.
Smart supply-side policy addresses itself to the specific obstacles facing production at a given time and uses the tools appropriate to overcoming those obstacles. Reagan himself knew this to be true, even if his successors eventually forgot it.
Globalization has likewise altered the calculus for business investment. Beginning in the 1990s and accelerating with China’s accession to the World Trade Organization in 2001, multinational corporations have shifted their investments in productive capacity outside of the United States. Even in advanced technology products, America’s $24 billion trade surplus in 1999 collapsed into a $192 billion deficit by 2020. Growth in manufacturing output stalled and, since 2007, output has declined. Productivity growth turned negative: American factories required more labor in 2022 to produce the same level of output as in 2012.
The modern supply-sider should not begin with a tax cut any more than Reagan began with Wendell Wilkie’s 1940 agenda. Smart supply-side policy addresses itself to the specific obstacles facing production at a given time and uses the tools appropriate to overcoming those obstacles. Reagan himself knew this to be true, even if his successors eventually forgot it.
Trade policy is an obvious example, relevant in the modern context. American automakers’ struggles in the face of intense competition from Japanese imports during the 1980s could not be relieved with a tax cut. The Reagan administration solved the problem by aggressively protecting the industry from Japanese competition through direct diplomatic intervention that curtailed the level of imported vehicles. In a win-win for American workers, Detroit’s Big 3 manufacturers had time to get back on their feet, while Japanese automakers relocated significant production to the U.S., prompting extensive investment and creating hundreds of thousands of jobs in the process.
Creating strong incentives to meet domestic demand with domestic rather than foreign production is quintessentially supply-side policy, and much needed today to reverse the harms wrought by globalization. Policymakers should take a page from Reagan’s (other) playbook and seek to boost the relative attractiveness of domestic productive capacity. Import tariffs and local content requirements are tools better suited than tax cuts to the task. Reducing taxes on desirable activity is the right way to alter incentives in some situations, but raising taxes—a tariff is, after all, simply a tax on imports—on the undesirable alternatives can be the better approach in others. Far from a departure from supply-side principles, using tariffs to privilege domestic production over foreign imports is a direct application of those principles to the problem of globalization.
Financialization, too, must be directly confronted with policies that channel capital away from unproductive investments and make productive ones more attractive in comparison. Congress should ban stock buybacks, closing the avenue by which the U.S. corporate sector disgorges so much of its cash rather than investing it. Congress should discourage financial engineering and high-risk leveraged buyout strategies by eliminating the tax deductibility of interest. It should reduce speculation that contributes no real economic value by imposing a financial transaction tax that would disadvantage high-frequency trading and prod Wall Street back towards long-term capital investment.
Investment can also be supported with industrial policy aimed squarely at the goal. Funding for pre-competitive research partnerships can foster industry-strengthening innovation that no tax cut could. A national development bank that can provide financing and expertise to major industrial projects, and activate many times more private capital than the public capital deployed, is a much smarter way to jumpstart supply-side focus on urgently needed projects that private markets currently ignore.
Smart tax incentives certainly do matter, too. The tax code should subsidize research and development and privilege long-term capital investment. But taxes are not the reason that cutting-edge semiconductor manufacturing moved abroad, or the reason half of publicly traded firms are eroding their own fixed capital faster than they invest in it.
When Congressman Kevin Brady, a chief architect of the 2017 tax cuts and the top Republican on the House Ways and Means Committee, went on Fox News in July 2022 to argue against the CHIPS and Science Act, he did so by appealing to the same prescription as always: tax incentives:
I think we’re missing the bigger picture here … China in their “Made in China 2025” economic plan are seeking to dominate ten manufacturing and technologies in the world. It doesn’t make sense to me to cede … to China nine of those industries and provide tax breaks to one. Republicans have proposed that we have tax incentives that help all of our industries compete and win against China, and that includes doubling the research and development tax credit. That means guaranteeing 100% expensing so they can write off that expensive equipment, whatever industry they’re in. And then, of course, making sure R&D is fully deductible.
The congressman’s mistake was not to recommend incentives for R&D and full expensing for capital investment; those are sensible suggestions. His mistake was to consider this sufficient—as if tax rates were the main reason advanced manufacturing had fled the U.S., and finding just the right tax break would bring it back.
While supply-side economic policy has generally been associated with the right-of-center, especially insofar as it consists predominantly of calls for tax cuts, a new school of self-identified “supply-side progressives” has emerged in recent years. Represented by writers like Ezra Klein, Matthew Yglesias, and Derek Thompson, the new supply-side progressives distinguish themselves by embracing progressive comfort with activist government on one hand and a concern for production and growth on the other.
Motivated by the rising cost of living for middle-income households, supply-side progressives argue that expanding the supply of essential goods to lower their price should be a policy priority.
Supply-side progressivism (or “a liberalism that builds” or “an abundance agenda”) finds much to appreciate in traditional supply-side theory. A key point of shared emphasis is the relationship between supply and price. Motivated by the rising cost of living for middle-income households, supply-side progressives argue that expanding the supply of essential goods to lower their price should be a policy priority. In some instances, the implication of this emphasis is greater public investment in certain kinds of production (electric vehicles, for example), but in others it prompts a deregulatory stance that recognizes the ways government can hinder production and advocates reforming or scrapping the offending rules.
Housing is a paradigmatic example. For supply-side progressives, foolish zoning laws are a key obstacle preventing the production of more housing. To increase the housing supply, and therefore make housing less expensive, they propose a rethinking or repealing of zoning restrictions. Likewise, and to the chagrin of their more traditionally progressive colleagues, they recognize that implementation of laws like the National Environmental Policy Act (NEPA) has metastasized into a mechanism for ideological actors to hinder needed construction. Influenced by these arguments, Democrats have begun to show some openness to permitting reform—President Joe Biden agreed to Republican provisions in this vein in the July 2023 debt ceiling deal.
Supply-side progressivism thus represents a helpful corrective to standard progressive thinking, which often struggles to see past its go-to solutions of redistribution and proscriptive regulation. The overlapping enthusiasm for a new supply-side economics on both Right and Left generated bipartisan support for the CHIPS and Science Act, even as the Wall Street Journal’s editorial board joined Senator Bernie Sanders in lamenting it as corporate welfare.
But supply-side progressivism has so far failed to resolve the Democratic coalition’s fundamental challenge: too many conflicting goals. “Investment” means anything and everything the coalition deems important, as memorialized in Senator Kirsten Gillibrand’s infamous comment, “Paid leave is infrastructure. Childcare is infrastructure. Caregiving is infrastructure.” Public support for domestic semiconductor production is good—but only if it also advances numerous unrelated but party-mandated policy goals, “adding subsidies with one hand and layering on requirements with the other.” The Inflation Reduction Act (IRA) seeks to be both emissions-reduction policy and American manufacturing revitalization policy simultaneously, and thus attempts to serve two masters that can demand contradictory things.
The result of this dynamic, memorably termed “Everything-Bagel Liberalism” by Klein, is a Democratic Party that increasingly acknowledges the importance of a new supply-side agenda, but seems to only ever get halfway to the finish line—too stretched between competing commitments to make decisions and accept the tradeoffs that pursuing such an agenda requires.
Supply-Side Economics for the 21st Century
Some forms of investment are more socially valuable than others; some pursuits of profit are more conducive to the common good and the national interest.
An obsession with tax cuts follows naturally from market fundamentalism’s insistence that all economic activity is of equal value, simply because the market places a price on it. A supply-side economics grounded in reality, however, must account for the fact that this view has served America poorly. The American public does not seem to agree that profits generated by offshoring, or the capital gains from trading a millisecond ahead of a competitor by placing a fiber optic cable a bit closer to the stock exchange, are just as valuable as those generated by building productive capacity in the United States and creating secure jobs for American workers. The policymakers who represent that public shouldn’t agree either. Some forms of investment are more socially valuable than others; some pursuits of profit are more conducive to the common good and the national interest. Supply-side theory for the 21st century must reflect this judgment as it updates its toolkit.
America faces a range of serious economic challenges that have little to do with tax rates. Just as Reagan looked beyond the orthodox but ineffective policies of the 1970s when confronted with that decade’s stagflation, conservative policymakers today need to look beyond the received orthodoxy of tax cuts, observe the actual circumstances in which American business operates, and write a new chapter in the American playbook that addresses the obstacles that currently constrain supply-side growth. A reality-based supply-side economics must seek to expand the set of tools available to the urgent task of expanding domestic investment and capacity, not simply reuse an old tool that has long since worn out.
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