The early 1980s saw the emergence of a new school of thought that emphasized the impact of aggregate supply on the economic growth of nations. This new school of thought was called supply-side economics.
Supply-side economists argued that creating an economic environment that provided incentives for people to work and save money, and also an environment that is conducive for firms to invest and create employment would cause an increase in aggregate supply. The supply-side economists assumed that the aggregate demand of the nation was always adequate and that it would absorb the aggregate supply, thus indicating their acceptance of Say’s law. Supply-side economics, thus, laid emphasis on reduction in tax-rates and social spending, promotion of free labor markets and liberalization of economy.
The supply-side economists believed that incentives and tax-rates influence the economy’s aggregate supply to a great extent. According to them, the tax-rates induce people either to produce or to utilize their resources in a productive manner i.e. tax-rates have an impact on people’s consumption and saving activities. This is because tax rates determine the level of disposable income. Disposable income is the income available with people for personal consumption, saving, investment, etc. The main objective of the supply-side policies is to improve employment and reduce inflation in the economy and thereby achieve economic growth.
Factors Determining Economic Growth in Supply-Side Economics
Role of Incentives
Supply-side economists believe that fiscal policy plays a major role in determining the aggregate supply and economic growth in an economy. They propose that tax cuts influence post-tax factor rewards. Enforcing tax cuts would imply increase in the after-tax rewards that individuals earn for working, saving or investing. When people gain having higher rewards or incentives, it encourages them to work more or invest more in order to gain higher incentives. Therefore, workers increase their productivity and entrepreneurs infuse more capital into the economy. Thus, it impacts the aggregate supply in the economy. Supply-side economists believe that a reduction in taxes on income received from interest rates, or dividends, would lead to an increase in savings, investment, and economic growth.
Some of the incentives that would encourage growth activities like savings and investments include:
- A reduction in corporation tax that would encourage entrepreneurs to invest more as they would be exposed to lower entrepreneurial risks.
- A reduction in the marginal rate of income tax, as this would encourage individuals to save more as they would have higher post-tax incomes. However, this reduction in tax-rate might reduce the total tax revenue for the government.
Another important feature of supply-side economics is its emphasis on large tax-cuts. The advocates of supply-side economics criticized Keynesian economics on the grounds that Keynesian economics laid too much emphasis on the impact of tax-rates on aggregate demand (the multiplier effect of tax-rates on aggregate demand and output). One of the main proponents of supply-side economics, Arthur Laffer argued that high tax rates led to a reduction in tax revenues. According to him, higher tax-rates led to shrinking tax bases. This was because higher tax-rates caused reduction in economic activity. There would be a reduction in economic activity because huge taxes discouraged individuals from working (as they got less disposable income in the higher income slabs) and entrepreneurs to invest (as they would have to pay higher interest rates). As the government keeps increasing the tax rates, it is less worthwhile for the individual to work more as he gets less disposable income in hand. So he withdraws his work effort and increases his leisure. This means that the higher tax rate results in less economic effort and output, and at a very high tax rate, the higher rate no longer gives the government a higher total tax revenue. So the government will stand to gain more tax revenue by reducing the tax rate, thus pushing up the incentive to work and increasing the base on which taxes are levied. Economic activity as a whole (including consumption) is also encouraged by lower tax rates, once again increasing the base on which taxes are levied and contributing to higher total tax revenues. Therefore, Laffer advocated tax cuts for economic growth.
The Laffer Curve
Arthur Laffer, an American economist, proposed that there is an optimal tax-rate that provides the Government with maximum revenues. This concept is explained by him with the help of a curve, which is popularly known as the ‘Laffer curve’. In the Figure, x-axis represents the tax revenues of the Government and y-axis represents the tax rate imposed by the Government. In the figure, at zero tax-rate, the Government cannot generate any tax-revenues. Hence, there is no tax-revenue for zero tax-rate. As can be seen in the diagram, the curve originates at this point. Similarly, at 100 percent tax-rate, people will have no incentive to work because the entire income is paid to the Government in the form of taxes. Therefore, at 100 percent tax-rate too, the Government cannot earn any revenues. Thus, the curve ends at the horizontal axis at the point where the tax-rate is equal to 100. In between these two tax-rates, the Laffer curve takes an inverted U-shape. This indicates that tax-revenues rise along with the increase in tax-rate until it reaches the point T1. After this point, the tax-revenues begin to fall with the increase in tax-rates i.e. increase in tax-rate is counterproductive to tax revenues. This is because higher tax rates discourage people from working and there will be less people working. This reduces the revenue generated on taxes. Thus, Laffer proposed that at T1 rate of tax, the Government can maximize its revenues.
However some economists vehemently opposed Laffer’s theory that reducing tax rates would increase tax revenues. Laffer’s critics pointed out that a cut in tax rates could provide a disincentive to work. The reduction in tax-rate would reduce the amount of work required to earn a given after-tax income. So, people might opt for more leisure rather than working more because they can now earn the earlier income by putting in less effort. Therefore, people might decide to work less and enjoy more leisure. Thus it has an unfavorable impact on government revenues as the base on which the tax is levied shrinks.
Supply-side economists proposed a complete restructuring of the tax system through ‘supply-side tax cuts.’ This approach was based on the following premises:
- The reforms to restructure the tax system must be made with a view to encourage workers and entrepreneurs by lowering tax rates.
- The restructured tax system should reduce the tax burden on individuals with high incomes.
- The restructured tax system must be designed to encourage productivity and supply of factors of production instead of controlling or influencing aggregate demand.
Supply-side economists propose numerous tax cuts that would encourage incentives. Some of the tax cuts they suggest are:
- Lowering the tax rates on personal incomes.
- Reduction in the corporation tax.
- Reduction in the tax rates of income earned from savings.
- Tax exemptions to firms making investments in new businesses, new plants and buildings, etc.
During the 1980s, the UK government deregulated its economy with a view to encourage investment from businesses and improving productivity in the economy. The Thatcher government in the UK at the time believed that fostering competition would lead to increased production efficiency and lowered prices of goods and services. As a result, there were a string of reforms taken up by the UK government to encourage competition. Following are some of the highlights of the supply-side reforms undertaken by the Thatcher government:
- It opened up the telecommunication equipment sector to private firms.
- It opened up the local bus transport and encouraged private firms to compete with the government.
- It enacted the Local Government Act 1988, which compelled local authorities to contract services such as cleaning, ground maintenance, repairs, catering, etc. to private business houses.
Ronald Reagan (Reagan) popularized supply-side economics during his tenure as the President of the US, so much so that supply-side economics was even given the name ‘Reaganomics.’ Reagan’s economic program for his nation was based upon four objectives:
- To reduce government spending
- To reduce tax-rates
- Encouragement of money restraint
- To relax the regulatory burden on businesses
Reagan announced that his economic program when put into practice, would increase the level of productivity and employment and decrease the inflation rate in the country. The Economic Recovery Act of 1981, meant to bring supply-side reforms in the US, was also passed as an extension of this program. As a result of this act, the American economy saw substantial changes in its tax laws. Some of the highlights of the changes in tax laws were as follows:
- There were huge cut in personal income tax rates. The rate of (maximum) personal income tax on investment income recorded a steep fall from 70% to 50% (as on January 1, 1982).
- The Reagan government drew up a pension plan called Individual Retirement Account (IRA), according to which, any wage earner could contribute an amount up to $2,000 in a year. Further, the individual was not required to pay taxes on the contribution or the interest received (till he/she withdrew funds from the plan)
- Measures were taken to provide incentives to businessmen to invest in new businesses. Firms were given a 6% investment tax credit for purchasing new cars, small trucks, and research equipment and a 10% investment tax credit for purchasing other equipment.
- The Reagan government reduced the corporate taxes for corporations whose earned profit was less than $50,000.
Reagan’s economic program which was based on supply-side approach to factors of production was criticized on the following grounds:
- Analysts said that the impact of incentives, if any, on labor supply, saving and investment spending was negligible.
- Analysts opined that the aggregate expenditure or demand could increase more rapidly when compared to aggregate supply, which in turn would aggravate inflationary tendencies.
- Analysts also pointed out that the reduction in personal income tax rates favored individuals who earned high incomes.