The Reagan Variety Show

Near the end of his second year in office, John Kennedy proposed a dramatic reduction in federal income-tax rates. The maximum rate, applied to income above $200,000, would fall from 91 percent to 70 percent, and down through the rest of the income distribution, rates would be cut by an average of 20 percent. Corporate taxes were to be cut, too. The reductions were enacted soon after Kennedy’s death, and their first stage took effect in 1964. Immediately afterward, America entered a period of unparalleled prosperity.

Nothing that any Democratic president has done in peacetime has commanded more Republican admiration than these reductions. In political discourse, the “Kennedy tax cut” has become one of those phrases, like “Munich” or “Bay of Pigs,” that is thought to prove an argument merely by being stated. Congressman Jack Kemp, in his tireless advocacy of reducing tax rates, has invoked the “Kennedy tax cut” hundreds of times. (The Republicans rarely call it what many economists do: the “Kennedy-Johnson tax cut.”)

Paul Craig Roberts, who with Kemp has been one of the most consistent proponents of “supply-side economics,” turns to the Kennedy tax cut several times in his new book. He says that when taxes went down, the incentive to save went up, as did the eagerness of America’s entrepreneurs to draw on those savings and make productive investments. Kennedy’s advisers, most of them Keynesians, may have thought that the tax cut would stimulate the economy by giving consumers more money to spend. But, according to Roberts, “what the policy-makers really got was a burst of saving and investment activity that spurred the economy…to faster growth of the ability to produce…. As Stanford economics professor Paul Evans has said, ‘the critics who assert that there is not a shred of evidence [for supply-side economics] just have not looked for it.”‘

Herbert Stein, the chairman of the Council of Economic Advisers during the Nixon administration, also examines the Kennedy tax cut in his new book. But to him, the cause-and-effect relationship that seems so simple and obvious to Roberts looks a little more complicated.

It is conceivable, Stein says, that the tax cut had at least some of the effects that supply-siders such as Roberts say it did. But it is more likely that it did not. As the nation’s output increased, it did not display the trait the supply-siders would have predicted: faster growth in output per worker, resulting from modernized factories and equipment. Instead, Stein says, “all of the increase in the rate of growth of output after the 1964 tax cut went into effect resulted from the faster growth in the number of persons employed. Output per person employed actually grew more slowly after the tax cut than before, although one would have expected the reverse if the supply-side effects were dominant.” The expanded work force, in turn, reflected a higher level of aggregate demand. But did that demand arise from the tax cut, as the Keynesians believed, or from the expansion of the money supply that had been underway since 1961?

In short, Stein says, “many other things were going on besides the tax cut, and it is hard to disentangle the effects of the tax from the other effects. But still, the weight of the evidence is against the idea that the supply-side effects of the tax cut were dominant.”

These contrasting views of the Kennedy tax cut are important, because they suggest the gulf between the supply-siders and everyone else. The significant point in Stein’s analysis is not simply that he places less emphasis on supply-side effects. Rather, the crucial difference is that Stein can imagine more than one force at work in the world. Paul Craig Roberts’s book, precisely because it is so cogent an expression of the supply-side view, makes clear that what is most distinctive about the supply-siders is their desire to reduce the complexities of political choice and economic life to one simple idea.

In its way, The Supply Side Revolution is a delightful book because it is a pure reflection of a culture and a place. The place is Washington; the culture, that of political infighters. During the first year and a half of the Reagan administration, Roberts was the assistant secretary of the Treasury for economic policy, part of a team within the Treasury that unwaveringly defended the president’s tax-cut plan. For five years before that, as a congressional staff assistant and an editorial writer for the The Wall Street Journal, he had helped soften the ground for the supply-side policies of the Reagan years.

Roberts, who has spent most of his working life in Washington, continually professes to be scandalized by the city’s mores. The many sentences in his book that begin “In Washington…” all end with laments about the sins and wickedness of the capital (“principles are an imported product,” or “no one is ever chastised for being a chameleon, since the town itself operates that way”). “Washington is not a place where people expect to find a sincere person,” Roberts says, and there can be no doubt that he sees himself as just such a well-meaning crusader doomed to grapple with those less scrupulous than he.

The charming aspect of his approach is that Roberts comes across as the perfect reflection of the environment that so dismays him. His is a chronicle in which tides turn on Evans and Novak columns and invitations to White House dinner parties. No extra-Washington happening of any sort makes its way into the narrative—not the formation of a business or the taking of a risk, or any of the other wealth-generating activities that Roberts says are his constant concern. Nothing in the book indicates that Roberts has ever lived in, visited, or inquired about any other place. He writes with wounded resentment about those Washingtonians who stooped to the detestable tactic of making “ad hominem” comments about him. Meanwhile, he is putting the shiv into everyone in sight. His targets include Arthur Laffer, Jude Wanniski, James Baker, Richard Darman, David Gergen, Lawrence Kudlow, and most unspeakably craven and Washingtonian of all, David Stockman. Each of these, of course, is a member of Roberts’s own party, and most have been part of the Reagan administration. The bitterness of the in-house feuding is another sign of the Washington-ness of Roberts’s tale.

Taken at face value, most of Roberts’s complaints revolve around the themes of ambition and treachery. He says that the others proved loyal only to their careers or to the conventional wisdom, rather than to the supply-side cause, which only he and the president adequately defended. “It was clear that a person could get nowhere within the Reagan administration by supporting the President’s program,” Roberts says in both sorrow and anger, contrasting his exclusion from White House meetings with Stockman’s all-powerful role. “It may be that the most dangerous position in Washington is that of loyal aide to the President.” Roberts kept a pipeline open to the editorial pages of The Wall Street Journal, and he sent out articles designed to expose backsliders who masqueraded as the president’s friends. “It was clear that I had far more allies outside the administration than within, so my decision to protect the independence of my pen was sound. I estimated that I could help to keep the President out of the establishment’s cage for a year.”

Yet there is more to such sniping than the intrasquad rivalry that every administration has known. What Roberts objects to in the others, especially Stockman, is that they cared about matters that the supply-side reasoning had defined out of the political equation. Two great acts of exclusion and oversimplification undergird the supply-side faith. One concerns the nature of federal budgeting; the other, the sources of economic growth.

Let us start with the supply-side theory, as Roberts would wish to see it defined. Economic activity, he tells us, depends on incentives. People must expect some return for the effort they put into manual or professional labor, for the risks they take in starting an enterprise, for the satisfactions they defer when money is saved rather than spent. Taxes reduce the value of that return, and therefore they can affect the decisions people make. Other things being equal, then, “lower tax rates mean better incentives to work, to save, to take risks, and to invest. As people respond to the higher after-tax rewards, or greater profitability, incomes rise and the tax base grows.” Lower taxes, and the consequently greater incentives, increase the supply of goods available to society, whence the term “supply-side economics.”

So far, so good. But if the argument, as stated, seems logically valid, it also seems of limited importance. True, this line of reasoning has already changed public policy in one way that is likely to endure. During those periods when the government desires to stimulate economic activity—and when, unlike the present, it is willing to increase its deficits in order to do so—the supply-side argument means that it is more sensible to reduce taxes than to increase federal spending. The Keynesians, Roberts says, naturally preferred larger spending programs, since they believed that increased consumer demand was the exclusive engine of recovery, and knew that some of the money returned by tax cuts would be saved, not spent. By arguing that savings and investment, not simply consumer demand, are the real sources of long-term growth, the supply-siders have since the late 1970s convinced both Democrats and Republicans to justify their economic proposals according to savings rates and incentives for enterprise.

As Roberts points out, the high-water mark for this kind of supply-side thinking may have come in 1979, when the congressional Joint Economic Committee, which embraced figures ranging from the liberal senators George McGovern and Edward Kennedy to such conservatives as Senator Lloyd Bentsen and Congressman Clarence “Bud” Brown, released a unanimous report recommending more emphasis on tax incentives and other measures to stimulate investment.

But this accomplishment, substantial as it may have been, hardly encompasses what “supply-side economics” has come to mean. For the last four years, despite Roberts’s attempts to limit its definition, the phrase has implied an overall approach to federal finance. Unfortunately, in the leap from limited congressional recommendations to the full-scale budget proposals issued by the Reagan administration, the supply-side philosophy itself did not expand. Having originally concentrated on the government’s role as taxing agent, it barely acknowledged that the government spent money as well as collected it, and that the balance between the inward and outward flows could affect the nation’s economic health.

Roberts takes a hard line in claiming that serious supply-side economists, including himself, never contended that the Kemp-Roth tax cuts would pay for themselves by stimulating so much entrepreneurial activity that they would return extra revenue to the Treasury. Roberts is angry at Arthur Laffer and Jude Wanniski because they raised the bogus hope that the tax cuts would amount to a free lunch. The evidence for their proposition was Laffer’s famous “curve,” which purported to demonstrate that certain levels of taxation might be so onerous that, by reducing taxes, the government might actually collect more tax revenues. What was always missing from Laffer’s argument was any evidence that American rates had reached that onerous point. (As W. W. Rostow points out, “the proportion of GNP (and taxes) flowing to government was higher in Switzerland and Germany, where private sectors flourished, than in the United States.”)

Herbert Stein carefully demonstrates, in case such an exercise should still be necessary, how fatuous Laffer’s reasoning is. If the after-tax rewards of work and saving go up, he says, some people will indeed work harder and save more. Others, who are saving for finite purposes, such as college tuition, may work or save less. The overall effects of a tax cut will depend on how many people respond each way.

Stein gives an estimate of the effects of a 30 percent across-the-board cut in tax rates, the original goal of the Kemp-Roth bill. For a doctor earning $120,000 a year, this would mean a reduction of $12,000 in his tax bill; for someone earning $25,000, a reduction of about $1,000. If the tax cut were to pay for itself, the doctor would have to respond to the attractive new incentives by working nearly 30 percent more hours than before, and the other man would have to work 20 percent more than he used to. Some people might do so, but would everyone, or even most? “These examples illustrate the basic point about the supply-side doctrine,” Stein says. “The validity of the doctrine depends on certain quantities, not on general philosophies or directions.”

Roberts fiercely denies that the Laffer curve has anything to do with supply-side policy, rightly understood. “The case for supply-side economics does not depend on whether tax-rate reductions fully pay for themselves,” he says. All he claims is that they will partly pay for themselves, and that the increased savings they stimulate will give the government a place to turn when it borrows to cover its deficits. But in dismissing Laffer’s argument, he ignores the political reality of the 1980 presidential campaign and the 1981 congressional session, in which the tax-cut legislation was passed. In those days, the only people who were saying loudly that Laffer was wrong were Ronald Reagan’s opponents, not the strict-constructionists among the supply-siders. In order to do fend his version of supply-side economics, Roberts must pretend that the no sacrifice theme, which was so central to the Reagan campaign and its version of supply-side economics, was a mere misstatement.

The administration’s promise of a free lunch involved more than the Laffer curve, of course. What George Bush called “voodoo economics” was the proposition that Reagan could cut taxes, increase military spending, and balance the federal budget, all at the same time. Unfair as this must seem to Paul Craig Roberts, that package of promises is what Reaganomics and supply-side policy have come to mean.¹ Yet Roberts is in no position to complain, for his relative indifference to the question of federal spending amounts to an endorsement of the free lunch.

The only man who is lower in Roberts’s regard than Arthur Laffer is David Stockman. His stated offense is to have stage-managed events so as to place more emphasis on cutting the budget and reducing deficits than on continuing the campaign against taxation. Yet to anyone not involved in the tong wars inside the administration, it should have been obvious that Stockman’s efforts advanced the supply-side cause, rather than retarding it. Even Roberts admits that, in the long run, budget deficits can undo the benefits that tax cuts are supposed to bring. He says, “Continual deficits year after year are a sign either that government spending is growing faster than the economy that supports it or that something is wrong with the economy such that the budget does not move into balance even in the best years.”

“Continual deficits” are the legacy of supply-side economics—the real difference between the Reagan administration’s deficits and those of the past is that Reagan’s will persist even if the economy should boom. They will persist because David Stockman failed in his mission, and government spending is growing faster than the economy that supports it.

In 1980, federal expenditures represented 21 percent of the gross national product. In 1984, after the full course of budget reductions and austerity campaigns, the government’s share has risen to 24 percent. Except during World War II, it has never before been so high. The increase in expenditures is partly deliberate, because of the military buildup; partly automatic, because of the rising costs of pension programs and medical care; and partly a snowballing result of previous slowdowns in economic growth and failures to balance the budget, because interest payments on the national debt have grown faster than any other item in the budget. All in all, the growth in outlays is at least as responsible for Reagan’s deficits as his tax cuts could possibly be. (Federal revenues were 20.1 percent of the gross national product in 1980, versus 18.8 percent in 1984.)

Why, then, do Paul Craig Roberts and other supply-side proponents detest Stockman so much? Why does Herbert Stein build his book around the need to balance public resources with public obligations, while the supply-siders ignore the need for balance and talk about nothing but the tax side of the equation?

The reason, I believe, is that the supply-siders have been recommending something easy, while Stockman was talking about steps that are hard. Roberts complains that big spenders in the Congress hate to vote for tax reductions. Nothing could be more ridiculous; congressmen love to lower their constituents’ taxes. What they resist are the steps Stockman recommended before he took office: restricting federal benefits to those who “really need them,” rather than letting their clientele expand to include most of the population.

Stockman was talking, that is, about “sacrifice,” a word that most succinctly expresses what the supply-siders oppose. Time and again, Roberts emphasizes that the wonderful thing about supply-side economics was how it allowed Republicans to sound. On the first page of his book, he says that with supply-side legislation, “Republicans were ridding themselves of the albatross of ‘negativism.”‘ They could be like Democrats. They could start saying yes and stop saying no.

Reagan’s ability to inspire hope has been an important part of his appeal. In 1980, Carter had no chance of topping Reagan’s upbeat promises with his own sobersided discourses on difficulties and constraints. Since the election, the president’s stand-tall rhetoric has seemingly insulated him from bearing responsibility for the consequences of his acts. He increasingly plays the part of a genial variety-show host, who can share a chuckle with his audience when one of the guest acts bombs. Stockman is one of those acts, a sweaty, tiring wrestler who can’t get a grip on the budget, while Reagan keeps his distance and keeps making speeches about runaway spending. The supply-siders watch the performance and boo Stockman for creating an unseemly row. They have moved beyond a mere determination to offer good news, to a denial that the world’s circumstances can ever be challenging or harsh.

In Roberts’s case, this is clearly a matter of intelligence being subordinated to ideology. Near the end of his book, he offers a careful, sober chapter on the Social Security system. Patiently and with clarity he describes the combination of technical and political forces that lie behind its disproportionate growth. He explains the quirk in the indexing formula that offered each generation of retirees more and more generous compensation. An average worker who retired in 1969 received initial benefits equal to 31 percent of his last year’s income, but his counterpart who retired in 1974 received 41 percent and, in 1981, 55 percent. Moreover, Roberts argues, Social Security was slowly and not-quite-consciously transformed from a kind of welfare program—insurance against catastrophe—into a national pension.

Roberts recommends a technical adjustment that will, he says, return the program to solvency. (He suggests that the cost-of-living formula be based on the annual increase in prices, instead of wages, since in a healthy economy the price increase will be the lower of the two.)² The tone and even the placement of the Social Security chapter, which is segregated from the main narrative, suggest how alien the idea of reducing benefits is to the supply-side cause. Roberts apparently believes that there is no point in attempting to distinguish between strong and weak claims to federal support. After all, “sufficient cuts in nondefense spending are difficult to achieve, and the need for a buildup in defense spending is widely recognized.”

Roberts thus dismisses the idea that some domestic programs may be more useful or necessary than others, or that any part of the current military buildup might be considered excessive, misguided, wasteful, or dumb. Of the $40 billion the administration is planning to add to non-defense programs between 1985 and 1989, more than half is for increases in foreign military aid. (Over the same period, other nonmilitary programs are to be cut by $111 billion.) The 1985 budget requests $8.2 billion for acquisition of thirty-four B-1B bombers, $5 billion toward construction of an MX missile system (officially rechristened “Peacekeeper” in the president’s budget request) that is expected to cost three times that much by the time it is finished, and $2.5 billion for the proposed space-descent systems, often referred to as “Star Wars.” Roberts and his allies cannot be bothered by the distinctions among these systems, by the Scowcroft Commission’s utter demolition of the argument in favor of the “Peace-keeper,” or by the technical implausibility of the space-war scheme, described most recently by the physicist Freeman Dyson.³ Attempting to contain federal spending is more difficult, “intellectually and politically,” than offering something for nothing. But out of the supply-sider’s determination to avoid “negativism” at all costs has come a fiscal gamble in which, as Felix Rohatyn put it, we are betting the company.

Roberts does end with one suggestion for bringing federal accounts more into balance, while still observing supply-side principles. His answer is the “flat-rate tax,” under which most deductions and exemptions would be eliminated and nearly all income would be eliminated and nearly all income would be taxable, but at a much lower rate—say, 20 percent. The greatest virtue of the flat tax is that it would end the erosion of the taxable base and eliminate the waste of money, energy, and talent now expended in moving income into nontaxable shelters. The principal objection to it is that it would shift the burden of taxation away from the rich, although not as dramatically as the change in the maximum rate might suggest, since so much of the income theoretically subject to heavy taxation is now sheltered. Roberts says that the solution to this problem is expanded government benefits for the poor. (“Those who wish to redistribute income should rely on the expenditure side of the budget.”) As a practical matter it is hard to imagine the supply-siders fighting for such benefits quite as vigorously as for the rate reductions.

The Democrats’ counterpart is the “fair tax,” sponsored by Congressman Richard Gephardt (Missouri) and Senator Bill Bradley (New Jersey), and endorsed by Gary Hart. The most obvious effect of the Bradley-Gephardt bill would be to simplify the tax-rate structure.⁴ Its sponsors say it would raise as much money as present laws do and would have no effect on the progressive character of the system. Because it would make federal taxes less cumbersome and blunt their perverse influences on the economy, the flat-rate tax may be one of the few attractive “new ideas” to emerge from this year’s campaign. It is practically the only one in which supply-side principles accord with the real circumstances of public finance.

Disregard for the balance between revenues and spending is the first great over-simplification of the supply-side view. The second is its indifference to the circumstances in which economies flourish or fade.

As Paul Craig Roberts would tell it, one prime variable determined the course of the economy through the 1960s and 1970s: the marginal tax rate. He concedes that other factors, such as the growth of the monetary supply or the relative strengths of foreign currencies, may have played their parts. But if Roberts were forced to isolate a single causal difference between the relatively healthy economy of the Kennedy-Johnson years and the stagnation under Ford and Carter, it would be the heavier burden of taxation.

Nowhere in Roberts’s book do the words “Organization of Petroleum Exporting Countries” appear. Not once does he mention the dramatic increases in the price of oil in 1973 and 1979. Roberts is not the first to observe how much higher the American inflation and unemployment rates were during the 1970s than during the 1960s, and how much lower was the increase in productivity. But he is one of the few to ignore OPEC’s debilitating impact on the West. In the decade after 1973, the average inflation rate was three times as high, the unemployment rate twice as great, and the real growth rate half as much as in the preceding, cheap-oil decade. Oil does not explain everything, but neither do marginal tax rates.

W. W. Rostow, who in other days was known for clear, simple theses of his own, devotes much of his new book to outlining the changed environment in which American governments and enterprises must make their way. One of his central points is that the world economy has entered another of the “long-wave,” or Kondratieff, cycles that seem to explain the peaks and valleys of economic activity over the last two hundred years. During the “upswing” stage of the cycle, the prices for primary products are rising around the world, and the performance of the developed countries stagnates. Rostow says that the latest upswing began in the mid-1960s, was dramatically accelerated in the 1970s, and may still resume. In addition to the rising price of energy, the world’s reserves of food-producing capacity have also been shrinking since the 1960s. The technologies that had fueled the postwar expansion—motor vehicles, plastics, synthetic fibers—slipped to a much slower growth path during the 1960s. Moreover, Rostow says, air and water pollution and the decay of such basic fixtures as roads, ports, highways, and canals all impose additional fixed cost on developed economies, further depressing their performance.

Rostow claims to be agnostic on the recent weakness in the oil market. Perhaps it is a temporary anomaly in an upswing that still has many years to run; or perhaps it signifies that modern economies can adapt more quickly to changed circumstances than in the past, thereby shortening the duration of Kondratieff waves. In either case, his purpose in this powerful, carefully reasoned book is to make clear that economic life is more complicated than any one-factor theory can account for. He, too, is interested in a “supply-side” approach, but one that does justice to the countless forces beyond marginal tax rates that equip a society to earn its way. Rostow says:

The concepts required to illuminate the path to sustained, high, noninflationary growth deal with variables systematically ignored or set aside for ad hoc observations by mainstream macroeconomists: technology and its relation to the structure of the working force; the dynamics of the rise, decline, and rehabilitation of industries; the process of generating adequate supplies of basic commodities, including clean air and water; the provision and maintenance of an adequate physical infrastructure; and the institutional methods by which wages in major industries are set.

Economic historians invariably dwell on factors such as those that Rostow lists; economic policy makers rarely do. Even without the benefit of historical perspective, much of today’s economic story can be explained by influences that the supply-side argument cannot hope to comprehend. The differing fates of Pittsburgh, Houston, San Jose, and Detroit may have something to do with the arguments that embroiled Paul Craig Roberts in Washington, but only something. To speak with the entrepreneurs of the electronics industry is to realize that marginal tax rates are low on their lists of motivating factors. To visit the industrial towns whose industries are dying is to recognize the impact that managerial habits, class divisions, and union practices had—quite apart from tax rates and fluctuations on the international currency exchange. The supply-siders have no inkling of these things; neither, in fairness, do many Keynesians.

In an immediate political sense, the Democratic party’s argument over “industrial policy” may prove a handicap. The deepest divisions within the party, mirrored in Gary Hart’s challenge to Walter Mondale, are also reflected in the quite different industrial proposals that Democrats have made. To the elements of the party most in sympathy with organized labor—the Mondale wing—“industrial policy” means in large part a protectionist approach designed to safeguard the nation’s heavy industry. To the Democrats who view organized labor, along with corporate management, as having contributed to America’s economic difficulties through shortsighted and selfish demands, industrial policy means a congeries of proposals that would speed the nation’s adaptation to changing economic conditions. Gary Hart’s endorsement of “individual training accounts” is a classic illustration of this second approach. It would provide a partial public subsidy for workers who wanted to retrain themselves for positions in the “sunrise” industries.

There are faults to be found with almost any version of “industrial policy.” Retraining programs have been most successful when industries undertake them on their own, because they need more workers. Tripartite councils, such as those that figure prominently in Felix Rohatyn’s and Robert Reich’s plans, could easily turn into mechanisms for dividing the spoils between corporations and organized labor, and passing the costs on to unorganized workers and consumers. Any industrial policy that rests on “picking winners” among industries assumes a degree of economic foresight that no government has consistently achieved.

Still, for all their imperfections, the industrial policy proposals have one great virtue. They represent attempts to talk about a real economy in which the unexpected and the irrational can often confound logical plans, in which people and companies are less flexible than they might ideally be, in which factors that do not appear on supply-and-demand charts can make a tremendous difference in the health of a national economy, in which neat, simple ideas can often mislead.

In their efforts to define an industrial policy, that is to say, the Democrats are directing political attention to the broadest sources of economic growth. The supply-siders, by contrast, view the world through the lens of a single idea.