For the past 15 years, Keynesian demand-management policies have been applied to the U.S. economy. They have left an empiracal track record -- one of progressively worsening economic performance with rising rates of inflation and unemployment. Keynesians have attributed the failure of their policy to Arab oil lords, unions, big business and to a mystical and worsening "underlying rate of inflation," which they believe is independent of fiscal and monetary policies.
The culprit, however, is demand-management itself, which puts monetary policy on the roller coaster and pushes taxpayers higher in the progressive income tax system.
Keynesian economics uses the government's budget as its tool for managing the economy. Unemployment requires a budget deficit to increase total demand or spending in the economy. Inflation requires a budget surplus to reduce total demand in order to relieve pressures on the price level. In practice, this approach produced deficits every year for the past decade.
In an unemployment year, the policymakers would calculate the size of the "fiscal stimulus" or budget deficit required to bring spending up to the full employment level. For the deficit to actually add to spending, the Federal Reserve had to accommodate it with a monetary expansion. Otherwise, the government's borrowing would drive up interest rates and choke off the demand it was trying to stimulate. In effect, it was a policy of fighting unemployment by printing money.
The monetary expansion would push up the inflation rate, and soon the Federal Reserve would be under pressure to cool down the economy by tightening up on the money supply and rising the interest rate. The government's revenues (but not spending) would decline as the economy soured, and this time the budget would unintentionally go into deficit.
Recession would push inflation concerns aside. The policymakers would calculate the size of the budget deficit necessary to restore full employment, and the "business cycle" would be off and running again. As the chart shows, each round of the roller coaster left a larger residue of unemployment on the upside and successively higher inflation rates on the downside. Soon policymakers were talking about worsening trade-offs between inflation and unemployment.
The demand-managers didn't realize it, but their problems were created by mixing together demand stimulus with supply disincentives. The inflation that accompanied the demand stimulus eroded the real value of business' depreciation allowances and pushed taxpayers into higher marginal tax brackets.
In 1965, the highest tax bracket encountered by a median income family of four was 17 percent. That means the family got to keep 83 cents of an additional dollar earned. A family with twice the median income encountered a top bracket of 22 percent.
Unless tax rates are cut, in 1981 the median income family will encounter the 28 percent bracket -- a 65 percent increase in the tax rate applied to additional earnings. A family with twice the median income has been pushed from the 22 percent bracket into the 43 percent bracket -- a doubling of the marginal tax rate.
Unless President Reagan's tax proposals become law, by 1984 the median income family will be in the 32 percent bracket -- which was, as recently as 1975, the highest bracket encountered by a family with twice the median income. A family with twice the median income will face the 49 percent bracket.
When Social Security and state income taxes are added in, the disincentives are even harsher. Today a median income family that resides in Maryland is in the 40 percent marginal tax bracket; one that resides in New York is in the 44 percent bracket. After 15 years of demand-management, ordinary people are now in tax brackets that once applied only to the rich. Little wonder output has stagnated while inflation has roared.
Under President Reagan's proposals, the median income family will be in the 23 percent federal bracket in 1984. That doesn't turn the tax clock all the way back to 1965, but it is a big step in the right direction.
Demand-side economists don't understand the importance of this step. To them, the function of a tax cut is not to restructure incentives but to increase demand. Thus, over the last decade when they cut taxes, they focused on lowering the average tax rate on existing earnings (through such means as larger personal exemptions and standard deductions) and allowed the marginal tax rate on additional or new income to rise. As a consequence, today for the majority of the population the incentive to produce additional income is the lowest in our history, and the personal saving rate is the lowest in anyone's memory.
The failure of demand-side economists to take into account supply-side economics explains the pessimistic analysis of President Reagan's economic program published by the Congressional Budget Office on March 25. They see the personal income tax rate reduction as a fiscal stimulus, but its effect on demand is offset by the budget cuts and the tight monetary policy, both of which reduce demand. In the Keynesian view, the administration's policies cancel out, leaving the economy essentially unaffected. Without an improved economy, the budget can't be balanced -- thus CBO's projection of a $49 billion deficit in 1984.
The president's economic program looks radically different when viewed through supply-side eyes. The purpose of the tax cut is to increase incentives, not demand. Therefore, the Federal Reserve is not under pressure to accommodate a fiscal stimulas with an expansionary monetary policy, so there is no source of inflation. The purpose of the budget cut is to preven private savings from being diverted from private capital formation and used instead to finance spending growth. The purpose of the regulatory cuts is to reduce production costs.
The expansion of the economy that the administration foresees results from better incentives and higher after-tax rates of return, not from higher demand. We agree with CBO that our program will not provide a direct stimulas to demand, but we disagree that the economy will not respond to improved incentives. It is the focus on incentives that makes the tax cut the centerpiece of the president's program.