Grade economic policy on a curve

North Carolina has become a national leader in implementing supply-side economics — but that doesn’t mean what you think it means.

For some supporters and many critics, the term “supply-side economics” is all about the Laffer Curve. Popularized by the economist Art Laffer, it’s really an ancient insight about public finance. If a government’s tax rate is zero, it will collect no revenue. But if its tax rate is 100 percent, it will also fail to collect any revenue, because people won’t work for nothing or they will hide their incomes from a rapacious government.

Somewhere between those two poles lies a point at which government will maximize revenue collection. In the early 1960s, when the top federal income tax rate was 91 percent, President John F. Kennedy and many economists argued Washington was far above that point. They were clearly correct.

In the 1970s, when Laffer was drawing his revenue-maximization curve on a napkin and the top income tax rate was 70 percent, he and other economists thought Washington was still on the downward-sloping side of the curve. They were probably correct.

President Ronald Reagan and bipartisan majorities in Congress responded by reforming the tax code and, ultimately, pulling the top rate down to 28 percent. It went up a bit during subsequent administrations. But will likely never reach the stratospheric levels that predated Reagan, because the supply-siders clearly won the revenue-maximization argument.

But for most supply-siders, that wasn’t their key argument. Their goal wasn’t to maximize government revenue. It was to maximize employment, incomes, and economic growth. Like many political labels, the term “supply-side economics” was concocted by a critic, not an advocate.

During the mid-20th century, “demand-side” economics was in the ascendancy. Following the teachings of John Maynard Keynes — and those who translated his rambling texts into comprehensible sentences and manageable equations — demand-side economists argued that one of government’s most important jobs was to “manage” the economy by smoothing out its peaks and valleys.

Recessions, they argued, were the result of sudden, irrational drops in consumer demand. During those periods, governments ought to prop up demand with spending, funded primarily by borrowing. During boom years, they ought to raise taxes and rein in spending to pay off the debts incurred during recessions. Moreover, the argument went, governments should impose high tax burdens on the wealthy, who save and invest much of their money, and redistribute the proceeds to those who will spend virtually all of it.

This was a cockamamie idea, if you think about it — and that’s precisely what free-market economists did in the 1960s and 1970s. They pointed out that investment is how the economy becomes more productive. That, in turn, is how workers gain incomes and average living standards rise.

Supply-side economics is a broad policy of promoting work, savings, and investment through tax and regulatory reforms — which boost private investment — and through budget and policy reforms that raise the payoff from public-investment activities such as infrastructure and education.

The best symbolic representation of supply-side thinking is the Armey Curve, named after economist and former Congressman Dick Armey. It grants that the absence of government would be economically disastrous. But it also observes that after a certain point, taxing people to pay for more services makes them worse off.

The Armey Curve has lots of empirical support. Most modern studies of growth differentials among American states, for example, show that high taxes (and regulations) are negatively associated with economic performance, while high government spending isn’t positively associated with economic growth. That suggests most states and localities are larger than they ought to be. They are on the wrong side of the Armey Curve.

Since 2010, state and local spending as a share of North Carolina’s economy has dropped by 10 percent. The goal of North Carolina conservatives is not to reduce it to zero. The goal is keep government from encroaching too much on the private investment that is the primary driver of economic progress.

John Hood (@JohnHoodNC) is chairman of the John Locke Foundation and appears on “NC SPIN,” broadcast statewide Fridays at 7:30 p.m. and Sundays at 12:30 p.m. on UNC-TV.


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