Supply-Side Tax Policy : Its Relevance to Developing Countries

Ved Gandhi, Liam Ebrill, Parthasarathi Shome, Luis Manas Anton, Jitendra Modi, Fernando Sanchez-Ugarte, and George Mackenzie

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1987
• eBook ISBN: 9780939934911

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PART I
Overview and Summary

1
Relevance of Supply-Side Tax Policy to Developing Countries
A Summary

Ved P. Gandhi

Within the short span of a few years, “supply-side economics” has come to be considered in some quarters to be the “new” economics that is most relevant to policymaking for solving the economic problems of the 1980s. However, the basic propositions of supply-side economics, including the belief that taxes affect economic behavior and the substitution effects of taxes are important for the efficient allocation of resources, are as old as neoclassical economics itself. What is new is the conviction of some supply-side economists that a substantial reduction of tax burdens, in general, and the rates of income tax, in particular, will have significant effects on the level of output and growth rates. In 1984, the Fiscal Affairs Department of the International Monetary Fund undertook a research project to analyze the relevance to developing countries of the tax policy recommendations of supply-side economics made in the context of developed countries. This volume contains the studies that were prepared as part of this research project.

As explained in greater detail in Section I of this chapter, there are at least two interpretations of supply-side economics, and, consequently, of supply-side tax policy—the traditional or the “basic” view and the new or the “popular” view. Most of the studies included in this book assess the validity of the arguments of popular supply-side economics, while others deal with the validity of selected propositions of basic supply-side economics.

The volume is in three parts. Part I provides an overview and summary of findings and conclusions. Part II presents seven papers reviewing the evidence on the validity of popular supply-side tax policy. Part III contains four papers dealing with selected aspects of basic supply-side tax policy or tax policy for efficiency and growth. The book also has two appendices. Appendix I contains statistical information that is readily available on the revenue structures of developing and developed countries relevant to the various studies. Appendix II presents a selected bibliography of publications on popular supply-side economics of interest to the general reader.

The term supply-side economics originated in the United States in the mid-1970s primarily as a reaction to government economic policies based on Keynesian macroeconomic theory and represents a new way of looking at government economic policies.¹ The term, however, has evolved over time and has come to mean different things to different people. It is, therefore, important at the outset to clarify in broad terms what supply-side economics stands for and then to define with greater precision those aspects of supply-side tax policy that have received the most attention in the United States and whose relevance is analyzed in the context of developing countries in the papers included in this volume.

These concepts are explained in Section I of this chapter. Section II describes the scope of the project and the broad conclusions reached under it. Sections III and IV contain the main findings and conclusions of individual papers on the validity and relevance of popular supply-side tax policy and tax policy for efficiency and growth. Finally, Section V summarizes several supply-side-oriented proposals for tax reform that have emerged from the various studies.

I. Scope of Supply-Side Economics

Supply-side writers have founded their work on the strong conviction that free markets, with few exceptions, allocate resources most efficiently.² This belief drives both their economic tenets and the way they view politics and the social order.

On the political side, supply-side economists see governments, which are usually monopolists and not subject to the requirement of profit maximization, as inherently inefficient because of their lack of market discipline and as subject to a tendency to grow without bound. Because the agents of government have personal objectives which, by definition, differ from the goals of the society at large, neither politicians nor bureaucrats in policymaking positions can be trusted to act effectively in the social interest.³

On the economic side, the belief that any policy that distorts free-market-determined relative prices distorts resource allocation has led supply-siders to espouse at least three important propositions that have major consequences for government policy. (1) Most government regulations aimed at protecting consumers and workers are generally costly and indefensible in terms of their cost-benefit ratios; eliminating them would, therefore, improve resource allocation in the economy; (2) most welfare and entitlement programs discourage work effort (including retraining); limiting access to such programs to the really needy would, therefore, restore work incentives; and (3) personal income tax is inherently biased against work effort (on the ground that work is taxed but leisure is not), as well as against savings (since income saved is taxed twice, while income consumed is taxed only once) and investment (since productive investment is taxed but unproductive investment is not) and that high marginal income tax rates exacerbate these biases significantly; reducing marginal income tax rates would, therefore, increase labor supply, savings, and investment. As will be shown below, many of the propositions of supply-side economists are implicit in the behavioral and market structure assumptions made by most neoclassical economists.

In general, thus, supply-side economists emphasize minimizing the distortions in market-determined relative prices that result from regulations, subsidies, and high income taxes and believe that the reduction of such distortions would encourage savings and production by allowing the economic incentives of a free market to work. They also believe that the private sector is generally capable of bringing about sustained economic growth, so that there is no need to tolerate the inefficiencies of large government in the economy. At least two interpretations of supply-side economics, and, consequently, of supply-side tax policy have evolved within this general framework over time. These interpretations have been referred to in this volume as basic supply-side economics and popular supply-side economics.

Basic Supply-Side Economics: Return to Classical and Neoclassical Economics

The first interpretation, basic supply-side economics, is simply an application of classical and neoclassical economic theory to government policy-making. According to this view of supply-side economics, government economic policies should focus on aggregate supply rather than on aggregate demand. As aggregate supply is the result of the economic behavior of producers, they, rather than consumers, should be considered the driving force in the economy and their economic behavior should be considered the most important determinant of real and nominal economic activity. As government economic policies can, and frequently do, have significant negative substitution effects (drive economic agents away from rational—welfare maximizing—economic decisions), they should be structured in such a way so as to minimize the substitution effect.

If one follows this interpretation, supply-side economics is essentially no different from mainstream classical and neoclassical economics. It emphasizes the objective of efficient allocation of resources more than any other objective of economic policy and recognizes the importance of negative substitution effects of government economic policies and, particularly, of tax policies. These beliefs were also held by Smith, Say, Mill, Marshall, Pigou, and Ramsey and others who obviously were supply-siders long before the term was coined.

A basic supply-side economist believes that government tax policy can, and does, create a “wedge” between pretax and posttax producer prices as well as rates of return to factors of production and, given the negative substitution effect, is likely to distort the economic behavior of producers as well as the suppliers of factor inputs. Given the importance of efficient resource allocation to aggregate output, a basic supply-side economist seeks to reduce distortions in resource allocation that individual taxes and tax structures can cause. Distortions can arise because of a number of factors such as (1) the economic aggregate or the base on which taxes are levied; (2) tax rules and provisions that affect the taxable base for individual producers and factor suppliers; (3) the height of nominal tax rates and the degree of progression in the tax rate schedule; and (4) the interaction between inflation, the taxable base, and tax liabilities. A basic supply-side economist is one who seeks to reform all of these aspects of a tax structure.

The recommendation that tax policy be reformed along these lines is also not new; it is well known in public finance literature. Most books on traditional public finance, for example, contain detailed analyses of the effects of various forms of taxation on the efficiency of resource allocation.⁴ The relative merits of income and consumption as alternative tax bases and their possible effects on savings are frequently discussed at length. Similarly, the effects of alternative tax rules and provisions—relating to depreciation allowances and inventory valuation, loss-offset and carryforward privileges, debt versus equity, etc.—on capital formation, risk-taking, and financial policies are discussed in considerable detail in the literature. The argument that the “excess burden” of a tax depends on the nominal rate of the tax is also well known to students of public finance.⁵ The resource allocation costs of the lack of inflation-adjustment of the income tax system, which have been dealt with extensively as the rates of inflation have accelerated in the 1970s, are also well known.

Thus, basic supply-side tax policy would seem to be no different from the views of fiscal economists who, on efficiency grounds, recommend the reform of (1) the economic base on which taxes are levied; (2) various tax breaks and loopholes that signify distortionary economic signals; (3) the levels and progressivity of nominal tax rates; and (4) tax rules and provisions that raise the effective tax rates in inflationary times. If these are the aims of supply-side tax policy, then fiscal economists such as Pigou, Simon, Haig, Kaldor, Harberger, Feldstein, Boskin. and McLure obviously were supply-siders long before the term “supply-side tax policy” was conceived.⁶

In a sense, supply-side economics is as old as economics itself, if all that it stands for is that efficiency of resource allocation is an important objective of economic policy and that market-determined resource allocation is basically optimal. Most economists would find it hard to disagree with its contents in theory and under normal circumstances. As a clone of classical and neoclassical economics, basic supply-side economics contains policy prescriptions based on the latter’s specific assumptions relating to, first, what the proper role of the government should be and, second, how developed the commodity and factor markets are or how well they function. But one can still question whether both of these assumptions are strictly valid in the special circumstances of developing countries. To what extent, for example, should one whole-heartedly accept the “appropriate” role of the government implicit in supply-side economics (as well as in classical and neoclassical economics) which states that the main aim of the government should be ensure an efficient allocation of the economy’s resources through private initiative and enterprise and that all other roles of state, such as its role as an active agent of income redistribution or of economic stabilization or of the growth of the economy, whenever in conflict with the former, should receive lesser priority? Similarly, to what extent should one accept the fundamental faith of supply-side economists (as well as of classical and neoclassical economists) that private markets are capable of delivering “appropriate” levels of goods and services and that, in the interest of achieving maximum welfare of the society, governments...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Content
• Foreword
• Preface
• Part I. Overview and Summary
• Part II. Income Taxes and Growth: Evidence on Popular Supply-Side Tax Policy
• Part III. Tax Policy for Efficiency and Growth: Aspects of Basic Supply-Side Tax Policy
• Appendices
• Footnotes