Commentary

Supply-Side Goes to Harvard

This article was published in the Washington Times, Aug. 25, 2002.

The president’s economic gabfest at Waco, like similar events in the past, was an insult to the economic profession. As a wise teacher once remarked, “If economics is that simple, why do we pay professors to teach it to our kids?”

The few token economists at Waco were from an older generation, and therefore burdened by a legacy of theories and assumptions that younger economists know to be quaint deceptions.

Complex theories make some people oblivious to simple facts. President Bush thought the only reason to trim a mere $5 billion from federal spending is that budget deficits push up interest rates — a remarkable thing to say while bonds yields are the lowest in four decades. Attachment to theories that don’t match the facts is a legacy of Keynesian speculations that were all the rage in the 1960s, particularly at Yale and Harvard. But economics has made giant strides since then, and Harvard is no exception.

In the 1980s, Harvard’s top economists included Marty Feldstein, Dale Jorgenson, Larry Lindsey and Larry Summers — all of whom contributed to the “microeconomic” analysis known as supply-side economics. Yet when it comes to talking about the overall economy (“macroeconomics”), that generation of Harvard economists often reverts to Keynesian folklore. A younger generation of economists, however, has noticed that Keynesian notions of what stimulates or injures an economy are upside down. Once again, some leading innovators are from Harvard, notably Robert Barro and Alberto Alesina.

The latest American Economic Review features a startling study about “Fiscal Policy, Profits and Investment” in 18 large economies by Profs. Alesina, Ardagna, Perotti and Schiantarelli. For simplicity, call it the Alesina study.

Harvard economists once thought cutting government spending was contractionary, something that would shrink the private economy. The Alesina study finds that big cuts in government spending are expansionary, making economies boom. Ireland slashed government spending by more than 7 percent of GDP in 1986-89, and economic growth from 1989 to 2001 averaged 7.2 percent per year. Japan spent hundreds of billions on Keynesian public works schemes after 1991, and economic growth averaged only 1.1 percent.

Part of the explanation is taxes. Ireland now has a 15 percent tax on corporate profits, a 20 percent tax on inflation-indexed capital gains and lower tax rates on labor. Japan imposed new taxes on sales, property and capital gains, while maintaining Asia’s most punitive income-tax rates.

Alesina found that “labor taxes have the largest negative impact on profits and investment,” partly because private workers “react to tax hikes or more generous transfer payments by decreasing the labor supply or asking for higher pretax real wages.” But this study also found that big government spending is inherently bad for economic growth, even aside from taxes. Government hiring and pay raises lure workers from private businesses, which are forced to raise wages even if that means reduced hiring. Higher labor costs per employee depress profits and investment.

Many other new studies find equally bad effects of big government on economic growth. In the May issue of the same journal, for example, Ed Prescott of the University of Minnesota found that “differences in the consumption and labor tax rates in France and the United States account for virtually all of the 30 percent difference in the labor input per working-age person.” Mr. Prescott calculates that the French would be 19 percent better off if they had a tax system no worse than ours.

I believe the United States would be 50 percent better off with a tax system like Hong Kong’s, but that is another story for another day.

In any case, the Alesina study concluded that “fiscal stabilizations that have led to an increase in growth consist mainly of spending cuts, particularly in government wages and transfers, while those associated with a downturn in the economy are characterized by tax increases.” The study explained that “since aggregate demand-driven models fail to capture significant aspects of fiscal policy we concentrate on the supply side.”

Jude Wanniski and I came up with a name for that back in April 1976: We called it supply-side economics. To concentrate on the supply side may sound like an old idea to those who opine about economics without bothering to study the subject. But it is an exciting new idea in leading universities like Harvard and also in newly prosperous countries such as Ireland and Russia. It always works.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.