“The Way the World Works”

That is the title of a book written by Jude Wanninski, who is considered one of the fathers of supply-side economics. This book has a profound influence on my economic and political philosophy. One of the important tenets that Mr. Wanninski establishes is that the primary role of government is to act as a referee between the public and private sectors. Government should not place a wedge between promoting economic growth in the private sector while pursuing what it considers policies for the public good.

Confiscatory taxation can create this wedge. When tax rates reach a very high level, it discourages work on the margin. Moreover, higher taxes may not produce a dollar-for- dollar increase in tax revenues. Taxpayers will find all kind of ways to avoid taxation, legally or illegally. In fact, it has been documented that the wealthiest tax payers actually contributed a higher percentage of overall tax revenues after the Kennedy and Reagan tax cuts. Furthermore, empirical evidence demonstrates that tax rate cuts have an incentive effect that works to promote growth in a short period of time. The best evidence of this is the 1963 and 1964 Kennedy/Johnson tax cuts, the 1981, 1983 and 1986 Reagan tax cuts and, finally, the 2003 Bush tax cuts. Refer to my blog commentary, “Economics is a Dismal Science.”

Many economists point to the Clinton years as a repudiation of supply-side economics. The highest marginal income tax rate was raised from 28% to 39.6%. Nevertheless, this was one of the most productive periods of rising employment and economic growth. While President Clinton raised taxes, he also kept spending under control. Federal government deficits were reduced, thereby, creating less supply of government debt, which helped to promote lower interest rates. This was Treasury Secretary Rubin’s gambit. Just focus on the bond market in order to reduce interest rates and economic growth will follow. Another important driver of economic growth during this period was President Clinton's embracement of free trade. Thus, there were countervailing forces to compensate for the negative impact of rising taxes, therefore; overall government policy was pro growth.

Today we have the opposite problem. We have very low interest rates and an exploding deficit. President Obama’s gambit is to raise the deficit in order to stimulate economic growth in this period where the economy is contracting sharply. Unfortunately, the government is increasing spending to unprecedented levels that could be forming the wedge Jude Wanninski talks about. The current amount of deficit spending is so large, even if the economy recovers, deficits may not be effectively reduced to a manageable level in the future. The Government will not only have to cut back spending some time in the future, it will probably have to raise taxes on more than the top 3% of income earners that Obama has outlined in his ten-year budget. The reason for this is that many economists believe Obama’s yearly GDP growth projections are too optimistic.

In fairness to President Obama, he did not create our current economic problems. However, his policies have the potential to make these problems much worse.
Historically, it has been very difficult for the Government to rein in spending. The Government never seems to be able to reduce actual spending. What is reduced is the rate of growth of spending. President Reagan found this out the hard way. He made this Faustian bargain with congress that if he would raise some taxes in order to reduce the projected deficits, congress would cut back spending on a 2 to 1 margin. Congress never fulfilled its part of the bargain. Nevertheless, President Reagan substantially lowered the marginal tax rates on individuals from 70% to 28% at the end of his eight-year term in office. This created an important foundation for the economic growth we experienced in the 1980s.

Unfortunately, President Bush and President Clinton did not strike the appropriate balance between free markets and government regulation. Under President Clinton in 1999 the Glass Steagall Act was effectively repealed. This act separated commercial banking from investment banking during the depression. The idea was to prevent banks from investing in more risky activities that could compromise their financial integrity. In addition, the regulators under President Bush, along with Chairman Greenspan, permitted our financial institutions to increase leverage to imprudent levels. Moreover, there was absolutely no regulatory oversight for the credit-default- swap market. These obligations are basically insurance contracts on bond obligations. AIG was rescued by the Federal Government with billions of dollars of tax-payer’s money. This company was one of the largest insurance companies in the world. It overextending itself in this market and nearly caused a major collapse in our financial system. Currently, it is a mere shell of its prior existence.

Jude Wanniski is correct in stating that the proper role of government is to act as a referee between the public and private sectors of the economy. While it will never be perfect, government should endeavor to pursue an appropriate balance between its policies for the public good and overall economic growth.