Why is supply side economics called that

An increase in marginal tax rates adversely affects the output of an economy in two ways. First, the higher marginal rates reduce the payoff people derive from work and from other taxable productive activities. When people are prohibited from reaping much of what they sow, they will sow more sparingly. Thus, when marginal tax rates rise, some people—those with working spouses, for example—will opt out of the labor force. Others will decide to take more vacation time, retire earlier, or forgo overtime opportunities.

Still others will decide to forgo promising but risky business opportunities. In some cases, high tax rates will even drive highly productive citizens to other countries where taxes are lower. These adjustments and others like them will shrink the effective supply of resources, and therefore will shrink output.

Second, high marginal tax rates encourage tax-shelter investments and other forms of tax avoidance. This is inefficient. If, for example, a one-dollar item is tax deductible and the individual has a marginal tax of 40 percent, he will buy the item if it is worth more than sixty cents to him because the true cost to him is only sixty cents.

Yet the one-dollar price reflects the value of resources given up to produce the item. High marginal tax rates, therefore, cause an item with a cost of one dollar to be used by someone who values it less than one dollar. Taxpayers facing high marginal tax rates will spend on pleasurable, tax-deductible items such as plush offices, professional conferences held in favorite vacation spots, and various fringe benefits e.

Real output is less than its potential because resources are wasted producing goods that are valued less than their cost of production. Critics of supply-side economics point out that most estimates of the elasticity of labor supply indicate that a 10 percent change in after-tax wages increases the quantity of labor supplied by only 1 or 2 percent.

This suggests that changes in tax rates would exert only a small effect on labor inputs. However, these estimates are of short-run adjustments.

One way to check the long-run elasticity of labor supply is to compare countries, such as France, that have had high marginal tax rates on even middle-income people for a long time with countries, such as the United States, where the marginal rates have been persistently lower. Recent work by edward prescott , corecipient of the Nobel Prize in economics, used differences in marginal tax rates between France and the United States to make such a comparison. Prescott found that the elasticity of the long-run labor supply was substantially greater than in the short-run supply and that differences in tax rates between France and the United States explained nearly all of the 30 percent shortfall of labor inputs in France compared with the United States.

He concluded:. I find it remarkable that virtually all of the large difference in labor supply between France and the United States is due to differences in tax systems. I expected institutional constraints on the operation of labor markets and the nature of the unemployment benefit system to be more important. I was surprised that the welfare gain from reducing the intratemporal tax wedge is so large. Prescott , p. The supply-side economic policy of cutting high marginal tax rates, therefore, should be viewed as a long-run strategy to enhance growth rather than a short-run tool to end recession.

Changing market incentives to increase the amount of labor supplied or to move resources out of tax-motivated investments and into higher-yield activities takes time.

The full positive effects of lower marginal tax rates are not observed until labor and capital markets have time to adjust fully to the new incentive structure. Because marginal tax rates affect real output, they also affect government revenue. An increase in marginal tax rates shrinks the tax base, both by discouraging work effort and by encouraging tax avoidance and even tax evasion.

In regard to lower capital-gains tax rates, they believe that lower rates induce investors to deploy capital productively. At certain rates, a supply-sider would even argue that the government would not lose total tax revenue because lower rates would be more than offset by a higher tax revenue base—due to greater employment and productivity. On the question of regulatory policy, supply-siders tend to ally with traditional political conservatives—those who would prefer a smaller government and less intervention in the free market.

This is logical because supply-siders—although they may acknowledge that the government can temporarily help by making purchases—do not think this induced demand can either rescue a recession or have a sustainable impact on growth. The third pillar, monetary policy, is especially controversial. By monetary policy, we are referring to the Federal Reserve's ability to increase or decrease the quantity of dollars in circulation i. A Keynesian tends to think that monetary policy is an important tool for tweaking the economy and dealing with business cycles, whereas a supply-sider does not think that monetary policy can create economic value.

While both agree that the government has a printing press, the Keynesian believes this printing press can help solve economic problems. But the supply-sider thinks that the government or the Fed is likely to create only problems with its printing press by the following:.

A strict supply-sider is, therefore, concerned that the Fed may inadvertently stifle growth. This principle is the key to understanding why supply-siders often advocate a return to the gold standard , which may seem strange at first glance and most economists probably do view this aspect as dubious. The idea is not that gold is particularly special, but rather that gold is the most obvious candidate as a stable "store of value.

As an investment theme, supply-side theorists say that the price of gold—since it is a relatively stable store of value—provides investors with a " leading indicator " or signal for the dollar's direction. Indeed, gold is typically viewed as an inflation hedge. And although the historical record is hardly perfect, gold has often given early signals about the dollar.

It is called supply-side economics because the theory believes that production the "supply" of goods and services is the most important macroeconomic component in achieving economic growth. The opposite of supply-side economics is Keynesian economics, which believes that the demand for goods spending is the key driver for economic growth. Reaganomics is a term for President Ronald Reagan's economic policies that focused on tax cuts for the wealthy, believing that they would lead to savings and higher investments, which would produce economic benefits that would trickle down to the entire economy.

Reaganomics also focused on increased military spending and the deregulation of domestic markets. Keynesian economics is demand-side economics, which believes that demand in the economy is the key driver to growth. The increase or decrease in demand for goods and services impacts how much supply producers bring into the economy. Keynesian economics believes that If consumer demand is decreasing then it is the responsibility of the government to increase spending and intervene with fiscal and monetary stimuli.

Supply-side economics believes that producers and their willingness to create goods and services set the pace of economic growth while demand-side economics believes that consumers and their demand for goods and services are the key economic drivers. Supply-side economics has a colorful history. Some economists view the supply-side as a useful theory. According to the supply-side view the combination of a decline in tax avoidance and increase in business activities would permit lower rates with little or no loss of revenues in the top tax brackets.

At the same time, most supply-side economists, though perhaps not all, noted that reductions in low tax rates would lead to revenue losses. Empirical studies of tax cuts that happened during the twenties and sixties buttressed the supply-side position.

Prodded by Secretary of the Treasury Andrew Mellon, three major tax cuts reduced the top marginal tax rate from 73 percent in to 25 percent in In addition, the tax cuts eliminated or virtually eliminated the personal income tax liability of low-income recipients.

The results were quite impressive. The economy grew rapidly from through Thus, as the tax rates were cut, the revenues collected from high-income taxpayers rose, while those collected from lower-income taxpayers declined. The tax cuts of the twenties substantially increased the percent of taxes paid by the wealthy. The results of the Kennedy-Johnson tax cuts of the midsixties were similar. Between and , tax rates were reduced by approximately 25 percent.

The top marginal tax rate was cut from 91 percent to 70 percent. Simultaneously, the bottom rate was reduced from 20 percent to 14 percent. For most taxpayers the lower rates reduced tax revenues. As in the case of the tax cuts of the twenties, the rate reductions of the sixties reduced the tax revenue collected from low-income taxpayers while increasing the revenues collected from high-income taxpayers. Major tax legislation passed in and reduced the top U. The performance of the U.

The growth rate of real GNP accelerated from the sluggish rates of the seventies. The critics of the eighties tax policy argue that the top rate reductions were a bonanza for the rich. The taxable income in the upper tax brackets did increase sharply during the eighties. But the taxes collected in these brackets also rose sharply. The percentage increases in the real tax revenue collected from the top 1 and top 5 percent of taxpayers were even larger.

These findings confirm what the supply-siders predicted: the lower rates, by increasing the tax base substantially in the upper tax brackets, caused high-income taxpayers to pay more taxes.

In effect, the lower rates soaked the rich. Probably the most detailed study of the tax changes in the eighties was conducted by Lawrence Lindsey of Harvard University. Lindsey used a computer simulation model to estimate the impact of the eighties' tax-rate changes on the various components of income.

Critics of this theory argue that it can be more costly and more difficult to implement with less desirable results. Overall, multiple studies have been produced through the years that support both supply and demand-side fiscal policies. However, studies have shown that due to multiple economic variables, environments, and factors, it can be hard to pinpoint effects with a high level of confidence and to determine the exact outcome of any one theory or set of policies.

The Laffer Curve helped formulate the concept of supply-side theory. The curve, designed by economist Arthur Laffer in the s, argues that there is a direct relationship between tax receipts and federal spending—primarily that they substitute on a one-to-one basis. The theory argues that a loss in tax revenue is made up by an increase in growth; thus, tax cuts are a better fiscal policy choice. In the s, President Ronald Reagan used supply-side theory to combat stagflation that followed the recession in the early part of the decade.

Bush R : 2. This supply-side fiscal policy of tax cuts to boost economic growth remained popular among U. In and , President George W. Bush also instituted wide-ranging tax cuts. These applied to ordinary income as well as dividends and capital gains among others. In , President Donald Trump enacted a tax bill that, in principle, is based on supply-side economics.

Since then, the provisions have benefited high earners disproportionately and hurt some working- and middle-class taxpayers.

During his presidential term, Trump also focused on supply-side fiscal policy through trade relations that raised tariffs on international producers with the aim of creating an opportunity for U.

Critics of these types of policies point to the growing trend among corporations to engage in stock buybacks. Buybacks occur when companies place the cash they may gain from lower taxes back into the pockets of their shareholders rather than investing in new plants, equipment, innovative ventures, or their workers. Bartlett, B. Canto, V. Foundations of supply-side economics: Theory and evidence. Academic Press. Center for American Progress. Mazerov, M. Center on Budget and Policy Priorities, January , The Guardian.

The World Bank. Congressional Research Service.