Does Supply-Side Economics 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 increased production drives economic growth. The factors of production are capital, labor, entrepreneurship and land.  

Supply-side fiscal policy focuses on businesses. Its tools are tax cuts and deregulation. Companies that benefit from these policies hire more workers. The resultant job growth creates more demand which further boosts growth.

Supply-side is the opposite of Keynesian theory. It states that demand is the primary driving force. Its fiscal policy focuses on consumers regardless of whether they work or not. Its tools are government spending on infrastructure, unemployment benefits and education. 

How It Works

Supply-side works by giving incentives to businesses to expand. Deregulation removes restrictions to growth and the costs associated with complying. Companies are then free to explore new areas of growth.

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 increases workers' incentive to remain employed. That increases the supply of labor. This increase in supply boosts economic growth. 

Supply-side is similar to trickle-down economics. That says what's good for corporate America will trickle-down to everyone in the society.

In addition, it says that greater growth will make up for the lost tax revenue. A strong economy allows companies to sell more and raise prices. It allows workers to bargain for higher wages. Both pay more taxes on their increased income. (Source: "How Supply-side Economics Trickled Down," The New York Times, April 6, 2007.)

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. That's because 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? How high was the tax rate? 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 Did It Work?

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 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. Compare to other presidents in Debt by President.

President Bush also used supply-side economics to cut taxes in 2001 with EGTRRA and 2003 with JGTRRA. 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 FOMC lowered the Fed funds rate from 6 percent at the beginning of 2001 to a low of 1 percent 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 GDP by 0.7 percent. But the model assumes that the revenue lost by the cuts were offset by reduced fiscal spending, 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.)

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. 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.