Supply side economics revolves around the central concept that changes in economic growth can be brought about more rapidly by making changes in the ‘aggregate supply’ rather than changes in the ‘aggregate demand’.
Supply side economists prefer policies such as cuts in tax rate (Which increase the supply of workers and thereby increase employment, as a result increased incentive to work) to various other demand side policies such as changes caused about by monetary policies, such as an increase in the money supply or fiscal policies, such as a progressive tax.
Conservative economists are of the view that tax cuts need to be concomitant with cuts in government expenditure or purchases, so that the effect on the budget is neutral.
History of Supply-side Economics
Robert Mundell is the person who furnished the theoretical genius behind ‘supply-side economics.’ The ideas and premises of supply-side economics are described most lucidly in the writings of a political science and journalism graduate of UCLA, Jude Wanniski. Those writings, in turn, reveal that three individuals were primarily responsible for advancing the ideas of supply-side economics: Robert Mundell as the economic theoretician; Arthur Laffer as the pragmatic economist with a flair for public relations; and Jude Wanniski as the journalistic link between the two economists, the public, and the worlds of Wall Street finance and Washington politics. [Jett 2003]
America and Supply-side Economics
The US of A experimented with supply side policies in 1980. Ronald Reagan was the man behind it and his opponent, George H. W. Bush called it ‘Voodoo Economics’. Reagan cut the marginal tax rate on the highest income earners from 75% to 38%. His rhetoric was that if taxes were lowered, these rich would earn more and thus increase the gross taxes collected.
In a nutshell, here is Krugman’s account of the ascent and record of supply-side economics. Except for a few renegade professors like Arthur Laffer, supply-siders come from outside the economics profession. They come from journalism (Wall St. Journal columnists, Jude Wanniski, George Gilder), political staffs and think tanks. They convinced key Republicans that the cause for slowing U.S. economic growth was high taxation and excessive regulation. Supply-siders asserted big government was the problem. The cure required tax cuts, which would 1) bring back growth, 2) raise investment, and 3) enable deficit reduction. Disregarding sophisticated conservative economists like Martin Feldstein, politicians seized on the cruder, easy to peddle supply-side message that the economy would benefit from tax cuts – without concern for offsetting spending cuts.
The track record of early 1980’s tax changes can now be gauged from economic history regarding the three supposed benefits. Krugman presents and discusses the evidence summarized below.
1) The U.S. long-term rate of economic growth was not changed by supply-side tax cuts or by anything else since 1973. Productivity growth in the 80’s was 0.8% on an annual basis, compared to 2.8% in the prosperous period after World War II until 1973.
2) “By any measure, over any time period, investment fell” in the U.S. during the 1980’s, a result contrary to supply-side claims. As one example, net national savings was only 3.4% of GDP in the 1980’s, compared with 8% in the 1970’s.
3) In the absence of high economic growth or deep spending cuts, the deficit ballooned – to 4.9% of GDP in 1992 compared with 2.7% in 1981 when Ronald Reagan became President. The resulting debt will burden taxpayers for decades to come. [Neubauer 1996]
Pindyick and Rubinfeld say that some supply policies can shift actual output, but not all supply side policies can. Assistance of demand side policies is required.
If an economy is growing close to full employment level, i.e. with the presence of only natural unemployment(Frictional unemployment) then such ‘tax cuts’ will be beneficial. But, if such policies are implemented in developing countries, with the presence of large degrees of unemployment, all it will do is widen the inequalities of income between rich and poor.