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Supply-side economics is a Macroeconomics theory postulating that economic growth can be most effectively fostered by Tax cuts, Deregulation, 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:
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 and Arthur Laffer. The term is contrasted with demand-side economics.
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....
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.
Barry P. Bosworth's book, Tax incentives and economic growth, published in 1984, provided another definition by presenting supply-side economics from two perspectives:
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.
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.
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".
Switching from earlier monetary policy, Federal Reserve chair Paul Volcker implemented tighter monetary policies including lower money supply growth to break the inflationary psychology and squeeze inflationary expectations out of the economic system.Malabre, Jr., pp. 170–1. Therefore, supply-side supporters argue that Reaganomics was only partially based on supply-side economics.
Congress under Reagan passed a plan that would slash taxes by $749 billion over five years. Critics claim that the tax cuts increased budget deficits while Reagan supporters credit them with helping the 1980s economic expansion and argued that the budget deficit would have decreased if not for massive increases in military spending. As a result, Jason Hymowitz cited Reagan—along with Jack Kemp—as a great advocate for supply-side economics in politics and repeatedly praised his leadership.Malabre, Jr., p. 188.
Critics of Reaganomics claim it failed to produce much of the exaggerated gains some supply-siders had promised. Paul Krugman later summarized the situation: "When Ronald Reagan was elected, the supply-siders got a chance to try out their ideas. Unfortunately, they failed." Although he credited supply-side economics for being more successful than monetarism which he claimed "left the economy in ruins", he stated that supply-side economics produced results which fell "so far short of what it promised", describing the supply-side theory as "free lunches".Malabre, Jr., p. 195.
Economist Paul Krugman wrote in 2017 that Clinton's tax increases on the rich provided counter-example to the supply-side tax cut doctrine: "Bill Clinton provided a clear test, by raising taxes on the rich. Republicans predicted disaster, but instead the economy boomed, creating more jobs than under Reagan."
Supply-side economist Alan Reynolds argued that the Clinton era represented a continuation of a low tax policy (from the 1980s):
The cuts were based on model legislation published by the conservative American Legislative Exchange Council (ALEC), and were supported by The Wall Street Journal, supply-side economist Arthur Laffer, economics commentator Stephen Moore and anti-tax leader Grover Norquist. The tax cuts have been called the "Kansas experiment", and was described by the Brookings Institution as "one of the cleanest experiments for how tax cuts affect economic growth in the U.S."
Brownback compared his tax cut policies with those of Ronald Reagan, but also described them as "a real live experiment ... We'll see how it works." Brownback forecast his cuts would create an additional 23,000 jobs in Kansas by 2020, and was intended to generate rapid economic growth, which he said would be "like a shot of adrenaline into the heart of the Kansas economy." The Kansas Legislature's research staff warned of the possibility of a deficit of nearly 2.5 billion by July 2018.
By 2017, state revenues had fallen by hundreds of millions of dollars, causing spending on roads, bridges, and education to be slashed, "Kansas Legislature approves budget deal, after lawmakers deliver blistering critiques of state finances," May 2, 2016, Topeka Capital-Journal "Kansas Republicans Sour on Their Tax-Cut Experiment" February 24, 2017, The Atlantic but instead of boosting economic growth, growth in Kansas remained consistently below average. A working paper by two economists at Oklahoma State University (Dan Rickman and Hongbo Wang) using historical data from several other states with economies structured similarly to Kansas found that the Kansas economy grew about 7.8% less and employment about 2.6% less than it would have had Brownback not cut taxes. In 2017, the Republican Legislature of Kansas voted to roll back the cuts, and after Brownback vetoed the repeal, overrode his veto.
According to Max Ehrenfreund, economists generally agree that an explanation for the reduction instead of increase in economic growth from the tax cuts is that "any" benefits from tax cuts come over the long, not short run, but what does come in the short run is a major decline in demand for goods and services. In the Kansas economy cuts in state government expenditures cut incomes of state government "employees, suppliers and contractors" who spent much or most of their incomes locally. In addition, concern over the state's large budget deficits "might have deterred businesses from making major new investments".
One problem Kansas encountered is that while studies have shown that tax cuts increase economic growth, the increased revenue from that growth at the new lower tax rates are only enough to make up for 10–30% of the tax cuts, meaning that to avoid deficits, spending cuts must also be made.
Supply-side economics holds that increased taxation steadily reduces economic activity within a nation and discourages investment. Taxes act as a type of trade barrier or tariff that causes economic participants to revert to less efficient means of satisfying their needs. As such, higher taxation leads to lower levels of specialization and lower economic efficiency. The idea is said to be illustrated by the Laffer curve.(Karl Case and Ray Fair, 1999: pp. 780–1).
Supply-side economists have less to say on the effects of deficits and sometimes cite Robert Barro's work that states that rational economic actors will buy bonds in sufficient quantities to reduce long-term interest rates.
Karl Case and Ray Fair wrote in Principles of Economics, "The extreme promises of supply-side economics did not materialize. President Reagan argued that because of the effect depicted in the Laffer curve, the government could maintain expenditures, cut tax rates, and balance the budget. This was not the case. Government revenues fell sharply from levels that would have been realized without the tax cuts."
Supply side proponents Trabandt and Uhlig argue that "static scoring overestimates the revenue loss for labor and capital tax cuts" and that "dynamic scoring" is a better predictor for the effects of tax cuts.
A 1999 study by University of Chicago economist Austan Goolsbee examined major changes in high-income tax rates in the United States from the 1920s onwards. It concluded that there were only modest changes in the reported income of high-income individuals, indicating that the tax changes had little effect on how much people work. He concluded that the notion that governments could raise more money by cutting rates "is unlikely to be true at anything like today's marginal tax rates". In 2015, one study found that in the past several decades, tax cuts in the U.S. seldom recouped revenue losses and had minimal impact on GDP growth.
A 2008 working paper found that in the case of Russia, "tax rate cuts can increase revenues by improving tax compliance."
The New Palgrave Dictionary of Economics reports that estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70%.
At the same time, some studies have found a relatively robust response to tax cuts from the top 5% of tax returns.Henderson, David R., Are We All Supply-Siders Now?, Western Economic Association International, 1989. There has been identified an increase of 7.7% in revenues from the top 5%, from $17.17 billion US in 1963 to $18.49 billion in 1965. Hereby, the data have provided evidence that the group has been in the prohibitive part of the Laffer curve, because its input to total tax revenues have increased despite the tax rates decreasing significantly.
Both CBO and the Reagan Administration forecast that individual and business income tax revenues would be lower if the Reagan tax cut proposals were implemented, relative to a policy baseline without those cuts, by about $50 billion in 1982 and $210 billion by 1986. FICA tax revenue increased because in 1983 FICA tax rates were increased from 6.7% to 7% and the ceiling was raised by $2,100. For the self-employed, the FICA tax rate went from 9.35% to 14%. The FICA tax rate increased throughout Reagan's term and rose to 7.51% in 1988 and the ceiling was raised by 61% through Reagan's two terms. Those tax hikes on wage earners, along with inflation, were the source of revenue gains in the early 1980s. The Reagan Tax Cuts: Lessons for Tax Reform – Joint Economic Committee
It has been contended by some supply-side critics that the argument to lower taxes to increase revenues was a smokescreen for "starving" the government of revenues in the hope that the tax cuts would lead to a corresponding drop in government spending, but this did not turn out to be the case. Paul Samuelson called this notion "the tape worm theory—the idea that the way to get rid of a tape worm is to stab your patient in the stomach".Malabre, Jr., pp. 197–8.
There is frequent confusion on the meaning of the term "supply-side economics" between the related ideas of the existence of the Laffer Curve and the belief that decreasing tax rates can increase tax revenues. Many supply-side economists doubt the latter claim while still supporting the general policy of tax cuts. Economist Gregory Mankiw used the term "fad economics" to describe the notion of tax rate cuts increasing revenue in the third edition of his 2007 Principles of Macroeconomics textbook in a section entitled "Charlatans and Cranks":
In 1986, Martin Feldstein – a self-described "traditional supply sider" who served as Reagan's chairman of the Council of Economic Advisors from 1982 to 1984 – characterized the "new supply siders" who emerged circa 1980:
What distinguished the new supply siders from the traditional supply siders as the 1980s began was not the policies they advocated but the claims that they made for those policies ... The "new" supply siders were much more extravagant in their claims. They projected rapid growth, dramatic increases in tax revenue, a sharp rise in saving, and a relatively painless reduction in inflation. The height of supply side hyperbole was the "Laffer curve" proposition that the tax cut would actually increase tax revenue because it would unleash an enormously depressed supply of effort. Another remarkable proposition was the claim that even if the tax cuts did lead to an increased budget deficit, that would not reduce the funds available for investment in plant and equipment because tax changes would raise the saving rate by enough to finance the increased deficit ... Nevertheless, I have no doubt that the loose talk of the supply side extremists gave fundamentally good policies a bad name and led to quantitative mistakes that not only contributed to subsequent budget deficits but that also made it more difficult to modify policy when those deficits became apparent.
In 2006, the CBO released a study titled "A Dynamic Analysis of Permanent Extension of the President's Tax Relief". This study found that under the best possible scenario making tax cuts permanent would increase the economy "over the long run" by 0.7%. This study was criticized by many economists, including Harvard Economics Professor Greg Mankiw, who pointed out that the CBO used a very low value for the earnings-weighted compensated labor supply elasticity of 0.14. In a paper published in the Journal of Public Economics, Mankiw and Matthew Weinzierl noted that the current economics research would place an appropriate value for labor supply elasticity at around 0.5.
The Congressional Budget Office (CBO) estimated that extending the Bush tax cuts beyond their 2010 expiration would increase the deficit by $1.8 trillion over 10 years. The CBO also completed a study in 2005 analyzing a hypothetical 10% income tax cut and concluded that under various scenarios there would be minimal offsets to the loss of revenue. In other words, deficits would increase by nearly the same amount as the tax cut in the first five years with limited feedback revenue thereafter.
Nobel laureate economist Milton Friedman agreed the tax cuts would reduce tax revenues and result in intolerable deficits, though he supported them as a means to restrain federal spending. Friedman characterized the reduced government tax revenue as "cutting their allowance".
Douglas Holtz-Eakin was a Bush administration economist who was appointed director of the Congressional Budget Office in 2003. Under his leadership, the CBO undertook a study of income tax rates which found that any new revenue from tax cuts paled in comparison to their cost.
Dartmouth economics professor Andrew Samwick was the chief staff economist for the Bush Council of Economic Advisers from July 2003 to July 2004. Writing on his blog in 2007, Samwick urged his former colleagues in the Bush administration to avoid asserting that the Bush tax cuts paid for themselves, because "No thoughtful person believes it...Not a single one."
Analysis conducted by the Congressional Research Service on the first-year effect of the tax cut found that little if any economic growth in 2018 could be attributed to it. Growth in GDP, employment, worker compensation and business investment slowed during the second year following enactment of the tax cut, prior to the emergence of the COVID-19 pandemic.
Following the Trump tax cut, top White House economic advisor Larry Kudlow falsely asserted that federal revenues had increased about 10% since the tax cut, though they had actually declined. He also falsely asserted that the CBO had found the "entire $1.5 trillion tax cut is virtually paid for by higher revenues and better nominal GDP".
Writing in 2010, John Quiggin said, "To the extent that there was an economic response to the Reagan tax cuts, and to those of George W. Bush twenty years later, it seems largely to have been a Keynesian demand-side response, to be expected when governments provide households with additional net income in the context of a depressed economy."
Cutting marginal tax rates can also be perceived as primarily beneficial to the wealthy, which some see as politically rather than economically motivated:
According to studies that analyzed the tax cuts in 2001 (EGTRRA): the decrease in taxes have provided a generally positive impact on the future output from the effect of the lower tax rates on human capital accumulation, private saving and investment, labor supply; however, the tax cuts have produced adverse effects such as higher deficits and reduced national savings. Thus, Gale and Potter (2002) concluded that these tax cuts could not affect the GDP levels in any significant way in the next 10 years.Gale, William G., and Samara Potter. 2002. “An Economic Evaluation of the Economic Growth and Tax Relief Reconciliation Act.” National Tax Journal 55 (1): 133-86.
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