Reaganomics Revisited Jude Wanniski May 9, 2003

To: Students of Supply-Side University
From: Jude Wanniski
Re: “Here We Go Again”

This week’s lesson will be devoted to a commentary on the April 29 Fortune article, "Here We Go Again," by Justin Fox. The reason for the article is the obvious influence of supply-side economics on this second tax package sent to Congress by President Bush – the first being designed in a demand-side framework, that being only one reason it failed. A bright young reporter, Justin Fox came to Morristown, N.J. to interview me for the article and spent almost four hours taking notes and a stack of client letters I’d written in recent years. His article is just okay in that he gets the general drift correct, but as you will see he would benefit greatly by registering as a student at SSU. My comments will be interspersed throughout, in Capital letters.

TAXES
Here We Go Again
Supply-side economics is back! 
But this is not 1981--and that's why Bush's tax plans don't quite cut it.
Fortune
Tuesday, April 29, 2003
By Justin Fox

The economy is sputtering. A Republican President vows to cut taxes to get it moving again. Critics say the proposed cuts will leave the rich richer, federal deficits bigger, and the economy worse off.

You've heard it all before. Unless, that is, you weren't old enough to be paying attention in 1981, when Ronald Reagan unleashed supply-side economics on the nation, putting an end to decades of rising taxes and ushering in yawning budget deficits that would take 15 years to erase.

TAX CUTS USHERING IN YAWNING BUDGET DEFICITS TELLS US UP FRONT CUTTING TAXES DOES NOT WORK, BUT WE WITHHOLD JUDGMENT TO SEE WHAT LIES AHEAD.

The tax cuts President Bush hopes to push through Congress in the coming months (and the ones he got through in 2001) don't measure up to Reagan's 1981 cuts in either scale or political import. But they are the biggest news on the tax-cutting front since then, and they're unleashing the same debates about deficits, growth, and supply-side economics that dominated political discourse 22 years ago.

YES.

That raises an important question, one that must be answered before anything meaningful can be said about whether Bush's tax proposals make sense. Who was right back in 1981?

If you define the goals of the 1981 tax cuts narrowly enough, it's easy to come up with an answer--President Reagan and his supply-side advisors were dead wrong. Back in 1981 the most zealous supply-siders argued that Reagan could cut tax rates and government revenues would go up.

THE MOST ZEALOUS ARGUED REVENUES WOULD GO UP INSTANTLY, BUT THOSE OF US WHO ADVOCATED LOWER TAX RATES ARGUED THAT THEY ONLY NEED TO EXPAND THE ECONOMY ENOUGH SO THAT INCREASED REVENUES WOULD SERVICE THE DEBT NEEDED TO FINANCE THE TAX CUTS. BOB MUNDELL WAS A STICKLER ON THIS POINT. IT IS TRUE THERE WERE SUPPLY-SIDE FOOT SOLDIERS WHO MADE THE ZEALOUS ARGUMENT, BUT THERE WAS NOTHING WE COULD DO TO STOP THEM.

The basis for the argument was something called the Laffer curve--first drawn on a cocktail napkin at Washington's Two Continents restaurant on Dec. 4, 1974, legend has it, by University of Chicago economist Arthur Laffer for the edification of Wall Street Journal editorial writer Jude Wanniski and Ford administration staffer Dick Cheney (yes, that Dick Cheney). Actually, neither Laffer nor Cheney remembers it, but Wanniski went on to make the moment immortal nonetheless.

LAFFER DOES NOT REMEMBER DRAWING THE CURVE, BUT CHENEY RECENTLY TOLD ME HE REMEMBERS IT AS IF IT HAPPENED JUST YESTERDAY.

The gist of the Laffer curve is this: If tax rates are high enough, it's possible to cut rates and increase revenue. This was not a controversial, or new, proposition. But when Reagan backers argued that across-the-board cuts in income tax rates wouldn't bring big deficits--now that was controversial. "Voodoo economics" was what one of Reagan's Republican-primary opponents, George H.W. Bush, famously called it during the 1980 campaign. He was right.

THIS IS A SILLY STATEMENT BY THE REPORTER. IF IT IS NOT CONTROVERSIAL THAT LOWERING TAX RATES CAN INCREASE REVENUES, WHY IS IT “RIGHT” FOR BUSH #41 TO SAY THIS WAS ‘VOODOO ECONOMICS.’? A SOPHOMORIC MISTAKE, FOR WHICH I BLAME THE REPORTER’S EDITOR.

"When Reagan cut taxes after he was elected, the result was less tax revenue, not more," wrote a prominent Harvard professor in 1998 in his best-selling economics textbook. "Revenue from personal income taxes (per person, adjusted for inflation) fell by 9% from 1980 to 1984, even though average income (per person, adjusted for inflation) grew by 4% over this period."

THIS IS SOPHISTRY, IN PARENTHESIS. WHEN WE SEE THAT REVENUES “ADJUSTED FOR INFLATION” ACTUALLY FELL AFTER THE REAGAN TAX CUTS, THE CASE SEEMS TO BE CLOSED. BUT THE INFLATION OCCURRED IN THE CARTER YEARS, AS GOLD LEAPED TO $625 FROM $120. IN THE REAGAN YEARS, THE INFLATION BAKED IN CARTER’S GOLD CAKE ROSE, BUT THE GOLD PRICE FELL TO $350. IF REVENUES ARE “ADJUSTED FOR DEFLATION” THEY ARE STUPENDOUS. THIS IS WHY REAGAN WON HIS LANDSLIDE RE-ELECTION VICTORY, AS THE ELECTORATE KNEW HOW THE TAX CUTS HAD WORKED THEIR MAGIC.

That failure of tax cuts to work budget magic has tainted the supply-side cause ever since. Opponents of the current President's tax plans have relished bringing up the old ghosts. "Deja-voodoo economics" is House Democratic whip Steny Hoyer's charming phrase for Bush's $726 billion tax cut.

Are the critics right? Are Bush's tax-cut plans--which consist chiefly of eliminating taxes on dividends and accelerating income tax cuts that were approved by Congress in 2001--the rankest charlatanism? Well, that Harvard professor quoted above is named N. Gregory Mankiw. He's the chairman-elect of President Bush's Council of Economic Advisors and has, of course, endorsed his new boss's tax plans. He also used to write a column for FORTUNE. That doesn't make those tax plans right--as you'll read, we aren't enthusiastic about anything but the proposal to cut dividend taxes. What it does indicate, though, is that the lessons of 1981 aren't as cut-and-dried as you might think.

NOT AS CUT AND DRIED? IN A SENSE, JUSTIN FOX HAS USED THE CONVENTIONAL BASHING OF SUPPLY-SIDERS TO PIVOT IN A MORE POSITIVE DIRECTION.

Which brings us back to Reagan and his tax cuts. As we now know, it took five tax increases and a decade and a half of economic growth to deliver the balanced budget Reagan promised in 1980. But given how crushing taxes were at the time, the man had to do something.

INTERESTING WAY TO PUT IT: THE MAN HAD TO DO SOMETHING.

In 1981 the federal tax burden hit 19.6% of GDP, a new peacetime record (and not far below the all-time peak of 20.9%, in 1944). What brought taxes to that level was something called bracket creep, in which inflation pushed ever more middle-income taxpayers into high tax brackets--the top rate back then was 70%--and ever more poor people onto the income tax rolls for the first time.

Inflation's impact was especially dire for investors. Taxes on capital gains and interest were not (and still aren't) adjusted for inflation--so in the high-inflation 1970s it was entirely possible to lose money in real terms on your stock or bond investments yet still owe serious taxes on them. Rising prices meant a similar tax penalty for corporate investments in new equipment and factories, which are deducted from income not all at once but over a period of years.

In other words, the interaction of inflation and the tax code had pushed the overall tax burden toward record levels and especially punished savings and investment. Possibly as a result, the U.S. economy just wasn't working the way it was supposed to. According to the demand-oriented Keynesian wisdom of the time, the national economy was like a big hydraulic system. Pump deficit spending in here, and higher GDP growth spurts out there. Pump in inflation, and out comes lower unemployment. But despite growing budget deficits in the 1970s, the economy kept sputtering. Despite rising inflation, unemployment kept going up.

THIS IS ALL CORRECT. IT WAS THE KEYNESIAN MODEL THAT HAD BROKEN DOWN. IF IT HAD NOT, THERE WOULD NOT HAVE BEEN A NEED TO REVIVE THE CLASSICAL SUPPLY MODEL.

That's where supply-side economics came in. The term was popularized by the Journal's Wanniski, who borrowed it from economist Herb Stein, and the "supply" he was talking about was the supply of labor and capital. What could government do to make people work harder? What could it do to induce people to save more and businesses to invest more? His answer: Cut taxes! There was nothing new about this thinking--it was simply a revival of the "classical" economic theories swept away by the Great Depression and the persuasive powers of John Maynard Keynes. But in the environment of the 1970s, it seemed revolutionary.

SEVERAL POINTS HERE:

1. THE ORIGIN OF “SUPPLY-SIDE ECONOMICS” AS A LABEL DID COME FROM STEIN, WHO REFERRED TO MUNDELL, LAFFER AND ME IN A SPEECH AS A SMALL BAND OF “SUPPLY-SIDE FISCALISTS.” ECONOMIST ALAN REYNOLDS WAS IN THE AUDIENCE AND TOLD ME ABOUT STEIN’S PEJORATIVE REMARK. I DECIDED ON THE SPOT TO ENLARGE IT TO INCLUDE ALL OF CLASSICAL THEORY – MONETARY AND REGULATORY AS WELL AS FISCAL, AND TO USE IT AS OUR BANNER.

2. “SUPPLY” DID NOT REFER DIRECTLY TO LABOR AND CAPITAL BUT TO “PRODUCTION,” AS OPPOSED TO “CONSUMPTION.”

3. THERE WAS NEVER ANY THOUGHT OF ‘MAKING PEOPLE WORK HARDER.’ ECONOMICS SHOULD BE ABOUT MAKING PEOPLE MORE PRODUCTIVE, I.E., PRODUCING MORE WITH LESS EFFORT.

4. THERE WAS NEVER ANY THOUGHT ON HOW TO INDUCE PEOPLE TO SAVE MORE AND BUSINESS TO INVEST MORE. THESE ARE DEMAND-SIDE TERMS. THE OBJECTIVE WAS TO REMOVE IMPEDIMENTS TO A BIGGER ECONOMY IN THE TAX, MONETARY AND REGULATORY POLICIES. IN A BIGGER ECONOMY, THERE WOULD NATURALLY BE MORE CONSUMPTION AND MORE SAVING AND INVESTMENT.

5. THE ANSWER WAS NOT “CUT TAXES,” BUT "CUT THOSE TAX RATES" WHICH WERE UNNECESSARILY HIGH, DISCOURAGING PRODUCTION AND PRODUCING SMALLER TAX REVENUES THAN THEY WOULD IF LOWERED TO INVITE A BIGGER ECONOMY.

6. THERE WAS A NEW ELEMENT, WHICH MUNDELL POINTED OUT AT THE TIME, HAVING TO DO WITH THE FACT THAT THIS WAS THE FIRST GREAT INFLATION THAT OCCURRED COINCIDENT WITH NEAR UNIVERSALITY OF PROGRESSIVE TAX SYSTEMS. WHEN THE US LEFT THE GOLD STANDARD IN 1971, THE DOLLAR INFLATION LED A WORLDWIDE INFLATION WITH BRACKET CREEP EVERYWHERE PUSHING UP TAX BARRIERS TO PRODUCTION.

The 1981 tax cut was the revolution made real. It included big tax breaks for corporate capital investment. So big, in fact, that it became possible to make money, after taxes, on money-losing investments--which is why most of those breaks were repealed in 1986. But the really giant cuts were on the personal income tax side, and they've survived. The top marginal rate went immediately from 70% to 50%, and in lower brackets rates were reduced 10% a year for three years. Those brackets also were tied to the consumer price index to prevent inflationary bracket creep.

THE 1981 REAGAN TAX CUTS DID COUPLE THE KEMP-ROTH REDUCTIONS ON MARGINAL INCOME-TAX RATES TO THE TAX BREAKS FOR BIG BUSINESS WHICH WERE NOT PART OF THE SUPPLY-SIDE AGENDA.

What did people do with all that extra money? By the reckoning of economist Larry Lindsey--who was, until a few months ago, chief economic advisor to President Bush--taxpayers in the lower income brackets spent it, delivering an old-fashioned Keynesian boost to the economy but failing to deliver on supply-side promises that revenue would rise. In the highest brackets, though, something remarkable happened. People actually paid more taxes at a 50% marginal rate than at a 70% rate. Arthur Laffer was right. "The core supply-side tenet--that tax rates powerfully affect the willingness of taxpayers to work, save, and invest, and thereby also affect the health of the economy--won as stunning a vindication as has been seen in at least a half-century of economics," Lindsey wrote in his 1990 book, The Growth Experiment.

HERE JUSTIN FOX GOES TO LARRY LINDSEY, A CONSERVATIVE KEYNESIAN, TO VALIDATE THE EFFECTS OF THE SUPPLY-SIDE TAX CUTS. THAT’S WHY THIS PARAGRAPH IS SO JARRING. THERE WAS NO “EXTRA MONEY” PRODUCED BY THE RATE CUTS, BUT MORE OUTPUT, A BIGGER ECONOMY. AT THE LOWER RATES, THERE WERE MORE WORKERS WILLING TO COME OUT OF THE UNDERGROUND ECONOMY WHERE THEY AVOIDED TAXATION AND WORK, AND THE LOWER TAX RATES ON CAPITAL GAINS BROUGHT MORE CAPITAL INTO THE ECONOMY. LINDSEY USES “CASH FLOW” ARGUMENTS THAT DO NOT BELONG IN A CLASSICAL SUPPLY MODEL.

Well, maybe. Other economists who've studied the 1981 cuts, and the subsequent 1986 tax reform that brought the top marginal rate all the way down to 28%, agree with Lindsey that lowering rates on the rich brought in more money. But many attribute it more to a decline in tax avoidance than to an increased "willingness ... to work, save, and invest." And the effect of tweaking marginal rates diminishes as they drop below 50%. Some supply-siders predicted economic disaster in 1993 when Congress raised the top rate back up to almost 40%. They were clearly wrong.

LOWERING TAX RATES DOES FACE A LAW OF DIMINISHING RETURNS. AND SOME SUPPLY-SIDERS DID PREDICT DISASTER WHEN THE TOP RATE ON INCOME WAS RAISED TO 38.6% FROM 31% IN 1993, BUT I ONLY SAID IT WOULD ONLY LOWER A POSITIVE GROWTH TRACK, AS CONGRESS DID NOT INCREASE THE CAPITAL GAINS TAX AND THE FEDERAL RESERVE HAD SUCCEEDED IN STABILIZING MONETARY POLICY.

So the economic lesson of 1981 may be this: Something had to be done. It could have been done better. To a certain extent it was done better in the tax reform of 1986. That effort, inspired by Democratic Senator Bill Bradley and adopted by the Reagan White House, was an attempt to get tax rates as low as possible without reducing revenue, by eliminating deductions, exemptions, and special preferences. (Supply-siders had mixed feelings about it, since it meant getting rid of some of their special preferences, like a lower tax rate for capital gains.) But true economic voodoo in 1981 would have been continuing with the tax-and-inflation status quo.

SENATOR BRADLEY AND HIS HOUSE PARTNER, RICHARD GEPHARDT, WERE IMPORTANT FIGURES IN THE ’86 TAX REFORM, BUT IT GOES TOO FAR TO SAY THEIR BILL “INSPIRED” THE REFORM, WHICH WAS PART OF THE 1984 GOP PLATFORM. ALL SUPPLY-SIDERS WERE UPSET WHEN, AS PART OF THE BIPARTISAN DEAL, THE CAPITAL GAINS TAX WAS RAISED TO 28% FROM 20%. THE ECONOMY HAD TO STRUGGLE WITH THE HIGHER RATE UNTIL IT WAS LOWERED AGAIN TO 20% IN THE 1997 BIPARTISAN TAX LEGISLATION.

Fast-forward to 2003. The economy is troubled, but--unlike in 1981--it would be quite a stretch to blame the tax system for those troubles. Voters certainly aren't blaming it: According to Gallup, dissatisfaction with the federal income tax is at its lowest level in 41 years. So if the tax code isn't to blame for the economy's problems and the electorate isn't clamoring for change, why do we need a tax cut? The President says we need it to stimulate growth. That's a good reason. But it's not clear his tax cuts fit the bill.

IN MY 4-HOUR INTERVIEW, I CAREFULLY EXPLAINED THE REASONS FOR THE ECONOMY’S WEAKNESS, PRIMARILY THE BURDEN OF THE MONETARY DEFLATION THAT BEGAN IN 1997 WITH A SHARP DECLINE IN THE PRICE OF GOLD. FOX LEFT THIS OUT OF ARTICLE BECAUSE IT MADE IT TOO COMPLICATED, HE TOLD ME.

The one element of the current tax proposal most likely to spur growth is, sadly, the one most likely to collapse in Congress. That's the elimination of the double taxation of corporate income. If a company pays income tax on its profits, then shareholders wouldn't have to pay taxes when they got those profits in the form of dividends or capital gains. The thinking behind the cut is supply-side, sort of. The idea is not so much to increase the supply of capital as to make it flow more efficiently. Corporations would no longer face a tax-induced bias to fund themselves with debt (interest payments are tax-deductible) instead of equity, or to buy back shares instead of paying dividends. Owning shares in corporations would be a better deal, at least for those doing their investing outside tax-protected accounts like 401(k)s and IRAs, and that would give the battered stock market a boost.

ONCE AGAIN, WE SEE FOX USING A DEMAND-SIDE CASH-FLOW JUSTIFICATION FOR THE PROPOSED ELIMINATION OF THE DOUBLE-TAX ON DIVIDENDS. HE TRIES TO FOLLOW THE MONEY FROM DEBT TO EQUITY IN SEEING A BOOST TO THE STOCK MARKET. IT IS MUCH SIMPLER: THE ECONOMY WANTS TO EXPAND WITHOUT INFLATION, WHICH MEANS MORE CAPITAL IS NEEDED. BUT THE SYSTEM TAXES THE RETURNS TO CORPORATE CAPITAL TWICE AT A COMBINED RATE CLOSE TO 70%. CUTTING THAT IN HALF PERMITS CAPITAL TO FORM AT A GREATER RATE OUT OF THE UNDERUTILIZED TIME, ENERGY AND TALENTS OF THE WORK FORCE.

It's an intriguing plan that might just have a significant economic impact. How significant is anyone's guess. The estimates coming out of Washington of more than a million new jobs a year are almost certainly delusional, but given the relatively low cost of the dividend proposal (about $36 billion a year after five years, or 0.3% of projected GDP), it's a reasonable gamble.

A MILLION NEW JOBS IS HARDLY DELUSIONAL WHEN THE ECONOMIC WEAKNESS OF RECENT YEARS HAS REDUCED EMPLOYMENT BY MORE THAN 2 MILLION JOBS. JUST AS IMPORTANT, THE HIGHER LEVEL OF CAPITAL IN THE SYSTEM WOULD MEAN GREATER PRODUCTIVITY AND HIGHER REAL WAGES FOR THE WORK FORCE.

The rest of the $726 billion in tax cuts (over ten years) that Bush wants, and most of the $500 billion or so that, at most, he's likely to get, consists of speeding up and making permanent the tax cuts approved by Congress early in Bush's term. And therein lies the problem.

The 2001 bill consisted of cuts in personal income tax rates, expanded child credits, an easing of the marriage penalty, elimination of the estate tax, and accelerated depreciation of corporate capital spending. When it became law, we were fresh off a $236 billion surplus, and the federal tax burden as a share of GDP hit 20.8%--breaking the 1981 peacetime record. In other words, a tax cut was certainly a reasonable alternative to running huge budget surpluses that, in any case, were likely to tempt Congress out of the frugality it had adopted in response to the big deficits of the 1980s.

THE IMMEDIATE COSTS OF THE 2001 BILL WERE RELATED TO THE MAMMOTH ‘TAX REBATE’ SCHEME DESIGNED BY LARRY LINDSEY, THE ABOVE-MENTIONED CONSERVATIVE KEYNESIAN, FOR THE BUSH WHITE HOUSE. THIS KIND OF ‘TAX CUT’ HAS NEGATIVE SUPPLY EFFECTS, REDIRECTING CASH FLOW FROM BOND SALES TO THE POCKETS OF CONSUMERS. WE ADVISED THE BUSH ADMINISTRATION THIS WOULD BE THE RESULT. THIS SECOND ROUND IS DEFINITELY SUPPLY-SIDE IN ORIENTATION.

Two years later we're back in Kansas. The fantastic gains in tax revenue of the late 1990s turned out to be ephemeral, the product of a stock market that had become detached from economic reality. When the stock market boom evaporated, so did they. As a result, the tax burden is already down to a far more reasonable 17% of GDP, and those 2001 cuts will no longer be gnawing away at a giant surplus but will--if they're made permanent--bring chronic budget deficits. The deficits projected by the Congressional Budget Office aren't on the scale (as a percentage of GDP) of the whoppers of the mid-1980s. But they do mean the cuts must be judged by different standards from those of two years ago.

THE TAX BURDEN CANNOT BE CALLED REASONABLE OR UNREASONABLE BECAUSE IT IS A CERTAIN SHARE OF GDP, 17% OR 21%. SOME OF THE POOREST COUNTRIES IN THE WORLD HAVE ‘TAX BURDENS’ OF LESS THAN 10% OF GDP, BECAUSE THE TAX ‘RATES’ THEIR ECONOMIC SYSTEMS FACE ARE IN THE UPPER REACHES OF THE LAFFER CURVE.

One standard is Keynesian. Economists--and politicians--haven't entirely abandoned demand-side thinking because over the short run pumping up demand works. The 2001 tax plan included a well-timed bit of pumping--$36 billion in tax rebates sent out during the summer months, in what turned out to be the depths of the 2001 recession. The new proposal would give a similar boost later this year, but there are cheaper ways to provide Keynesian stimulus--government spending or temporary tax relief--than permanent tax cuts.

OF COURSE, IF YOU SIMPLY WISH TO AVOID AN OFFICIAL RECESSION, YOU CAN DO SO BY SPENDING FINANCED IN THE BOND MARKET. THE ECONOMY SIMPLY BORROWS PRODUCTION FROM THE FUTURE, WHEN TAXES MUST BE PAID TO RETIRE THE BONDS. GIVING AWAY TAX REBATES OR SPENDING ON PERPETUAL WARS WILL DO THAT, BUT THE PEOPLE IN THE SYSTEM KNOW THINGS ARE NOT RIGHT. THE NATIONAL STANDARD OF LIVING IS IN DECLINE ALTHOUGH GOVERNMENT STATISTICS SAY OTHERWISE.

Then there's the standard of fairness. As the chart shows, the effective federal tax rates (including Social Security and other taxes) paid by most Americans have barely budged over the past two decades. The wealthiest taxpayers, however, have seen their burden drop a bit, and since President Bush has taken over, it has dropped further. In ivory-tower economics terms that isn't all bad--there's often a tradeoff between economic efficiency and income equality. But one of these days Americans might decide it's worthwhile to give up a little economic growth for the sake of reducing inequality.

THE ELECTORATE WILL ONLY VOTE FOR SOCIALISM TO REDUCE INCOME INEQUALITY IF CAPITALISM IS FAILING TO PRODUCE RISING LIVING STANDARDS THROUGH PRODUCTIVE GROWTH – WHICH THE GOP SUPPLY-SIDE TAX PACKAGE WOULD DO.

The main standard by which the Bush tax proposal deserves to be judged, though, is the standard that created it: supply-side economics. And that is where it runs into the most trouble. The challenge for supply-side policymaking in a time when the tax code isn't positively stifling economic activity, as it was in the late 1970s, is that there are no easy targets. Income tax rates are already low enough that cutting them slightly--the top rate is set to drop from 39.6% to 35%--won't bring the kind of behavioral change wrought by the rate cuts of the 1980s. Sure, there'll be a positive economic impact from people working harder and sheltering less income. It just might not be big enough to measure.

THIS IS AGAIN CORRECT, ALTHOUGH KEYNES HIMSELF SAID INCOME SHOULD NOT BE TAXED AT HIGHER THAN 25% AND POLLS OF THE AMERICAN PEOPLE AGREE ON THAT CEILING.

Another supply-side prescription for economic growth is to reduce the size of government, the idea being that the private economy is better at allocating resources than Congress. Economists disagree about that, especially since the government's share of the U.S. economy (31%, including state and local governments) is already at the low end among the world's rich countries. In any case the discussion is irrelevant: Federal spending has been rising sharply since Bush came into office. There is the argument that by cutting taxes and running huge deficits, as Reagan did in the 1980s, you force future governments to rein in spending. But if that's the true motivation behind the President's tax proposals, we'd sure like to hear him say it.

OF COURSE THERE ARE REPUBLICANS WHO DO NOT BELIEVE IN SUPPLY THEORY AND WHO EVEN DISLIKE THE IDEA THAT GOVERNMENT CAN INCREASE ITS TAX REVENUES BY LOWERING TAX RATES. PRESIDENT BUSH AND TREASURY SECRETARY JOHN SNOW ARE NOT IN THIS CAMP.

Finally, we come to the core of the modern supply-side case, the one area where the supply-siders have truly won the hearts and minds of the economics profession. Today the accepted formula for long-run economic growth mixes capital, labor, and a bit of inspiration. Increasing the labor supply brings growth but not necessarily higher living standards. Increasing the rate of inspiration--a.k.a. technological progress--is a tall order, at least for the tax code. That leaves capital, which is anything that can be used to produce something else: factories, software, tractors, office buildings and, as economists have become increasingly aware in recent decades, human capital like education and skills. There is now widespread consensus that a tax code that favors capital accumulation and investment over consumption could increase economic growth by a few tenths of a percentage point a year--which would, over the course of a few decades, seriously add up.

ALL’S WELL THAT ENDS WELL. STOP TAXING CAPITAL FORMATION. BUT THE EFFECT OF THE TAX CUTS NOW BEING CONSIDERED BY CONGRESS – A COMBINATION OF A LOWER CAPITAL GAINS TAX AND LOWER TAX ON DIVIDEND INCOME -- WOULD ADD MUCH MORE THAN A FEW TENTHS OF A PERCENTAGE POINT A YEAR TO GDP. ENDING THE DOUBLE TAX ON DIVIDENDS WOULD IN ITSELF ADD 3 PERCENTAGE POINTS A YEAR TO GDP IN PERPETUITY, RECKONS GARY ROBBINS, PROBABLY THE BEST SUPPLY-SIDE TAX ANALYST AROUND. IT WOULD TAKE A FEW YEARS TO RAMP UP TO THAT HIGHER LEVEL OF OUTPUT, HE SAYS, BUT ONCE THERE IT WILL ALWAYS BE A PART OF THE BIGGER ECONOMY.

That is certainly the view of Bush advisors like Greg Mankiw and his predecessor at the Council of Economic Advisors, Glenn Hubbard, and Harvard's Martin Feldstein, a mentor to both who was chairman of Reagan's CEA from 1982 to 1984. But here's the weird part: It's also the view of many of the 450 economists, including ten Nobel Prize winners, who signed a statement in February condemning Bush's tax cuts. What's up with that? "I don't know of anybody who says this is a bad idea because of tax policy," says Feldstein. "What they say is, this is a bad idea because of the budget."

The core idea of the 2001 tax cuts was to get people to save and invest money--after they had spent some of it buying a car, to give the economy a bit of a Keynesian kick. (Hey, we never said this stuff was simple.) The elimination of the estate tax was most obviously conceived along those lines. So far, so good. But if the whole idea is to increase saving, having the federal government borrow money to pay for the tax cut entirely defeats that purpose. So much that some economists otherwise sympathetic to the supply-side argument on saving, like Alan Auerbach of the University of California at Berkeley, are pretty sure the 2001 cuts will reduce long-run economic growth.

For the cuts to have their desired growth impact, Congress would eventually have to either cut spending sharply or approve a few savings-friendly tax increases. What would a savings-friendly tax increase look like? Well, the current tax code massively subsidizes the consumption of housing, which plays no role in that long-run growth equation. The mortgage-interest deduction is probably sacrosanct, so some economists suggest a tax on new housing construction as a (slightly) less politically charged substitute. Another possibility would be to increase federal taxes on gasoline, something Mankiw suggested in his FORTUNE column a couple of years back.

LIKE LARRY LINDSEY, MANKIW AND FELDSTEIN HAVE NEVER QUITE UNDERSTOOD SUPPLY-SIDE ECONOMICS. THEY ARE CASH-FLOW KEYNESIANS. GLENN HUBBARD, ON THE OTHER HAND, IS A GENUINE SUPPLY-SIDER, THE ECONOMIST WHO DESIGNED THE BUSH TAX PROPOSAL THIS SECOND TIME AROUND.

In other words, there's nothing there that would win George Bush any votes in November 2004. But once it's clear that the recession is over, the President is going to have to start addressing the budgetary consequences of his actions. If he fails to, his tax cuts may eventually be seen as only so much deja-voodoo, all over again.

THE BUDGET PROBLEMS ASSOCIATED WITH THE RETIREMENT OF THE BABY BOOMERS IN 2012 ARE ENORMOUS, BUT THEY CAN ONLY BE ADDRESSED BY FURTHER REDUCTIONS IN THE TAXATION OF CAPITAL. THAT’S THE IDEA THE FINANCIAL PRESS AND THE DEMOCRATIC PARTY HAS TO FACE.

Feedback: jfox@fortunemail.com