Mike Lee's Anti-Supply-Side Tax Cut
By David Henderson
Arguably, one of the biggest accomplishments of supply-side economist Art Laffer in the late 1970s and early 1980s was to get mainstream economists to take marginal tax rates seriously. We all knew that the deadweight loss from a tax is proportional to the square of the tax rate so that, say, doubling the tax rate quadruples the deadweight loss. But, for some reason, economists talked very little about this. And this was during an era when the top federal marginal tax rate on income in the United States was a whopping 70 percent and the top federal marginal tax rate on “earned” income was 50 percent.
But, in part due to Laffer, mainstream economists like Jerry Hausman of MIT started looking at the potentially large negative effects of high marginal tax rates on labor supply, especially the labor supply of married women.
Laffer’s other big accomplishment was to get politicians, especially Republican politicians, to recognize the damage to incentives and, therefore, to real output, done by high marginal tax rates.
Many Republicans got sloppy though, advocating almost any kind of tax cut and often using supply-side rhetoric to justify such cuts.
Unfortunately, U.S. Senator Mike Lee from Utah now advocates a tax cut with a strong “anti-supply-side” component. According to Matthew Continetti of the Weekly Standard, Lee’s “tax plan would simplify and reduce rates and offer a $2,500 per-child credit (up from $1,000 today) that would offset both income and payroll taxes.” The “simplify and reduce rates” part, assuming I understand it correctly, is great. The problem is the $2,500 per child tax credit.
Why? This gets us to one of the points Laffer emphasized. Any cut in tax rates has two effects that offset: an income effect and a substitution effect. When tax rates are cut, people’s real incomes net of tax are higher and they use some of that higher real income to “purchase” leisure. That is, they work less. That’s the income effect.
But the cut in marginal tax rates also increases the “price” of leisure. Every hour you don’t work, you’re giving up more real income because your net-of-tax income per hour has increased. So you’re inclined to work more. This effect is called the substitution effect.
Laffer argued that the substitution effect, especially for higher-income workers in high tax brackets, outweighed the income effect and so the net effect of a cut in marginal tax rates at the high end would be more work and more output.
But what happens if the government doesn’t cut marginal tax rates and, instead, simply increases tax credits? Then there’s no substitution effect towards more work and more output. People’s net-of-tax real income increases and, therefore, they “buy” more leisure. That is, they work less and the economy’s real output is less. All the distortions from those high marginal tax rates remain.
According to Continetti, Lee proposes lowering tax rates also. But for a given loss in revenue to the federal government or for a revenue-neutral tax cut, rates could be cut even more without that increase in tax credits. So, relative to a straight cut in marginal tax rates that yield the same revenue as Lee proposes, his tax cut would make the economy smaller.
Art Laffer, call your office.