Some people continue to defend trickle-down theories which assume that economic growth, encouraged by a free market, will inevitably succeed in bringing about greater justice and inclusiveness in the world. This opinion, which has never been confirmed by the facts, expresses a crude and naive trust in the goodness of those wielding economic power and in the sacralized workings of the prevailing economic system.
Debates in Macroeconomics
(Part G)
by
Charles Lamson
Supply-Side Economics
From our discussion of equilibrium in the goods market, beginning with the simple multiplier in part 130 and continuing through parts 148-169, we have focused primarily on demand. Supply increases and decreases in response to changes in aggregate expenditure (which is closely linked to aggregate demand). Fiscal policy works by influencing aggregate expenditure through tax policy and government spending. Monetary policy works by influencing investment and consumption spending through increases and decreases in the interest rate. The theories we have been discussing are "demand-oriented." The 1970s were difficult times for the U.S. economy. The United States found itself in 1974 to 1975 with stagflation---high unemployment and inflation. In the late 1970s, inflation returned to the high levels of 1974 to 1975. It seemed as if policymakers were incapable of controlling the business cycle. As a result of these seeming failures, orthodox economics came under fire. One assault was from a group of economists who expounded supply-side economics. The argument of the supply-siders was simple. Basically, they said, all the attention to demand in orthodox macroeconomic theory distracted our attention from the real problem with the U.S. economy. The real problem, said supply-siders, was that high rates of taxation and heavy regulation had reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus but better incentives to stimulate supply.  If we cut taxes so people take home more of their paychecks, the argument continued, they will work harder and save more. If businesses get to keep more of their profits and can get away from government regulations, they will invest more. This added labor supply and investment, or capital supply, will lead to an expansion of the supply of goods and services, which will reduce inflation and unemployment at the same time. The ultimate solution to the economy's woes, the supply-siders concluded, was on the supply side of the economy. At their most extreme, supply-siders argue that the incentive effects of supply-side policies were likely to be so great that a major cut in tax rates would actually increase tax revenues. Even though tax rates would be lower, more people would be working and earning income and firms would earn more profits, so that the increases in the tax bases (profits, sales, and income) would outweigh the decreases in rates, resulting in increased government revenues. The Laffer Curve Figure 2 represents a key diagram of supply-side economics. The tax rate is measured on the vertical axis, and tax revenue is measured on the horizontal axis. The assumption behind this curve is that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate. There is obviously some tax rate between 0 and 100 percent at which tax revenue is at a maximum. At a tax rate of 0, work effort is high, but there is no tax revenue. At a tax rate of 100, the labor supply is presumably 0, because people are not allowed to keep any of their income. Somewhere in between 0 and 100 is the maximum revenue rate. FIGURE 2  The big debate in the 1980s was whether tax rates in the United States put the country on the upper or lower part of the curve in Figure 2. The supply-side school claimed that the United States was around A and taxes should be cut. Others argued that the United States was nearer B and tax cuts could lead to lower tax revenue.  The diagram in Figure 2 is the Laffer Curve, after Arthur Laffer, who, as legend has it, first drew it on the back of a napkin at a cocktail party. The Laffer Curve had some influence on the passage of the Economic Recovery Tax Act of 1981, the tax package put forward by the Reagan Administration that brought with it substantial cuts in both personal and business taxes.The individual income tax was to be cut 25 percent over three years. Corporate taxes were cut sharply in a way designed to stimulate capital investment. The new law allowed firms to depreciate their capital at a rapid rate for tax purposes, and the bigger deductions lead to taxes that were significantly lower than before. Evaluating Supply-Side Economics Among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor. Supporters of supply-side economics claim that Reagan's tax policies were successful in stimulating the economy. They point to the fact that almost immediately after the tax cuts of 1981 were put into place, the economy expanded and the recession of 1980 to 1982 came to an end. In addition, inflation rates fell sharply from the high rates of 1980 and 1981. Except for one year, federal receipts continued to rise throughout the 1980s despite the cut in tax rates. Critics of supply-side policies do not dispute these facts but offer an alternative explanation of how the economy recovered. The Reagan tax cuts were enacted just as the U.S. economy was in the middle of its deepest recession since the Great Depression. The unemployment rate stood at 10.8 percent in the fourth quarter of 1982. It was the recession, critics argue, that was responsible for the reduction in inflation---not the supply-side policies. In addition, in theory, a tax cut could even lead to a reduction in labor supply. Recall our discussion of income and substitution effects in parts 27 and 29. Although it is true a higher after-tax wage rate provides a higher reward for each hour of work and thus more incentive to work, a tax cut also means households receive a higher income for a given number of hours of work. Because they can earn the same amount of money working fewer hours, households might actually choose to work less. They might spend some of their added income on leisure. Research done during the 1980s suggest tax cuts seemed to increase the supply of labor somewhat but the increases are very modest.  What about the recovery from the recession? Why did real output begin to grow rapidly in late 1982, precisely when the supply-side tax cuts were taking effect? Two reasons have been suggested. First, the supply-side tax cuts had large demand-side effects that stimulated the economy. Second, the Fed pumped up the money supply and drove interest rates down at the same time that the tax cuts were being put into effect. The money supply expanded about 20 percent between 1981 and 1983, and interest rates succumbed. In 1981, the average 3-month U.S. Treasury bill paid 14 percent interest. In 1983, the figure had dropped to 8.6 percent. Certainly, traditional theory suggests that a huge tax cut will lead to an increase in disposable income and, in turn, an increase in consumption spending (a component of aggregate expenditure). In addition, although an increase in planned investment (brought about by a lower interest rate) leads to added productive capacity and added supply in the long run, it also increases expenditures on capital goods (new plant and equipment investment) in the short run. Whether the recovery from the 1981 to 1982 recession was the result of supply-side expansion or supply-side policies that had demand-side effects, one thing is clear: The extreme promises of the supply-siders did not materialize. President Reagan argued that because of the effect depicted in the Laffer Curve, the government could maintain expenditures (and even increase defense expenditures sharply), 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. After 1982, the federal government ran huge deficits, with nearly 2 trillion dollars added to the national debt between 1983 and 1982.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 658-66* end |
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