2004: A test of Supply Side economics

What are the Economic & Theoretical Ramifications of the 2003 Holiday Shopping Season?

The holiday shopping season of 2003 provided a fascinating glimpse into the goings on beneath the surface of the macro economy. It also provides a fresh opportunity to examine the validity of a specific economic theory — Supply Side / Trickle Down Economics — and to lay a fresh challenge to the proponents of that school of thought.

Our inquiry begins with this simple question: Why did the luxury sector do so smashingly well this Christmas, while the low end of the market — in particular, the mass discounters — performed below expectations? Contrast the year over year revenue gains for high end retailers Tiffanys, Coach, Nordstrom and others, with the performance reported by Wal-Mart, Target, CostCo, and the rest.

The explanation reads like an overview of 2003: The wealth effect from a rising stock market, along with a relatively healthy bonus pool this year, contributed to the surge in luxury goods sales following several years of pent up demand. But the true key to the 2003 holiday sales performance is found in the Bush economic plan. For higher income families, a holy trinity of tax cuts put a healthy serving of dollars into their pockets: Tax brackets were cut, capital gains taxes decreased, and an entirely new class of much lower dividend taxes created. The results from the retailers of higher end goods suggests that much of that money was spent on luxury items.

For middle and lower income families, the bulk of the tax benefits — manifested in the form of $400 Treasury checks reflecting lessened federal witholding tax (due to the lowered tax rates and the larger standard deduction for married couples) — were long spent prior to holiday shopping. This group may also have reined in their spending a bit, as they remain somewhat skittish about the employment situation. Bearing this out is the irregular gyrations of the monthly consumer confidence numbers. While middle income families will continue to see benefits from the Bush tax cut — they will be rather modest. They will certainly not pay for many purchases from Nieman Marcus.

Viewing this phenomena through the lens of economic theory, the contrast between the luxury and discount retailers raises curious theoretical issues: Might some economists explain this discrepancy as an example of “Supply Side” economics in action? If the economy continues to strengthen going forward, will this school of thought finally be validated?

Long disparaged by classical econ scholars as the bastard stepchild of economics, the “Supply Side, Trickle Down Thesis” has been out of favor — at least publicly — since Ronald Reagan left the White House. While dedicated Supply Side proponents remained active in think tanks and media, they were at most influencing, but not pulling, the levers of power. Today, however, the Supply Side school of thought dominates the Bush Administration’s economic policies as thoroughly as the NeoCons dominate its foreign policy.

In the 1980s, as Ronald Reagan’s “Trickle Down” policies were put into effect, the top tax bracket was slashed in half, from 70% to 35%. That’s the sort of meaningful change to the tax code which economists believe create significant changes in investor behavior. President Bush, on the other hand, made what many pundits (present company included) derided as an “incremental cut” — less than 10% for the highest tax bracket. The assumption was that “incremental tax cuts for tax cuts sake” would not have all that profound of an impact.

What may have been overlooked at first blush was the cumulative effect of all the tax cuts discussed above. Capital gains taxes were sliced 25% (from 20% to 15%), and the new dividend tax cut — at least for investors in the top bracket — was more than chopped in half, (from 38.6% to 15%). Collectively, these three changes to the tax code seem to be having a meaningful effect on high end consumption. Whether it will have a trickle down effect on employment and business spending is as of yet unknown.

But we shall soon enough find out. Thus, Supply Side school of thought — derided on the campaign trail by Bush the elder as “Voodoo economics” — now has a golden opportunity to redeem itself. Failing to do so, however, may relegate it once and for all to the trash heap of economic theory.

The architects of President Bush’s economic plans are former National Economic Council head Larry Lindsey, and former Council of Economic Advisers director Glenn Hubbard. Hubbard is widely credited as being the man behind the dividend tax cut — he first proposed it while working for Bush I. Both are known as “strong supply-siders with conservative think tank roots.” These advisers have since moved on. Lindsay resigned last December; Hubbard followed him out the door a few months later. These top bracket tax cutters were confident enough that their plan was irrevocably in motion that they retired to the worlds of think tanks and academia.

To us, here is where things get interesting: Harvard economics professor Gregory Mankiw replaced Hubbard at the Council of Economic Advisers. The Professor has been described as not a Supply Sider — at least, according to Stephen Moore (Club for Growth President and NRO contributor).

Moore cites Mankiw’s “Principles of Macroeconomics” textbook, where the professor disparingly refers to Ronald Reagan’s supply-side advisers as “charlatans and cranks.” The obligatory excerpt:

An example of fad economics occurred in 1980, when a small group of economists advised Presidential candidate, Ronald Reagan, that an across the-board cut in income tax rates would raise tax revenue. They argued that if people could keep a higher fraction of their income, people would work harder to earn more income. Even though tax rates would be lower, income would rise by so much, they claimed, that tax revenues would rise. Almost all professional economists, including most of those who supported Reagan’s proposal to cut taxes, viewed this outcome as far too optimistic. Lower tax rates might encourage people to work harder and this extra effort would offset the direct effects of lower tax rates to some extent, but there was no credible evidence that work effort would rise by enough to cause tax revenues to rise in the face of lower tax rates. . . .

However, prominent Supply Side commentators strongly dispute Moore’s cranky assessment; Mankiw, we are assured, has both feet solidly planted in the Supply Side camp.

So is there a split within the economic apparatchiks of the Administration? Bush continues to maintain prominent Supply Side/Trickle Down theorists, the most prominent of which is VP Dick Cheney. This group remains extremely influential with the President.

The present team seems to have more fiscal conservatives — including budget balancers and otherwise traditional economists — and self-described “responsible adults.” Should the President win a second term, these budget balancers expect to be the “clean up team” — imposing fiscal discipline on a White House and Congress that has yet to meet a spending increase they didn’t love.

The rest of the President’s term may play out as a fascinating economics drama between two schools of thought. We will be witnesses to a trial of the trickle down school of thought. The large disparity between the two end points of the retail sector that materialized suggests a real time, live test of the Supply Side economics.

Indeed, the key to which wing of Bush’s economic team will win subsequent budget and tax battles is likely to be determined by how the economy behaves between now and Inauguration Day 2005.

Is Supply Side Already Working?
The recent economy has something for every school of economics: There’s been enough deficit spending too keep the Keynesians happy; Money supply increases (at least, up until recently) were sure to warm the hearts of Monetarists. Yet the economy seemed not to respond to either of these stimulants — not until the 2nd Quarter of 2003, when the second round of tax cuts kicked in. Indeed, supply siders might even argue that a test in 2004 is unnecessary, as the recovery in 2003 more than proves the case.

Perhaps that assessment is premature. As Ned Davis said, “give me a trillion dollars and I’ll throw you one hell of a party.” The proof of Supply Side success will come once the economy demonstrates it is on a self sustaining path – that includes robust job creation. That’s something notably absent in this post recession recovery cycle, and which the Supply Side team expects to occur in the first half of 2004.

If the economy is in full recovery by this time next year, that will go a long way towards rehabilitating the supply side school amongst traditional economists. If on the other hand, the economy slips back into a slow growth mode without much in the way of job creation, or (gasp!) a contraction, that may very well spell the death knell of trickle down as a credible economic thesis.

As an economic agnostic — I believe in the “smorgasbord approach” of taking a little of what works from each school of thought — I simply can’t wait until next year to see how this plays out.

Redemption or repudiation awaits . . .

Hail Hubbard
by Bruce Bartlett
National Review, January 13, 2003, 8:00 a.m.

Think Twice About Gregory Mankiw
This Harvard economist does not belong on the Bush economic team.
By Stephen Moore
National Review, February 28, 2003 11:30 a.m.

Principles of Macroeconomics
by N. Gregory Mankiw
International Thomson Publishing; 2nd edition (June 2000)

Cheney the Supply-Sider
Cheney the Supply-Sider
Larry Kudlow,
National Review, 7/24/00 6:45 p.m.

David Stockman, The Triumph of Politics: Why the Reagan Revolution Failed
(New York: Harper & Row, 1986), p. 56.

The Education of David Stockman
William Greider
Atlantic Monthly, December 1981, pp. 46-47.

Q&A Gregory Mankiw
Top economic adviser to George Bush
Time, Monday, Oct. 06, 2003

Secondary Resources:

Trickle-Down Economics: Four Reasons Why It Just Doesn’t Work
By Mehrun Etebari
July 17, 2003

The Rise of Supply-Side Economics

Trickle Down Economics and corporations: How corporate taxes cost jobs
By Brad Wardell
Posted Wednesday, September 03, 2003

Trickle down economics comes of age
By: Tim Wood
Posted : 2002/06/14 Fri 04:00  | © Moneyweb 1997-2003

Trickle-down Economics and Ronald Reagan
Jim Blair

The “Trickle Down” Economics Straw Man
by Thomas Sowell  
September 27, 2001, Capitalism Magazine

Trickle Down Economics in Full Flow (PDF)
Center for Impact Research, April 2003

Supply-side Economics has Supporters in Academia
Monday, September 29, 2003
by Bruce Bartlett

A Supply-Side History And The Road Ahead Part I
By Wayne Jett, August 1, 2003 Part I
and Part II:
A Supply-Side History And The Road Ahead Part II

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What's been said:

Discussions found on the web:
  1. Bob commented on Dec 27


    I disagree with one item you mentioned: “… the Bush Tax Cuts”.

    Although cleverly disguised, those were NOT tax cuts. Those were/are Government Transfer Payments. Money is being transferred FROM the poor and the middle class TO the wealthy.

    It is a (stealthy) frontal attack on the middle class.

    IMHO, that perspective helps explain what happened in retailing this season. The wealthy have plenty of disposable income…the poor and middle — not so.

  2. The American Mind commented on Dec 29

    Carnival of the Capitalists

    This is the last Carnival of the Capitalists for 2004. What a toppsy-turvy year in the economics/business world it was.

  3. K Harris commented on Dec 29

    Very nice work in general (not just this piece, but most). However, I have a quibble of major proportion with this post.

    Finding out whether demand stimulus through trickle down (getting the rich to spend, thereby providing jobs and incomes for the less rich) is not the same as testing supply-side assertions. Trickle-down, at least as described here, is a demand management effort, rather than a supply-side effort. Only if we are manipulating incentives on the supply side are we engaged in a supply-side experiment.

    What is needed to assess the supply-side impact of the Bush tax overall economic policy program is to assess whether those policies have encouraged greater than normal investment in capital of any or all kinds, and whehter that greater than normal investment has worked out to the general benefit of the economy. The rise in capital spending recently underway is not sufficient evidence of the success of such policies, since there is very frequently a capital spending rise in the aftermath of a slowdown, without regard to tax or other economic policies.

    Extraordinary investment requires extraoridinary savings, so the burst of luxury spending over the holidays is, in fact, evidence against a supply-side impact from the tax cuts. It is not conclusive evidence, as there may well be enough cash in the tax cuts to allow tax-cut beneficiaries to spend and save more. That is certainly what happened in Q3 in response to tax rebate checks, but that was across income levels (as far as we can tell now), so it doesn’t tell us what we want to know about the behavior of the well-off, who benefitted most from the Bush tax cuts.

    And again, the US economy as a whole needs to benefit from any rise in investment for supply-side notions to be validated. A pick-up in the pace of gold or fx speculation in response to a tax wind-fall (as an extreme instance) is unlikely to add to GDP beyond the fees charged for the trades, and is unlikely to add to employment much, either.

  4. Barry Ritholtz commented on Dec 31

    I don’t disagree with you; I think we are more or less on the same page.
    Perhaps I’m guilty of lumping Supply Side & Trickle Down together,
    but having more or less come of age during the Reagan Administration,
    I cant help but think of them together.

    If the entire economy is healthier one year from now, I would think that
    would in large part validate SSE; If on the other hand, we slip backwards,
    it may rpeudiate the thesis.

    In the real world, we never get ideal laboratory conditions and optimal
    control groups — but I think that the Bush Team was as close to true
    Supply Siders as we are likely to see . . .

  5. Kevin Harris commented on Dec 31

    Oh, I know this little terrier out to let go to the sock, but I can’t. 

    “Tax” and “supply side” are overlapping sets, but not identical sets.  A tax cut the main result of which is to stimulate demand is not a supply side policy.  The rebate checks, to the extent they stimulated spending in Q3, are a tax policy, sure enough, but not a supply side policy.  So far, those rebate checks are the strongest and least ambiguous source of growth from tax policy under Bush.  To the extent they stimulate decisions on the supply side – to work longer or harder, to invest more – then rebate checks are also a supply side policy.  We have good evidence they stimulated demand.  However, from the perspective of economic theory, an after-the-fact rebate cannot stimulate a decision to work harder in the period already passed, so rebates don’t qualify as supply side. 

    The rest of the package, the part that mostly goes to high earners and investors, is not specifially designed to provide supply side effects.  It is just money going to (or kept by) a particular group.  From a theoretical standpoint, the choice of incidence of the dividend tax change is not optimal as a supply-side stimulus.  Firms, rather than individuals, would be given a dividend tax break if we wanted to make the policy unambiguously “supply-side”.  There were White House economic advisors who reportedly made this argument, but were ignored.  From an empirical point of view, we need to see a stronger than normal, sustained rise in investment (and work hours among the best paid managers) to validate any supply-side suspicion.  Not enough just to cut taxes. 

    Tax cuts, by themselves, are without doubt a Keynesian solution – run a bigger deficit.  It is the microeconomic impact of tax cuts that tells you whether it is supply side in intent, the strength of capital formation that tells you about a supply side effect.  The microeconomic assessment so far must be that this is not particularly supply-side stuff.  Too soon to tell about the empirical results.

    Just for fun, it is worth noting that, just as tax cuts are not necessarily a supply side sort of thing (depends on the details), it is entirely possible for government spending to be a supply side thing.  Highway construction can provide a supply-side boost, if resulting lower transportation costs induce private investors to make capital and human investments.  Government dredging of harbors can lead to private investments in shipping, warehousing and freight handling facilities.  Government R&D spending, or creation of a computer communication network like the internet, can have massive supply-side effects.  One can argue that these government outlays ought to be carried out by private concerns, but that is not the same as saying they are not supply-side policies. The sort of government spending projects noted here are supply-side policies, without question. 

  6. Liudvikas Bukys commented on Jan 2

    This would be a better editorial if you avoided the loaded phrases and pre-digested thought bites.

    “Supply side” means “improving the incentives for the producers at the margin.”
    “Trickle down” is just a pejorative.

    Kevin Harris’s comments are right on.
    The Bush tax cuts were a mix of supply-side marginal rate changes and demand-push one-shot pennies from heaven. On balance a good thing, but definitely a mixed bag.

    As for judging the results: note that you’re using exclusively short-term demand-oriented metrics (a natural hazard for the Christmas retail season, I know).
    But the important result is not increased spending, it is increased investment leading to increased productivity.

  7. Barry Ritholtz commented on Jan 2

    I always that “Trickle Down” referred to Supply Side economics; Perhaps that was a bit naive of me –I hadn’t realized was going to be perceived in such a pejorative way — I’ve heard it used interchangeably with Supply Side for a long long time (since th 1980s). I’m now aware (thru several emails) that it is more of a loaded phrase than I expected.

    I see LB’s point about that.

    As tot he Xmas retail issue — I used those numbers merely as a leaping off point — it answered some questions regarding consumer confidence, while raising other general issues
    about the broader economy. The dichotomy is certainly curious, and is worth exploring further.

    This certainly has become an interesting thread!

  8. BOPnews commented on Aug 16

    2004: A test of Supply Side economics

    A few posts below, Stirling makes The Liberal Case for Supply Side Economics. Back in December, I reached a rather different conclusion — I thought it was far too wonky for this crowd. You can see the details here: 2004:…

  9. Stirling Newberry commented on Aug 27

    “”Trickle down” is just a pejorative.”

    Incorrect, trickle down is the theory that large concentrations of wealth create employment, and therefore leaving them untaxes will create more jobs and money will “trickledown”.

    Mercantilism is a “trickledown theory” of growth – and for nations which can and must focus on exporting, it works: large capital investment to export becomed jobs, which creates hard money flows in, which create incentives for others in the economy to spend their productive time and effort in ways that will secure hard currency for themselves, and so on.

    Whether trickledown economics works in an internally based economy, where the vast majority of employment is created from franchises, home building and other activities that do not rest on large concentrations of money, is another question. So far the answer seems to be “no”.

  10. A Lewis commented on Feb 11

    Looks like supply side theory works again! Here we are in early 2007 with a booming economy, low unemployment and a record DOW.

  11. diva commented on Mar 3

    Barry – Jude Wanniski explained why this is exactly what would happen (before he died). Capital has been ’empowered’ to the point that labor would be the secondary gainer during this economic expansion. I’m no expert. Maybe Wayne Jett could expand upon this, if you contact him.

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