One of the Reasons Supply-Side Economics Does Not Make Sense To Me

In his column in the Sunday NYTimes, former GW Bush economic advisor and current Harvard Economics Professor, N. Greg Mankiw argues against the Health Care bill because of the way that the insurance subsidies are structured.  He contends that it would discourage workers from working to their full potential.

He writes:

The bill that recently came out of the Senate Finance Committee illustrates the problem. Under the proposed legislation, Americans would have the opportunity to buy health insurance through government-run exchanges. Depending on a family’s income, premiums and cost-sharing expenses, like co-payments and deductibles, would be subsidized to make health care more affordable.

A family of four with an income, say, of $54,000 would pay $9,900 for health care. That covers only about half the actual cost. Uncle Sam would pick up the rest.

Now suppose that the same family earns an additional $12,000 by, for example, having the primary earner work overtime or sending a secondary worker into the labor force. In that case, the federal subsidy shrinks, so the family’s cost of health care rises to $12,700.

In other words, $2,800 of the $12,000 of extra income, or 23 percent, would be effectively taxed away by the government’s new health care system.

That implicit marginal tax rate of 23 percent is a significant disincentive. And it comes on top of the explicit marginal tax rate the family already faces from income and payroll taxes. Altogether, many families would face marginal rates at or above the 50 percent level that animated the Reagan supply-side revolution.

In making his point, Professor Mankiw cites the policies favored by President Reagan, namely cutting taxes to stimulate economic growth:

The starting point for Ronald Reagan was the idea that people respond to incentives. The incentives that he most worried about were those provided by the tax system. According to his budget director, David A. Stockman, Mr. Reagan would regale the staff with stories of how he, as an actor, used to alter his work schedule in response to the tax code.

“You could only make four pictures, and then you were in the top bracket,” Mr. Reagan would say. “So we all quit working after four pictures and went off to the country.”

The key economic concept here is the marginal tax rate, which measures the percentage of a family’s incremental income to which the government lays claim. During Mr. Reagan’s time in office, the top marginal tax rate on earned income fell to 28 percent from 50 percent.

The political and economic term for this policy is “supply-side economics.”  But the Reagan acting example illustrates exactly what is wrong with supply side economics (at least for those not at the top of the economic ladder).  First, in the Reagan acting example, Reagan had the ability to determine how many movies to make in a particular year.  He had the power to determine his work schedule.  If he decided that it was not financially worthwhile to make a fifth movie—because the government would take too much in taxes—he simply declined to make the additional movie.  But for most people, they do not have this kind power or leverage over their employers.  Employers usually determine the employee’s work schedule.  If that employee refuses to work what the employer asks, they will be out of a job.  It is rare that the employee determines how many hours they will work.

Second, supply-siders mistakenly believe that all people will be similarly incentivized by given marginal tax rates.  They believe that if marginal tax rates are raised that all workers will work less because they get to keep less dollars.  But this assumes that all workers value each additional dollar the same.  This is simply wrong.  Those who are lower down the economic ladder value each additional dollar more than those higher up the ladder.  Mankiw postulates that because the health care bill may raise certain families’ marginal tax rates to over 50% for the last $12,000 they earn, those families will forego the opportunity to work the additional hours to earn the additional income.  Higher taxes may discourage rich individuals like Reagan, who have already earned a lot of money during the year, from working more (but the rich may have noneconomic reasons for working more such as prestige or trying to amass a bigger fortune than their neighbor).  For example, someone who is making $500,000 may not want to work another hour because they will only take home 60 cents on every dollar they earn for the extra hour.  They may value time off more than the 60 cents in income net of taxes.

But for those individuals or families who are struggling to make ends meet, the additional income may be well worth the additional effort regardless of the fact that they will pay more in taxes or lose some of their subsidies.  The additional $6,000 may go towards a new car, vacation, college tuition, or simply rent and food.

Only where taxes reduce net income so much that people do not value the additional net income more than additional work will supply side policies make sense.  For the vast majority of people, especially those who are barely getting by, the chance for an additional $6,000 income in exchange for additional work will most like be welcome even if their marginal tax rate is almost 50%.

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One Response to “One of the Reasons Supply-Side Economics Does Not Make Sense To Me”

  1. J.A. Says:

    What’s the other reason?

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