Supply Side Economics
Jim Blair

Supply Side economics (SS economics henceforth) concentrates on the effect marginal tax rates have on the incentives of firms to invest and of people to work.

When marginal income tax rates are reduced, some capital investment projects that previously were passed over by firms as unprofitable will suddenly become profitable. The additional investment increases the capital base of the economy, advances the application of new technologies, improves productivity, and lowers the unit cost of production. The increased production capacity of the economy reduced inflationary pressures.

When personal income tax rates are lowered, the incentive to work is increased. This will attract some additional workers into the labor force which increases the pool of productive resources available.

Lower marginal tax rates also reduce the incentive to engage in unproductive tax-dodging schemes. Less time is spent trying to avoid taxes and more time is spent in productive activities.

On the macro level, lower marginal tax rates may result in more total revenue collected by the government, as indicated by the Laffer Curve. It may also result in upper-income groups paying a larger portion of total taxes than before. Both possibilities depend on whether the change in taxes is on the positive or negative sloping part of the LC.

SS economics makes different predictions than Keynesian economics. The Keynesian model would predict that a cut in the marginal tax rate (if we start at full employment, stable prices) will increase aggregate demand, increase real GDP in the short run, and lead to inflationary pressures.

SS agrees that aggregate demand will increase, but also argues that aggregate supply will increase because of the increased incentives to work, invest, and produce that are also created by the tax cut. Their prediction is that the tax cut will increase both Aggregate Demand (AD) and Aggregate Supply (AS), increase real GDP in both the short run and the long run, and have less inflationary consequences than the Keynesian prediction. In fact, if the increase in AS is greater proportionally than the increase in AD, then the price level will actually fall.

SS has its problems, though. A tax cut has an indeterminant effect on the supply of labor. A lower tax rate allows workers to either earn more net pay by working the same number of hours, or earn the same net pay by working fewer hours. Either way the workers are better off, since leisure is a good also. However, whether the income effect described here will dominate the substitution effect is generally not known. Therefore, we cannot know with reasonable certainty how current workers will choose to respond to the tax cut.

Also, if the AS effect described earlier is less than the AD effect, then inflationary pressure will result in the short run. This can be the case when businesses are generally pessimistic about the future. They will decide to pocket the tax cut rather than reinvesting it immediately, which is a key assumption of the SS model.

I think the SS model is valuable because it gives traditional Keynesian analysis another angle to think about. And it also reminds us that all decisions are based on the margin.

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