Business, Politics, & Society

Learn About Supply-Side Economics: History, Policy, and Effects on Taxes and the Economy (With Video)

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 was 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 supply of goods and services is the most important factor in determining economic growth, and that governments can boost supply by lowering taxes and reducing regulations on suppliers. The theory is 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.

Critics of supply-side economic policy given it the pejorative nickname “trickle-down economics.” This is because supply-side economists believe that their policies will benefit wealthier people first, then eventually filter down to everybody else.

Paul Krugman graph of GDP and Tax Rate

How Does Supply-Side Economics Work?

Economists are divided about the theory of supply-side economics. Supply-siders argue the following points:

  • Taxes have a distorting effect on the economy, making it less efficient.
  • Higher taxes discourage investment because producers know their economic gains will be taxed at a high rate.
  • Lowering taxes, therefore, makes the economy more efficient, increasing investment in production 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.

Opponents of supply-side economics argue that rather than increasing revenue for the government, lowering taxes will instead increase the deficit. As a result, 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.

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Supply-Side Economics in 4 Steps

Here’s the thinking behind supply-side economics and how it works in four steps:

  1. Corporations and businesses that produce goods and services are responsible for growing the economy.
  2. Instead of taking their money through taxes, governments let these producers reinvest their capital in their companies. In practical terms, this means lower tax rates and decreased regulation.
  3. These actions enable entrepreneurs and companies to produce more goods, stimulating the economy and leading to more growth.
  4. In turn, this economic growth will offset the costs of lowering taxes, ultimately leading to increased tax revenues for governments.

What Is the Differences Between Supply-Side Economics and Demand-Side Economics?

The opposing theory to supply-side economics, demand-side economics is often referred to as Keynesian economics, after British economist John Maynard Keynes, who promoted it in the first half of the twentieth century.

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

  • Producers vs. consumers. Demand-side economists argue that instead of enabling businesses to produce more goods, as supply-side economists want to, governments should instead focus on helping the people who buy goods and services, who are far more numerous. Governments can do this by spending money to create jobs, which will in turn give people more money to put toward products and services.
  • Government intervention. While supply-side economists argue for minimal government oversight of production and the economy, demand-side economists like Keynes generally argue for increased regulation. For instance, When demand for goods weakens—as it does during a recession—the government has to step in to stimulate growth. 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.

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Paul Krugman explains more about supply-side economics and its impact on taxes.

What Are the Origins of Supply-Side Economics?

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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, yet government spending didn’t seem to be boosting the economy. This confounded Keynesian economists (most economists were Keynesians at the time) who believed that inflation rose with employment levels. The theory was that higher employment meant people had more money to buy things, leading to higher prices.

Arthur Laffer, one of the first major proponents of supply-side economics, was serving as an economist in President Richard Nixon’s administration (1969-1974) at the time. Laffer argued that the solution to stagflation was to lower taxes on those who produced goods and services.

Most economists, disagreed with this approach: they maintained that lowering taxes without reducing government spending would lead to increased deficits, and that 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 new administration. Laffer drew a graph on a napkin indicating why the theory of supply-side economics would work. This so-called “Laffer curve” went on to inspire economists, policy experts, and politicians in the Republican Party—including Paul Craig Roberts, Bruce Bartlett, Milton Friedman, Robert Mundell, and eventually Ronald Reagan.

Supply-Side Economics During the Reagan Administration

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The best-known real-world test of supply-side ideas came during Ronald Reagan’s presidency (1981-1989). President Reagan lifted price controls, repeatedly lowered capital gains, corporate, and income taxes, and reduced government regulations on everything from environmental pollution to traffic safety.

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

  1. Taxes and government regulations were stifling the entire economy, especially producers, who created jobs and drove growth.
  2. By cutting taxes and easing government regulations, government would free producers to grow the economy.
  3. 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.
  4. 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.

Because they were implemented in tandem with other policies, such as boosted spending on the military and on highways, it is difficult to isolate the effects of Reagan’s supply-side policies. (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.)

Nevertheless, one effect was clear: budget deficits during Reagan’s presidency exploded, doubling from levels during the presidencies of his two predecessors, Jimmy Carter and Gerald Ford. Deficits peaked at six percent of GDP in 1983, turning the United States into the world’s biggest debtor nation. These deficits provided the strongest evidence against supply-side theory, since the revenues generated by growth resulting from Reagan’s tax policy didn’t approach the levels needed to make up for the shortfall caused by tax cuts. In layman’s terms, the tax cuts didn’t pay for themselves, as supply-side economists had claimed they would.

At the same time, there were also positive aspects to the economy during the Reagan years, though their relationship to supply-side tax cuts is unclear. Most notably, inflation, which had been 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 were a major factor, but the tax cuts likely played a role by leading producers to offer more goods and services, thereby lowering their prices.

How Does Supply-Side Economics Work Today?

Though it’s best associated with the Reagan years, supply-side economic theory has lived on in the hands of modern policymakers and in debates among economists.

Conservatives credited tax cuts for the rapid recovery of 1982-1984, though this probably mainly reflected monetary policy. President Bill Clinton, however, raised taxes in the early 1990s and the economy experienced an even bigger boom. George W. Bush then cut taxes in the early 2000s, resulting in hardly any growth. Similarly, tax increases instituted by President Obama in 2013 seemed to have no effect on the economy at all. Finally, President Donald Trump put supply-side economics into action once again in 2017 by cutting taxes on corporations.

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.

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