Supply-side economics is a macroeconomic theory postulating that economic growth can be most effectively fostered by lowering taxes, decreasing regulation, and allowing free trade. According to supply-side economics theory, consumers will benefit from greater supply of goods and services at lower prices, and employment will increase. Supply-side fiscal policies are designed to increase aggregate supply, as opposed to aggregate demand, thereby expanding output and employment while lowering prices. Such policies are of several general varieties: Investments in human capital, such as education, healthcare, and encouraging the transfer of technologies and business processes, to improve productivity (output per worker). Encouraging globalized free trade via containerization is a major recent example. Tax reduction, to provide incentives to work, invest and take risks. Lowering income tax rates and eliminating or lowering tariffs are examples of such policies. Investments in new capital equipment and research and development (R&D), to further improve productivity. Allowing businesses to depreciate capital equipment more rapidly (e.g., over one year as opposed to 10) gives them an immediate financial incentive to invest in such equipment. Reduction in government regulations, to encourage business formation and expansion.
A basis of supply-side economics is the Laffer curve, a theoretical relationship between rates of taxation and government revenue. The Laffer curve suggests that when the tax level is too high, lowering tax rates will boost government revenue through higher economic growth, though the level at which rates are deemed "too high" is disputed."the U.S. marginal top rate is far from the top of the Laffer curve." “There is certainly some level of taxation at which cutting tax rates would be win-win. But few economists believe that tax rates in the United States have reached such heights in recent years; to the contrary, they are likely below the revenue-maximizing level”
The term "supply-side economics" was thought for some time to have been coined by the journalist Jude Wanniski in 1975; according to Robert D. Atkinson, the term "supply side" was first used in 1976 by Herbert Stein (a former economic adviser to President Richard Nixon) and only later that year was this term repeated by Jude Wanniski. The term alludes to ideas of the economists Robert Mundell, Arthur Laffer and Milton Friedman. The term is contrasted with demand-side economics.
Historical origins
Supply-side economics developed in response to the stagflation of the 1970s.Case, Karl E. & Fair, Ray C. (1999). Principles of Economics (5th ed.), p. 780. Prentice-Hall. . It drew on a range of non-Keynesian economic thought, including the Chicago School and New Classical School. Bruce Bartlett, an advocate of supply-side economics, traced the school of thought's intellectual descent from the philosophers Ibn Khaldun and David Hume, satirist Jonathan Swift, political economist Adam Smith and United States Secretary of the Treasury Alexander Hamilton. In 2007, Bartlett stated:
Today, hardly any economist believes what the Keynesians believed in the 1970s and most accept the basic ideas of supply-side economics – that incentives matter, that high tax rates are bad for growth, and that inflation is fundamentally a monetary phenomenon. Consequently, there is no longer any meaningful difference between supply-side economics and mainstream economics.
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Today, supply-side economics has become associated with an obsession for cutting taxes under any and all circumstances. No longer do its advocates in Congress and elsewhere confine themselves to cutting marginal tax rates – the tax on each additional dollar earned – as the original supply-siders did. Rather, they support even the most gimmicky, economically dubious tax cuts with the same intensity. ... today it is common to hear tax cutters claim, implausibly, that all tax cuts raise revenue.
Current day advocates of supply-side economic policies claim that lower tax rates produce macroeconomic benefits and emphasize this benefit rather than their traditional ideological Classical liberals opposition to taxation because they opposed government in general. Their traditional claim was that each man had a right to himself and his property and therefore taxation was immoral and of questionable legal grounding.Gray (1995). Liberalism. Minneapolis: University of Minnesota Press. . pp. 26–27 Supply-side economists argued that the alleged collective benefit (i.e. increased economic output and efficiency) provided the main impetus for tax cuts. As in classical economics, supply-side economics proposed that production or supply is the key to economic prosperity and that consumption or demand is merely a secondary consequence. Early on, this idea had been summarized in Say's law of markets, which states: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." or, in other words, production (supply) must first occur to enable economic activity or trade.
Supply-side economics rose in popularity among Republican Party politicians from 1977 onwards. Prior to 1977, Republicans were more split on tax reduction, with some worrying that tax cuts would fuel inflation and exacerbate deficits. In 1978, Jude Wanniski published The Way the World Works in which he laid out the central thesis of supply-side economics and detailed the failure of high tax rate progressive income tax systems and United States monetary policy under Richard Nixon and Jimmy Carter in the 1970s.
Definition and principles James D. Gwartney and Richard L. Stroup provide a definition of supply-side economics as the belief that adjustments in marginal tax rates have significant effects on the total supply. Gwartney and Stroup said "that the supply-side argument provided the foundation for the Reagan tax policy, which led to significant reductions in marginal tax rates in the United States during the 1980s".
Barry P. Bosworth's book, Tax incentives and economic growth, published in 1984, provided another definition by presenting supply-side economics from two perspectives:
"A broad interest in the determinants of aggregate supply – the volume and quality of the capital and labor inputs and the efficiency with which they are used" "A narrower focus on tax reductions as a means of increasing the supply of savings, investment, and labor."
Supply-side vs. previous approaches to economic policy
Supply-side economics has originated as an alternative to Keynesian economics, which focused macroeconomic policy on management of final demand. Demand-side economics relies on a fixed-price view of the economy, where the demand plays a key role in defining the future supply growth, which also allows for incentive implications of investment.
The Keynesian policy approaches focus on demand management as a major instrument to affect aggregate production and GNP, while Monetarism focuses on management of monetary aggregates and credit. Unlike supply-side economics, demand-side economics is based on the assumption that increases in GNP result from increased spending.Son, Hyung Chan (1990). "Supply-side economics in the Republic of Korea". Monterey, California: Naval Postgraduate School.
Traditional policy approaches were challenged by the theory of supply-side economics in the Reagan Administration of the 1980s. It claims that fiscal policy may lead to changes in supply as well as in demand.Fink, Richeard H., Supply-Side Economics, University Publications of America, 1982. So, when marginal tax rates are high, consumers pursue additional leisure and current consumption instead of pursuing current income and extra income in the future. Therefore, there is a decline in work effort and investment, which in turn causes a decrease of production and GNP, regardless of the total demand levels.
On these assumptions, supply side economists formulate the idea that a cut in marginal tax rates has a positive effect on economic growth.
Role of the marginal tax rates The main focus of supply-side economics is promotion of economic growth. In this regard, some studies have suggested to consider two relative prices.
The first one influences decisions of individuals on the distribution of their income between consumption and savings.Roberts, Paul C., The Supply-Side Revolution, Harvard University, 1984. The cost of individual's decision to assign a unit of income to either consumption or savings is a future value of the unit, which has been given up by choosing either to consume or to save. The unit of income value is defined by the marginal tax rates. Therefore, higher tax rates would decrease the cost of consumption, which would cause a fall in investment and savings. At the same time, lower tax rates would cause the investment and savings levels to rise, while the consumption levels would fall.
The second price influences decisions of individuals on the distribution of their time between work and leisure. The cost of individual's decision to allocate a unit of time either to work or leisure stands for current income, which was given up by choosing either work or leisure. The cost also includes the future income, which was given up for leisure instead of enhancing the professional skills. The value of lost income is defined by the tax rate assigned to the additional income. Therefore, the increase in marginal tax rates leads to a decrease in the price of leisure. However, if the marginal tax rate decline, the cost of leisure increases.
Both the amount of retained and taxed income is determined by the marginal tax rate. That is why, from a supply-side economist's standpoint, marginal tax rates play a significant role in determining the development of the economy. Due to crucial role in determining how much time workers will spend on work and leisure or how much income will be spent on consumption and for savings, supply-side economists insist on decreasing tax rates as they believe it could improve the growth rates of the economy.
Laffer curve Laffer curve illustrates a mathematical relationship between tax revenues and tax rates, which was popularized by economist Arthur B. Laffer in 1974. The Laffer Curve posits the existence of a maximum point when tax revenue is maximized at a specific (unknown) tax rate. Many interpret the Laffer Curve as higher tax rates can sometimes decrease the tax base, which will lead to the decrease in tax revenues even if the tax rates are high. Due to the effect exerted by taxes on the taxed income, the adjustment of tax rates may not lead to proportional changes in tax revenues. That is why, some supply-side economists insist decreasing high tax rates can result in an increase of tax revenues.
The Laffer curve embodies a postulate of supply-side economics: that tax rates and tax revenues are distinct, with government tax revenues the same at a 100% tax rate as they are at a 0% tax rate and maximum revenue somewhere in between these two values. Supply-siders argued that in a high tax rate environment lowering tax rates would result in either increased revenues or smaller revenue losses than one would expect relying on only static estimates of the previous tax base.
This led supply-siders to advocate large reductions in marginal income and capital gains tax rates to encourage greater investment, which would produce more supply. Supply-sider Jude Wanniski and many others advocate a zero capital gains rate.Wanniski, Jude "Taxing Capital Gains".
History
Reaganomics