Supply-Side Economics With Examples

Does It Work?

Supply side economics
••• Ronald Reagan Presidential Library

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.

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.

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. 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 theory, putting more money into consumers' pockets directly drives the demand that increases growth. A study by Economy.com found that every dollar spent on unemployment benefits stimulates $1.73 in economic demand. For example, the Obama benefit extensions cost taxpayers $10 billion every month. But they generated $17.3 billion in economic growth per month.

Its tools are government spending on infrastructure, unemployment benefits, and education. A University of Massachusetts at Amherst study found that building roads, bridges, and other public works are the most effective. One billion dollars spent on public works created 19,975 jobs. It works because it puts people right to work.

Every $1 billion spent on unemployment benefits created 19,000 jobs. The unemployed must spend all the benefits to buy necessities such as groceries, clothing, and housing right away. The third most effective spending solution is education. For each $1 billion spent, it created 17,687 jobs.

Theory Behind Supply-Side Economics

The Laffer Curve is the theoretical underpinning of supply-side economics. Economist Arthur Laffer developed it in 1979. 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.

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? The Congressional Budget Office did a comprehensive study of the number of jobs created by different government policies. It analyzed seven types of tax cuts. It found the most cost-effective policy was payroll tax cuts targeted to new employees. It created 18 jobs for every $1 million in lost tax revenue. Across-the-board tax cuts only created four jobs for that same revenue.

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 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

Reagan was an advocate of laissez-faire economics. 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 percent to 28 percent. He reduced the top corporate tax rate from 46 percent to 40 percent. That helped boost the economy out of the worst recession 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 percent.

President George W. Bush also used supply-side economics to cut taxes in 2001 with the Economic Growth and Tax Relief Reconciliation Act and in 2003 with the Jobs and Growth Tax Relief Reconciliation Act. 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 stimulation. 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.

(Source: "Historical Fed Funds Rate," New York Federal Reserve.)

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 Treasury Department 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. (Source: "A Dynamic Analysis of Permanent Extension of President Bush's Tax Relief" U.S. Treasury Department, 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," NBER, December 2004. "No, the Bush Tax Cuts Do Not Increase Revenue," Townhall.com, November 15, 2007.)

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.