The Supply-Side Solution
If tax-cut strategies don't work, why are they so popular abroad?

BY STEPHEN MOORE

I recently spoke with Mart Laar, the former prime minister of Estonia and the godfather of that nation's flat tax. The major opposition to his tax reform, he explained, was not the citizenry; rather it came from the economists and the other Wise Men of government.

"I was told, 'We cannot do a flat tax. It is untested. It will not work. It will cause budget deficits," Mr. Laar recalls. However, he believed it would work because of what he'd read about it in Milton Friedman's classic, "Free to Choose." And so, in 1994, Mr. Laar ignored the economic pundits and snapped into place a 23% flat tax. Estonia has since experienced one of the most rapid growth spurts of any nation in the world.

There's a lesson here for our country: Revolutionary ideas in economics, especially if they don't leverage the power of the state, are often resisted by the intellectual elite. Ronald Reagan discovered this in 1980 when he was ridiculed by the establishment for proposing cuts in marginal tax rates as a cure for the high inflation and economic malaise of the 1970s.

Gardner Ackley, a former chairman of the Council of Economic Advisers, famously told Congress that it would be "a miracle" if the tax cuts worked to reduce inflation and increased growth. But reduced inflation (with an assist from Fed Chairman Paul Volcker) and increased growth is what happened in the 1980s.

Here we are 27 years later--with 40 million more jobs and a nearly $50 trillion higher net worth--yet the left intelligentsia is still obsessed with discrediting supply-side economics. In recent weeks, the New York Times, the New Yorker, the New Republic and many other liberal publications have devoted great space and attention to attacking the entire theory that lower tax rates can increase incentives for investment, saving and work.

The original champions of these ideas, men such as Arthur Laffer and George Gilder, are not just misguided, they are, according to the New Republic, "deranged," "crackpots," and even "possibly insane." James Surowiecki complains in the New Yorker that supply-side tax prescriptions for the economy are the equivalent of "saying that the best way to treat sick people is to bleed them to let out the evil spirits."

The quality of this discourse rarely rises above the level of trash talk. Nevertheless, some arguments are repeated with such regularity that they need to be addressed. One is that supply-siders dishonestly claim that tax rate cuts increase tax revenues. Now, we can argue forever whether tax revenues would have been higher or lower without the Bush 2003 tax cuts. But one stubborn fact remains: Tax receipts are up, not down, by $745 billion in four years since the 2003 tax cuts.

It's one thing for the supply-side critics to have predicted four years ago that the Bush tax cuts would increase the budget deficit. But Mr. Surowiecki tells us, today, that "myriad studies" find that the Bush tax cuts "led to bigger budget deficits."

Bigger deficits? After the second Bush tax cut of 2003, the budget deficit tumbled to $163 billion in FY 2007 from $401 billion in FY 2003.

Supply-side economics is also denounced as a flim-flam whose sole purpose is to give jumbo-sized tax handouts to corporations and high-income earners. Since so many upper-income and wealthy Americans are Democrats, however, it's not clear why Republicans would be so preoccupied with helping them.

In any case, the share of taxes paid by the top 1% and 5% income earners has consistently risen from 1980 through 2007, even as tax rates declined. Today the highest income tax rate is half what it was in the 1970s. Yet the share of taxes paid by the top 1% of income earners is twice (39%) today what it was then (19%).

Regardless of what one believes about the distributional effects of the Reagan and Bush tax cuts, there's no expunging the reality that the economic growth rate surged after each of these changes--just as they did in the 1960s after President Kennedy's tax rate cuts. Robert Rubin and others reply that the economy boomed in the 1990s too, after Bill Clinton raised taxes. But supply-siders never argued that only tax cuts matter. Trade matters. Sound money matters. Regulations matter. In the 1990s, monetary, trade and spending policies were all leaning in a pro-growth direction, possibly offsetting the negative impact of the Clinton tax rate hikes.

What the critics have no plausible answer for is this: If the supply-side tax rate reduction model is truly so abhorrent, why are so many nations around the world latching on to it? What explains the Irish Miracle? Why are Germany, France and the U.K. slashing their corporate tax rates? Why are there 18 countries with flat taxes? Are their leaders deranged, or been bamboozled by crackpots? Perhaps a better explanation is that they know intuitively what a new National Bureau of Economic Research study has found: Nations with low tax rates on business have statistically significant higher rates of new business formation, investment and income.

History is clearly not on the side of the antisupply-side attack dogs, and they're losing the policy debate every day in political capitals around the world. Poland just announced it wants to implement a 15% flat tax by 2009. But the American left's obsession with the notion that tax rates don't matter tells us something important about the future. They are preparing the ground for massive tax increases if and when they capture control of the presidency.

I asked Rep. Paul Ryan of Wisconsin, a leading economic policy maker in the GOP, how many of the Democrats he works with buy into these screeds against supply-side economics. "Are you, kidding?" he replied. "Every one of the Democrats who sits in the front row of the Ways and Means Committee does. They've already got Charlie Rangel's tax increase baked into the cake."

Estonia, anyone?