Supply Side Cuts Work

Maybe I have mentioned this before...

The WSJ Ed Page today is ready to name names, who was right and who was wrong.

The Labor Department said Friday that the U.S. jobless rate fell to 5% in June, the lowest since 2001. Federal tax revenues continue to rebound, at a nearly 15% annual rate so far this year (see below), and economic growth continues to average nearly 4% despite $60 oil and rising interest rates. Maybe it's time to give the tax cuts of 2003 the policy credit they deserve.

My Rubinomics buddies were all so certain that President Bush was exploding the deficit with irresponsible tax cuts, destroying the currency, and driving interest rates to the moon.

I said back then "So, you're short the 10-year?" These people seemed to know so much more than the bond market. "Short the dollar at $1.29 to a Euro?"

Thankfully, my friends do not have courage of conviction, so they were not wiped out. But we do need to give the occasional I -told-you-so, to ascertain that we treat the next slowdown with the economics of Art Laffer and Milton Friedman -- not Keynes and Galbraith.

The tax cuts worked and should be made permanent, the demand-side rebates did not and should ne'er be considered again.

Almost from the very day in May of 2003 when those tax reductions became law, the U.S. has experienced a robust expansion driven by investment and productivity gains, not by consumer spending. This is demonstrated by the nearby graph comparing the trend in consumption versus investment over the past five years. Consumer spending has been close to flat over the period with a modest dip at the very bottom of the recession. But investment has experienced a stunning U-turn.

One result has been a strong stock market recovery, especially in 2003 and 2004, with shareholder wealth rebounding by roughly $2 trillion since the market collapse that began in 2000. Another sign of growth is the return of venture capital funding for start-ups -- the leading candidates to be tomorrow's Dell or Home Depot. This market has recovered enough from its 2002 trough that the National Venture Capital Association says, "We're in the beginning stages of a new cycle of venture capital financing, and the capital gains cut has had a lot to do with that." Initial public offerings have also quadrupled since 2002, despite the new burdens of Sarbanes-Oxley.

One lesson in all of this is that not all tax cuts are created equal. Tax rebates and other temporary measures aimed at stimulating consumer demand don't work. Consumers aren't irrelevant, but prosperity is created on the supply side of the economy with the incentives to produce goods or services that people want to consume. So tax cuts in marginal rates that boost incentives to work and invest provide a much bigger bang for the buck.

The dark side, acknowledged by the column, is that spending has tried to keep pace, else we would see much larger deficit reductions with these big revenues.

The GOP has not only countenanced this spending, but they have lost faith in their successes already.

The other, albeit ironic, danger is that even many Republicans don't seem to recognize their tax-cutting policy success. Congress lacks the votes to make the 2003 tax cuts permanent, and even Mr. Bush missed the opportunity to push for permanence immediately after his re-election. Most of the Bush tax cuts expire in 2010, or 2008 in the case of dividends and capital gains. But their impact will ebb if investors begin to worry that they are only temporary. Amid their many other priorities, Republicans can't afford to forget that tax-cutting remains their most important achievement of the last five years.

UPDATE: Donald Luskin (frequent guest on Kudlow & Co. and supply-sider extraordinaire) adds fuel to the fire, laughing at Paul Krugman's refusal to accept the conclusions of this chart:

Economics and Markets Posted by jk at July 12, 2005 12:39 PM