Supply-side economics

Supply-side economics is a school of macroeconomic thought which emphasizes the importance of tax cuts and business incentives in encouraging economic growth, in the belief that businesses and individuals will use their tax savings to create new businesses and expand old businesses, which in turn will increase productivity, employment, and general well-being. While all macroeconomics involves both supply and demand, supply-side economics emphasizes the importance of encouraging increases in supply. It was popularised in the 1970s by the ideas of Robert Mundell, Arthur Laffer, and Jude Wanniski. The term was coined by Wanniski in 1975.

U.S. monetary and fiscal experience

Supply-side economists seek a cause and effect relationship between lowering marginal rates on capital formation and economic expansion. The supply-side history of economics since the 1960s hinges on the following key turning points:

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

The Kennedy tax cuts which reduced marginal rates are believed by supply-side economists to be responsible for the 1960s prosperity. The more generally accepted political stand among supply-side detractors is that the tax program of 1963, by reducing the incentives to shelter income, reduced economic distortion. For example, while the theoretical top bracket rate was originally 90%, in practice, no one paid this rate, using various loopholes and deductions to avoid paying.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

In 1971, Richard Nixon ended the Bretton Woods gold standard. Commodity prices, including oil and gold particularly, which had been rising steadily in response to the dollar glut, spiked upwards. The supply-side explanation for this event is that taxation on investment had depleted the incentive to capital investment either in new sources of materials or in substitute goods, which when combined with eroding confidence in the U.S. dollar cause it to be rapidly devalued. Many supply siders agree with gold investors in saying that the value of commodities remained constant and that it was the dollar that devalued.

Related Topics:
Richard Nixon - Bretton Woods - Gold standard

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

At the same time the Flemming-Mundell model of currency flows gained greater credence when it was codified into a single set of equations, and became increasingly influential in neo-liberal economics. The argument for a floating currency regime had first been adopted by Friedman, but supply-side economists such as Wanniski typically argued that exchange rates should be fixed relative to gold. Mundell was the author of the influential view that it was Johnson's budget deficits that were the cause of inflationary pressure. However, as Lester Thurow pointed out, the standard model of inflationary pressure shows that Johnson's peak year of deficits would have created only a small upward pressure, that instead it was persistent American trade deficits through the 1960s which had a greater effect on the imbalance between the value of the U.S. dollar and the gold to which it was, in theory, convertible.

Related Topics:
Neo-liberal - Lester Thurow

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Robert Mundell believes Nixon's failure to cut taxes in the early 1970s to be the cause of stagflation, his argument being that the incentive for individuals to invest was reduced to below zero. Measuring the S&P 500 in inflation-adjusted terms, the stock market lost half of its value between the market peak of 1972 and its bottom in 1982, with money seeking better returns in real estate and commodities instead. The argument from the supply-side point of view then goes on to state that the cuts in capital gains tax rates that were part of the 1981 tax package returned incentives to invest. The Keynesian point of view is that after a long bear market, money had fled from stocks and was set to return, once the expectation of inflation had been reduced. Neither of these two arguments fully accounts for the rise of equities over the course of the "long Bull Market" of 1982-2000.

Related Topics:
Stagflation - S&P 500 - Stock market - Real estate

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

The importance of this argument needs to be seen in light of the effects of the inflation of the late 1970s, where credit became constricted, as interest rates rose rapidly, and the number of borrowers who could qualify for even standard mortgages fell. Inflation acted as a tax on wage increases, because the highly progressive income tax system of the time meant that more and more households suffered from "bracket creep" - in which a wage increase would be reduced in value by the increased taxes collected. The effects of inflation produced, in 1980, a strong political consensus for a change in basic policy.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Ronald Reagan made supply-side economics a household phrase, and promised an "across the board" reduction in income tax rates and an even larger reduction in capital gains tax rates. When vying for the Republican party presidential nomination for the 1980 election, George H.W. Bush derided Reagan's supply-side policies as "voodoo economics". However, later he seemed to give lip service to these policies to secure the Republican nomination in 1988, and is speculated by some to have lost in his re-election bid in 1992 by allowing tax increases. (See: ".")

Related Topics:
Ronald Reagan - Republican party - 1980 election - George H.W. Bush - 1992

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Supply-side economics was critiqued from the right as well, for example hard gold standard advocates, such as the Ludwig von Mises Institute, have argued that there is no such thing as a dollar, merely a specific quantity of gold. Therefore, according to this view, the entire central bank mechanism which supply-side economics advocates is a needless fiction which creates anomalies in the price of commodities. In their view, the central problem was that the United States needed to reassert a hard gold standard first, and this would force the necessary reductions in expenditures.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

The centerpiece of the supply-side argument is the economic rebound from the 1980-1982 double dip recession, combined with the continued fall in commodity prices. The "across the board" tax cuts of 1981 are seen as the great motivator for the "Seven Fat Years". Critics of this view point out that the "rebound" from the "Reagan Recession" of 1981-1982 is exactly in accordance with the "disinflation" scenario predicted by IS/LM models of the late 1970s: essentially that the increases in fed funds rates squeezed out inflation, and that federal budget deficits acted to "prime the pump". This model had been the basis of Volcker's federal reserve policy.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

In 1981, Robert Mundell told Ronald Reagan that by cutting upper bracket taxation rates, and by lowering tax rates on capital gains, national output would increase and as a result government tax revenues would also increase. The economic expansion would also mop up excess liquidity and bring inflation back under control. Revenues did increase in real terms (though not as a % of GDP, which opponents of Supply-Side economics point to as failure. However, Supply-Side economic tax cuts propose to do exactly what was delivered -- an expanded pie such that a smaller % still yields a larger piece. Under such conditions, a drop in revenues as a % of GDP is a mathematical certainty. In other words, such complaints miss the point, which is that real tax revenues will (and did) increase on lower tax rates), and federal budget deficits exploded due to profligate congressional spending; however, the incentive to invest in equities worked: in 1982 the stock market began a rally which nearly tripled the Dow Jones between its low in 1982 and its pre-crash high in August 1987.

Related Topics:
Robert Mundell - Ronald Reagan - Dow Jones - 1987

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Critics of supply-side economics pointed to the lack of academic credentials by movement leaders such as Jude Wanniski and Robert Bartley to imply that the theories were bankrupt. Mundell in his Nobel Prize lecture countered that the success of price stability was proof that the supply-side revolution had worked. The continuing debate over supply-side policies tends to focus on the massive federal and current account deficits that have accumulated in the U.S. since 1980, even though the Laffer Curve only predicts revenue increases and has nothing to do with government spending.

Related Topics:
Robert Bartley - Nobel Prize - Laffer Curve

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

After the emergence of supply-side economics, several economists using supply-side theory began advocating a flat-tax system. While generally associated with conservative politics, such as former Presidential candidate Steve Forbes, flat-tax systems based on Value-Added Taxes have been proposed by liberal economists and by at least one Democratic Presidential Candidate.

Related Topics:
Flat-tax - Steve Forbes

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

The paradigm of a tax system which rewards investment over consumption was accepted across the political spectrum, and no plan not rooted in supply-side economic theories has been advanced in the United States since 1982 (with the exception of the Clinton tax cuts of 1993) which had any serious chance of passage into law. In 1986, a tax overhaul, described by Mundell as "the completion of the supply-side revolution" was drafted. It included increases in payroll taxes, decreases in top marginal rates, and increases in capital gains taxes. Combined with the mortgage interest deduction and the regressive effects of state taxation - it produces closer to a flat-tax effect. Proponents, such as Mundell and Laffer, point to the dramatic rise in the stock market as a sign that the tax overhaul was effective, although they note that the hike in capital gains may be more trouble than it was worth.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Supply-siders blame the 1991 recession on the Federal Reserve, and argue that Clinton's tax increases, since they did not change marginal capital gains tax rates, left the supply-side nature of the 1986 tax bill in place. Similarly, supply-side economists have argued that since the early phases of the massive tax breaks of George W. Bush's first two years were based on credits and not cuts in marginal rates, they did not act to stimulate the economy, although the effect on individual income remains the same.

Related Topics:
Clinton - George W. Bush

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

More generally, traditional economists point to the "overhang" of deficits from the Reagan era, the S&L bailout, the effects of a ballooning federal budget deficit, the defense budget cuts which began in earnest in 1989, and the expectation of a lack of continued fiscal discipline as the source of the recession. These arguments blame the legacy of Democrat Deficits forced upon Reagan, rather than deficits created by Reagan's own administration. Critics of supply-side economics often argue the inflated government deficits that accompanied the arrival of supply-side economics are of greater concern than the economic and stock market success of supply-side theory.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Stronger critiques of supply-side economics dismiss the entire project as a complete failure which is a trojan horse for reducing marginal tax rates on upper income brackets. These critiques are found in Samuel Bowles' work, which argues that real productivity fell under supply-side taxation regimes on a unit-worker basis. Paul Krugman, of MIT, called supply-side economics "Peddling Prosperity" and dismissed it as being unworthy of serious economists in a 1994 book written for the general audience. Since Krugman's early work was in international currency areas, the very theory for which Mundell received his Nobel Prize, his criticism was drawn in specifically sharp terms.

Related Topics:
Paul Krugman - Nobel Prize

~ ~ ~ ~ ~ ~ ~ ~ ~ ~

These criticisms point to the explosion in deficits, the failure of the Laffer curve to materialize, and the conversion of price volatility to currency volatility as proofs that supply-side economics does not work. Supply-side defenders counter that the theory was never designed to consider government spending, and therefore cannot be blamed for this outcome. They also counter that tax revenues and the economy grew under supply-side policy, as predicted.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~