I wish we had a better term for the great advances in economic understanding that began in the mid-1970s and became known as “supply-side economics.” One president, and not a socialist either, called it “voodoo economics,” which shows just how weird it seemed at the time. It was really an expansion of the Classical school of economics, which most people trace to Adam Smith and his precursors such as Cantillon or Hume.
If you could sum up the insights of the 1970s and 1980s in two words, it would be that “taxes matter.” Today, the importance of this insight is still not very well understood, even by those think tank researchers who craft detailed tax reform proposals, and certainly not by academics today, or the economic hit men of the
From 1950 to 1970, the Japanese government reduced tax rates, and introduced various business-friendly adjustments such as accelerated depreciation, every single year. Every single year, by their own “static” calculations, these changes were supposed to reduce tax revenue. It won’t surprise anyone when I say that tax revenues actually went up. It might be surprising, however, when I say that tax revenues rose by sixteen times, even with the yen linked to gold, while the tax revenue/GDP ratio didn’t change much at all. Tax revenue, in 1970, was multiples of total GDP in 1950.
This is good, but it is just one aspect of a much broader picture. In the 1950s and 1960s, economists didn’t really have any way at all of explaining this phenomenon. One popular explanation was that it was caused by the rebuilding effort after the widespread destruction of physical assets in World War II. This was Frederic Bastiat’s “broken window fallacy” on a galactic scale.
Before 1870 or so, people discussed “political economy,” which basically meant: government economic policy. Since taxation is the government’s biggest economic policy, except for communistic central-planning regimes and those governments (rare in history; common today) who engage in fiat currency manipulation, taxation was often a topic of discussion though one that was not understood very well.
The “marginal revolution” of the 1870s, beginning with people like Carl Menger and Leon Walras, created the modern study of “economics” – and with it, a number of gross errors that continue to the present day. Driven by physics-envy, they created new mathematical models of “pure economics” that mimicked ideal gas laws and other insights then revolutionizing engineering and physics. In the process, the elements of economics that seemed mathematical and quantifiable in nature – Prices, Interest and Money – became the focus, and everything else largely disappeared.