Supply side economics is a macroeconomic theory that posits that production or supply is the main driver of economic growth.
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Understanding supply side economics
In essence, supply side economics is concerned with the determinants of productive capacity (output) over time.
The theory is based on the belief that increased production is the best way to drive economic growth.
Production can be stimulated by policies such as:
- Deregulation – which removes certain restrictions and lowers the cost of compliance so that businesses are free to explore new opportunities.
- Tax cuts – corporate tax cuts enable the company to invest more in hiring workers and capital infrastructure. Income tax cuts, on the other hand, increase the impetus for workers to remain employed and creates more labor output.
Supply side economics is otherwise known as Reaganomics because it formed part of U.S. President Ronald Reagan’s strategy to combat stagflation in the 1980s.
Reagan instituted deregulation, tax cuts, and decreased social spending with the belief that these benefits would “trickle down” from businesses and wealthy individuals to society in general.
In other words, as businesses expanded, they would employ more workers, increase their wages, and put more money in workers’ pockets.
The strategy remained popular in subsequent decades among U.S. Presidents. George W. Bush implemented broad tax cuts between 2001 and 2003 across income, dividends, and capital gains.
In 2017, President Trump cut income and corporate tax rates to stimulate growth and increased tariffs on foreign companies to encourage American manufacturers to produce more.
Is supply side economics effective?
Supply side economics rests on the central tenet that tax cuts for wealthier individuals produce more economic benefit than tax cuts for lower-income individuals.
However, there are two fundamental problems with this idea.
For one, tax cuts for wealthy individuals do not stimulate economic activity or create new jobs.
This is because the extra money tends to be saved, invested, or used to reduce debt. Instead, tax cuts aimed at lower and middle-class earners are a much better way to stimulate macroeconomic activity.
Proponents of supply side economics also believe that tax cuts incentivize workers to earn more money.
In reality, however, studies show that these cuts boost output by increasing discretionary income and thus stimulating demand.
Supply side economics and the Laffer Curve
The Laffer Curve was developed by economist Arthur Laffer in the 1970s. Laffer created the model to show the direct relationship between tax rates and government tax revenue, arguing that each substitutes the other on a 1:1 basis.
The curve showed that a reduction in tax revenue could be offset by the subsequent increase in economic growth which Laffer believed made tax cuts a more prudent policy choice.
Again, however, the efficacy of supply side economics may be limited. The National Bureau of Economic Research (NBER) found that over the long term, just 17% of income tax cuts were recouped via economic growth.
Corporate tax cuts faired a little better, with 50% of the loss in tax revenue compensated by increased economic activity.
Key takeaways:
- Supply side economics is a macroeconomic theory that posits that production or supply is the main driver of economic growth.
- Supply side economics is otherwise known as Reaganomics because it formed part of U.S. President Ronald Reagan’s strategy to combat stagflation in the 1980s. The idea remained popular with successive U.S. presidents.
- Supply side economics believes that tax cuts for wealthier individuals derive the most economic benefit, but in truth, tax cuts for low and middle-income earners are more effective. The ability of supply side economics to compensate for lower tax receipts with higher economic growth is also questionable.
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