Big tax-cut windfall seen from earnings 'on the sly'

Peter Gutmann has won himself something of a reputation in the economics profession by his analysis of the "subterranean economy." Now this professor, who teaches economics and finance at Baruch College of the City University of New York, has come up with a related idea -- the "Gutmann curve."

His basic thesis is that high tax rates create a strong incentive for individuals to escape from taxation by shifting their economic activity from the legal to the subterranean economy -- money earned by legal or illegal activity but on which no taxes are paid.

A carpenter who works weekends for cash and pays no income tax on that money is part of the subterranean economy. So is the drug dealer. As taxes are raised, at some point the switch into such tax-free activities becomes so great that government revenues level off and start to decline. Or, vice versa, a cut in taxes could encourage some people to return their subterranean incomes to the legal economy, pushing up revenues.

Mr. Gutmann has high estimates of the size of the subterranean economy -- $ 220 billion in 1978 and more today. So presumably a substantial switch back into the legal economy could add billions to tax revenues.

This "Gutmann effect" (Professor Gutmann uses his own name liberally as a shorthand way of labeling his ideas) could be combined with the "Laffer effect" -- an economic thesis well known in Washington. Prof. arthur Laffer of the University of Southern California argues that a reduction in tax rates can increase the amount of government revenues. It does so by encouraging people to work harder and save more of the capital needed to increase in national output and of tax revenue that can exceed the amount of the tax cut.

Writing in the latest issue of the Financial Analysts Journal, Mr. Gutmann notes: "This most happy result solves the politician's dilemma: He can satisfy those constituents who believe in tax reduction a la Proposition 13 and also those constituents who want to continue government spending. He can advocate, at one and the same time, tax reduction and a balanced budget. Small wonders that Laffer's proposition has been taken up with alacrity by a number of nationality known members of Congress."

The trouble is that a 1 percent reduction in tax rates must release enough labor and capital to result in an increase in national output or more than 1 percent. Unfortunately, most economists, including Mr. Gutmann, doubt that the United States tax level is severe enough that a tax cut would produce a fully offsetting gain in tax revenues.

"Alas! The politician's dilemma cannot be resolved by reference to the Laffer curve," he says.

But would the addition of the Gutmann effect to the Laffer effect produce a favorable revenue balance for a tax cut?

Professor Gutmann speculates that lower tax rates might actually boost tax collections in Britain, where tax rates are very high. But in this country, he says, it might or it might not.

He adds, however, that "lower tax rates would increase both the potential of the legal economy to produce gross national product and, as a result, the potential of the legal economy to move to higher productivity -- something that is very urgently needed. Higher national productivity means in turn that the need for any given level of government expenditure, hence revenues, would diminish."

Mr. Gutmann's paper is part of a wave of attention among economists and politicians to what is called "supply-side economics."

Dr. Martin Feldstein, president of the National Bureau of Economic research, comments: "In a sence, [supply-side economics] is a relabeling and catchy phrase for something that people in the economics profession have emphasized for a long time."

After the great depression, John Maynard Keynes, the famed British economist, led his field to devote its attention to the demand side of economics. He urged that the government had to spend more to increase consumer demand for goods and services, and thereby step up production and decrease unemployment.

"At best that is only half the story," Dr. Feldstein notes. If an economy is operating with full employment and utilizing most of its industrial or service capacity, increased demand doesn't increase output but merely raises price.

So economists have been looking more intently at ways to improve human capital (through education and training to make people more productive); add to the amount of capital available for new, more efficient plants and offices; and advance technology.

The slow gains in productivity and output during the 1970s, both tending to worsen inflation, have further stimulated this increased interest in supply-side economics.

"It is a return to ideas which we have known to be important a long time ago, " said Dr. Feldstein.

In Washington, this trend has meant that in considering tax cuts, both the administration and Congress are looking at ways to encourage savings or stimulate business to increase its efficiency. One proposal would make the first $201 of savings interest for the individual taxpayer and $400 for the married couple free from income tax. Another would lowere corporate income taxes, liberalize depreciation allowances, and provide tax credits for technological research and development. One reason for the renewed interest in the tax on value added (a type of sales tax) is to switch some of the tax burden away from supply to demand (consumption).

Dr. Feldstein suggests "indexing" the tax burden on savings, bond interest income, depreciation, and capital gains to offset inflation.

In general, speaking of supply-side economics, he maintains that "it is a very good redirection of emphasis."