Politicians are an interesting crop of individuals. Unlike the average person whom from day to day tries to do what is best for him and his family, the politician is trying to figure out a way how to get an advantage over everyone else irrespective of the unforeseen consequences. In other words, he is trying to find the proverbial free lunch. A free lunch is defined, according to John Black's Dictionary of Economics, as "a policy or combination of policies which produces advantages without any offsetting disadvantage." Another way to say this is to exclaim that eating a cheeseburger frequently at McDonalds will have no effect on a person's weight. Of course, this is an obvious example of a free lunch. But there are less obvious ones, which have the appearance of holiness but are anything but that. I am referring to the an economic thought that goes under the name of supply-side economics, which rose to preeminence during the Reagan years, has been followed by Bush II, and is intended to be used by the presidential candidate John McCain. Few (including myself) questioned whether supply-side economists had actually any thought at all. One thing is clear though, while all of us make a fool of ourselves occasionally, some hold out longer than others.
Supply-side economics is rooted in the belief that a reduction in the marginal tax rates will cause the supply of labor to increase because of higher disposable income--that is, income after taxes. Now, the increase in labor supply will have the effect of expanding the output (GDP) capabilities of a nation. In technical terms, this is refer to as full-employment output (aka natural real GDP), the maximum output that can be produced when labor supply equals labor demand for a given capital stock and production function. No one disagreed with this assertion.
Since people always tend to save a portion of their income, supply-siders went even further to proclaim that the lower marginal tax rates would have a significant positive contribution to productivity (output per unit of input) and saving. This in turn would cause tax receipts to increase. Are you scratching your head? Yep. That's what their theory expressed.
During the Regan administration indeed the tax rate declined, beginning with the Economic Recovery Tax Act of 1981 and then with the 1986's Tax Reform Act ; but the salutary effects of the policies envisioned by their creators fell far from short. Empirical evidence demonstrates that labor supply and productivity grew more slowly in comparison to the years of Carter administration (source: Robert Gordon, Macroeconomics, pg. 348).
The Punch Line
But here is the clincher for one of greatest Ponzi schemes, in my view, in the modern history of the U.S. economy: the infamous Laffer Curve. Attributed to Dr. Arthur Laffer, who supposedly drew it on a napkin over a meal in a Washington restaurant, this curve demonstrates the parabolic relationship between tax receipts and tax rates. In other words, one can lower taxes and increase government receipts. Make no mistake, i support all tax cuts. What the economic theory did for politicians of the Reagan kind, who publicly endorsed a small government but in reality left much to be desired, was to legitimized its ambitious spending spree.
"You mean to tell me that we can reduce taxes and spend more?" one can still hear Reagan ask Dr. Laffer. Supply-siders turned Republicans, who traditionally shunned fiscal deficits, into embracing persistent deficit spending. In other words, they concocted a Keynesian world with a small government moniker: Truly a free lunch! In fact, government debt has increased from $1 trillion when Reagan began his presidency to the current figure of about $9.5 trillion! Over the last 25+ years, the U.S. Federal government has been behaving like the average U.S. citizen over the last 6 years: spending away to prosperity. Democrats will quickly point out and say, "hey, at least Bill Clinton reduce the budget deficit." Unfortunately, however, that's not entirely true. Although i won't go in much detail in this post, the figure Clinton reported to the public was not what actually was booked. In fact, the Clinton administration recorded a deficit almost every year he was in office.