Democrat vs Republican Tax Cuts
Both Parties Have Enacted Tax Cuts in Last Half Century
In a previous Hub (see "How Tax Cuts Work") I discussed how a supply side tax cut works. For the past quarter of a century tax cuts have been synonymous with supply side economic theory and Republican Administrations (Reagan in the 1980s and now President Trump).
However, in the 1960s tax cuts were being pushed by the Democrats in the Kennedy-Johnson Administration. Unlike today, where Republicans were urging tax cuts and Democrats opposing them, in those days it was the Democrats pushing the tax cuts and Republicans opposing them.
Was this just partisan politics in which one party proposes the policy and the other one feels obligated to automatically oppose it? The answer is “No”. There are actually two economic theories concerning how and why taxes should be cut.
One theory is aligned with the policy objectives traditionally pursued by Democratic administrations and the other is aligned with policy objectives traditionally pursued by Republican administrations.
Democratic Tax Cuts - Keynesian Theory
The theory favored by the Democrats is the Keynesian theory put forward by the British economist John Maynard Keynes in the 1930s and 1940s.
Keynes' theory sought to manage an economy so as to keep it on an even keel and avoiding fluctuations in the business cycle - both the booms with their rising prices and busts (recessions / depressions) with their unemploym
Keynes' prescription for downturns in the economy was to stimulate demand by increasing government spending and/or cutting taxes.
The idea was to get money into the hands of consumers so that they would begin buying, which would cause business inventories to decline and this, in turn, would cause businesses to replenish the inventories by re-hiring laid off workers and putting idle factories and machinery back into production.
As workers were re-hired, they would begin spending their new paychecks which would further stimulate demand and so on until the economy was back to full employment and full production. Of course, at this point, the government would have to pull back by reducing spending and/or increasing taxes, least demand outpace production and lead to serious inflation.
Since the objective of Keynesian tax cuts during a recession was to put money into the economy and encourage people to spend money, deficits were encouraged. To provide the stimulation needed to get the economy going, Keynes insisted that the government increase, or at leas maintain, current spending levels.
Offsetting tax cuts with corresponding cuts in government spending, would, according to Keynes' theory, be self defeating in that the object was to encourage spending by consumers. Further, to be effective, Keynesian tax cuts had to be directed toward the lower income brackets since these brackets contained the people with the lower incomes.
The lower a household's income, the more of that income the household has to spend to survive. Wealthy people, on the other hand, can afford to save large portions of their income because their incomes are more than enough to meet life's needs.
According to Keynes, savings was not desirable because, to be effective, savings have to be invested, but why encourage investment in building more factories and equipment when a large portion of the existing stock was already idle?
During economic downturns (recessions or depressions) the government, according to Keynesian theory, was supposed to run a deficit. However, once the economy pulled out of the downturn, the theory called for the government to cut back on spending and/or raise taxes. This was to pull money out of the economy so as to keep demand from increasing to the point where it exceeded productive capacity and inflation resulted. The government, according to the theory, was now supposed to run a budget surplus.
When President Kennedy called for cutting taxes during the 1960 election it was a Keynesian style tax cut that he was proposing. The Republicans immediately went into opposition for two reasons. First, the proposal was inflationary (which is exactly what Keynes prescribed for pulling an economy out of a recession) and, second, it would generate a deficit thereby threatening to add to the national debt.
Republican Tax Cuts - Supply Side Theory
Instead of Keynes, the Supply Siders looked to a nineteenth century French economist named Jean-Baptiste Say (1767 - 1832) who is best known for his observation that "supply creates its own demand". In other words, "you make it and they will buy it". Just as John Maynard Keynes was popular with Democrats because he distrusted the free market and saw the government as the manager of the economy, the Conservative Republicans that President Reagan led, looked to Jean-Baptiste Say because his theories supported the idea of leaving the control of the economy in the hands of the market and keeping government intervention to a minimum. Along with Say was another, contemporary, economist, Arthur Laffer of California. Laffer had advanced the theory that, by reducing high marginal tax rates, the government could both stimulate economic growth and increase revenue. He even produced a graph, which came to be known as "the Laffer Curve", which showed that, over a certain range, reductions in tax rates would lead to increases in tax revenues.
Laffer's theory solved two problems for President Reagan and his Young Turk supporters in Congress (notably Jack Kemp and David Stockman) who were looking for ways to reinvigorate the conservative wing of the party. First, it promised a way to get the economy growing and out of the stagflation that was choking it and, second, it was a way to overcome the old line conservative (the Robert Taft wing of the party) insistence on cutting spending first and then cutting taxes. Inflation was this group's fear and they were opposed to any tax cut that threatened to be inflationary. With the Democrats in control of both houses of Congress, there was no way President Reagan and his team were going to obtain the spending cuts necessary to put through a tax cut. Laffer's theory provided a way that would reassure the old time fiscal conservatives, without having to get spending cuts through a Democratic controlled Congress.
The idea behind Supply Side tax cuts is that high marginal tax rates discourage both work and investment. As I stated in my original tax cut article, after a certain point, people have earned enough income to satisfy their basic needs for food clothing and shelter and, if most of any additional income earned, from either more work or investment, is taxed away, people have little incentive to work or invest beyond this point. By lowering marginal tax rates, people have the incentive to earn more by working and investing and, when they do this, the extra income they produce is significantly high so that, even at a lower tax rate, the total tax collected is greater than before when the rates were higher but, additional income lower. This is how tax cuts result in greater tax revenue.
Now, it must be understood that true Supply Side tax cuts only work with higher income households. These would be households with wealthy individuals or upper middle class households where both husband and wife work. Cutting lower brackets to help lower income people, simply reduces the amount of taxes collected. The reason is that people in the lower income brackets have low incomes and are probably working as much as they can to support their families. Obviously the increased take home pay helps them, but, if both husband and wife are already working one or more jobs each, they can't physically work more and, if their total income has not reached the high marginal bracket levels then the cut provides no incentive to try to work more. This is the opposite of the Keynesian tax where we want to put money into the hands of lower income people because we know they will spend it.
For analytical purposes, one of the problems with the Kennedy-Johnson, Reagan and Bush tax cuts is that all three contained elements of both Keynesian and Supply Side tax cuts. None of the three were a pure Keynesian or Supply Side tax cut. All three tax cuts had to go through the political process and politics is the art of compromise.
In the case of the Kennedy -Johnson tax cut, Democrats controlled both houses of Congress. However, many of the Democrats from Southern states at that time were fiscal conservatives and tended to vote with the Republicans on fiscal matters. As a result, the Kennedy-Johnson tax cut was an across the board tax cut that reduced rates in both the upper and lower brackets. The cut in the top bracket was major - the tax rate in the top bracket was cut from 91% to 70%, a 21% reduction. This tax cut did supply both a demand side stimulus that was credited with pulling the economy out of recession as well as a supply side stimulus that resulted in economic growth. Unfortunately, the expected Keynesian deficits ballooned as a result of President Johnson's decision to both expand the war in Vietnam as well as launch his very expensive "War on Poverty".
In the case of Presidents Reagan and Bush, in order to generate the political support they needed from both Congress and the public, they had to make cuts in all brackets. While the thrust was supply side, there were elements of Keynesian demand side cuts in lower brackets as well. In fact, in the case of President Bush's cut, he used Keynesian demand side arguments as well as supply side arguments in his selling of the idea to the American people. Deficits did appear, as anticipated, under the Reagan tax cut as a result of Congress continuing to increase spending despite the initial reduction in tax revenue (as I described in the previous article, there is a lag between the tax cut and the increase in revenues). However, the rising deficits did end up pressuring Congress to reign in some of their spending. Suddenly it was Democrats who were concerned about rising deficits but this could be due to both the public's concern about inflation, having recently experienced double digit inflation in the 1970s as well as frustration over having to cut back on new spending programs due to the inability to raise taxes to pay for them.
As to the future, we can probably expect Republicans to continue to be the party of tax cuts because these are in line with both their political and economic agendas. While Democrats will probably stay away from tax cuts as a policy tool in the near term and rely on increased spending as the tool of choice for combating downturns in the economy.
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© 2006 Chuck Nugent