What Stimulates More? Tax Cuts or Spending Reductions?

The late, great supply-sider Jude Wanniski long ago invented The Two Santa Claus Theory of political economy. Wanniski's view, one held by many supply-siders to this day, was that Republicans should focus their energies on tax rate reduction.

Taxes are a price like anything else, or better yet a penalty placed on work, so Wanniski's thinking was that the GOP should focus on reducing the penalties placed on work with an eye toward stimulating more of it. Nothing wrong at all with the latter (I consider myself a supply sider and always promote shrinking the tax, regulatory, trade and monetary barriers to the creation of supply), taxes are a work deterrent, and then Wanniski correctly felt that the prosperity wrought by tax cuts would have the salutary effect of reducing reliance on government in ways that would ultimately shrink the size of government overall.

But if given the choice about how to boost the economy, what would be more stimulative? Big reductions in government spending, or a similarly big reduction in the rate of taxation on income?

At dinner several years ago with Louis Woodhill and his wife Marla, we talked about exactly this. Louis is a great thinker, one of my favorite economics writers, and with the exception of former Wanniski lieutenants Paul Hoffmeister, Nathan Lewis, Cedric Muhammad, and Vlad Signorelli, Woodhill has arguably done more than anyone to keep Wanniski's genius alive. Woodhill said in very sober fashion that spending cuts certainly help growth, but incentives matter much more. His point, and it was one that I did not argue with or disagree with, was that a reduction in the penalty placed on work (for the purposes of this thought piece other taxes like those on corporations and capital gains won't be discussed, nor will the Keynesian measure of the economy that laughably presumes government spending is growth, GDP) was and is the best tax policy way to stimulate economic activity; that income tax cuts would beat shrinkage of the certain economic burden that is government spending.

With clarity in mind, it's important to point out up front that if given the choice of one policy lever to fix the economy right now, Woodhill would almost certainly seek stabilization of the dollar's value in terms of gold. For what it's worth, so would I. Nothing else comes close. Just the same, Woodhill's ideal individual tax would not hit income at all; rather it would be levied on consumption. Same here.

But if income taxes and spending were the only two levers with which to boost growth, Woodhill, judging by our dinner from a few years ago, would take reductions in the tax on income over spending cuts. As he puts it so well, "if the Republicans aren't about growth, they're about nothing." In that case focus on shrinking the penalties governments foist on work.

For the longest time I've completely agreed with Woodhill that light rates of taxation trump light government expenditure when it comes to prosperity. But now, not as much. To be fair, Woodhill's views may have changed too. Given my own choice, if fiscal policy were the only option to boost growth, I would choose a 50% reduction in government spending over a 50% reduction in the top tax rate. And it wouldn't even be close. Importantly, this view would be very much informed by the tautology that is supply-side economics.

The basics of supply-side thinking are that if you want to stimulate demand, the only way to do so is to reduce barriers to production, or supply. We go to work and we produce things because we want what others are producing. Our work, or our production, is what we exchange for that which we don't have.

In that case, while we'd all much prefer a 10% tax rate on income (once again, the ideal would be a tax on consumption) to the present top rate of 39.6%, it's fair to say that a penalty quite a bit higher than 39.6% would never have deterred the late Steve Jobs from innovating, nor Jeff Bezos, nor FedEx founder Fred Smith now. Figure Smith founded FedEx during the high tax 1970s.

Woodhill himself is a very successful software entrepreneur, and it's fair to say that he too would work very productively at higher rates of taxation. So would many other supply-siders, and for that matter demand-siders from the Keynesian and monetarist schools. Work brings its own reward and dignity even if taxed heavily as evidenced by all the wealth produced in overtaxed states such as California and New York. None of this is to excuse high rates of income taxation for even a second. It's just to say that the feeling of accomplishment that comes with hard work trumps for many the tax penalties placed on that same work.

So while taxes are an obnoxious penalty placed on production, they're not an insurmountable barrier to it. Individuals will work despite the greedy hand of the unctuous tax man. Will we all work at usurious rates? It's hard to say. An economy is a collection of individuals.

But what about government spending? Like Woodhill, the feeling here is that hand wringing over budget deficits is a silly waste of time. If we ignore that deficits are generally the preserve of rich countries (ask yourself how willing investors are to buy the debt of Peru?), the real economic burden is the level of government spending overall. Deficits are just finance. With production in mind, any supply-sider would gladly take an annual deficit of $1 trillion based on $1.1 trillion in spending over a balanced annual budget of $3.5 trillion. Governments have no resources, so the less they spend the more resources left in the private sector to fund actual production.

Of course that's why spending reductions are arguably more stimulative than are tax rate cuts. While the entrepreneurial among us have varying individual Laffer Curves (see once again all the wealth creation taking place in high-tax New York and California), there are no entrepreneurs without capital. They quite simply cannot give their innovations life without investment. Uber founder Travis Kalanick may be willing to work at high rates of taxation given the morale boost that is work itself, but without capital there is no Uber.

To be fair, high rates of taxation reduce the amount of capital available to producers in addition to serving as a barrier to production, but for the purposes of this piece it should be said that while high rates of taxation don't seem to have sapped U.S. entrepreneurial vigor too much, government spending has by definition shrunk the amount of capital necessary to fund the leaps that power any economy forward.

Government spending has nothing to do with investment simply because outlays by government are in no way held up to the essential market discipline that starves bad ideas when they prove unworthy. In short, Warren Buffett would be a tragically inept investor of the public's money were ‘Senator' in front of his surname. Government spending IS consumption of precious capital.

In light of the above, Henry Hazlitt explained that "what is saved on consumers' goods is spent on capital goods," and of even greater import to supply siders, with capital not consumed "producers invest in new capital goods - that is, they buy new and better and more ingenious tools - because these tools reduce costs of production." There's no such thing as idle capital short of stuffing the measure (money) that mobilizes it under a mattress, so when government consumes less in the way of economic resources (capital), then there's more available to stimulate production of the very supply that tautologically drives all demand.

Thinking about all this, and knowing George Gilder's brilliant truth that economic advancements result from information-pregnant experimental leaps, it should sicken all readers to consider all the investment that never took place over the decades thanks to politicians of both political parties being equal opportunity consumers of the resources created by us. Along these lines, the problem with Wanniski's Santa Claus argument wasn't the thinking behind it, but that it perhaps left out the human nature that informs all politicians: their purpose is to spend. Even though prosperity doubtless does reduce the illusory need inside the electorate for more government, the wonderful supply-side revolution that began realistically in the late ‘70s, and took on great speed in the Reagan ‘80s has in no credible way reduced the burden on growth that is government spending. It just grows and grows no matter the party in power, and no matter the tax regime.  

So while taxes matter, and they do a lot, modern economic history reveals the happy truth that even nosebleed (sorry, but a 39.6% tax rate is 'nosebleed') rates of taxation don't keep what Reuven Brenner refers to as our "vital few" from taking risks on new ideas. Taxes should come down for moral reasons beyond those of growth, but even if they don't, producers will keep producing.

But imagine what would happen if federal spending were cut in half a la the early 1920s? With capital once again never idle, imagine the growth that would take shape with so much more investment reaching the productive, experiment-focused private sector? It's sad and exciting to think about at the same time. In our present state, government spending and usurious rates of taxation are both barriers to production. But it says here that government spending is the bigger barrier.