The Canadian Entrepreneur Jude Wanniski June 6, 1997

Supply-Side Economics Lesson No. 26

Memo To: Students of Supply-Side University
From: Jude Wanniski
Re: The Canadian Entrepreneur

In all U.S. national elections since 1988, the Republican Party has consistently promised the voters a cut in the capital gains tax. They never deliver on the promise, always finding an excuse to push it down the list of priorities. But at least they pay lip service to entrepreneurial capitalism and increased rewards to entrepreneurial risk-taking. In Canada, which seems to have the highest capital gains tax rates of the OECD countries, there is never a mention of reducing them by the national parties. In Canadian elections this week, there were feeble promises of tax cuts by the Reform and Conservative Parties, but no mention of capital gains taxes. Even in Ontario, where there is a "supply-side" Conservative Premier, Mike Harris, who has been cutting provincial tax rates, capital gains are treated as ordinary income. In the last dozen years, I've had occasion to visit Montreal at least five times a year, and Toronto and Vancouver occasionally, and find the topic of entrepreneurial capitalism does not come up. The concept of risk-taking as the source of economic growth is unheard of in polite society. There are business risks taken in Canada of course, but basically it is a nation of shopkeepers at one end of the spectrum and mature corporations at the other. Entrepreneur is a French word, yet even in French Quebec not much of an entrepreneurial tradition has survived the last several generations. A man or woman who opens a shop is an entrepreneur, but not if they run a shop opened by their parents or grandparents. An entrepreneur who opens a shop and establishes it as a going concern, and is satisfied with the result, then ceases to be an entrepreneur. This most often happens everywhere in the world when the success of a shop encounters confiscatory tax rates at the next level. If there are risks to be taken at the corporate level, very often government will be on hand to help shoulder the risks through subsidies. Canada is definitely a Mommy country, which puts its highest premiums on security and fairness, even if it leads to an unemployment rate of 9.3%, twice that of the United States.

And yet I've cited Reuven Brenner of McGill University in Montreal as perhaps the best economist in the world. Reuven, remember, was our guest lecturer on May 2, in Lesson 21. I recently asked Reuven what economic textbook he uses when teaching economics, and he says there is none he considers worth the trouble. He will use his own books and monographs and selected readings of various economists dead or alive who have something worthwhile. In the textbooks we listed in Lesson 25, two are written or edited by Canadians. One is by Richard G. Lipsey of Simon Fraser University in British Columbia. The other is by Michael Parkin of the University of Western Ontario. The Lipsey textbook, 881 pages, has no index reference to either enterprise or entrepreneurship. Neither does the Parkin text, of 1,057 pages.

In the Lipsey text, we find a mention of "Supply-side economics" on Page 567:

President Ronald Reagan (in office 1981-1989) used the promise of enhanced supply to justify the large tax cuts that took place from 1981 to 1983. (During this time, the top income tax rate fell from 70 percent to 50 percent; in 1986 it was cut to 28 percent. In 1991 it was increased to 31 percent.) On some occasions Reagan and his advisers argued that the tax cuts would generate so much increased supply that tax revenues would actually increase. This would be possible if income increased by a higher percentage than the reduction in tax rates. These predictions did not materialize.

By increasing disposable income and consumption, the Reagan tax cuts shifted the AD curve to the right. There is little clear evidence that there was much effect on supply either in the short or the long run. Thus, the net effect was inflationary, due to the rightward shift of aggregate demand.

What this back-of-the-hand treatment asks us to believe is that supply-side "Reaganomics" promised that a cut in federal tax rates would produce higher federal revenues and that this could only happen if income increased by a higher percentage than tax rates were cut. And because this did not happen, obviously the tax cuts were inflationary. As you already know from the previous lessons, this cursory disposition of supply-side economics is simply silly. Tax rates can only be cut where they are impeding production to a point where a lower rate can at least earn the interest on bonds needed to finance the projected revenue loss. In addition, lower federal tax rates will have state and local tax revenue effects, which would mean the total revenues may be higher than needed to pay interest on the bonds, in which case the demand for bonds will outstrip the supply. Worse yet, the Canadian textbook is so certain it is correct in its theoretical assessment that it concludes there was no growth and there was increased inflation in the Reagan years. ("Thus, the net effect was inflationary.") Of course, the economy grew in real terms by the size of the West German economy, and the inflation rate came down from double digits to the 3% range.

Michael Parkin's text, out of Western Ontario, has nothing to say about the role of the entrepreneur or of risk-taking as a source of growth. On Page 905, it at least disposes of supply-side economics in a paragraph that is innocuous enough:

Another way of balancing the budget is to increase government revenue. But there is disagreement and two competing views on how this objective might be achieved. One, supported by former President Ronald Reagan, is that tax reform and lower tax rates will increase revenue by stimulating economic activity. The incomes on which taxes are paid will increase by enough to ensure that lower tax rates will bring in higher revenue. The other view is that revenue can be increased only by increasing tax rates and introducing new tax rates.

There is no other discussion about the mechanics of either method of balancing the budget. There is another mention of the Reagan tax cuts on Page 909: "The Kennedy tax cuts of the early 1960s and the Reagan tax cuts in 1986 were followed by strong economic growth, but for other tax cuts the record is mixed." The evidence of Reagan's 1986 tax cuts being the source of economic growth (but not the 1981 tax cuts) is a chart that shows GDP falling by more than 2% in 1982. The fact that the Reagan tax cuts did not take full effect until 1983, when GDP rose by 3.5% and then 6.7% in 1984, is never mentioned. Nor is the monetary deflation engineered by the Federal Reserve in 1980-82, to offset the horrendous inflation of the demand-side Carter presidency, during which the price of gold quadrupled. So much for supply-side.

In the American college textbooks, there is at least a discussion of the role of the entrepreneur, and some occasionally get it right. The 14th edition of Paul Samuelson's Economics, co-authored by Yale's William Nordhaus, is fairly broad in the concept of the entrepreneur. On pp-699-700 they have this observation: "One of the key tasks of economic development is the fostering of an entrepreneurial spirit. A country cannot thrive without a group of owners or managers willing to undertake risks, open new plants, adopt new technologies, confront strife, and import new ways of doing business. Government can help entrepreneurship by setting up extension services for farmers, educating and training the work force, establishing management schools, and making sure the government itself maintains a healthy respect for the role of private initiative."

Canadian students do not even get this much. Unfortunately, the Samuelson text does not delve into the question of how the government might maintain a healthy respect for the role of private initiative. There is no discussion on the impact of taxation on capital formation. In a National Public Radio telephone interview last year, Samuelson and I discussed the Republican proposal to cut the capital gains tax in half. He insisted it would do nothing more than widen the income gaps between rich and poor. The textbook itself is hopelessly neo-Keynesian and intellectually dishonest. On Page 332, the book dismisses supply-side economics with this: "The central prediction of the supply-side economists — that working and saving would increase dramatically as marginal tax rates were cut — has up to now proven incorrect. By the usual scientific standards, the supply-side experiment suggests that the underlying theory should be rejected."

The underlying theory, of course, was not that work and saving would increase, but that production would increase. On Page 562 of the same textbook, we find that the authors are aware of that distinction: "Just as the supply-siders predict, the net effect of a massive supply-side tax cut is to increase output significantly.... In the short run, the major source of the economic expansion from supply-side tax cuts is through its impact on aggregate demand rather than the effect on potential output and aggregate supply. Some economists have argued that the Reagan economic expansion of the mid-1980s was indeed a demand-side recovery dressed up in a supply-side cloak."

In other words, there was a recovery, but it was a Keynesian recovery, which got the economy rolling by putting more money into people's pockets. It had nothing to do with dramatically increased returns to capital investment — by bringing down interest rates at the same time tax rates were dropping at the margin to 28% from 70%. The Samuelson text tells us: "Inflation was brought down sharply in the early 1980s. But the decline was, as the Keynesians had predicted, bought at a high price in terms of unemployment during the deep recession and high unemployment in 1981-83."

The Keynesians had predicted no such thing. Note the convenient omission of why there was an inflation that had to be brought down in the 1980s, the result of the weak dollar policies of the 1977-80 Democratic administration of Jimmy Carter — aided and abetted by Carter's appointment as Fed Governor, Paul Volcker, a lifelong Democrat. When Carter was elected, the price of gold was about $140. At his defeat by Reagan, it was $620. In the first year of the Reagan presidency, the price of gold was hacked in half by Volcker, which was the cause of the deflation and serious recession of 1981-83. Supply-siders lost the battle to enact the Reagan tax cuts with an immediate effective date in 1981, to offset the monetary deflation. It was not until the summer of 1983 that Volcker allowed the gold price to rise, from $300 to $400, as the tax cuts kicked in too. The professional economists who serve the Democrats know this story, but they have been able to control the news media. One of the ways they do so is have all college kids who are planning to go into financial journalism be forced to read college textbooks. Samuelson and Nordhaus should be ashamed of themselves for the dishonest treatment of supply-side economics. Here are two more examples on Page 563:

Supply-side economists predicted that the lower tax rates, increasing saving and investing, would increase national saving. All the supply-side encouragement of increasing saving appears to have had no net positive effect on the national savings rate. Indeed, the national savings rate fell sharply over the 1980s and reached its lowest level since World War II in 1987.

Note how the wording shifts from a promise of increasing savings to the reality of a fall in the savings rate. Supply-siders never said the savings rate would rise. We said production would rise, and because production = consumption + savings, that savings would rise even though the rate might fall. In other words, if my family has an 8-inch pizza and eats six of eight slices, our savings rate is 25%. If I produce a 12-inch pie and we eat seven of eight slices, my savings rate is 12.5%. Which is better? With the small pie and a 25% savings rate, we save 12.57 square inches. With the large pie, a 12.5% saving yields 14.13 square inches. In other words, consumption increases from about 38 square inches to almost 100 square inches, while savings increases too. That is what economics is supposed to do for a family or for the national family. To get standards of living rising in this fashion requires entrepreneurs, as Samuelson & Nordhaus will agree. But they not only refuse to acknowledge the fatal flaws in their economic model, which tries to increase the welfare of the national family by taking slices away from mine. They also go to great lengths of dishonesty in presenting numbers and straw men to kid their young followers into thinking they are right and we are wrong. Lastly, again on Page 563:

The fundamental goal of supply-side policies was to increase the rate of growth of potential output. The average rate of growth  of potential output is estimated to have fallen from 3.6% per year in 1960-1970 to 3.1% in 1970-1980 to 2.3% per year in 1980-90. While the fall in potential growth in the 1980s cannot be entirely attributed to macroeconomic policies, the decline does suggest that there was no sea change in economic performance in the supply-side years.

Again, note how the text will not credit the supply-side Kennedy tax cuts of 1964 for producing the non-inflationary boom that followed, which resulted in an overall growth rate of 3.6% a year. Note then supply-siders are stuck with 1980-82 in their 10-year span, which takes the string of 4% growth rates of 1983-1990 and averages them in with the failures of the Carter Keynesianism.

If we are to have a renaissance of entrepreneurial capitalism, there will be no help from the aging academic economists, liberal and conservative, who sold politicians, liberal and conservative, on the redistributionist model of economic growth. Entrepreneurs themselves have to fight for every inch of help in beating back the forces that do not want more entrepreneurs. It is clear from looking through these selected textbooks that we can expect no help from Canada. It is more likely that good economics textbooks will be appearing in China sooner than they will in North America.