Politics & Society

Learn About Supply-Side Economics: History, Policy, Effects

Written by MasterClass

Jan 17, 2019 • 7 min read

Theories abound for why economies behave the way they do—and how they might be made to work better. In the 1980s, there was no more influential theory in the United States than supply-side economics. Supply-side economics were popularized by President Ronald Reagan—and it has been controversial ever since.

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What Is Supply-Side Economics?

The theory of supply-side economics holds that the strength of the supply of goods and services is the most important factor in determining economic growth—and that government can boost supply by lowering taxes and reducing governmental regulations on suppliers. It’s called supply-side economics because it focuses on what the government can do to increase the overall supply of goods and services that are created in the economy.

It’s been given the pejorative nickname of ‘trickle-down economics,’ because supply-side economists believe the benefits of their policy would accrue to the wealthier parts of the population first but eventually trickle down to everybody else.

How Does Supply-Side Economics Work?

Here’s the thinking behind supply-side economics:

  1. Producers of goods and services are responsible for growing the economy.
  2. Instead of taking their money through taxes, government lets these producers invest their capital in their companies.
  3. In practical terms, this means that government lowers taxes and decreases regulation.
  4. These actions then induce entrepreneurs and companies to produce more goods, stimulating the economy and leading to more growth.
  5. Those results, in turn, will bring in more money for the government through additional tax revenue.

What Is Demand-Side Economics?

Demand-side economics is the traditional contrasting theory to supply-side economics. It is often referred to as "Keynesian economics," after British economist John Maynard Keynes, who promoted it in the first half of the 20th century.

The Main Differences Between Supply-Side and Demand-Side Economics

Here’s how demand-side economics differs from supply-side:

  • Demand-side economists argue that instead of focusing on producers, as supply-side economists want to, the focus should be on the people who buy goods and services, who are far more numerous.
  • Demand-side economists like Keynes argue that when demand weakens—as it does during a recession—the government has to step in to stimulate growth.
  • Government can do this this by spending money to create jobs, which will give people more money to spend.

This will create deficits in the short-term, Keynesians acknowledge, but as the economy grows and tax revenues increase, the deficits will shrink and government spending can be reduced accordingly.

Does Supply-Side Economics Work?

Economists argue both for and against supply-side economics. Here are the main arguments that supply-side economics works:

  • Taxes have a distorting effect on the economy, making it more inefficient.
  • Higher taxes discourage investment because producers know their economic gains will be taxed at a high rate.
  • Lowering taxes, therefore, means the economy will become more efficient, growing the economy and generating additional revenue for the government.

Since it gained prominence, supply-side economics has been derided as mathematical make-believe by traditional economists. George H.W. Bush, who later became Reagan’s Vice-President, famously described supply-side ideas as “voodoo economics” when he and Reagan squared off during the Republican primaries in 1980. Here are the main arguments that supply-side economics does not work:

  • Lowering taxes will not increase revenue for the government, according to opponents of supply-side.
  • It will, by contrast, increase the deficit.
  • The government will have to cut programs or raise other taxes to make up for this shortfall, unless it wishes to run a permanent deficit.

The History of Supply-Side Economics

In the 1970s, the Western world suffered a crisis marked by simultaneous unemployment and high inflation—a phenomenon that became known as “stagflation.” The U.S. budget deficit was massive but government spending didn’t seem to be boosting the economy. This confounded Keynesian economists—and most mainstream economists were Keynesians at the time—who believed that inflation rose with employment levels, since more people working means more people have funds to buy things, leading to higher prices.

Arthur Laffer, an economist in President Richard Nixon’s administration (1969-1974), argued that the solution to stagflation was in lowering taxes on those who produced goods and services—the suppliers. Most economists, conversely, believed that lowering taxes without reducing government spending would lead to increased deficits, and were an inefficient way to grow the economy since the high-income producers could simply pocket the money instead of pumping it back into the economy.

But Laffer suggested that lowering taxes on high-income people would actually lead to higher revenues for the government because these individuals would stimulate the economy with their freed-up resources. In a famous 1974 meeting, Laffer met with high-ranking members of President Gerald Ford’s Administration, which had just succeeded Nixon’s. Laffer drew a graph on a napkin indicating why the theory of supply-side economics would work. Other economists, such as Nixon’s economic advisor Herbert Stein, are credited with coining the term, but Laffer is usually identified as its best-known advocate.

Economists, policy experts, and politicians in the Republican Party—including Paul Craig Roberts, Bruce Bartlett, Milton Friedman, Robert Mundell and eventually Ronald Reagan—seized on Laffer’s ideas and promoted them as a solution to the economic problems that were plaguing the U.S. economy.

Case Study: Demonstrating the Effects of Supply-Side Economics With the Reagan Administration

The best-known real-world test of supply-side ideas came during Ronald Reagan’s presidency, which lasted from 1981-1989. President Reagan lifted price controls, reduced government regulations on everything from environmental pollution to traffic safety, and repeatedly lowered taxes on incomes, businesses, and estates.

Supply-side economists explained the logic of these decisions and predicted what their effects would be:

  • Taxes and government regulation were stifling the entire economy, especially the producers, who created jobs and drove growth.
  • By cutting their taxes and easing government regulations, government would be freeing producers to grow the economy.
  • Flush with new sources of revenue, producers would pump their new money back into their businesses, hiring new workers and investing in research and development.
  • Higher profits for producers and additional jobs for workers would mean additional tax revenue for the government, which would make up for the money lost from the tax cuts.

Isolating the effects of supply-side actions are difficult, because they were taken in tandem with other policies Reagan implemented that were unrelated to supply-side economic measures, such as boosted spending on the military and on highways. Reagan also increased non-individual taxes, by introducing the Tax Equity and Fiscal Responsibility Act of 1982 and the Social Security Amendment of 1983, which ran contrary to supply-side thinking. With so much happening, isolating the effects of just a handful of policies is tricky.

Still, one thing can be concluded pretty definitively. Budget deficits during Reagan’s presidency exploded, doubling from the levels they were during the presidencies of his two predecessors, Jimmy Carter and Gerald Ford. Deficits peaked at six percent of GDP in 1983 and turned the United States into the world’s biggest debtor nation. The deficits provided the strongest counter-evidence to supply-side theory, since the revenues generated by growth resulting from the tax cuts didn’t approach the levels needed to make up for the shortfall caused by those same cuts. In layman’s terms, the tax cuts didn’t pay for themselves, as supply-side economists had claimed they would.

However, there were also undoubtedly positive aspects to the economy during the Reagan years, although their relationship to supply-side tax cuts is highly debated. Most notably, inflation, which had been stubbornly high throughout the 1970s, shrank dramatically, decreasing from 10% in 1980 to 4% in 1988. Decisions made by the Federal Reserve to cut interest rates beginning in the late 1970s played a major role here, but the tax cuts likely did as well, by leading producers to offer more goods and services, lowering their prices.

Supply-Side Economics in Modern Government

Although best associated with the Reagan years, supply-side economics have lived on, in the hands of policymakers and in debates among economists. Conservatives credited tax cuts for the rapid recovery of 1982-4, although this probably mainly reflected monetary policy. President Clinton, however, raised taxes in the early 1990s and the economy experienced an even bigger boom. George W. Bush then cut taxes again in the early 2000s and there was hardly any boom. President Obama raised taxes again in 2013 and it seemed to have no effect on the economy at all.

When President Donald Trump cut taxes on corporations at the end of 2017, he was putting supply-side economics into action once again, betting that tax cuts would stimulate growth. Among most economists, the grandest claims of supply-side economics are not taken seriously. In the middle of 2016, a poll taken of economists found that not a single one believed that a cut in the federal income taxes would generate more tax revenue above that brought in at existing tax levels. Subsequent polls of economists have found a similar consensus against supply-side thinking.