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Supply-side economics

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Supply-side economics is a school of macroeconomic thought which emphasizes the importance of tax cuts and business incentives in encouraging economic growth, in the belief that businesses and individuals will use their tax savings to create new businesses and expand old businesses, which in turn will increase productivity, employment, and general well-being. While all macroeconomics involves both supply and demand, supply-side economics emphasizes the importance of encouraging increases in supply. It was popularised in the 1970s by the ideas of Robert Mundell, Arthur Laffer, and Jude Wanniski. The term was coined by Wanniski in 1975.

In 1978 Wanniski published The Way the World Works in which he laid out the central thesis of supply-side economics and detailed the supposed merits of low taxation and a gold standard.

In 1983, economist Victor Canto, a disciple of Arthur Laffer, published The Foundations of Supply-Side Economics. This theory focuses on the effects of marginal tax rates on the incentive to work and save, which affect the growth of the "supply side" or what Keynesians call potential output. While the latter focus on changes in the rate of supply-side growth in the long run, the "new" supply-siders often promised short-term results.

Contents

Historical origins

Supply-side economics was principally a response to perceived failings of Keynesian ideas that had steadily risen to dominance following the Great Depression. In particular, the point of disagreement was the question of the stagflation of the 1970s, and the failure of Keynesian policies to produce growth without inflation, and the failure to provide a clear solution for the series of recessions which occurred in the wake of the oil crisis in 1973. As with the crash of 1929, whether particular policies could have avoided the negative outcomes of history is a matter of intense debate.

Specifically, supply-side economics grew out of monetarists' critiques of Keynesian economics, and instead focused on encouraging investment, which they asserted was the basis of classical economics. In particular it proposed the notion that production or supply is the key to economic prosperity and that consumption or demand is merely a secondary consequence. In classical times this idea had been summarised in Say's Law of economics, which had been opposed by Keynes in the 1930s. This led the supply-siders to advocate large reductions in marginal capital gains tax rates to encourage allocation of assets to investment, which would produce more supply (Jude Wanniski, in fact, advocates a zero capital gains rate). The increased supply would then lower prices because of competition, hence the term "Supply-Side Economics". Furthermore, in response to inflation, supply-siders called for lower marginal income tax rates, as price/wage inflation had pushed wage earners into higher marginal income tax brackets that remained static; that is, as wages increased to maintain purchasing power with prices, income tax brackets were not adjusted accordingly and thus wage earners were pushed into higher income tax brackets.

Like many conservative versions of economics, many supply-side advocates claim that they are merely reinstating classical economics. (See Keynesianism for a discussion on Keynes and the classical critiques of his theory) However, to most economists they are practicing Keynesian economics, with the alteration of promoting demand side for investment and upper income consumption, that there is nothing to distinguish "Supply-Side Economics" from ordinary borrowing to finance present budget deficits.

Supply-siders maintain that they offer a production-centred world view, and that this was behind the writing of classical economists such as Adam Smith and Karl Marx. In contrast to the modern Keynesian world view these authors are thought, by supply-siders, to focus exclusively on production, as opposed to the effects of demand. Despite both economists being frequently characterised as polar opposites in economic thinking, Jude Wanniski says that their production-centered world view puts them closer to each other than to Keynesian economic thinking. By appealing to Say's Law supply-side economists such as Jude Wanniski seek to return the emphasis of macro-economic analysis to these classical traditions.

Critics of supply-side economics, such as Paul Krugman, quote one-time Reagan aide, David Stockman, who argued that this rhetoric was merely "a trojan horse for upper bracket tax cuts without economic justification." They point out that demand is crucial to both Marx and Smith, and that Keynes formulated demand side ideas because there had been a demand side failure in the late 1920s and early 1930s.

Supply-side supporters broke with Friedman and Lucas in that they argued that cutting tax rates alone would be sufficient to grow GDP, lift tax revenues and balance the budget. Supported by the powerful editorial page of the Wall Street Journal, seconded by the somewhat less prestigious and questionable voice of Washington Times, supply-side economics became a force in public policy starting in the early 1980s.

In the United States commentators frequently equate supply-side economics with Reaganomics. The fiscal policies of Ronald Reagan were largely based on supply-side economics. During Reagan's 1979 presidential campaign, the key economic concern was double digit inflation, which Reagan described as "Too many dollars chasing too few goods", but rather than the usual dose of tight money, recession and layoffs, he promised a gradual and painless way to fight inflation by "producing our way out of it". However, by the time he took office, Federal Reserve chair Paul Volcker, based on standard Keynesian and monetarist theory, had already embarked on harsh monetary policies and Reagan had little choice but to embrace them: Volker pursued a policy of using high interest rates and low money supply growth to squeeze inflationary expectations out of the economic system. Hence supply-side supporters argue that "Reaganomics" was only partially based on supply-side economics. Nonetheless, Jude Wanniski cited Reagan--along with Jack Kemp--as a great advocate for supply-side economics in politics and repeatedly praised his leadership.

Supply-side theorists also point to the success of the Kennedy tax-cuts to defend their case (even though they were justified at the time by Keynesian theory).

Fiscal policy theory

Supply-side economics holds that increased taxation steadily reduces economic trade between economic participants within a nation and that it discourages investment. Taxes act as a type of trade barrier or tariff that causes economic participants to revert to less efficient means of satisfying their needs. As such higher taxation leads to lower levels of specialization and lower economic efficiency. The idea is said to be illustrated by the Laffer curve.

Crucial to the operation of supply-side theory is the expansion of free trade and free movement of capital. It is argued that free capital movement, in addition to the classical reasoning of comparative advantage, frequently allows an economic expansion. Lowering tax barriers to trade provides to the domestic economy all the advantages that the international economy gets from lower tariff barriers.

Supply-side economists have less to say on the effects of deficits, and sometimes cite Robert Barros' work that states that rational economic actors will buy bonds in sufficient quantities to reduce long term interest rates. Critics argue that standard exchange rate theory would predict, instead, a devaluation of the currency of the nation running the high budget deficit, and eventual "crowding out" of private investment.

According to Mundell "Fiscal discipline is a learned behavior." Or to put it another way, eventually the unfavorable effects of running persistent budget deficits will force governments to reduce spending in line with their levels of revenue. This view is also promoted by Victor Canto.

The central issue at stake is the point of diminishing returns on liquidity in the investment sector: is there a point where additional money is "pushing on a string"? To the supply-side economist, reallocation away from consumption to private investment, and most especially from public investment to private investment, will always yield superior economic results. In standard monetarist and Keynesian theory, however, there will be a point where increases in asset prices will produce no new supply, that is where investment demand will out run potential investment supply, and produce instead, asset inflation, or in common terms a bubble. The existence of this point, and where it is should it exist, is the essential question of the efficacy of supply-side economics.

Monetary policy theory

Supply-siders advocate that monetary policy should be based on a price rule. The aim of monetary policy should be to target a specific value of money irrespective of the quantity of money that must be created or withdrawn by the central bank to achieve this target. This contrasts with monetarism's focus on the quantity of money, and Keynesian theory's emphasis on real aggregate demand. The important difference is that to a monetarist the quantity of money, specifically represented by the money supply is the crucial determining variable for the relationship between the supply and demand for money, while to a Keynesian adequate demand to support the available money supply is important. Keynes famously remarked that "money doesn't matter".

This is an area where supply-side theory has been particularly influential. Under macroeconomic theory, the general level of price was based on the strict increase in price of a basket of goods. Under supply-side theory, the rate of inflation should be based on the substitutions that individuals make in the market place, and should take into account the improved quality of goods. In the late 1980s and through the 1990s, under Presidents of both American political parties, shifts were made in the calculation of the broadly followed measure of inflation the "Consumer Price Index for Urban Consumers", or CPI-W, which reflected supply-side ideas on substitution. The argument for factoring in goods quality was not accepted, which has led supply-side economists to claim that the real CPI is actually between .5% and 1% lower than the stated rate.

This area represents one of the points of contention between conservative economic theorists who argue for a quantity of money theory of inflation, including Austrian economics, many strict gold standard economists and traditional monetarists, and supply-side theorists. According to the increases in money supply during the 1990s, the real rate of inflation must be higher than is currently stated. These economists argue that the cost of housing is understated in the CPI-W, and that the inflation rate should be between .5% and 1% higher. It is for this reason that many central bankers, investment analysts and economists follow the GDP deflator which measures the total output of the society and the prices paid for all goods, not merely consumer goods.

Typically, supply-siders view gold as the best unit of account with which to measure the price of fiat money, which is defined as a money supply not directly limited by specie or hard assets. Hence the purest supply-siders are in general advocates of a gold standard. However the reverse is not true, many gold standard advocates are harsh critics of supply-side economics.

Supply-side economists assert that the value of money is purely dictated by the supply and demand for money. In fiat money system the government has a legislated monopoly on the supply of base money. Hence it has complete control over the value of money. Any decline in the value of money (or appreciation) is hence viewed as the result of errant central bank policy.

U.S. monetary and fiscal experience

Supply-side economists seek a cause and effect relationship between lowering marginal rates on capital formation and economic expansion. The supply-side history of economics since the 1960s hinges on the following key turning points:

The Kennedy tax cuts which reduced marginal rates are believed by supply-side economists to be responsible for the 1960s prosperity. The more generally accepted political stand among supply-side detractors is that the tax program of 1963, by reducing the incentives to shelter income, reduced economic distortion. For example, while the theoretical top bracket rate was originally 90%, in practice, no one paid this rate, using various loopholes and deductions to avoid paying.

In 1971 Richard Nixon ended the Bretton Woods gold standard. Commodity prices, including oil and gold particularly, which had been rising steadily in response to the dollar glut, spiked upwards. The supply-side explanation for this event is that taxation on investment had depleted the incentive to capital investment either in new sources of materials or in substitute goods, which when combined with eroding confidence in the U.S. dollar cause it to be rapidly devalued. Many supply siders agree with gold investors in saying that the value of commodities remained constant and that it was the dollar that devalued. Both of these views are not accepted in most economic literature because of fierce ideological resistance to supply-side economics.

At the same time the Flemming-Mundell model of currency flows gained greater credence when it was codified into a single set of equations, and became increasingly influential in neo-liberal economics. The argument for a floating currency regime had first been adopted by Friedman, but supply-side economists such as Wanniski typically argued that exchange rates should be fixed relative to gold. Mundell was the author of the influential view that it was Johnson's budget deficits that were the cause of inflationary pressure. However, as Lester Thurow pointed out, the standard model of inflationary pressure shows that Johnson's peak year of deficits would have created only a small upward pressure, that instead it was persistent American trade deficits through the 1960s which had a greater effect on the imbalance between the value of the U.S. dollar and the gold to which it was, in theory, convertible.

Robert Mundell believes Nixon's failure to cut taxes in the early 1970s to be the cause of stagflation, his argument being that the incentive for individuals to invest was reduced to below zero. Measuring the S&P 500 in inflation-adjusted terms, the stock market lost half of its value between the market peak of 1972 and its bottom in 1982, with money seeking better returns in real estate and commodities instead. The argument from the supply-side point of view then goes on to state that the cuts in capital gains tax rates that were part of the 1981 tax package returned incentives to invest. The Keynesian point of view is that after a long bear market, money had fled from stocks and was set to return, once the expectation of inflation had been reduced. Neither of these two arguments fully accounts for the rise of equities over the course of the "long Bull Market" of 1982-2000.

The importance of this argument needs to be seen in light of the effects of the inflation of the late 1970s, where credit became constricted, as interest rates rose rapidly, and the number of borrowers who could qualify for even standard mortgages fell. Inflation acted as a tax on wage increases, because the highly progressive income tax system of the time meant that more and more households suffered from "bracket creep" - in which a wage increase would be reduced in value by the increased taxes collected. The effects of inflation produced, in 1980, a strong political consensus for a change in basic policy.

Ronald Reagan made supply-side economics a household phrase, and promised an "across the board" reduction in income tax rates and an even larger reduction in capital gains tax rates. When vying for the Republican party presidential nomination for the 1980 election, George H.W. Bush derided Reagan's supply-side policies as "voodoo economics". However, later he seemed to give lip service to these policies to secure the Republican nomination in 1988, and is speculated by some to have lost in his re-election bid for allowing tax increases.

Supply-side economics was critiqued from the right as well, for example hard gold standard advocates, such as the Ludwig von Mises Institute, have argued that there is no such thing as a dollar, merely a specific quantity of gold. Therefore, according to this view, the entire central bank mechanism which supply-side economics advocates is a needless fiction which creates anomalies in the price of commodities. In their view, the central problem was that the United States needed to reassert a hard gold standard first, and this would force the necessary reductions in expenditures.

The centerpiece of the supply-side argument is the economic rebound from the 1980-1982 double dip recession, combined with the continued fall in commodity prices. The "across the board" tax cuts of 1981 are seen as the great motivator for the "Seven Fat Years". Critics of this view point out that the "rebound" from the "Reagan Recession" of 1981-1982 is exactly in accordance with the "disinflation" scenario predicted by IS/LM models of the late 1970s: essentially that the increases in fed funds rates squeezed out inflation, and that federal budget deficits acted to "prime the pump". This model had been the basis of Volker's federal reserve policy.

In 1981, Robert Mundell told Ronald Reagan that by cutting upper bracket taxation rates, and by lowering tax rates on capital gains, national output would increase and as a result government tax revenues would also increase. The economic expansion would also mop up excess liquidity and bring inflation back under control. Revenues did increase in real terms (though not as a % of GDP, which opponents of Supply-Side economics point to as failure. However, Supply-Side economic tax cuts propose to do exactly what was delivered -- an expanded pie such that a smaller % still yields a larger piece. Under such conditions, a drop in revenues as a % of GDP is a mathematical certainty. In other words, such complaints miss the point, which is that real tax revenues will (and did) increase on lower tax rates), and federal budget deficits exploded due to profligate congressional spending; however, the incentive to invest in equities worked: in 1982 the stock market began a rally which nearly tripled the Dow Jones between its low in 1982 and its pre-crash high in August 1987.

Critics of supply-side economics pointed to the lack of academic credentials by movement leaders such as Jude Wanniski and Robert Bartley to imply that the theories were bankrupt. Mundell in his Nobel Prize lecture countered that the success of price stability was proof that the supply-side revolution had worked. The continuing debate over supply-side policies tends to focus on the massive federal and current account deficits that have accumulated in the U.S. since 1980, even though the Laffer Curve only predicts revenue increases and has nothing to do with government spending.

After the emergence of supply-side economics, several economists using supply-side theory began advocating a flat-tax system. While generally associated with conservative politics, such as former Presidential candidate Steve Forbes, flat-tax systems based on Value-Added Taxes have been proposed by liberal economists and by at least one Democratic Presidential Candidate.

The paradigm of a tax system which rewards investment over consumption was accepted across the political spectrum, and no plan not rooted in supply-side economic theories has been advanced in the United States since 1982 (with the exception of the Clinton tax cuts of 1993) which had any serious chance of passage into law. In 1986, a tax overhaul, described by Mundell as "the completion of the supply-side revolution" was drafted. It included increases in payroll taxes, decreases in top marginal rates, and increases in capital gains taxes. Combined with the mortgage interest deduction and the regressive effects of state taxation - it produces closer to a flat-tax effect. Proponents, such as Mundell and Laffer, point to the dramatic rise in the stock market as a sign that the tax overhaul was effective, although they note that the hike in capital gains may be more trouble than it was worth.

Supply-siders blame the 1991 recession on the Federal Reserve, and argue that Clinton's tax increases, since they did not change marginal capital gains tax rates, left the supply-side nature of the 1986 tax bill in place. Similarly, supply-side economists have argued that since the early phases of the massive tax breaks of George W. Bush's first two years were based on credits and not cuts in marginal rates, they did not act to stimulate the economy, although the effect on individual income remains the same.

More generally, traditional economists point to the "overhang" of deficits from the Reagan era, the S&L bailout, the effects of a ballooning federal budget deficit, the defense budget cuts which began in earnest in 1989, and the expectation of a lack of continued fiscal discipline as the source of the recession. These arguments blame the legacy of Democrat Deficits forced upon Reagan, rather than deficits created by Reagan's own administration. Critics of supply-side economics often argue the inflated government deficits that accompanied the arrival of supply-side economics are of greater concern than the economic and stock market success of supply-side theory.

Stronger critiques of supply-side economics dismiss the entire project as a complete failure which is a trojan horse for reducing marginal tax rates on upper income brackets. These critiques are found in Samuel Bowles' work, which argues that real productivity fell under supply-side taxation regimes on a unit-worker basis. Paul Krugman, of MIT, called supply-side economics "Peddling Prosperity" and dismissed it as being unworthy of serious economists in a 1994 book written for the general audience. Since Krugman's early work was in international currency areas, the very theory for which Mundell received his Nobel Prize, his criticism was drawn in specifically sharp terms.

These criticisms point to the explosion in deficits, the failure of the Laffer curve to materialize, and the conversion of price volatility to currency volatility as proofs that supply-side economics does not work. Supply-side defenders counter that the theory was never designed to consider government spending, and therefore cannot be blamed for this outcome. They also counter that tax revenues and the economy grew under supply-side policy, as predicted.

See also

External links


Macroeconomic schools of thought

Keynesian economics | Monetarism | New classical economics
New Keynesian economics | Austrian School | Supply-side economics
Post-Keynesian economics
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