Plain Sense Economics

In Principles of Macroeconomics we compare the dueling strategies of John Maynard Keynes and supply side advocates. Keynesian strategies rely on government spending to stimulate demand during recessions. Supply siders argue that we should reduce tax rates, and let income earners (individual and corporate) keep more of what they earn, thereby increasing their incentive to work hard and earn more.

Gregory Mankiw leans more towards the supply side argument, and is concerned that the current healthcare reform bill has very high marginal tax rates. You can read his analysis from The New York Times here.

New York Times - Sunday, November 1

However, let’s put aside the specifics of the healthcare reform proposals and go to the heart of the supply side argument. From Mankiw,

[S]ubstantial evidence supports the more modest proposition that high marginal tax rates discourage people from working to their full potential.

The phrase marginal tax rates means the rate applied to an additional amount of income. It is different from average tax rate which applies to the family’s entire income. Imagine that you are earning $30,000 currently and have a chance to earn an extra $10,000  by taking a night job. If, though, your marginal tax rate is 20 percent, the tax on that additional $10,000 is $2,000. So your take home page as a result of taking the second job is $8,000.

Now the questions start lining up. Would you be less willing to take that job if you knew your marginal tax rate would be so high? And if you take that second job, will the economy benefit from your added participation? The answer to the first question lies in your opportunity cost – what you give up, in the form of leisure, to take the job, and what you give up, in the form of added income, if you decided to spend your evenings at home. The impact on the economy comes from your higher income, some of which you would spend. What is harder to estimate is whether your participation is more effective than someone else who might take the job if you did not.

As Mankiw reminds us, “the verdict on supply side economics is mixed.” Some argue that there is no compelling evidence to support supply side strategies, while at least two Presidential administrations (Reagan and George W. Bush) based their economic platform on this principle. To my mind, supply side strategies are not very effective in stimulating demand, and have earned political support mostly as a justification for a less-government-is-better-government platform.