Supply-side economics, for babies

Suppose you're deciding how much gas to purchase. The gas station charges $x per gallon, but you also have to pay a gas tax of $y per gallon. The effective price of gas for you, then, is $(x+y) per gallon.

Suppose first that y = 0.25. In that case, let's say you want to buy 10 gallons. Now suppose that y = 0.75. Do you still want to buy 10 gallons? Those same 10 gallons would cost you $5 extra. Even if that isn't enough to make you want to buy a little less gas, it's plausible that someone out there is going to buy fewer gallons than they otherwise would, right?

How will the change in y impact the government's income? On the one hand, y goes up, which means every gallon purchased adds $0.50 more to the government's income. On the other hand, the gallons of gas purchased probably go down, which means every gallon not purchased deducts $0.25 from the government's income. If the former effect dominates, then the government's income rises with the tax hike. If the latter effect dominates, then the government's income falls with the tax hike.

Suppose you're deciding how many hours to work. Your employer pays you $x per hour, but you also have to pay a tax of y% on your wages. Your effective wage, therefore, is $x(1 - y/100) per hour.

Suppose first that y = 0.25. In that case, let's say you want to work 40 hours. Now suppose that y = 0.75. Do you still want to work 40 hours? Those same 40 hours would earn you only half as much. Even if that isn't enough to make you work less, it's plausible that someone out there is going to work fewer hours than they otherwise would, right?

How will the change in y impact the government's income? On the one hand, y goes up, which means every hour worked secures the government more income. On the other hand, hours worked probably go down, which means every hour not worked loses the government more income. If the former effect dominates, then the government's income rises with the tax hike. If the latter effect dominates, then the government's income falls with the tax hike.

What's the difference? Well, if the price of gas goes up, you become poorer, which makes you buy fewer things in general (and gas in particular). If the price of work goes up, you still become poorer, but that makes you work more hours to make up the difference. Thus, there is a third effect, which reinforces the revenue-reducing aspect of the gas tax, but reinforces the revenue-raising aspect of the wage tax. Common sense suggests, therefore, wage tax hikes are likely to be more successful in raising revenues than gas tax hikes.

What do the data tell us? Higher income taxes unambiguously raise more revenue, but some expected revenue is lost because some people do not generate (or report) as much income. In other words, the supply-siders had a point, but one that was way overblown. So when peeps tell you cutting taxes raises revenue, understand that there are multiple things going on, and that we have pretty solid evidence that other, more intuitive effects, tend to dominate in the end. Doesn't mean higher tax rates are desirable, but they would raise more revenue--possibly a lot more.