According to the macroeconomic theory called supply-side economics, an effective way to grow the economy is by lowering taxes and decreasing government regulation. These two actions would encourage businesses to expand their business activities that in turn, would increase economic activity.
Arguments: The Supposed Advantages or Benefits of Supply-Side Economics
A central tenet of supply-side economics is a proposition that production or more specifically, shifting aggregate supply to the right is key to economic growth, and consumption and demand is only a secondary consequence of economic prosperity. Hence, this macroeconomic theory directly opposes demand-side economics.
There are also two major principles under this macroeconomic theory: first is that marginal tax rates influence economic activities and second, the degree of control of a government over its economy affects business or investment decisions, developments within specific industries and sectors, and the overall trajectory of the economy.
Proponents of supply-side economics believe that high marginal tax rates negatively affect the incentive to earn, thus discouraging output and the efficient and productive use of resources. In addition, it also compels organizations and individuals to pursue different forms of tax avoidance or move their private wealth to tax havens.
Take note that some supporters of this macroeconomic theory also assert its relationship with the concept called trickle-down economics. This concept maintains that specific tax cuts on large corporations and wealthy individuals would benefit the society in the long run. Specifically, these tax cuts are supposed to encourage the super-rich to invest their money.
Another supposed benefit of supply-side economics is that it can increase government revenues based on the theoretical construct known as the Laffer curve. Modeled by economist Arthur Laffer in the 1970s from several antecedents, it illustrates the theoretical relationship between rates of taxation and the levels of government revenue.
The Laffer curve specifically illustrates how much revenue the government can raise from taxes, and at what level of taxation the revenue might decrease. Using a two-dimensional graph, it shows that tax rates at the lower levels correspond to increases in government revenues. The trend remains upward until it reaches a certain point in which tax rates at the higher levels correspond to declines in government revenues.
A study by economists Christina D. Romer and David H. Romer revealed that the peak of the tax rate or the point in which the line starts to curve downward, thus illustrating a decline in government revenue, is somewhere around 33 percent. In other words, what the study implies is that when tax rates go higher than 33 percent, the government receives fewer revenues.
Criticisms: The Disadvantages or Drawbacks of Supply-Side Economics
Some of the supposed advantages or benefits of supply-side economics do not have enough merits based on the contentions put forward by critics. Aside from expert opinions and insights from both politicians and economists, results from numerous studies indicate evidence against the effectiveness of this macroeconomic theory.
Specific studies have also produced evidence against the supposed trickle-down effects. A 2012 study by James Henry revealed that tax cuts allowed the super-rich to amass private wealth amounting to USD 21 trillion. Instead of reinvesting, they channeled their wealth out of their countries and hid them in offshore bank accounts.
A paper by the International Monetary Fund revealed that increasing the income share of the top 20 percent or the rich through tax cuts has been associated with lower growth in GDP. On the other hand, increasing the income share of the bottom 20 percent or the poor has been associated with higher GDP growth.
Economist Owen Zidar also demonstrated that that tax cuts for lower-income groups were positively related to an increase in employment rates. On the other hand, tax cuts on the top 10 percent of income share have small to negligible effects on employment growth.
The separate studies of Zidar, Henry, and the IMF essentially showed that supply-side and trickle-down policies only produce income inequality. Note that aside from income inequality tax cuts also negatively affect government revenues.
In their book “Principles of Economics,” economists Karl E. Case and Ray C. Fair noted that the promises of supply-side policies by previous American presidents did not materialize. They cited the case during the administration of former U.S. president Ronald Reagan. The tax cuts under the Reaganomics policy resulted in the sharp decline in government revenues.
The U.S. Congressional Budget Office produced a report that examined the effects of tax cuts. It specifically examined the effects of extending the tax cuts under the Bush administration beyond 2010. It revealed that the government would incur a budget deficit amounting to USD 1.8 trillion in 10 years and would affect economic trajectory due to reduced government spending.
Regarding the Laffer curve, a number of economists also explained its limitations. Note that even supply-side economists reminded that the illustrations produced by the curve are usually meant for pedagogical purposes. Essentially, the model does not represent the complex economic responses to tax cuts and it does not accurately represent economic reality.
Another significant argument or criticism against supply-side economics is demand-side economics. It specifically argues that the most effective way to promote economic growth is through the creation of a high demand for products and services. Hence, government policies should be aimed at driving consumption and increasing the consumption powers of the public.
Keynesian economics, a theory based on the works of British economist John Maynard Keynes, also supports the arguments for demand-side economics and thus, runs against the arguments of supply-side economics. The theory asserts that government intervention through fiscal policy is essential to stabilize the economy. The tenets of Keynesian economics were instrumental in ending the Great Depression and fostering economic growth through the 1950s and 1960s.
Summary of the Arguments and Counterarguments
The following are the arguments in favor of supply-side economics, thus indicating the advantages or benefits of this macroeconomic theory:
• A focus on the supply is the primary determinant of economic growth, while demand or consumption is only a secondary consequence.
• Lowering the tax rates will provide businesses with an incentive to expand their business activities, thus resulting in economic growth.
• Decreasing the level of government intervention further gives businesses an incentive to produce or invest.
• Long-term economic growth from supply-side policies would compensate for the short-term losses or costs from tax cuts.
• Trickle-down economics suggests that the benefits from specific tax cuts on wealth companies and individuals would trickle down to the masses.
•The Laffer curve illustrates that there is a point in which a specific level of tax rate would result in the government receiving fewer revenues.
On the other hand, the following are the counterarguments or criticisms against supply-side economics, thus indicating its disadvantages or drawbacks:
• Studies have provided evidence that trickle-down economics or tax cuts on the super-rich only produce income inequality.
• Tax cuts on the rich have been associated with lower GDP growth and higher unemployment rate while tax cuts on the poor have opposite effects.
• Supply-side policies also put the government at risk of losing revenues and incurring budget deficits as shown by historical analyses and projections.
• The Laffer curve does not accurately represent complex economic responses to tax cuts and the greater economic reality.
• Demand-side economics argue that the most effective way to promote economic growth is to stimulate high demand for products and services.
• Keynesian economics has demonstrated that government intervention is essential in stabilizing the economy and resolving recessionary periods.
FURTHER READINGS AND REFERENCES
- Case, K. E. and Fair, R. C. 2007. Principles of Economics. 8th ed. Upper Saddle, NJ: Prentice Hall. ISBN: 0-13-228914-8
- Dabla-Norris, E., Kochhar, K., Suphaphiphat, N., Ricka, F., and Tsounta, E. 2015. Causes and Consequences of Income Inequality: A Global Perspective. International Monetary Fund. ISBN: 9781513555188
- Henry, J. S. 2012. The Price of Offshore Revisited: New Estimates for “Missing” Global Private Wealth, Income, Inequality, and Lost Taxes. Tax Justice Network. Available via PDF
- Romer, C. D. and Romer, D. H. 2010. “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks.” The American Economic Review. 100(3): 763-801. DOI: 10.1257/aer.100.3.763
- Zidar, O. 2019. “Tax Cuts for Whom? Heterogeneous Effects of Income Tax Changes on Growth and Employment.” Journal of Political Economy. 127(3): 1437-1472. DOI: 10.1086/701424