Supply-Side Economics

What are the two most fundamental concepts in economics? Supply and demand. It turns out that these two concepts are at the heart of two very different views of how to generate economic growth. Keynesian economics is all about the demand side of the economy and generally involves increasing spending to boost economic growth. Supply-side economics is all about the supply side of the economy and generally involves cutting taxes to increase after-tax income, incentives to work and invest, tax revenue, and economic growth. If you would like to learn more about supply-side economics and how it impacts the economy, read on!

Supply-side Economics definition

What is the definition of supply-side economics? Well, the answer is not that clear-cut. For the most part, supply-side theory contends that aggregate supply is what drives economic growth rather than aggregate demand. Supply-siders believe that tax cuts will increase after-tax income, incentives to work and invest, tax revenue, and economic growth. However, whether tax revenue increases or decreases depends on where tax rates are before the changes are made.

The main idea behind the theory is that if tax rates are reduced, people will be more incentivized to work, enter the workforce, and invest because they get to keep more of their money. Leisure then carries a higher opportunity cost because not working means you lose out on more income compared to if tax rates were higher. With people working more and businesses investing more, the supply of goods and services in the economy increases, meaning that there is less pressure on prices and wages, which helps to keep inflation in check. Figure 1 below shows that when short-run aggregate supply (SRAS) increases, prices decline.

Fig. 1 - Supply Increase, StudySmarter Originals

The three pillars of supply-side economics are fiscal policy, monetary policy, and regulatory policy.

Supply-siders believe in lower marginal tax rates to boost saving, investing, and employment. Thus, when it comes to fiscal policy, they argue for lower marginal tax rates.

As for monetary policy, supply-siders don't believe that the Federal Reserve can impact economic growth much, so they tend not to favor monetary policy when it comes to trying to manage the economy. They advocate for low and stable inflation and stable money supply growth, interest rates, and economic growth.

Regulatory policy is the third pillar. Supply-siders believe in supporting the higher production of goods and services. For this reason, they support less government regulation to allow businesses to unleash their productive and innovative capacity to drive economic growth.

History of Supply-Side Economics

The history of supply-side economics started in 1974. As the story goes, when economist Arthur Laffer was having dinner at a Washington restaurant with some politicians and journalists, he pulled out a napkin to draw a simple chart explaining his ideas about taxes. He believed that at some optimal tax rate, tax revenue would be maximized, but that tax rates that were too high or too low would result in lower tax revenue. Figure 2 below is the chart that he drew on that napkin, which came to be known as the Laffer Curve.

Fig. 2 - The Laffer Curve, StudySmarter Originals

The idea behind this curve is the following. At point M, the maximum amount of tax revenue is generated. Any point to the left of M, say point A, would generate less tax revenue because the tax rate is lower. Any point to the right of M, say point B, would generate less tax revenue because the higher tax rate would reduce the incentive to work and invest, meaning the tax base is lower. Thus, Laffer claimed, there is a certain tax rate at which the government can generate the maximum tax revenue.

Notice that with a tax rate of 0%, everyone is happy and much more willing to work, but the government generates no tax revenue. At a tax rate of 100%, nobody wants to work because the government keeps all of everyone's money, so the government generates no tax revenue. At some point, between 0% and 100% is the sweet spot. Laffer suggested that if the government's main purpose in raising tax rates is to raise revenue, as opposed to slowing the economy, then the government should choose the lower tax rate (at point A) rather than the higher tax rate (at point B) because it will generate the same amount of tax revenue without hurting economic growth.

The marginal income tax rate is what supply-siders focus on the most because it is this rate that drives people's incentives to save and invest more or less. Supply-siders also support lower tax rates on income from capital to boost investment and innovation.

Supply-Side Economics Examples

There are several supply-side economics examples to look at. Since Laffer introduced his theory in 1974, many U.S. presidents, including Ronald Regan (1981, 1986), George W. Bush (2001, 2003), and Donald Trump (2017) have followed his theory when enacting tax cuts for the American people. How did these policies match up with Laffer's theory? Let's take a look!

Ronald Reagan Tax Cuts

In 1981 U.S. President Ronald Reagan signed the Economic Recovery Tax Act into law. The top individual tax rate was cut from 70% to 50%.¹ Federal individual income tax revenues rose 40% from 1980-1986.² Real GDP growth increased in 1981 and was never below 3.5% from 1983-1988.³ Thus, while it appears the tax cuts had their intended effect, they did not generate as much tax revenue as expected. This, coupled with the fact that federal spending was not cut, resulted in a larger federal budget deficit, so taxes had to be raised several times in the following years.¹

In 1986 Reagan signed the Tax Reform Act into law. The top individual tax rate was cut again from 50% to 33%.¹ Federal individual income tax revenues increased 34% from 1986-1990.² Real GDP growth remained solid from 1986 until the 1991 recession.³

George W. Bush Tax Cuts

In 2001 President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act into law. This law was largely aimed at providing tax relief for families. The top individual tax rate was cut from 39.6% to 35%. However, most of the benefits went to the top 20% of income earners.⁴ Federal individual income tax revenues fell 23% from 2000-2003.² Real GDP growth was much weaker in 2001 and 2002 after the tech bubble burst.³

In 2003 Bush signed the Jobs and Growth Tax Relief Reconciliation Act into law. This was largely aimed at relief for businesses. The law cut capital gains tax rates from 20% to 15% and from 10% to 5%.⁴ Federal corporate income tax revenues jumped 109% from 2003-2006.² Real GDP growth was solid from 2003-2007.³

Donald Trump Tax Cuts

In 2017, President Donald Trump signed the Tax Cuts and Jobs Act into law. This law lowered the corporate tax rate from 35% to 21%. The top individual tax rate was reduced from 39.6% to 37%, and all other rates were lowered as well.⁵ The standard deduction was nearly doubled from $6,500 to $12,000 for individuals. Federal individual income tax revenues rose 6% from 2018-2019 before falling in 2020 due to the pandemic. Federal corporate income tax revenues rose 4% from 2018-2019 before falling in 2020 due to the pandemic.² Real GDP growth was decent in 2018 and 2019 before falling in 2020 due to the pandemic.³

In nearly every one of these examples, federal tax revenues increased, and GDP growth was decent to strong after these tax cuts were passed into law. Unfortunately, because the tax revenues generated were not as much as expected and did not "pay for themselves", the result was that budget deficits increased in most cases. Thus, while supply-siders can claim some success, their opponents can point to higher budget deficits as a drawback to supply-side policies. Then again, it is the demand-siders that are usually against spending cuts, so both sides have contributed to higher budget deficits in some way or another.

Importance of Supply-Side Economics

What is the importance of supply-side economics? For one thing, it is a different way of looking at the economy as opposed to Keynesian, or demand-side, policies. This helps in debate and dialogue and prevents just one kind of policy from being the only policy used. Supply-side policies have been somewhat successful in increasing tax revenue and economic growth. However, without matching spending cuts, tax cuts have often led to budget deficits, which have sometimes required tax rates to be raised again in later years. That being said, supply-side policies are not designed to reduce or prevent budget deficits. They are designed to increase after-tax income, business production, investment, employment, and economic growth.

When it comes to government intervention in the economy, it almost always centers on changes to the tax code. Since tax policy can be controversial and political, supply-side economics has also had an enduring impact on politics and elections. When someone runs for political office, they almost always talk about what they will do with tax rates and the tax code, or at least what they support. Therefore, in order to make a well-informed decision on who to vote for, at least as far as taxes are concerned, voters need to pay close attention to what their candidate supports regarding taxes.

There is always debate about what the best policy is for the economy, and this entails fiscal policy, monetary policy, and regulatory policy. While supply-siders will argue for lower tax rates, steady money supply growth, and less government intervention, demand-siders generally want to see higher government spending, which they believe helps to drive stronger demand from consumers and businesses as the money moves throughout the economy. They also support stronger regulations to protect consumers and the environment. Therefore, in order to pay for a bigger government, they will often support raising taxes and usually target the wealthy.

There are many benefits of supply-side economics. When tax rates are reduced, people get to keep more of their hard-earned money, which they can use to either save, invest, or spend. This results in greater financial security as well as more demand for products and services. In turn, this leads to more demand for labor to meet the higher demand for products and services, so more people have jobs instead of being unemployed or on welfare. Thus, lower tax rates help to increase both the supply of and the demand for labor. In addition, more investment leads to more technological advances, making life better for everyone. Also, with more products and services on offer, there is less pressure on prices, which, in turn, means less pressure on wages, which are a very large expense for most businesses. This helps to support higher corporate profits.

Table 1 below sums up the results of these supply-side policies.

Table 1 - Results of Supply-Side Policies, Source: Bureau of Labor Statistics⁶

Finally, when tax rates are high, there is more incentive for people to engage in either tax avoidance or tax evasion, which not only deprives the government of tax revenue but also costs the government money to investigate, arrest, charge, and try those individuals in court. Lower tax rates reduce the incentive to engage in these behaviors. All of these benefits of supply-side economics lead to more efficient and wider-spread economic growth, thereby raising living standards for everyone.