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 increased economic growth will generate a larger tax base, which will recoup 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)
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 spending. In fact, the study showed that if the tax cuts were offset by future tax increases, they would have a negative impact on the economy in the long run.(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.
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. This will put downward pressure on the dollar which will increase inflation. This could lead to contractionary monetary policy, such as higher interest rates, which will lead to slower economic growth.
