Supply-side Economics: Does It Work?

Does Boosting Supply Create Economic Growth?

Supply side economics
President Ronald Reagan popularized supply-side economics. Ronald Reagan Presidential Library

Definition: Supply-side economics is the theory that says the supply of money, labor, and goods or services, creates demand. It is the opposite of Keynesian theory, which states that demand is the primary driving force. It recommends lower tax rates and deregulation to boost economic growth.  

Here's how supply-side economics is supposed to work. 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, increasing workers' incentive to remain employed, and thereby increasing labor. This increase in supply boosts economic growth. That's why supply-side is also known as trickle-down economics.

Businesses can raise prices, and workers can then bargain for higher wages, which will translate back into higher tax revenues. Some supply-side proponents even argue that, over time, any lost tax revenue will be recouped through greater tax receipts from a booming economy. (Source NYT, How Supply-side Economics Trickled Down, April 6, 2007)

Theory Behind Supply-Side Economics

Supply-side economics is based on the Laffer Curve. It was developed in 1979 by economist Arthur Laffer. He argued that the effect of tax cuts on the federal budget are immediate. They are also on a 1-for-1 basis. For every dollar cut in taxes reduces government spending (and its stimulative effect) by exactly one dollar.

However, that same tax cut has a multiplier effect on economic growth. Every dollar cut in taxes translates into increased demand. That's because it stimulates business growth, which results in additional hiring. 

How much effect tax cuts have depends on whether the economy is growing, how high taxes were to begin with, and which taxes are cut.

If taxes were in the prohibitive zone, then cuts will have the best effect. If taxes are already low, then cuts will only reduce government revenue and increase deficits without boosting growth enough to offset the revenue lost.

How Well Did It Work?

Supply-side economics was put into practice in the 1980s by President Reagan. He used it as a tool to combat stagflation, a rare combination of stagnant economic growth and high inflation. For this reason, supply-side economics is also known as Reaganomics.

Reagan cut the top marginal income tax rate from 70% to 28%. The top corporate tax rate was reduced from 46% to 40%. The economy recovered out of, what was then, the worst recession since the Great Depression

However, Reagan also increased federal spending on defense at the same time. He doubled the national debt while he was in office. According to Keynesians, this would have also boosted economic growth by putting more money into the economy, creating jobs and increasing demand. For more, see Debt by President.

President Bush also used supply-side reasoning to cut taxes in 2001 (JGTRRA) and 2003 (EGTRRA). 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 stimulator of the economy. The FOMC lowered the Fed Funds rate from 6% at the beginning of 2001 to a low of 1% by June 2003. (Source: New York Federal Reserve, Historical Fed Funds Rate)

A lot depends on which segment of society gets the tax cuts. Studies show that tax cuts to lower income families are more likely to be directly translated into increased spending. That boosts demand and economic growth. The same tax cuts to higher income families can instead be used to pay off debt, invested or saved. It could help the stock market or banks, but isn't as powerful an economic stimulus because it doesn't drive increased sales at the cash register. For more, read Do Tax Cuts Create Jobs?

Studies That Support Supply-Side Economics

The Treasury Department developed a model which showed that the Bush tax cuts would ultimately increase annual GDP by 0.7%. However, it is important to note that the model assumes that the revenue lost by the cuts were offset by reduced fiscal spending, keeping the budget balanced. If instead, tax cuts now were balanced by future tax increases, they would have a negative impact on the economy in the long run. The future tax increases would be needed to pay off the additional debt incurred by a combination of tax cuts without reduced fiscal spending. (Source: U.S. Treasury Department, A Dynamic Analysis of Permanent Extension of President's Tax Relief, July 25, 2006)

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. (Source: NBER, Dynamic Scoring: A Back of the Envelope Guide, December 2004. Townhall.com, "No, the Bush Tax Cuts Do Not Increase Revenue," November 15, 2007)

Conclusion

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. Tax cuts 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. 

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