Supply-Side Economics

The origins of the supply-side economics school of thought can be traced to the 1970s as a conservative reaction against postwar Keynesian “demand-side” economic policies associated with changes in government spending levels to smooth out business cycles and to fund social spending programs. The central idea in this framework is that government can stimulate growth in aggregate supply through suitable tax policies, which in turn will result in an expansion of gross domestic product, accompanied by a decline in inflation.

The policies associated with supply-side economics are typically tax cuts. A prime example of such a policy is a cut in the top marginal income tax rates, which has the greatest effect on the highest income earners. According to the theory, a reduction in the marginal income tax rates will raise the after-tax compensation of the income earners. Since they will get to keep more of their earnings, individuals will now have an incentive to work harder and thus raise their earnings. Furthermore, some individuals who may have previously opted to stay out of the labor force may now be enticed back into the workforce. Consequently, the supply of labor increases, which in turn will cause an increase in the aggregate supply of goods and services in the economy. The projected results are higher output, lower unemployment, and lower inflation.

One variant of the supply-side argument asserts that the reduction in tax rates will result in increased tax revenues for the government. This argument is encapsulated by the Laffer curve (Arthur Laffer reportedly drew the curve on a restaurant napkin), which depicts the effect of tax rates on revenues.

Initially, as tax rates rise, so do revenues, but after a certain point, any further increase in tax rates is accompanied by declining revenues as the higher tax rates begin to exert a stultifying influence on work effort. Furthermore, higher tax rates may also encourage increased use of tax avoidance measures; in some cases, these measures might include illicit efforts to conceal income. Under these circumstances, a reduction in the tax rate will not only engender greater work effort but also reduce the extent of tax evasion, leading to a robust increase in economic growth and an overall increase in tax revenues.

Proponents of a flat tax also make similar arguments. Notably associated with Steve Forbes, flat tax proposals seek to levy the same (low) tax rate on all incomes, thereby effectively providing a sizeable tax cut for high-income earners. To prevent large increases in the budget deficit, some versions propose outlawing the myriad tax deductions currently enjoyed by the middle class and upper-income groups. These include eliminating the mortgage interest deduction, a particular favorite of homeowners and the real-estate industry. Stiff resistance from those who would be affected by the loss of such tax breaks has frustrated proponents of the flat tax.

The empirical evidence on the relationship between tax rates and revenues is mixed, at best. Most studies show that cutting tax rates leads to less revenue, not more. The Reagan administration's tax cuts of the early 1980s resulted in a decrease in tax revenues. Between 1980 and 1984, a period when average incomes (per person, adjusted for inflation) rose following the tax cuts, revenues from personal income taxes (per person, adjusted for inflation) fell. The decline in revenues continued throughout the decade; by the end of Reagan's second term, the record of large budget deficits had been firmly established.

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