Supply-side economics is the theory that says increased production drives economic growth. The factors of production are capital, labor, entrepreneurship, and land.
Supply-side fiscal policy focuses on creating a better climate for businesses. Its tools are tax cuts and deregulation. According to the theory, companies that benefit from these policies are able to hire more workers. The resultant job growth creates more demand which further boosts the economy.
- Supply-side economics advocates tax cuts and deregulation to drive economic growth.
- The Laffer Curve is the visual representation of supply-side economics.
- The opposite of supply-side is demand-driven Keynesian theory.
- President Reagan used supply-side economics to combat stagflation. It was dubbed Reaganomics, for this reason.
- Research shows that tax cuts don’t always translate to increased growth.
How It Works
Supply-side works by giving incentives to businesses to expand. Deregulation removes restrictions on their growth. It lowers the costs associated with complying. Companies are then free to explore new areas of commerce.
A corporate tax cut gives businesses more money to hire workers, invest in capital equipment, and produce more goods and services.
An income tax cut increases the dollars per hour worked. It boosts workers' incentive to remain employed and creates more labor. That is one of the four factors of production that drive supply. Adding to supply will allow the economy to grow.
Supply-side is similar to trickle-down economics but there are a few key differences.
That says what's good for the wealthy will trickle down to everyone in the society. Proponents believe that investors, savers, and company owners are the real drivers of growth.
Advocates of trickle-down economics promise that businesses will use the extra cash from tax cuts to expand. Investors will use their tax-cut windfall to buy more companies or stocks. Owners will invest in their operations and hire workers.
Supply-siders claim that this greater growth will always make up for the lost tax revenue.
Supply Side Versus Demand Side Economics
Supply-side is the opposite of Keynesian theory. It states that demand is the primary driving force of economic growth. Supporters use fiscal policy to better the lives of consumers regardless of whether they work or not.
According to the Keynesian theory, putting more money into consumers' pockets directly drives the demand that increases growth.
A study by Moody's and Economy.com found that every dollar spent on unemployment benefits stimulates $1.73 in economic demand. For example, the Obama benefit extensions cost taxpayers, but generated economic growth per month, too. Its tools are government spending on sectors like education and health care, which creates jobs and puts people to work.
Theory Behind Supply-Side Economics
The Laffer Curve is the theoretical underpinning of supply-side economics. Economist Arthur Laffer developed it in 1974. He argued that the effect of tax cuts on the federal budget are immediate. They are also on a 1-for-1 basis. Every dollar cut in taxes reduces government spending, and its stimulative effect, by exactly one dollar.
According to Laffer, that same tax cut has a multiplier effect on economic growth. Every dollar in tax cuts translates into increased demand. It stimulates business growth, which results in additional hiring.
How much effect tax cuts have depends on conditions when they occurred.
Was the economy growing or in a recession? Which taxes were cut? Another criterion to consider is how high was the tax rate before the cut took place? If taxes were in the prohibitive zone, then cuts will have the best effect. If taxes are already low, then cuts won't do as much. They will only reduce government revenue and increase deficits without boosting growth enough to offset the revenue lost.
How Well It Worked
President Ronald Reagan put supply-side economics into practice in the 1980s. He used it to combat stagflation. That's a rare combination of stagnant economic growth and high inflation. For this reason, supply-side economics is also called Reaganomics.
He believed that the free market and capitalism would solve the nation's woes. His policies matched the "greed is good" mood of 1980s America.
Reagan cut the top marginal income tax rate from 70% to 28%. He reduced the top corporate tax rate from 48% to 34%. That helped boost the economy out of the worst recession (at that time) since the Great Depression.
Reagan also increased defense spending at the same time. He doubled the national debt while he was in office. According to Keynesians, that also boosted economic growth by putting more money into the economy, creating jobs, and increasing demand. As a result, he was the third greatest contributor to the U.S. debt ranked by president. He increased the debt by 186%.
President George W. Bush also used supply-side economics to cut taxes in 2001 and in 2003. The economy grew, and revenues increased. Supply-siders, including the president, said that was because of the tax cuts. Other economists pointed to lower interest rates as the real stimulus. The Federal Open Market Committee lowered the fed funds rate from 6% at the beginning of 2001 to a low of 1% by June 2003.
A lot depends on which segment of society gets the tax cuts.
Studies show that tax cuts aren't equally effective in creating jobs. Cuts to lower-income families directly translate into increased spending. That boosts demand and economic growth. Tax cuts to higher-income families are often invested, saved, or used to pay off debt. That boosts the stock market and banks, but not retail.
Studies That Support Supply-Side Economics
The U.S. Department of the Treasury developed a model showing that the Bush tax cuts increased annual gross domestic product by 0.7%. But the model assumes that the revenue lost by the cuts were offset by reduced fiscal spending and keeping the budget balanced.
If instead, tax cuts were offset by future tax increases, the impact would be negative. The future tax increases would have to pay off the additional debt.
Studies That Don't Support Supply-Side Economics
A study by the National Bureau of Economic Research found precise figures on how much revenue will be recouped by tax cuts.
For each dollar of income tax cuts, only 17 cents will be recovered from greater spending.
Corporate tax cuts do a little better. Each dollar cut returns 50 cents to revenue. This shows that, over the long-term, the revenue lost by tax cuts will be only partially regained. Without a decrease in spending, tax cuts lead to an increase in the budget deficit. That harms the economy over time.
The Bottom Line
Economists still debate whether tax cuts lead to increased economic growth over the long term. The Treasury Department study did mention that, in the short-term and in an economy that is already weak, tax cuts will provide an immediate boost. The NBER study found that tax cuts will create larger budget deficits unless spending is also cut.
Over the long term, and in a healthy economy, this will put downward pressure on the dollar which could ultimately increase inflation through higher prices for imports. In time, if inflation is high enough and the economy is strong enough, it could convince the Federal Reserve to initiate contractionary monetary policy, such as higher interest rates. The result of that is slower economic growth.