The Relationship Between Taxes and GDP is Precisely What Supply Side Economics Would Predict

A recent Jared Bernstein (who I'm a fan of) column in the Washington Post supposedly demolishes supply side economics. I've argued against this position before, pointing out that nations usually enact tax cuts when growth is slowing, and that when comparing GDP levels between lower tax nations, tax cutting nations, and high tax nations there appears to be a negative relationship between higher taxes and GDP Per Capita.

There is an even more important point to emphasize though, and one that supply siders rarely do. Once one accounts for the fact that tax cuts predominantly effect levels (roughly a ten year adjustment period), not the long-term growth path, and diminishing returns, a positive relationship between tax rates and growth is exactly what one would predict. To make a quick explanation as to why it effects levels, it takes time to adjust to new tax incentives (with regards to income taxes this is mainly effected by increases in labor supply), but labor supply isn't going to permanently increase unless taxes are permanently falling. So when we cut taxes to a new level, labor supply increases to a new level, but does not increase further. 

Let me explain. Say the top tax rate starts at 90%, and every 10 years it is cut by 20 points. So it goes from 90, to 70, to 50, etc, (stopping at 10%). When would the most growth occur, according to the supply side position? According to Bernstein, the years following it hitting 10%. Yet the correct answer is 70%. Why? Because the marginal income one earns triples when the rate is cut from 90% to 70%. With each further decrease of taxes, the percentage increase in take-home earnings gets smaller and smaller. So yes, one would expect higher taxes to be associated with higher growth, provided that they were cut from an even higher rate. It's worth noting too that this fits the data - the decade after the JFK tax cuts (which the top rate was cut from 91% to 70%) saw the fastest growth of the post-war period. Directly after the 10-year level path adjustment ended, we had stagflation (yes the RGDP numbers look solid, but that's only because the boomers and women were entering the workforce. Productivity was terrible). 

So one doesn't even have to do the cross-country comparison as Sumner did to make the case for supply side. One just has to understand levels and diminishing returns.

PS. My last post was pretty harsh towards DeLong, so I'll point out this excellent smackdown of Cochrane.