Supply-Side Economics: History and Relevance

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Supply-Side Economics: Its History and Relevance Today.

“Supply-side economics provided the political and theoretical foundation for a remarkable number of tax cuts in the United States and other countries during the eighties. Supply-side economics stresses the impact of tax rates on the incentives for people to produce and to use resources efficiently.”

-James D. Gwartney

Introduction

The theory of supply-side economics has several labels associated with it, some positive and others negative, with “Reaganomics” or the “Trickle-down” policy being the most notable. Simply put, supply-side economics centers on the idea that the path to economic strength is achieved by focusing on the supply side of the market rather than the demand. By implementing policies to reduce the cost of production, whether by influencing labor markets or easing the burden of tax regulations on businesses, this will create an incentive for people to work and businesses to invest, thus causing the free-market system to flourish (Canto).

Supply-side economics conflicts with the idea that the only way to generate revenue for the Federal Government is through taxation, whereas this theory supposes that high tax rates and increases in regulation actually hinder economic growth. Rather this theory suggests that by reducing tax rates and regulation on the market, a trickle down effect occurs by encouraging entrepreneurs and investment opportunities that will generate economic benefits to the overall national economy (Harper).

The Story Behind Supply-Side Economics

To explain how supply-side economics came about, we must first take a look at the example of Andrew Mellon, Secretary of Treasury in 1924. Secretary Mellon realized that high tax rates did not translate into larger revenue for the Government, but rather lower tax rates should. Secretary Mellon advocated for the reduction of the top income tax bracket from its significantly high 73% to as low as 24% over time, which eventually created an increase of revenue by 4.2% nationally over the coming years (Folsom, 103).

Some years later, this idea that over taxing to an extreme was not in the best interest for the national economy or individuals was further explained in what we today call the “Laffer Curve”. Arthur Laffer, while at dinner with the likes of Donald Rumsfeld (Chief of Staff to President Gerald Ford) and Jude Wanniski, an associate editor to the Wall Street Journal in 1978, sketched the diagram that follows in Figure 1. Figure 1(Laffer Center)

This illustration shows that when taxation is above 50%, the free-market system is weakened. Laffer explained that when the tax rate is at 0%, the Federal Government does not generate any revenue, and in the same fashion, when the tax rate is 100%, the work force would be too discouraged to work for no benefit. This Laffer curve is simply an illustration that by allowing high marginal tax rates to increase, at some point this will suppress productivity and output of the national economy. Laffer uses this illustration to show that a reasonable tax rate, one that is below 50%, can produce revenue without overburdening the labor market (Laffer Center).

Keynesian Theory That Ruled the Day

John Maynard Keynes, the economist whose ideas were most prominent from the 1930’s to the 1970’s, developed the theory that opposed the ideals of the soon to be supply-side theory, most notably the idea that the market can mend itself without some type of intervention from the government. Keynesian Demand Management is rooted in the concept of concentrating on increasing demand, regardless of the effects on output and price (Laffer Center). Keynesian economic ideals claimed that government spending was a greater stimulus for the national economy, rather than a decrease in tax rates. While the supply-side theory boasts that a drop in tax rates would incentivize a strong labor force, the Keynesian model believes...
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