Supply Side Theory

views updated

Supply Side Theory

What It Means

Supply side theory is an approach to economics based on the idea that the best way to make the economy grow is to encourage businesses to supply more goods and services for purchase. Supply and demand are the basic forces that shape all economic activity. Supply is the quantity of goods and services that businesses are willing and able to produce at any given time over a range of prices, and demand is the quantity of goods and services that consumers are willing and able to buy at any given time over a range of prices. These forces work in opposition to one another, and prices dictate the level of each of them. For example, if the price of digital cameras is high, then camera companies tend to produce as many digital cameras as possible. Conversely, consumers tend to buy fewer and fewer digital cameras as prices rise. Prices will therefore rise and fall to accommodate the competing desires of both the buyers and the sellers of digital cameras.

When a government wants to influence economic growth, it can focus on either the demand side or the supply side of the economy. It can use policies focused on spending (social programs, the military, or highways, for instance), taxes (tax increases, tax cuts), and the money supply (the amount of money in circulation) to change the quantities of products people want to buy or the quantities of products companies want to produce.

Supply siders, as those who believe in supply side theory are sometimes called, generally believe that supply creates demand, so they encourage governments to craft policies that will result in increased production. Often this translates into a consistent program of tax cuts, especially cuts in income taxes (the taxes individuals pay on the money they earn each year) and in taxes that affect businesses. The money that individuals and businesses save will, in the view of supply siders, be invested in businesses, which will increase production and cause the economy to grow.

When Did It Begin

In the eighteenth and nineteenth centuries, most economists believed that supply was more important than demand. When supply was high, the economy prospered. Consumer demand was of only secondary importance. The so-called classical economists of these centuries are generally seen as providing the ideological basis for the supply side theory of the late twentieth century.

In between these two eras, governments largely focused on the demand side of the economy. This was a result of the Great Depression, which began in 1929 and lasted through most of the following decade. During the Great Depression people lost their jobs in huge numbers, and factories and businesses of all types closed down in droves. With no jobs people had no money to spend on what they wanted and needed; hence, there was a shortage of demand in the economy. Companies had no incentive to supply products, since there was no one to buy them. The forces of supply and demand had essentially lost their power to regulate the economy.

The British economist John Maynard Keynes argued that government was the only force that could pull the economy out of such a depression and that it could do so by spending money. By spending money the government would move funds out of its own coffers and into the hands of private citizens, who would begin to demand products. Once there was demand for their products, companies would begin to supply those products again, and the economy would eventually recover. The United States and other governments followed Keynes’s theories and managed to pull themselves out of the Depression. Accordingly, most governments continued to focus on the demand side of the economy in the decades that followed.

But in the 1970s the United States experienced high inflation (the rising of prices across the economy, which makes money lose its value) as well as high unemployment (large numbers of people wanted jobs but could not find them). Some economists blamed this situation, called stagflation, on Keynesian economic policies, so the stage was set for what became known as the supply side revolution.

More Detailed Information

Keynesian economic policies justified the existence of high tax rates and other forms of government intervention in the economy. These policies were blamed for the struggling economy of the 1970s, and a number of economists and political conservatives began proposing other ideas for economic growth.

One of the most important of these, in the context of supply side theory, was the economist Arthur Laffer. In the late 1970s Laffer put forward the notion that high tax rates did not necessarily result in high tax revenues (the amounts of money actually collected by the government). He argued that cutting taxes could actually result in both higher revenues for the government and higher take-home salaries for individuals. This was because people who got to keep more of the money they earned would have more incentive to work hard. People who work hard produce more goods and services than people who work less hard. The increases in production would lead to increases in demand, and the resulting economic growth would increase the amount of total income for the government to tax.

In addition to tax cuts, supply side theory usually recommends that the government should decrease its regulation of business and provide other incentives for increases in production, such as tax breaks (amounts of money that can be deducted from the taxes owed to the government) for companies that invest in new equipment. Supply siders also often insist on the importance of free trade (the reduction or elimination of restrictions on goods imported from foreign countries) and the free movement of capital (the unhindered ability of money and other resources to move across borders), believing that restrictions on trade or capital movement negatively affect production.

Some of the most dedicated supply siders believe that the money system should be based on the gold standard. This means that they believe the value of, for instance, a dollar should be linked to the amount of gold that a dollar is worth. While this was once the way that most nations determined the value of their money, that has not been the case in the United States since 1971, when President Richard Nixon ended the nation’s reliance on the gold standard, which was hampering the economy. Instead, the value of U.S. money has since been determined by the amount of money in circulation, and the government controls this variable through its central bank, the Federal Reserve System.

Supply side economics was popularized by Ronald Reagan, the U.S. president from 1981 to 1989, who came to office promising to reduce the income tax for all Americans as well as taxes on corporations and investors. Reagan was said to have been strongly influenced by Laffer’s notion that the government could collect more taxes by lowering the tax rate. Under Reagan the U.S. Congress cut taxes by 25 percent. Reagan also initiated cuts in spending for education and welfare (various programs that provide aid to the poor and unemployed) and for government agencies such as the Environmental Protection Agency and the Civil Rights Division of the Department of Justice. Reagan simultaneously increased military spending by $1.5 trillion over five years.

Some critics of supply side economics, therefore, argued that the theories promoted by economists such as Laffer were actually smokescreens for conservative ideology. Conservatives had long supported decreases in tax rates without basing their desire for lower taxes on any sound economic theory, and they had likewise long criticized social programs such as welfare as wasteful and had been scornful of environmental and civil rights protections. Likewise, one of the only forms of spending not criticized by Republicans of the time was military spending.

Recent Trends

According to Reagan’s supporters, the supply side tax cuts he instituted were largely responsible for the enormous economic growth that the United States experienced, with minimal interruptions, between 1982 and 2000. Critics have argued that Reagan’s policies primarily benefited the rich, and that these benefits were often gained at the expense of the poor. Some people agree that Reagan’s economic policies are at least partly responsible for the economic prosperity enjoyed by at least some Americans in the 1980s and 1990s, but they argue that Reagan was in fact acting like a follower of Keynes rather than a true supply sider. They point to the fact that he increased government spending even though it meant going into debt. This form of spending, called deficit spending, had been advocated by Keynes.

The legitimacy of supply side theory has never been firmly established or rejected. While in the 1990s and in the early twenty-first century it was out of fashion among mainstream economists, tax policy since the time of Reagan has been greatly tied to supply side notions. Both Republicans and Democrats, since the time of Reagan, have generally supported tax cuts meant to stimulate supply, and the idea that tax cuts lead to economic growth has been accepted as fact by many people across the political spectrum.

About this article

Supply Side Theory

Updated About content Print Article