Deja Vu Voodoo Economics...or Supply Side Voodoo Black Magic...By - By Nouriel Roubini
Jun 20 2005
SourceI was yesterday morning on CNBC debating Arthur Laffer on supply side economics and the Bush tax cuts. Laffer is the father of the "Laffer Curve", the idea that tax cuts will not increase the budget deficit but would rather be self-financing given the strong suplly side response of labor, savings and investment to tax cuts. George Bush father referred to Supply Side Economics as "Voodoo Economics" when he was running for the Republican Presidential nomination against Ronald Reagan in 1980. Twenty five year later, supply side tax cuts are still Vooodo Economics!
The occasion for this renewed debate today was the news that in the first 8 months of the 2005 fiscal year, the US fiscal deficit has significantly shrunk relative to the first 8 months of the 2004 fiscal year; revenues are up relative to a year ago. For Laffer and other Voodoo economists this is the proof that tax cuts work. The reality is quite different when you consider the history of supply side economics for the last 25 years.
Voodoo economics was implemented in the 1980s by Reagan and it miserably failed. The 1981 tax cuts led to large fiscal deficits and current account deficits, an earlier episode of "twin deficits". By 1986 the budget deficit was as high as 5% of GDP and government revenues had fallen by over 2% of GDP since the introduction of the 1981 tax cuts. So much for the Laffer idea of self-financing tax cuts! The fiscal problem became so bad that Reagan was forced to reverse some of his tax cuts, first in 1982, then in 1984, and then again several times more in his second admnistration. Then, deficits started to fall to 2.9% of GDP by 1989; but by 1990-91 the reality of too low tax rates in face of rising spending and a short but painful recession pushed the deficit to an average of 4.2% of GDP in those two years. Voodo economics was such a failure that then President Bush - who had joined Voodoo Economics after making fun of it once he became the running mate of Reagan in 1981 - had to bite his tongue and lips and reverse his "Read My Lips: No New Taxes" promise and accept a tax increase as a way to start dealing with the fiscal mess that Voodoo Economics had created.
Once Bill Clinton was elected, he made fiscal discipline a priority and decided to seriously tackle the fiscal deficit via spending controls and, in part, a reversal of the Voodoo tax cuts of Reagan and Bush. At that time Laffer, the editorial page of the Wall Street Journals and plenty of Vooodo economics hacks (calling them economists would be an insult to the economics profession) screamed that the Clinton tax increases would have destroyed the economic recovery, reduced labor supply, savings and investment, would have led to a recession and and would have had self-defeating effects on the budget deficit because of negative supply side responses. This utter non-sense was also uttered through the halls of Congress and not a single Republican in Congress voted for the fiscal discipline package of Clinton.
And guess what: Voodoo hacks were totally wrong again for a second time. The tax increases and spending controls of Clinton led to eight years of exceptional economic growth, exceptional labor supply and employment growth (20 million new jobs) and a boom in investment. Productivity sored, the stock market boomed for years, inflation remained low and we went from a budget deficit of $290 b (4.7% of GDP) in 1992 to a budget surplus of $236 b (2.4% of GDP) in 2000, the last year of the Clinton administration. So much for the voodoo ideas that tax increases that impose fiscal discipline would have disastrous effects on the economy. Of course, the information technology boom helped the Clinton expansion but a fair assessment of the record suggests that restoration of fiscal discipline helped to prevent a crowding out of these new potential investments and was key in allowing the potential of the internet, IT and the new technologies to turn into an investment boom.
Then, in 2000 George W. Bush elected and, instead of listening to his father, who well knew that supply side tax cuts were Voodoo Economics, he decided to try again this bankrupt intellectual idea. So, we got another round of supply side tax cuts: income taxes were cut, capital gains taxes were cut, dividend taxes were cut, estate taxes were cut based on the delusional idea that you would get a huge increase in labor, savings and investment. So, Voodoo hacks claimed again that tax cuts would be self-financing. And, let us leave aside the fact that most of these tax cuts were effectively class warfare, i.e. taking from the middle class to give tax cuts to the very very rich, i.e. class greed disguised as trickle-down voodoo magic.
And what was the result of this second experiment in Voodoo magic? In 2000 the budget surplus was $236 b (2.4% of GDP) while by 2004 we had a budget deficit of $412b or 3.6% of GDP. This was a worsening of the fiscal balance of 6% of GDP in four years. What accounts for this worsening? Government revenues fell in those four years by 4.6% of GDP (from 20.9% in 2000 to 16.3% in 2004). In the same period government spending went up by 1.4% of GDP (from 18.4% to 19.8%). But almost all of the increase in spending is accounted by an increase in defense and homeland security spending triggered by 9/11 and the war on terrorism, Afghanistan and Iraq.
So, of the 6% of GDP fiscal deterioration, a full three quarters of it (or 4.6%) is accounted by a collapse in government revenues while only one quarter (or 1.4%) is accounted by an increase in spending. Worse, by 2004 government revenues were at a 50 year historical low: you had to go back to 1951 to find another time when government revenues were as low as 16%. Also note that excessive government spending had not been the cause of the budget problems. In the Reagan-Bush years (1981-1992), government spending had averaged 22%. Instead, by 2000, the last year of the Clinton administration, government spending had fallen more than 2% of GDP (down to 19.8%) relative to the years of the first Voodoo magic experiment. So, governments spending was not excessively high; if anything the Clinton years had been an epidose of significant spending control.
Note also that studies suggest that the 4.6% of GDP fall in revenues is mostly structural: about two thirds of it were due to the Bush tax cut while only about one third of it was due to the effects of the 2001 recession; indeed even three years after the recovery from the 2001 recession revenues were still down to 16% of GDP. Worse, there were no supply side effects of these tax cuts: from 2001 to 2004 there were net job losses (rather than the 10 million new jobs every four years created on average in each one of the two Clinton administrations), private savings fell to historical lows, investment recovered very slowly after its collapse in the aftermath of the IT investment bust and the stock market remained flat for four years.
Then, after four years of no jobs, runaway budget deficit, net job creation started at a modest rate in late 2004 and early 2005. So, of course, we are getting now some more income and some more income tax revenues; and given the surge in corporate profitability after four years of downsizing and deleveraging we are also getting some significant increase in the corporate tax revenues that had plunged to historical lows until 2004. But, as Douglas Holtz-Eakin the Republican head of the Congressional Budget Office (CBO) confirmed recently, most of the good news about the fiscal improvement are behind us; from now on, we can expect a further worsening of the fiscal balance. He told the Wall Street Journal: "These are the good ol' days. These are the best of times. After this it gets worse." Also note that some of the improvement is only due to technical or temporary reasons; for example, half of the increase in income tax revenues in May 2005 was due to the fact that May 2005 had once extra business day relative to May 2004.
Indeed, the CBO has considered the effects of making all the tax cuts (income, capital gains, dividends, estate taxes) permanent. If that voodoo magic goal of the Bush admnistration is implemented and if the AMT if fully fixed (another give-away to the very rich), then - if discretionary spending were to grow at its historical trend, i.e. at the rate of nominal GDP maintaining its share of GDP constant) - we would have budget deficits of $600b by 2009, well above the $412b of 2004 and totally off the stated goal of the admnistration of cutting the deficit by half by 2009. And note that the CBO forecasts include "dynamic scoring" i.e. they already include any positive supply side effect of tax cuts.
So today Laffer argued that the latest fiscal figures of increased revenues had vindicated his Voodoo Magic while the reality is that, of course, return to trend GDP growth was bound to eventually lead to some temporary recovery of revenues relative to their totally dismal lows of recent years. So, he must have been smoking some suspicious substance having spent too much time in Voodoo Cabal ceremonies to argue that the data vindicate his supply side Laffer Curve that should be better renamed as the Laughable Curve. We have now a country that has a structural gap between government spending and government revenues that averaged 3% of GDP now and is expected to increase to over 4% of GDP in the next four years. This reckless fiscal policy driven by reckless and unsustainable tax cuts is a major threat to the medium-term prospects of the economy. While these massive fiscal deficits have not led to increases in long term interest rates as most of the financing of these deficits comes from abroad, especially foreign central banks, this is a Ponzi scheme cannot last forever. At some point, foreign will tire of cheaply financing the U.S. and they will pull the plug. And no government can afford to permanently collect revenues at a rate that is 4% of GDP lower than what it spends.
And, as recently lucidly pointed out by Gale and Orszag in a recent LA Times op-ed piece, our long term fiscal problems are much more severe today than they were in the 1980s and early 1990s for several reasons: private savings rates were much higher then than now and thus the crowding out effects of budget deficits on investment and/or net exports are much more serious today; we were then a net foreign creditor while we are now a net debtor country, the biggest debtor in the world; we were then a quarter of a century away from the retirement of the baby boom generation while today those baby boomers are starting to retire in mass; Reagan had the sanity of reversing part of his tax cuts once he realized the impact of voodoo economics while the ideology of this administration is "tax cuts, tax cuts" to death regardless of reality; in the 1990s we got lucky with the end of the Cold War that led to a fall in defense spending of 3% of GDP while today defense and homeland security is way up and expected to go up even more; the Republicans allowed the PAYGO constraints to deficit spending to expire in 2002 and they are now vehemently against reintroducing them as they would clash with their senseless goal of making all tax cuts permanent.
So, while this voodoo magic religion seems to have also infested the halls of the the U.S. Congress, the next time you hear Mr. Laffer and his voodoo magicians tell you that their strange religion and odd beliefs have been vindicated, remember that this black magic has been tried twice before and has miserably failed. It is time for the U.S. to get rid of such barbarian delusional beliefs and get back to a reality-based mainstream economics of budget constraints. Otherwise, as predicted in a recent S&P study, the U.S. would be on its way to experience over the next decades an unsustainable death path would eventually lead to a junk bond credit rating status. That would be the ultimate verdict on supply side Voodoo Economics!