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Overview of Supply Side Policy

By murada07 Apr 06, 2013 5218 Words
Literature Review
Overview of supply side policy
Word count (2927 words)

Literature Review
Overview of supply side policy
Word count (2927 words)

2Literature review3
2.1Keynesian and Neoclassical – what is supply side3
2.2Models for Supply Side4
2.2.1Cobb-Douglass Production4
2.2.2Aggregate Supply Model5
2.2.3Empirical models5
2.3Baseline model for policy implications – Laffer curve, Reaganomics8
2.3.2Empirical results9
2.3.4Policy implemented and critics10

This is the literature review on Supply Side Policy in modern economics. It gives an overview on different empirical model to test the fiscal policy and current debate on policy directed to alter the supply. In macroeconomics, there are always debates on what kinds of policies are best for growing and stabilizing economy. Policies, especially fiscal policies, are usually tied with political aim and objectives. It is a common knowledge that in 1930s, when there was Great Depression, Keynes proposed that there should be more of government interventions, suggesting that the market is not perfectly competitive and there is a market failure. Keynes’ proposal worked very well and it led policy makers to aggressively intervene markets and making the role of government bigger and bigger during the next decades. However, Keynesians, demand-siders, were bewildered with the fact that during 1970s US economy experienced stagflation, the economy with increasing inflation and increasing unemployment, which was believed to be impossible based on Philips curve. This state of the economy gave a rise for the supply-side policy makers, notable example as being the policy known as Reaganomics. Supply-siders argued that high tax rate at the time discourage labor population to work. Unfavorable environment of firms, reflected as high production cost, reduce supply to be produced. These are causing both high unemployment rate and high price level. High tax rate reduces incentive to work. Less incentive to work leads to reduction in labor supply making the unemployment rate higher. Phenomenal high oil price during 1980s made production cost to increase, hence, driving up price level and depressed supply. As Fisher (1985) says “Supply side policies, of which a reduction in the payroll tax is the standard example, promise to reduce both inflation and unemployment”. Supply-siders proposed tax rate reduction in order to stimulate supply while at the same time promising that tax revenue gain from output increase offsets the tax revenue loss caused by tax reduction. This offsetting mechanism is one of the implications of Laffer curve, main argument of supply side economists who were prospering during 1980s. Arguments and implications of supply side policies are discussed in depth below in literature review part.

Literature review
Keynesian and Neoclassical – what is supply side
According to Ture, (1983, p. 26) there is a two distinguished framework to analyze fiscal policies: the Keynesian and the Neoclassical (or supply side) approaches. Keynesian mainly focuses on Aggregate Demand (AD), using tax as a tool to affect income which directly affects consumption parameter of AD. On the other hand, income changes are second-order effects of taxes under the supply side approach. Changes in tax rates cause changes in the relative prices of income and leisure (the leisure-labor choice), and the relative prices of savings and consumption. These are called first-order effects. Magnitude of first order effect determines the second-order effect, the effect of tax rate change on income. Hailstones (1982, p. 3) defined Supply side economics as a study of policies formulated to stimulate economic growth and promote price stability through various measures, such as increased savings, greater investment, lower taxation, and stronger work motivation, that affect the supply of goods and services. There are several macroeconomics supply side models, which corresponds to each of those measures, tested and justified by different researchers as discussed below.

Models for Supply Side
Cobb-Douglass Production
Literature shows that supply-production model in its simplest form can be expressed as Cobb-Douglass production function with two factors of input: Capital and Labor. Y=AKαL1-α, 0<α<1,

Property of the function is as following:
∂Y∂K>0; ∂Y∂L>0; ∂"Y∂K"<0;∂"Y∂L"<0; K is capital and L is Labor, Y is Output. A is catch all variable which explains the factors not explained by capital and labor, usually referred as total factor productivity, technological improvement. Conventionally it is accepted that it exhibits constant return to scale and α represents the share of capital and labor which consists output. They are proven to be elasticity of labor and capital respect to output. Theoretically, supply side policies will be directed to affect each of those factors A, K and L. Government may run a policy to sustain property rights, by maintaining proper legal institutions and enforcing legislations, which in turn increases amount of long term investments. Investors will be willing to invest in high risk projects, costly research and developments, which provide high return in the long-term future, consequently leading to improvement of the wealth (capital) of the nation as a whole. Miller and Benjamin (2010, p4) compares different legal law systems and their relation with real per capita income in their “Economics of Macro Issues” book. Their discussion emphasizes the importance of proper legal entity to protect property rights in order to sustain good economic growth. Improvement of the education structure led by the government policies help to achieve positive technological progress in a long run and to improve quality of effective labor forces. Government may run a policy to increase labor force participation rate by doing some structural reforms. Each of the examples above affects positively the factor of stated production function, hence, improves the capacity of the economy as a whole. It is important to note that supply side policies are considered to be more effective in a long run because of its accumulative nature. Aggregate Supply Model

According to Blanchard (2010), another basic model which formulates supply (output, Y) as a function of expected price level (Pe), employment (L) and supply side shock (z) is as following. It is also called as labor market relation as it is derived from equations of wage-price determination of labor market. P=Pe1+μf1-YL, z

It is not the comprehensive model to explain the dynamics of the real life economy, but it has strong implications for policy makers. In order to stimulate supply, policy makers may affect expectation of the price level, production cost (mark up) and labor forces. They can also make a supply side shock represented by variable z, which includes pensions, unemployment benefit, minimum wages, and labor union legislations. Empirical models

Followings are empirical models which were tested and their corresponding results: Barro (1990) developed his model of endogenous growth including government parameter which indicates the size of the government. His paper suggest that marginal tax rate can vary for a given government expenditure ratio of the output. Reduction in marginal tax rate increases the rate of growth and savings for a given level of expenditure ratio. Canto (1986) uses Capital Tax Sensitivity (CATS) model to scrutinize the effect of an overall reduction in the economy-wide average marginal tax to the state of the economy and the stock market in US. His finding establishes the negative relation between average marginal tax rate and state of the economy. Contraction in the economy and a decline in the stock market are associated with increase in the economy-wide marginal tax rate. Cover, Enders and Hueng (2006) employs following AD-AS model to analyze effect of the supply shock to the economy: AS≡ yts=t-1yt+αpt-t-1pt+εt, α>0

AD ≡ yt+ptd=t-1yt+ptd+φt
where yt and pt are the logarithms of output and the price level during period t; t-1yt and t-1pt are their expected values given information available at the end of period t-1; superscripts s and d represents supply and demand; εt and φtdenote the serially uncorrelated structural AS and AD shocks. AS equation is first proposed by Lucas (1972) in which output is positively related to unexpected increase in the price level and AS shock. They run the estimation based on the data on real GDP and GDP deflator for the period 1954 – 2001 which were obtained from United States Department of Commerce. Their estimate shows that 1% Supply shocks account for 0.78% increase in output. Their estimates are purely technical and they don’t give a word on what were the possible shocks during these periods. Hammond and Sempere (1995) and Krugman (2008) make an analysis for open economy with respect to trade. Both emphasize the importance of the free trade and smooth tax structure between the countries. According to Hammond and Sempere “there are efficiency gains to free international trade and other forms of market liberalizing 'supply side' policies”. One of the remarks of Krugman’s finding is that although global outsourcing seemed to cause high discrepancy in wage rate of the nation, high vertical specialization in developing countries helps to reduce cost of the production. Its finding is in the favor of free trade policies which are sometime opposed by labor unions for the sake of protecting national industries from the competition. According to Miller and Benjamin (2010, p154), history shows the adverse effect of trade restriction, to the extent that cost of the policy is much higher than the gain. Lindbeck and Snower (1988)tackles main proposition of modern day economics, that proves there is steady natural rate of unemployment and business cycle of the economy is merely the deviation of unemployment from its natural level. They argues that when incumbent workers have some power in wage determination, then 1. There may be no natural rate of unemployment

2. Both supply-side and demand-side policies may have lasting effects on the unemployment rate. They develop equilibrium in labor market using their own employment equation and wage equations. Model is specified as follow: Employment equation: b∙fiLI,LE=WI/P;i=I,E;

Wage equation: WIP=minb∙fiK,LE, WEP+CP;
Where b=(1-(1/e) and e is price elasticity of firm’s demand function. LI and LE are employment of insiders and entrants, WI and WE are nominal insider and entrant wage rate respectively. C is nominal cost of replacing an insider with entrant, whereas R equals to outsider’s real reservation wage which is taken to be an exogenous constant. K denotes for aggregate incumbent workforce. Their analysis suggests that “aggregate supply shocks may affect the labor market more directly and speedily than most aggregate demand shocks do.” Based on the assumption that insiders can affect the labor turnover cost, negative supply shock has permanent effect on natural rate of unemployment. It will permanently make it higher and when there is positive supply shock, only insiders will benefit by being able to raise their wage without the fear of being fired. They also argue that the policy, which has supply side effect, may have a larger impact on employment than policies without such effects.

Baseline model for policy implications – Laffer curve, Reaganomics Definition
One of the most debated theories in supply side policy literature is Laffer curve. Root of the main idea of the theory goes back as far as "Wealth of nation" written by Adam Smith. Implication is also well reflected with following statement by Say (1803/1999): “Taxation, pushed to the extreme, has the lamentable effect of impoverishing the individual, without enriching the state. … The diminution of demand must be followed by diminution of the supply of production; and, consequently, of the articles liable to taxation. Thus, the taxpayer is abridged of his enjoyments, the producer of his profits, and the public exchequer of its receipts . . . This is the reason why a tax is not productive to the public exchequer, in proportion to its ratio; and why it has become a sort of apothegm, that two and two do not make four in the arithmetic of finance. Excessive taxation … extinguishes both production and consumption, and the taxpayer into the bargain.” (p. 340) Laffer curve is a representation of the relationship between government revenue raised by tax and tax rate in economy. It was originally regarded as a pedagogical device (Laffer. 2009). Its basic idea is no tax revenue can be generated at the extreme tax rates, 0% and 100%, and any rate between them generates some level of tax revenue. There is, or are, such point(s) in curve which maximizes tax revenue. In its simplest pedagogical form, Laffer curve can be illustrated as below:

Empirical results
It’s commonly addressed by assessing historical data and responses to tax rate cuts. There is a lot of attempt to identify RMTR by various researchers with different methodologies. Traditional Keynesian IS-LM analysis showed a Laffer rate of about 76% (Fullerton, 1981). Statistical approaches to the Laffer rate indicated a rate that varies between 20% and 68% (e.g., Scully, 1995, 22.7%-32.4%; Scully, 2003, 51-66%). Approach based on the game theory indicated a rate between 49-66% (Sutter & Weck-Hannemann, 2003). An experimental economic approach indicated a Laffer rate of 50% (Levy- Garboua, Masclet, & Montmarquette, 2006). Finally, an econometric approach indicated a Laffer rate between 30% and 33% (Hsing, 1996). As we can see, the rate varies dramatically depending on the methods employed. Notable results among them were careful examination of the value-added tax rate to maximize revenue conducted by Matthews (2003) which gave the result around 18-19%. Brill and Hasset (2007) concluded corporate tax maximization rate seems to be between 25% and 35%. Laffer curve application led to the research on various elasticity of tax related variables. Research conducted by European Central Bank (2007) on the elasticity of capital-labor substitution, Gierts (2006) on the elasticity of the 1990 and 1993 tax cuts, Gruber and Saez (2000) on the elasticity of taxable income are notable empirical results. Laffer rate also comes in the form of the relationship between tax rates and economic growth as it was discussed above. The literature overall suggests initially positive relationship between government spending and economic growth that reverses at some point. Limitations

There are some limitations in Laffer rate literature:
* there is no consistent experimental results;
* existing knowledge largely ignores the effect of taxation on capital investment; * rate maximizations are almost entirely based on static analysis instead of dynamics; * one of its main assumptions are that the economy is closed (critical because high tax may result firms to migrate to other country affecting the state of the economy); * tax rates are calculated as an aggregate basis, whereas effect of the tax varies hugely with individual; * its main focus is on federal tax rate.

These theoretical limitations led to series of critics and probably the failure of supply-side economics, now in recent time referred as Voodoo economics or trickle-down economics by majority of non-supply-side economists. Policy implemented and critics

One of the notable examples of policy based on supply-side economics, and policy implication of the Laffer curve is Reaganomics in 1980s. Supply-siders argued that current tax rates are in prohibitive range (graph above), therefore, decreasing tax rate should increase tax revenue. There were four pillars in Reagan’s economic policy which were directed to tackle stagflation: 1. Reduce the growth of government spending

2. Reduce income tax and capital gains tax
3. Reduce government regulation of economy
4. Control money supply to reduce inflation
Economic performance of US economy was good for the consecutive years, leading United States to escape stagflation and be on a track of economic expansion. Supply-siders were happy with the result and it was a decade of supply-side tax reduction. However, when researchers tested effect of the tax reduction on the tax revenue, they did not find miraculous effect which was promised by advocates of Laffer curve. Instead, what they find was unpredicted government deficit, which caused by decreased tax revenue and increased government expenditure to stimulate economy. Arguably, Reaganomics is blamed partially for current increasing US debt, and high tax burden of the future generations. As a price to stimulate economy, united states were accumulating debt, false fully optimistic about the future increase in tax revenue. These views are shared with majority of researchers in this field: Chimerine: “It is premature at best, and incorrect and dangerous at worst, to conclude that supply-side economics is working to the extent that its proponents claim.” (1985) Feldstein: “Loose talk of the supply-side extremists gave fundamentally good policies a bad name and led to quantitative mistakes that not only contributed to subsequent budget deficits, but also made it more difficult to modify policy when those deficits became apparent.” (1986) Middleton: “Tax reform did set revenue limits but politicians responded by permitting substantial public deficits rather than risk the unpopularity associated with deep cuts in public expenditure programs”. (1997) Floyd: “Two decades ago, the supply-siders performed a valuable service. They persuaded a popular new president, who had been elected as a fiscal conservative, to slash taxes and claim that no budget deficit would result. Lower tax rates, they said, would miraculously bring higher tax revenues. That proved to be wrong.” (2001)

Literature on supply side policies is broad. It goes from general production theory, AD-AS analysis to the theoretical relation between the tax revenue and its effect on economy growth. There have been substantial researches on elasticity of different labor variable with respect to tax system. Supply side economics and its supply side policies are usually linked with neoclassical school of thoughts and their notable policy implication during 1980s. Although some researchers believe it was a failure and names it as “trickledown economics”, one cannot deny their strong argument backed up with classical economy and microeconomic foundations. It seems, series of research suggests the negative effect of the tax system on economic growth and gives a strong argument against a big government. While not denying importance of tax as a function of government revenue, supply siders argue on unnecessary harmful taxes, such as tax on capital gain and investment activities. They proved tax is the burden for the long term high standard of living, wealth of the nation. They limit the potential of economic growth and have a power to permanently put negative burden on natural rate of unemployment. Supply sides, implementation of Laffer curve logic and its strong relation to the economic growth has a huge potential for the research. It is one of the main sides of the macroeconomics, which nowadays modern economics should not neglect when talking about policy implications. As well as demand side policies, supply side policies are becoming major factor for grasping the nature of economic development and stability.

Barro, R. J., & Redlick, C. J., (2011). Macroeconomic effects from government purchases and taxes. The Quarterly Journal of Economics, 126(1), 51-102. Available from: <> [Accessed 1st November 2012] Barro, R. J., & Tenreyro, S., (2006). Closed and Open Economy Models of Business Cycles with Marked up and Sticky Prices. The Economic Journal, Vol. 116, No. 511 pp. 434-456. Wiley-Blackwell. Available from: <> [Accessed 1st November 2012] Barro, R. J., & Ursúa, J. F., (2008). Macroeconomic Crises since 1870. Brookings Papers on Economic Activity, Vol. 2008 pp. 255-335. Brookings Institution Press. Available from: <> [Accessed 1st November 2012] Barro, R. J., (1990). Government Spending in a Simple Model of Endogeneous Growth. Journal of Political Economy, Vol. 98, No. 5, Part 2: The Problem of Development: A Conference of the Institute for the Study of Free Enterprise Systems, pp. S103- S125. The University of Chicago Press. Available from: <> [Accessed 1st November 2012] Bartlett, B., (1985A). America's New Ideology: "Industrial Policy": With Neo-Keynesianism Joining Supply-Side Economics in History's Dust-Bin, It's Splitting Economists. American Journal of Economics and Sociology, Vol. 44, No. 1 (Jan.,), pp. 1-7. Available from: <> [Accessed 1st November 2012] Bartlett, B., (1985B). The Case for Ending the Capital Gains Tax. Financial Analysts Journal, Vol. 41, No. 3, pp. 23-30. CFA Institute. Available from: <> [Accessed 1st November 2012] Bosworth, B., & Burtless, G., (1992). Effects of Tax Reform on Labor Supply, Investment, and Saving. The Journal of Economic Perspectives, Vol. 6, No. 1 pp. 3-25. American Economic Association. Available from: <> [Accessed 1st November

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