Economics: Supply-Side Policy

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Ever so often in the press someone will refer to supply-side economics. What are they talking about? Well, we've talked about how fiscal and monetary policy work by shifting the aggregate demand curve. You can also imagine policies that work by shifting the supply curves. And you shift the supply curves by changing the incentives of the people who produce output, changing the incentives that affect workers or people who save money or people who supply raw materials to the economy. How do you change those incentives? One of the biggest things that affect people's incentives is the tax rate. The more of your income you get to keep after taxes, the more enthusiastic you're going to be about working extra hours, taking an extra job or doing a project if you're self-employed. So what is the relationship between the tax rate that you are charged on your income and the total amount of revenue that the government collects in taxes?
Think about it this way. Suppose the tax rate were a hundred percent, you had to pay all your income to the government. You wouldn't want to work at all so you'd work none and the government would get no tax revenue because there'd be no income to tax. On the other hand, if the tax rate is zero, you're going to be very enthusiastic about working, a lot of stuff is going to be produced, but the government would get no revenue because it isn't taxing any. Now somewhere in the middle is the point where the government is going to get maximum tax revenue. The higher the tax rate, the less enthusiastic you're going to be about working after a certain point and, therefore one economist, Arthur Laffer suggested that by reducing the tax rate, the government might actually collect more money in taxes because people would work harder.
Let's see his argument in a picture called the Laffer curve. On the horizontal axis, we have the tax rate, the percentage of your income that you pay in taxes to the government. On the vertical axis we have total tax revenue that's collected by the government and this total tax revenue is going to be a function of the tax rate. We've already looked at two extreme cases. If the tax rate is zero, the government is going to collect zero in revenue. If the tax rate is 100 percent, then the government is going to collect zero because no one's going to be working because they'd have to give all their money to the government. Well what happens, Laffer argues is that as the tax rate increases from zero towards a hundred, at first government revenue increases as people work and the government collects part of their paychecks in the form of taxes. But after a certain point as the tax rate rises, people are so unimpressed with their opportunities to earn money, that is, they have to give so much of it to the government, that they actually start working fewer hours and enjoying leisure instead. What happens then is that as the tax rate continues to rise, tax revenue actually falls back towards zero, which is what you're going to get when no one's working because the government gets all the money.
Laffer says the point that the government would like to be is right here. This is the point where you get maximum tax revenue. What is the tax rate that's going to give us that maximum revenue? t* - they can't be sure. But this is the argument that Arthur Laffer and other supporters of President Reagan made during the 1980 presidential campaign. Supply-side economics argued that taxes were above t*, that the tax rate was so high that some rate, call it t[H] for high taxes. That people were actually deterred from working and the argument was that if the government would cut the income tax rate from a high level to a lower level, that they would actually increase the total tax collections because people would work harder. That the additional income that people earned from extra effort would compensate for the lower tax rate. Now, for the most part, this is what happened after President Reagan's big tax cuts in 1981 and 1982. Total tax revenue did increase. The economy grew out of a recession and that was probably part of it, but some of it might have had to do with the fact that business incentives were increased by a lower tax rate.
On the other hand, if you are over here in this region of the Laffer curve, say with a low tax rate, if you cut tax rates even further, then you're actually going to get a reduction in tax revenue collected. If you cut that down to an extra low tax rate, then revenue is going to fall. The big question for an economist who's advising a politician then is where are we are we on the Laffer curve? Are we up here where lower tax rates would increase tax revenue or are we down here where lower tax rates would just be giving away tax money without providing sufficient incentives that compensate for the lower rate. It's an empirical question. It's a question that has to be answered by trial and error or by studies. So it looks like in the 1980's there is some evidence to suggest that we were at this point and that the Laffer argument actually applied. However, whether that would happen again today or not is not to be taken for granted. Supply-side arguments depend on such empirical information not just the logic that a Laffer curve might exist, but empirical information about where we are right now on the curve.
So this is what supply-side economics are about. Changing taxes, changing regulations in such a way that give people so much incentive to increase output that the lower tax rate is actually offset by the increased work effort.
Monetary and Fiscal Policy
Fiscal Policy: Alternative Approaches
Supply-Side Policy Page [1 of 1]