Supply-Side 101

One of my six regular readers emailed me with a request: to educate him on supply-side economics. This post is my attempt at that…

At the very heart of supply-side economics is an assumption about the way that individuals and companies behave. In almost any system or theory of economics, you’ll find the notion that demand is influenced by price. Basically this says that you’ll sell more of any good or service if you lower the price — the lower the price, the more consumers will make the decision to buy. I don’t know anyone who quarrels with that assertion, most likely because it is everybody’s personal experience.

There’s a related notion that not everyone understands as well: that it isn’t necessarily better for the seller to sell more of something. Perhaps a simple example will make this obvious. Suppose you went into business selling lemonade on the street in front of your house. We’re keeping this very simple, so further suppose that the only costs you have are lemons, sugar, and plastic cups — and that those costs total 10 cents per glass of lemonade. Not knowing what price you should charge, you run an experiment: you try four different prices (15 cents, 20 cents, 25 cents, and 30 cents) for one week each, and record the resulting sales (250 cups, 170 cups, 140 cups, and 90 cups). Which week is best for you? If you do the math, you’ll find that your profit for each week was $12.50, $17, $21, and $18 — so the best price for you (the seller) is 25 cents. You’ll sell lots more at 15 cents, but you make so little per cup that you’re worse off. So as the seller, where do you set the price? If you went into business in order to make money, then of course you’d set it at 25 cents.

If you made it through that, you might be wondering what the heck this has to do with supply-side economics! Well, it turns out that this is the heart of the matter. Most likely, as you read the example above, you accepted the notion that the number of glasses of lemonade you sold varied according to how much your customers had to pay. Of course, right?

This is exactly what supply-side economics says about the behavior of people and companies as tax rates change. If you think about it, from the consumer’s perspective tax rates are just a different price for whatever good or service they’re buying. Let’s take one example to make it concrete: long term capital gains tax. This is a tax on the profit you make by selling any security (e.g., stocks) you’ve owned for over a year. Buy a stock at $10, sell it two years later for $12, and you’ve got $2 in capital gains — which the federal government taxes you on. When you are deciding whether to sell a stock you own, do you take that tax into consideration? Well, you’d have to be pretty darned dense not to! I know that every time I’ve ever sold stock, I paid very close attention to that (blankety-blank) capital gains tax! So doesn’t it stand to reason that if the capital gains tax is lowered (effectively lowering the cost for you to sell stock) that more people will sell stock? Also the converse: if you raise the capital gains tax, don’t you think that fewer people will sell stock? Not only is the preceding common sense, it’s also borne out by experience: every time the capital gains tax has been reduced, stock turnover went up, and every time it has been increased, stock turnover went down.

If you absorbed the preceding, then (in technical terms) you have dismissed the “static model” of tax economics. The static model (which our government still uses for many forecasts!) assumes that nobody will change their behavior because tax rates change. That model seems to me to be just plain stupid. Click on the chart above right to see a graph of this. The red line shows the results of a static model: as tax rates increase, so does the tax revenue. Even as the tax rate goes to 50%, the revenue keeps going up — as if people would really behave this way! The static model’s main advantage is that it gives liberals a reason to screech about tax reductions. This only works if we’re all stupid sheeple. Oh, don’t get me started on this!

A simple alternative to the static model, and one that often comes first to mind when thinking about this, is the “linear model”. In this model, the assumption is that consumer behavior does change as price (or tax rates) change — and it changes in proportion to the change in price or tax rate. In other words, if you drop the price by 10%, then 10% more people will buy. If this was reality in the tax world, then it wouldn’t matter what tax rate you set — the revenues to the government would be the same. How boring is that? The problem with the linear model, however, is that pesky reality. People don’t really behave like this. Let’s take an example to illustrate: suppose that the price of a movie ticket was $10, and at that price 100 people watched the movie at your theater. Now cut the price in half, to $5 — what do you suppose would happen? Most likely, you’d get more than double the number of customers, because $5 seems like a major bargain (by today’s standards, anyway!). Now try the proportional opposite: double the price to $20. Do you think half as many customers will show up? I rather doubt it — $20 is so much higher than the competition that practically everybody will go to them. This is very non-linear behavior, and it’s quite the norm in the real world.

There are many ways to model non-linear behavior, and economists and mathemeticians debate them endlessly. But for the purposes of this discussion, these debates are all details that don’t matter, since all the models have a more complex, “curvy” something like the green line on the chart. The non-linear models (and reality) all have something in common: there’s always a “sweet spot” where the most profit (or tax revenues) will be made; a certain price (or tax rate) where they are maximized. In the example I’ve used, tax revenues are maximized at around a 6% tax rate, considerably lower than the 15% starting point. The sweet spot could just as easily have been on the other side of the current rate, at a higher rate — it all depends on how those tax rates affect people’s behavior.

The premise of supply-side economics, translated into tax policy, is that the government should never set tax rates higher than that sweet spot. At the sweet spot, not only are tax revenues maximized, but it’s a healthy, vibrant economy that’s causing it. Setting tax rates higher than the sweet spot means lower economic activity — not good from anybody’s perspective — and less tax revenue. That’s not good even from a liberal’s perspective, though getting one to admit that is pretty darned hard! Setting tax rates lower than the sweet spot isn’t necessarily bad — while it reduces tax revenues, it encourages economic growth in whatever area of activity is being taxed. This sounds like something a liberal would reflexively reject, and a libertarian reflexively embrace <smile>. For example, suppose we’re talking about the tax on the purchase of solar cells for powering homes, offices, or factories. Suppose the sweet spot on that (for maximizing tax revenues) was 5%. To encourage the adoption of solar power, one might consider reducing that tax, even to zero — despite the reduction’s impact on tax revenues.

Another key element of supply-side economics is what I’ll call the “regenerative effect”. This is another common-sense notion that virtually every economics system or theory embraces: the idea that economic activity has an impact greater than the immediate participants in the activity. For example, if I grow some corn and sell it to you for $10, then you and I have each benefited. But I’m going to take my $10 and do something with it (I’m going to buy a big box of chocolate!). The guy who sold me the chocolate now has $10 to do something with. The same thing is true for companies: the profit they make regeneratively increases overall economic activity, to everybody’s benefits. Liberal interpretation of corporate profits often diverges from this; listening to them, and reading their writings, I get the idea that they believe corporate profits all end up in the hands of evil, filthy rich “capitalists” (voiced in disdainful tones) who, presumably, bury it all in the cellar — because in their view it’s certainly not doing the world any good. This is a remarkably ignorant mindset, so obviously wrong-headed that I presume it to be an article of faith, rather than a reasoned position.

You might also wonder how (for example) outsourcing might affect supply-side economics. Well, really outsourcing is a completely separate issue — except so far as tax rates affect the rate of outsourcing. If you assume (and I most certainly and emphatically do not!) that outsourcing is bad, then as a matter of policy one could lower tax rates in the affected industry to make our domestic suppliers more attractive. But this really has nothing to do with supply-side economics; one could do the same thing even under traditional liberal economic theory…

That’s the lesson for today!

Education Follies

California finally acted to ensure that high school students met some minimum performance criteria before they could graduate — and look what happens:

From the San Jose Mercury News:

A lawsuit seeking to ensure that no high school senior is denied a diploma simply for failing California’s new exit exam was filed Wednesday in San Francisco Superior Court on behalf of tens of thousands of 12th graders who have not passed the test.

The complaint asserts that there are so many inequities in California public schools that some students have not had a fair opportunity to learn the eighth-grade math and 10th-grade English language skills the exam measures. It also states that funding for extra instruction to help students pass has been inadequate.

The plaintiffs will seek an injunction preventing the state from enforcing the exit exam requirement for this year’s graduating class.

According to the article, the basis for the suit (the “angle” they’re using to get the result they want) is that the legislation requiring that students pass the “exit exam” before they can graduate offers no alternative — pass the exam, or you don’t graduate. I don’t understand the legal theory behind this, as I know of no requirement for “alternatives”. But what do I know about creative lawyering?

Some who know me are surprised at my stance on education, as I am myself largely “uneducated” (at least, in the conventional sense) — I graduated from high school, but not from college; my professional education was done on my own. So folks expect me to espouse the benefits of self-education and to dismiss the benefits of a formal education. They’d be right on the former, but dead wrong on the latter.

My concerns about the state of our formal education stem from my politics — and my patriotism. I know that the vast majority of people need that formal education to learn the skills they need to get a job (especially that first one), to contribute to society, and to prepare them for independent adulthood. Because I’ve spent my entire career in high-tech industries, and because I’ve hired many people into the companies I founded or worked for, I’ve had occasion to witness firsthand how well our educational system achieves these goals. And because for the past 12 years I’ve worked extensively with employees in foreign countries (Estonia, Russia, and England), I’ve also had a chance to compare the results of our educational system with that of other countries.

And this makes me fear for my country’s future, folks — because I see the young people of other countries being educated in a manner that is frighteningly superior to ours. The example I’m most familiar with is Estonia (and this includes, to some extent, older Estonians who received all or part of their education under the Soviet regime). I know hundreds of people there, and I’ve worked closely with many of them. For the most part these are software engineers and computer scientists (by our terminology). My general observation: right out of school, the majority of the Estonians have a much better fundamental background in computer science and have far better mathematics skills than the majority of their American-educated counterparts will ever achieve. The only area in my own experience where the Americans have an edge is in the process and management of software development — and even here, the Estonians are catching up rapidly.

But perhaps even more importantly, the Estonians (and other non-Americans) by-and-large have a cultural expectation that what matters for their personal success is results. Not how hard they try, not how they feel about things, but results. In engineering terms, they understand that they need to get the right answer, or to build something that actually works.

This is not to say that Americans all don’t get the need for results — obviously, many do. But it seems to me that our educational system is not helping in this regard. Our system produces graduates — not all of them, but enough for me to be concerned — who really, truly, don’t understand that in order to succeed in their profession, the actually have to get results. The right answer is important; engineers really do have to build things that work. And not all of our high school or university graduates understand this at all.

On many occasions in my career as an employer, I have run into this in fuzzy or indirect ways, where I can only suspect that our educational system has done my employee no favors. On a few memorable occasions I have been slapped upside the head with an incident that unambiguously made the point. One example: a couple of years ago I was running the IT organization for a company with a substantial datacenter and about 50 US employees. One of the guys working for me was a desktop technician; his job was to keep all the desktop computers and laptops that our employees used working correctly. From my observations of his work, I thought he was a mediocre technician — he took a long time to resolve problems, and was unable to resolve far too many of them. In his annual review, I gave him relatively low ratings, and in our discussion about those ratings I explained why. As we talked, I could see this poor fellow getting more and more puzzled, until finally I just asked him why. He said “You’re not giving me any credit at all for working hard! I’ve been working 10 or more hours every day for months!” That led into a (for me) very interesting discussion about this issue, and we finally got to a point where he asserted to me that it “should” be true that someone who worked very, very hard but didn’t achieve the desired would be more rewarded by the company (raises, bonuses, etc.) than someone who achieved all the desired results with little effort. He really, truly believed that, and I could not dissuade him — so I told him he needed to find work at a company with beliefs more compatible with his own. He left shortly after this discussion.

I have never run into this attitude with an Estonian employee.

Back to the article and the lawsuit: the whole point of the exit exam is to prove the student can get results with their education. I support that 100%! That’s exactly what will be expected of them in the careers most of them pursue; most careers (politics, therapy, and few others excepted) demand results — and there is no “alternative” way to succeed. I believe the same thing should be true of our educational system; the only thing that makes me unhappy about the exit exam is how low it sets the bar. I’d like to see similar objective requirements put in place for university graduates. And I’d like to see the bar set high in all cases.

Such objective criteria are but a beginning. Next on my list would be a return to grading systems that actually mean something; where only a few students achieve the top rankings, and they achieve those rankings because they stand out in terms of the results they’ve delivered. But now I’m dreaming…

This lawsuit is unadulterated liberal poppycock. I hope is is summarily dismissed, with prejudice.