General Economic Concepts
What is Policy?
History of Macroeconomic Policies in the United States
Policy Goals: Maximum Employment
Policy Goals: Maximum Production
Policy Goals: Price Stability
Policy Goals: External Balance
Subsidiary Policy Goals
Conflicting Policy Goals
The Policy Makers
The Policy Instruments
The Decision-Making Processes
The Policy Indicators
The General Economic Model
Monetarist Monetary and Fiscal Policies
Keynesian Monetary and Fiscal Policies
Debt Management Policies
Supply Management Policies
The Long Wave
- Supply Management Policies
- Supply-Side Economic Policies
Typical monetary and fiscal policies are designed to attack the demand side of the market to control aggregate economic activity. However, in a period of stagflation (high inflation and high unemployment), when the Phillips curve has shifted up to the right, the government cannot use traditional macroeconomic policies that affect aggregate demand. To do so simply moves an economy around its Phillips curve, trading off higher rates of inflation for reduced unemployment (and vice versa). The decision-making authorities would have to risk a severe recession to reduce inflation or else risk hyperinflation to reduce unemployment. The tools of traditional macroeconomic policy cannot solve both problems simultaneously. Therefore, policies that shift the aggregate supply curve out are needed to solve the problems of stagflation.
Supply-side policies may take many forms. They may involve direct government intervention by way of public production, where the government owns and controls the means of production, or national economic planning, where the govenrment sets goals for output and prescribes resource usage. Or they may involve indirect government intervention by way of incomes and tax policies. The U.S. has very little direct government intervention. Its supply-side policies have consisted primarily of indirect intervention through manipulation of government expenditures, tax rates, and tax credits.
II. Supply Management Policies
Supply management policies consist of a combination of public production, economic planning, and regulations to direct resources around the economy. They involve heavy government intervention.
Material Balance Planning
III. Supply-Side Economic Policies
Supply-side economic policies are the antithesis of supply management policies. They attempt to eliminate government intervention in the economy. By eliminating government intervention and changing the relative prices of leisure/work and consumption/saving, supply-side economic policies attempt to increase potential output. The tools of supply side economics are (1) the size of the government (reduce it), (2) the federal government budget (reduce it), (3) tax rates (reduce them), (4) tax structure (flatten it), (5) the composition of government (shift it form social services to defense), (6) the regulatory environment (deregulate), (7) antitrust regulation (suspend it), and (8) money supply (increase it).
Supply-Side Economc Theories
Supply-side economic theory is a set of rules for economic behavior that underlie the use of monetary and fiscal policies to influence the supply side of the market. The policies are generally used to solve the problem of stagflation — high unemployment and high inflation. To solve the problem of stagflation, governments must adopt policies to push out the aggregate supply curve. Assuming aggregate demand does not fall, an increase in aggregate supply reduces the rate of inflation and increases employment. An increase in natural real output from Qfe1 to Qfe2 increases aggregate supply from LRAS1 to LRAS2. The increase in aggregate supply puts downward pressure on prices. The economy now has plenty of room for aggregate demand to increase from AD1 to AD2 without inducing higher rates of inflation. Supply-side economics seeks to establish a set of policies for controlling the supply side of the market to solve the problem of stagnation.
|LONG-RUN SHIFT IN AGGREGATE SUPPLY
Supply-side economics takes its foundation from Say's Law that states that goods are ultimately paid for with other goods. Say argued that "the encouragement of mere consumption is of no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus it is the aim of good government to stimulate production, of bad government to encourage consumption."
In 1977, Irving Bristol wrote of supply-side economics that "it arises in opposition to the Keynesian notion that an increase in demand, by itself, will increase supply and therefore accelerate economic growth. The 'new' economics asserts that an increase in demand, where the natural incentives to economic growth are stifled, will result simply in inflation. It is only an increase in productivity, which converts latent into actual demand by bringing commodities (old and new) to market at prices people can afford, that generates economic growth."
Most of the supply-side premises come from Monetarist economic theory, itself a derivative of Classical economics and Say's Law. Among the premises that establish the base for supply-side theory are three important assumptions.
The long-run framework
The shift from a short-run Keynesian time period to the long-run Monetarist time period is necessary for shifting the emphasis of macroeconomic policy from short-run cyclical stabilization to long-run growth objectives.
The ineffectiveness of fiscal policy
Monetarists believe that fiscal deficits or surpluses without corresponding changes in the money supply are ineffective. What effectiveness is observed comes from correspondent changes in the money supply and not from the fiscal stimulus, per se. For supply-siders, this irrelevance is necessary to develop the logic for cutting taxes in an inflationary environment.
To the Keynesians, all deficits are stimulatory and inflationary and all surpluses are contractionary and deflationary. It does not matter whether the deficit (surplus) comes from an increase (decrease) in government spending or a decrease (increase) in taxes. It does not matter whether the government spends on B-1 bombers, paper clips, or social services programs. It does not matter whether the government cuts personal or corporate tax rates or whether it cuts average or marginal tax rates. It does not matter whether the government passes a tax rebate, a tax cut for those with low incomes, or a tax cut for those with high incomes. What matters is the aggregate size of the deficit (surplus) that dictates the fiscal stimulus.
By contrast, supply-side economists argue that it makes a great deal of difference how the deficit or surplus is achieved rather than what the size of the imbalance is.
Domination of the substitution effect over the income effect
A tax cut financed by government borrowing from the public's saving out of its increased disposable income means that the income loss of the government is just offset by the income gain of the public. Since the income effects cancel, only the substitution effect is left. Economic participants make stock adjustments by responding to changes in relative prices.
Unlike their Monetarist brethren, however, supply-siders conclude that the federal government's budget can be used effectively to bring about supply-side adjustments. In other words, from the same basic set of assumptions, supply-siders draw different policy conclusions concerning the use and effectiveness of fiscal policy tools.
The principal policy weapon for supply-siders is a tax rate reduction. The Laffer curve, named for its author, the economist Arthur B. Laffer, shows that the government will collect the same tax revenue from two different sets of tax rates. At both 0% and 100% tax rates, the government's tax revenue is $0. At 0%, there is no tax levy, while at 100%, no one will earn income simply to transfer those earnings to the government. Resources will be diverted to tax-exempt and underground activities. As tax rates increase, but remain low (tlow), the income effect is dominant. Individuals will work harder to raise their incomes to compensate for the increased tax. At some higher tax rate (thigh), however, the additional income earned is taxed at such a high rate that the initiative to work harder and earn more income falls. At that tax rate, the substitution effect has set in and individuals cut back on their supply of productive effort and substitute leisure for work. As a result, the government collects the same tax revenue (T1) from the two different sets of tax rates. Between tlow and thigh is some optimum tax rate (t*) at which the government maximizes its tax revenues. The implication of this hypothesis is that, at some high tax rate (thigh), the government can actually take in more tax revenue by cutting taxes.
In advising presidential candidate, Ronald Reagan, in 1980, supply-siders argued that government had become two big. Rather than being the means to solving the economic problem of stagflation, big government was the problem. Their complete program called for both tax and spending cuts. In the Keynesian framework, such a fiscal policy alternative would have had a deflationary effect on both prices and employment. But the supply-siders argued, to the contrary, that what these cuts would do are to return resources and incentives to the private sector to stimulate productivity and production. Tax cuts should be structured to give maximum stimulus to investment, savings and work incentive. They should emphasize marginal tax rate reductions because they increase the trade-off between work and leisure, investment, and consumption. Similarly, they favor cutting corporate tax rates, which affect the rate of return rather than investment tax credits, which primarily affect cash flow.
Changing Relative Prices
The work-leisure trade-off A reduction in personal income tax rates and/or the progression of the rates increases after-tax wages. A change in the after-tax wage alters the work-leisure trade-off. An increase in after-tax wages raises the price of leisure. As after-tax wage rates rise, labor willingly substitutes more work for leisure. Labor is induced to work harder and longer for higher after-tax wages, thus increasing the supply of labor and its own productivity. This increased work effort keeps the wage bill component of prices and prices themselves down. When tax rates on wage income are reduced, the supply of labor increases, pre-tax wages fall, and employment increases.
The consumption-saving trade-off A reduction in personal income tax rates and/or the progression of the rates increases after-tax yields on financial assets. A change in after-tax yields alters the consumption-saving trade-off. An increase in after-tax yields raises the price of current consumption. As after-tax yields rise, households willingly substitute more saving (or future consumption) for current consumption. Households are induced to save more at the higher after-tax yields, thus increasing the supply of saving which is available for investment. This increased saving keeps the interest and dividend components of prices and prices themselves down. When tax rates on interest income are reduced, the supply of saving increases, pre-tax interest rates fall, and investment increases. The increased investment increases the nation's stock of capital, its resource base, and its potential supply of goods and services to the markets.
Increasing investment by increasing the expected after-tax rate on corporate earnings
A reduction in corporate income (profits) tax rates increases the expected rate of profitability on new capital. Lower corporate income (profits) tax rates increases investment demand at each and every interest rate. Businesses add new capital and update facilities, increasing the capacity to produce more new output. Coupled with lower interest rates from increased household saving, investment spending on new capital increases. The demand for new capital also increases the demand for labor. The demand for labor increases and employment rises, while wages are kept low by the increase in labor supply. The increased capacity of businesses will make output expansion possible at little or no extra cost, thus keeping prices from rising. The total effect of such tax reductions will be to increase employment, output, and income. This larger income, taxed at the lower rates, will raise as much, if not more, tax revenue for the government than without the reductions. Thus, tax cuts pay for themselves.
Government spending must fall
To prevent the absorption of the new saving by huge federal government deficits, government must cut back on what it spends. If the tax incentive program for saving and private capital investment is to succeed, the latter cannot be crowded out of the financial markets by excessive federal borrowing. As federal government borrowing falls, the demand for money falls, reducing interest rates. This frees up money balances to complement private sector saving. New investment demand increases the demand for money, but this increase in business borrowing can be accomplished without an overall increase in interest rates, because of the reduction in government borrowing and increase in household saving.
It must be noted that supply-siders are split on the necessity of decreasing government expenditures. Some would argue that failure to do so is inflationary and counterproductive, especially if inflation restores "bracket creep" and if the subsequent budget deficits merely shift government finances from taxes to borrowing. Others would argue that cutting the tax rate does much more than reduce government revenue. It reduces disincentives. The spending side of the federal government's budget is irrelevant.
The Time Dimension Constraint
Although the Laffer Curve may operate effectively in the long run, its proponents wish to use it for short-run budget balancing and fine-tuning the economy. After fifty years of tinkering with the demand side of the economy, the federal government is beginning to recognize the impossibility of effectively managing aggregate demand. Now, it wants to fine-tune the supply side instead. Supply-side fine-tuning may be even more difficult than demand side. Investment and production take time. Meanwhile, the immediate effect of a tax cut, ceteris paribus, is to lower government revenues and increases the budget deficit. If the government attempts to borrow this lost revenue from the private sector, it will inevitably raise interest rates and crowd-out the additional private investment demand sought by the tax cut. If the government decides to print money to finance its revenue loss, it merely shifts the required resources from the private to the public sector through inflation.
The Empirical Constraint
The task of the economic policy maker to find that tax rate t* that maximizes tax revenue Tmax along the Laffer curve may be all but impossible. No one knows the true shape of the Laffer curve and it may take another 50 years of tinkering with marginal tax rates to amass sufficient data for testing. Worse yet, the curve is an imaginary representation of peoples' tastes and preferences regarding work, leisure, saving, and investment. Since tastes and preferences are subjective, they cannot be measured easily. And even if people's preferences could be known for certain, they cannot be assumed to remain constant. By the time a tax cut is enacted and implemented, the curve may have shifted considerably. Or alternatively, the curve may not be smooth. It may be "bumpy" and have two or more revenue maximizing points.
Marginal versus Average Tax Rates
A major problem with the Laffer Curve and supply-side economics is that supply-side theorists fail to distinguish between marginal and average tax rates. Reducing average tax rates reduces tax collections and increases disposable income for households and after-tax profits for business. If taxes on wage income are reduced, households will work harder and increase their own productivity because the reward for work effort is increased. This increase in labor effort will push out the supply curve, keeping prices stable (or at least reducing the rate of inflation). Additionally, with the increased disposable income, households will be able to both consume and save more. The goal here is to raise disposable income sufficiently to encourage more saving, since more saving adds to the pool of funds available for lending and pulls down interest rates. At lower interest rates, businesses find new investment more profitable. The objective of lowering corporate profit taxes is also to encourage new investment by making the expected return from new investment higher. Thus, supply-siders would argue for a cut in average tax rates.
On the other hand, in a progressive tax system, tax payments will increase as personal income and corporate profits increase — not just because incomes and profits have risen, but also because the marginal tax rate is higher. If personal income and corporate profits rise solely because of inflation, economic participants pay a phantom tax that actually reduces real disposable income. As real disposable income and after-tax profits decline, individual incentive and entrepreneurial initiative are dampened. Productivity declines and income falls. Thus, supply-side proponents would argue for a cut in the marginal tax rate. A cut in the marginal tax rate, however, may be ineffective, if, at the same time, the taxable base — personal income and corporate profits — is broadened so that the tax liability increases and the average tax rate is raised (or, at best, does not fall).
Huge Federal Budget Deficits
The legacy of the supply-side tax cuts has been ever-growing federal budget deficits. While tax collections have increased, the increases have not been sufficiently large enough to eliminate the gap between federal government expenditures and revenues. The deficits soared for several reasons: Some observers blame the increase on Reagan's defense build-up, while others contend that Congress failed to give Reagan the spending cuts that he wanted to go with the tax cuts. Most supply-siders blame the Fed's tight monetary policy of the early 1980's that sent the economy into a recession before the tax cuts had a chance to work, while most mainstream economists lay the blame directly at the doorsteps of the supply-side tax cuts.
The Che Guevara Problem
Every revolution arises because people unite to destroy something they hate. Then, they splinter to set up new churches. In the late 1970's the group — an eclectic mix of conservative economists, activists, and journalists, who shared not so much a coherent view of the economy as a disdain for the prevailing economic wisdom — coalesced around the idea that high marginal tax rates were stifling economic incentives. Supply-siders argued that lower tax rates would revitalize the economy by stimulating more work, saving, and investment. The theories did not attract a large academic following but did prove enormously appealing in Washington. After years of Republican sermons about austerity and balanced budgets, President Reagan embraced the supply-siders tax cuts as a politically expedient way to force Congress to slow government spending, to loosen the government's grip on the economy, and to spur economic growth. As a result, tax rates tumbled from a high marginal rate of 70% in 1981 to 28% in 1988 (or 33% for some higher income tax payers).
But, after the tax cuts, what do supply-siders do for an encore? The taste of success has whetted the appetites of most supply-siders and has led them to pursue new issues. However, the new issues lack the same political clout as tax cuts. Nor do the new issues generate the same consensus within the group. By 1986, the original group was bitterly divided on complementary government policies. Today, they argue vehemently on such issues as whether to return to a gold standard, how to reform Social Security, and the selection of Alan Greenspan as the Federal Reserve Board chairman.
Some supply-siders have tried to make international monetary reform their next revolutionary victory. If they were true Monetarists, they would favor a floating exchange rate regime — and some supply-siders do argue that foreign exchange rates should float freely while nations control the growth of their money supplies to control inflation. Others are committed to the idea of a fixed exchange rate system with currency values based on gold. The latter contend that a stable currency would control inflation and promote growth. In between are countless variations. Even among those who advocate a gold standard, no two people are committed to the same type of gold standard. Rep. Jack Kemp (R. NY), a leading supply-side proponent and former Republican presidential candidate, advocates a fixed exchange rate system tied to gold. At a luncheon with his campaign advisers in the fall of 1986, Kemp endured an intense five-hour debate over the arcane issue of whether the dollar should remain an international reserve currency in a gold-based monetary system.
In economics, as in other sciences, nature abhors a vacuum. Therefore, in a world with economic problems, for which orthodox or mainstream economics has no solution to offer, new ideas are bound to emerge. Unfortunately, economics is not a pure science. Controlled experiments cannot be used to test the veracity of an hypothesis before it is applied. Rather, economics is a social science and must rely on real-life experimentation to verify the results of scientific inquiry. If the experiments are badly designed, or incomplete, and if people adjust to past disappointments, inappropriate conclusions will result.
What is known is that supply-side economics is not new. While not labeled "supply-side economics," former President Harry S. Truman tried policies similar to Reagan's. While unsuccessful in the short-term, they might have been considered successful in setting the stage for the post-War expansion that lasted through the early 1970s. But, the 1950s were not without sluggish periods of growth and several economic downturns; and while productivity did grow at its most rapid post-war rate, no one can say for certain that this productivity growth resulted from Truman's policies or from other factors. Whether Reagan's supply-side policies are responsible for what is now the longest peacetime expansion in the history of the United States (dating from March 1991), or whether the expansion will, in retrospect, be traced to other factors is left to the economic historians to recount.
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