The US Trials With Voodoo Economics

By Abheya Arora

When the Trump administration in America neared its hundred-day mark, a day that Trump had spoken of triumphantly in his campaigns, there had to be some major achievement to present to the public. So, the Trump government planned a massive tax cut. Stephen Mnuchin, the Treasury secretary said that “the plan will pay for itself with growth.”

Supply-side economics

The plan that Stephen Mnuchin is talking about follows a famous approach of supply-side economics. Supply-side economics state that consumption and living standards rely on production and supply. Thus, living standards and income levels can not be increased without a proportional expansion in output. How does this concept underlie Trump’s massive tax cut policy?

Since high tax rates affect corporations’ ability to expand production and supply, supply-side economists believe that higher taxes will translate into reduced income, output and efficiency of resource use. As a result, lowering tax rates is viewed to be favourable. The logic flows this way,  lowering taxes on the rich will lead them to increase investments, which in turn will generate employment and create jobs, and therefore increase the income in the economy. This raised income will ultimately increase the tax revenue. Thus, it is argued that tax cuts will not only pay for themselves but also augment the income levels of the economy. 

This economic miracle that follows from the slashing of tax rates, was best described, in 1980, by George E. Bush as “voodoo economic policy”

US  History

The belief and use of “voodoo economic policy” have been quite prevalent in US history. This has offered economists the opportunity to analyse the effect of this policy, given different economic scenarios. 

When the US economy was in a state of stagflation in 1979-82, President Reagen implemented huge tax cuts and the economy rebounded rapidly. Supply-side economists viewed this as a clear evidence of the success of their approach. Bill Clinton’s presidency provided an explicit comparison when he raised taxes on the rich. Supporters of Reaganomics [ a popular term for the supply-side policy-based approach used during the time of President Reagan]  feared a massive slump, but to their surprise, the economy boomed, leading to the creation of higher employment opportunities than during Reagan.

The experiment was repeated, George Bush lowered tax rates and supply-side economists predicted a “Bush Boom”, similar to what happened during Reagan. The difference between their prediction and reality couldn’t be more pronounced. The growth rate declined and led the economy to a severe financial crisis. Obama in his tenure reversed several of the tax cuts implemented in Bush’s regime and also added new taxes to support social security policies like Obamacare. Resultantly, his tenure recorded a better performance in terms of job creation in comparison to his predecessor. 

Why did the policy work during Reagan and not when bush implemented the same approach?

The answer is that the economic boom during Reagan’s tenure, was not a success of supply-side economics, it was a success of Reaganomics. Though Reaganomics has been used synonymously with supply-side economics, it is not that alike. Reaganomics was not only a lowering of tax rates but it also included high government spending, business regulations and lower interest rates. 

Though all these factors collectively contributed, lower tax rates are also believed to have played a role. The economy at that time was in recession and the tax rates were as high as 70%. Reagan cut the top marginal tax rate from 70% to 28% and the corporate tax rate from 48% to 34%. In such a scenario, a fall in tax rates did follow the approach believed by supply-side economics and led to a rise in income, driving demand and as a result the economy. 

The economy that Bush inherited was in a better state and the tax rates were not as high as during Reagan. As a result, the impact of the policy was detrimental to the economy. Instead of increasing employment, the lower tax rates made the rich richer and drove up income inequality. These tax cuts were supposed to raise incomes and thus, in a way pay for themselves. But the policy approached failed. This not only made the plan unfeasible but also significantly elevated public debt. Ultimately, exacerbating the economy and the general public. 

That is exactly what happened as a result of Trump tax cuts. In 2017, President Donald Trump signed the Tax Cut and Jobs Act (TCJA). An analysis by the US Department of Treasury stated the law would add $1.8 trillion in revenue, thus paying for the $1.5 trillion cost that would be incurred in implementing the cuts. The Tax Policy Centre found that as a consequence of the act, by 2027, the lowest 20% income levels would have to pay higher taxes. It was also reported that it would add $1 trillion in debt, after adjusting for the economic growth that might occur as a result of the tax cuts.  

 According to a report by the World bank,  if the ratio of debt-to-GDP is near 77%, a large debt translates as a tax increase on future generations. The report also stated that every percentage point of debt above this level would cost the economy 0.017 of a percentage point in growth. The US public debt-to-GDP ratio was 104% before the Trump tax cuts. By 2019, it had risen to 107%, this was excluding the intragovernmental debt. 

History repeats time and again

Here, an important question that needs an answer is, why is it so that the voters in the west have re-elected and supported politicians, time and again who propagate an approach that has failed and disproven multiple times.

The wealthy have clear reasons for favouring voodoo economics, as it drastically decreases their tax obligations and raises their income levels. The same cannot be said of the middle and poor people. As the tax cuts mainly focus on the top bracket. George Lakoff, an American linguist pointed out that the public appeal in voodoo economics might be arising out of the way the idea of taxes is framed. He expounded that the phrase, “tax relief” which was used several times during the Bush presidency suggested that tax is an affliction rather than a “duty to pay one’s dues to live in a civilised society that is democratic and offers opportunity, and where there’s an infrastructure”.He recommended that special effort should be put into rectifying the way taxes are described. They should not be viewed as a burden, rather they should be categorised as an investment, an investment in social security, education, health, infrastructure, and many more. 

What would be the impact of this policy on India?

It has been proven by historical evidence, that impact of tax cuts depends on two factors. Firstly, the growth rate of the economy when it is implemented and secondly the tax rates before the implementation. 

Even though economies like India were battered due to the onslaught of the COVID-19 pandemic and further damage occurred due to the recent second wave in April. Experts predict that the economy will recover and even after taking into consideration the second wave, the predictions for India are to have a growth in the upcoming Financial year.

Secondly and most importantly, the tax rates in India are low. A big component of the support of “voodoo economics” is the Laffer curve. The curve states that a decrease in tax rates rises tax revenue, what needs to be kept in mind is that, the Laffer curve works only when the taxes are in a prohibitive range, in other words, when taxes are very high. 

Thus, it is highly unlikely that tax cuts would spur economic growth in India.

What would work?

The opposite of supply-side economics is Keynesian theory. It states that the economy is driven by consumer demand and not by production, as supply-side economists believe. For the economy to grow, a rise in government expenditure in infrastructure, health and education are key. This was also one of the main components of Reaganomics. 

Conclusion

Thus, given the economic scenario, an increase in government expenditure is more likely to drive economic growth and pay for itself in the process than a fall in taxes. Supply-side economics or as it has been famously coined by Bush and used by supporters or Keynesian theory, Voodoo Economics, is been viewed as a classic case of a zombie doctrine, a view that should have been killed by evidence long ago, but just keeps shambling along. 

References

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  1. .Lall, R. R. (2021, June 23). It’s time we broke the spell of voodoo economics. The National. https://www.thenationalnews.com/opinion/comment/it-s-time-we-broke-the-spell-of-voodoo-economics-1.892510
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