Supply Side Economics:

Taxes & Economic Growth

 

 

By Michael Gethings

 

Business Economics

Professor Jim Stodder

MGMT 6300

Spring 2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

I       Abstract

The American economy has experienced relative prosperity over the past 25 years.  During this period, presidents from both parties have governed and had the opportunity to enact legislation that they feel would achieve economic growth through a variety of ways.  During President Reagan’s tenure, America experienced tremendous economic growth.  From 1983 through 1990, the United States experienced approximately 7 years of sustained economic growth.  Proponents of Reagan’s policies championed Reagonomics.  At the core of Reagonomics was a lesser-known economic theory called “Supply-Side” economics.  Supply-side economic theorists argue that lowering taxes on corporations and individuals will increase corporate investment in goods and services.  Lower taxes will increase consumer spending.  The confluence of these actions will result in economic growth.

President Reagan, along with the United States Congress, lowered income tax rates and corporate tax rates in 1981.  The tax cuts of 1981 were followed by what some economists have characterized as the worst recession in 50 years in 1982 but supply-siders attributed the economic woes of 1982 to previous years of economic mismanagement.  The ensuing years experienced tremendous economic growth. Critics of Reaganomics called it “voodoo economics” or trickle down and characterized these policies as tax cuts for the wealthy.

The Clinton Presidency also experienced unprecedented economic growth.  The recipe to achieve this growth was vastly different than the policies of Reagonomics.  Clinton enacted tax increases and oversaw increases in government expenditures in priority areas.  Nonetheless his eight years in office experienced record levels of growth. 

The presidency of George W. Bush has been characterized by a slow and sluggish if not recessionary economy.  President Bush has adopted the mantra of Ronal Reagan to resuscitate the economy.  He has championed supply-side like tax cuts.  Is he right? 

This paper will review supply-side economics and compare these policies with traditional Keynesian policies.  It will air the input and research of those for and against supply-side to determine if it is “voodoo economics” or the preferable alternative to policies of the past to ensure economic growth.

II      Supply-side Economics

The theory of supply-side economics was popularized under the presidency of Ronald Reagan in the 1980’s.  Proponents of supply-side espoused that tax rates, which were too high and thus discouraging production, should be cut.  Their prediction was that this would lead to increased private sector incentives, and higher rates of employment, productivity, and increased output in the US economy.  Tax revenues collected by the government would increase as a result of increased production. 

Although supply-side was popularized under Reagan, its proponents cite a number of historical figures as the first supply-siders.  George Gilder, in Wealth and Poverty, points to Adam Smith’s Wealth of Nations and his point that “real riches came from the power of production and supply, not the bullion collected through trade surplus” as evidence of his supply-side underpinnings.  Supply-side is based on producers versus traditional demand-side economics, which is based on consumption.  Another economist who is considered one of the original proponents of supply-side economics is Jean Baptiste Say.  Say was a noted French economist who came up with what is known as “Say’s Law”.  Say’s law asserts that “supply creates demand” and therefore overproduction in a free economy is impossible.  The hypothesis is that as supply or production increases prices will decrease to a point at which supply will sell (www.friesian.com).  The following graph depicts this:

At the risk of oversimplifying Say’s law, growth in production or supply will be automatically addressed in the free market by price movement, which will increase demand.

A more contemporary definition of supply-side was offered by Raymond Keating in “A Walk on the Supply Side”:  Supply- side economics places supply over demand in the hierarchy of economics, and therefore deals with enhancing economic production, efficiency, and growth within the context of the marketplace; largely- but not exclusively- focusing on relative prices such as incentives for working, saving, investing, and risk taking. 

Reagonomics is more focused on the area of tax policy than the broader spectrum of supply-side economics.  The focus on tax policy and the impacts of tax rate reduction is based on the “Laffer curve”.  The “Laffer Curve” is named for Professor of Business Economics at the University of Southern California, Arthur Laffer. 

The premise of the Laffer curve is that a decrease in tax rates leads to an increase in tax receipts enjoyed by the government.  Lower tax rates foster an environment where people are inclined to work and invest more.  Corporations in this environment are also motivated to invest more thus creating jobs and opportunities for workers.  The impact of increased corporate investments and production would ultimately increase the US tax base through creation of jobs and introducing dramatically more taxpayers into the economy.  The increased tax base would increase tax revenues although the rate of taxation would be decreased.  The Laffer curve demonstrates this point.  As taxes increase the revenue collected from taxes will reach a point where the receipts will actually decrease because workers are not motivated work incremental hours and businesses have less incentive to invest because of the negative impact to income on high tax rates.

 

III      Supply Side’s Critics

 

Supply-side economics is not without many critics.  In fact, research of initial years of the Reagan Administration shows that many members of the team were skeptical of the claims that supply-siders were making.  Many did not share their view about the positive impacts tax rate reduction would have on job creation.  Nor did they believe that an increased tax base would generate the revenues required to overcome or minimally offset the decrease in tax receipts from lower tax rates.  An ironic side note is that the most often cited name for these policies, “voodoo economics”, came from George H. W. Bush during the Republican primaries in 1979 as he fought Reagan for the Republican nomination.  Bush went on to be Reagan’s Vice-President. 

Critics of “voodoo economics” maintain that the positive impacts of tax rate reduction were wildly oversold in the 1980’s.  They point to the alarming budget deficit as the product of ill thought out supply-side policies that argued that revenues would materialize as a result of the lower tax rates.  The budget deficits of the 1980’s have caused many demand-side economists to declare that the Laffer curve has been discredited.

One of the most outspoken critics of supply-side economics is Princeton’s Paul Krugman. Krugman uses basic supply and demand theory to discredit the supply-side notion of endless economic growth as a result of tax cuts.  The following graphs were taken from Krugman’s website and depict two scenarios of the impact of tax cuts on the aggregate supply and demand curves.

 

 


                                                                                           

 

 

 

 

Krugman uses the graphs to demonstrate the impact of a positive stimulus on the aggregate demand.   In figure 2 you can see that AD has shifted to the right thus causing the equilibrium point to shift, which represents an increase in employment and output.  Krugman concedes that tax cuts will initially result in this rightward shift.  He argues however that this is a temporary phenomenon.  Figure 2 further demonstrates that the short term aggregate supply curve ultimately will shift upward causing the expansion to be temporary.  The point is that prices will increase but output will remain the same.  Basically, the jobs go away.

In addition to the basic economics lesson provided by Paul Krugman on why supply-side economics is not what its proponents claim it to be, many critics argue that it is inherently unfair because of the disproportionate benefits it bestows on the very wealthy in this country.  The constant refrain from its critics is that supply side amounts to tax cuts for the rich at the expense of the poor.  According to supply side detractors, the budget deficits that mount from tax cuts have the deliberate or unintended consequence, depending on the cynicism of the critic, of hurting the most needy Americans because social programs that are cut to address budget deficits.

IV     Conclusions

 

            At the outset of this paper I had sought to validate that supply side economics was responsible for the economic growth of the 1980’s and should be pursued by George W. Bush to stimulate growth in the economy.  My research has not led me to the unquestioned conclusion that supply siders are right on the fundamental economic arguments when they are put into practice in the real economy.  The most vocal critic that I came across was certainly Paul Krugman.  His basic economic arguments appear fundamentally sound but his consistent outrage towards all things conservative and his reflexive left wing bias caused me to question his credibility.  The article that seemed most credible in debunking the supply side argument was by Richard Kogan from the Center on Budget and Policy Priorities.  In “Does Cutting Tax Rates Increase Economic Growth?” Kogan cites empirical data on productivity, private savings, hours worked, and population over a number of business cycles to measure the impact of tax cuts.  The data indicates that productivity has declined from the 70’s and remained relatively constant through out the 80’s (His study does not include productivity statistics from the 90’s which have certainly improved due to information technology).  Private savings declined, and hours worked as well as the working population remained relatively constant.  This led Kogan to the conclusion that the dramatic tax cuts of the 1980’s did not have a material impact on economic growth.  The study did not include the 90’s but it is worth noting that both Clinton and Bush 41 raised taxes and therefore improvements in the areas studied by Kogan could not be the result of tax cuts. 

           

 

Economic Indicators, Past and Present*

 

Economic Growth

 

 

 

 

Business Cycle -- Peak to Peak

Potential

Actual

Trend Productivity

Private Saving

Total Hours Worked

U.S. Population Age 20-64

1960 to 1969

4.2%

4.3%

3.0%

8.4%

1.2%

1.3%

1969 to 1973

3.4

3.5

2.1

8.2

1.9

1.7

1973 to 1980

3.4

2.8

1.4

7.8

2.2

1.9

1980 to 1990

2.7

2.8

1.0

6.4

1.7

1.3

 

 

 

 

 

 

 

*Center for Budget and Policy Priorities, August 1996

 

            Much has been made of the current President Bush’s penchant for tax cuts. While my predisposition is to support tax cuts, m research has increased my skepticism as to their potential success in creating sustainable economic growth for the foreseeable future. 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References:

 

  1. Wealth and Poverty, George Gilder, Basic Books 1981
  2. www.waniski.com
  3. “Trickle Down Pain”, Robert Reich, The American Prospect, March 2003
  4. The Reagan Legacy, Charles O. Jones, Chatham House Publishing 1988
  5. www.wws.princeton.edu/~pkrugman/
  6. “Does Cutting Tax Rates Increase Economic Growth?”, Richard Kogan, Center on Budget and Policy Priorities, August 1996,    www.cbpp.org
  7. “Supply-side virus Strikes Again”, Paul Krugman, August 15, 1996, The Dismal Science
  8. “Where have all the Keynesians Gone?” Robert Kuttner, Business Week, February 3, 2003.
  9. “Say’s Law and Supply Side Economics, www.friesian.com

Updated: 2003-07-03, 14:58