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Supply-side Economics - What Is It and Does It Work?

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President Ronald Reagan

Supply-side economics was popularized by President Ronald Reagan.

Photo: Hulton Archive/Stringer/Getty Images
Supply-side Economics - What Is It and Does It Work?

Taxes must be in the prohibitive range for supply-side to work.

What Is Supply-side Economics?:

Supply-side economics, also known as trickle-down economics, is an economic theory that states that a reduction in taxes will stimulate the economy through increased consumer spending. Over time, the boost to economic growth will generate a larger tax base, which will make up for the revenue lost from the tax cut.

How Is Supply-side Economics Supposed to Work?:

An income tax cut translates into more money in workers' paychecks, which they will spend. This increased demand means businesses can produce more goods and services, which will lead to more jobs. Workers can then bargain for higher wages, which will translate back into higher tax revenues. Some supply-side proponents even argue that, over time, the original lost tax revenue will be recouped through greater tax receipts from a booming economy. (Source NYT, How Supply-side Economics Trickled Down, April 6, 2007)

A lot depends on which segment of society gets the tax cuts. Studies show that tax cuts to lower income families are more likely to be directly translated into increased spending. This boosts demand and economic growth. The same tax cuts to higher income families can instead be used to pay off debt, invested or saved. This could help the stock market or banks, but isn't as powerful an economic stimulus because it doesn't drive increased sales at the cash register. (For more, read Do Tax Cuts Create Jobs?)

How Well Does Supply-side Economics Actually Work?:

Economists disagree whether supply-side economics really works because it is difficult to find real-world proof. That's because it is nearly impossible to isolate the impact of tax cuts alone on economic growth and on revenue.

For example, President Bush cut taxes in 2001 (JGTRRA) and 2003 (EGTRRA). The economy grew, and revenues increased. Supply-siders, including the President, said that was because of the tax cuts. Other economists point to lower interest rates as the real stimulator of the economy. The FOMC lowered the Fed Funds rate from 6% in the beginning of 2001 to a low of 1% by June 2003. (Source: New York Federal Reserve, Historical Fed Funds Rate)

Studies That Support Supply-Side Economics:

The Treasury Department developed a model which showed that the Bush tax cuts would ultimately increase annual GDP by .7%. However, it is important to note that the model assumes that the revenue lost by the cuts were offset by reduced fiscal spending, keeping the budget balanced. If, instead, tax cuts now were balanced by future tax increases, they would have a negative impact on the economy in the long run. The future tax increases would be needed to pay off the additional debt incurred by a combination of tax cuts without reduced fiscal spending. (Source: U.S. Treasury Department, A Dynamic Analysis of Permanent Extension of President's Tax Relief, July 25, 2006)

Studies That Don't Support Supply-Side Economics:

A study by the National Bureau of Economic Research found specific figures on how much revenue will be recouped by tax cuts:

  • 17% of income tax cuts,
  • 50% of corporate tax cuts.

This shows that, over the long-term, the revenue lost by tax cuts will be only partially regained. Without a decrease in spending, tax cuts will lead to an increase in the budget deficit, which will harm the economy over time. (Source: NBER, Dynamic Scoring: A Back of the Envelope Guide, December 2004; Townhall.com, "No, the Bush Tax Cuts Do Not Increase Revenue," November 15, 2007)

Conclusion:

Economists still debate whether tax cuts lead to increased economic growth over the long-term. The Treasury Department study did mention that, in the short-term and in an economy that is already weak, tax cuts will provide an immediate boost.

However, if spending is not decreased, the tax cuts will lead to an increased budget deficit. Over the long term, and in a healthy economy, this will put downward pressure on the dollar which could ultimately increase inflation though higher prices for imports. In time, if inflation is high enough and the economy is strong enough, it could convince the Federal Reserve to initiate contractionary monetary policy, such as higher interest rates. The result? -- slower economic growth.

History of Supply-Side Economics:

Supply-side economics is based on the Laffer Curve, which was developed in 1979 by economist Arthur Laffer. He argued that the effect of tax cuts on the federal budget are immediate, and on a 1-for-1 basis -- for every dollar cut, government spending (and its stimulative effect) decline that same dollar. However, that same tax cut has a multiplier effect on economic growth. Every dollar cut translates into increased demand, which stimulates business growth, which results in additional hiring. How much effect tax cuts have depends on whether the economy is growing, how high taxes were to begin with, and which taxes are cut.

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