Sep 17 2010

Supply – side economists: “lower taxes, more growth, more tax revenue!”

This is a follow up to a recent post to this blog, Hey, what are you Laffing at? The relationship between tax rate and tax revenue

The unbearable lightness of being Martin Feldstein | Free exchange | Economist.com

Supply-side economics, advocated by most Republican politicians, including presidential candidate John McCain, places great emphasis on the idea that investment is the main engine of economic growth, price level stability, and low unemployment. To encourage firms to invest, government should play a minimal role in the economy; taxes should be sufficiently low to incentivize firms to invest, while at the same time government spending should be reduced to avoid crowding-out of private investment.

Without a healthy level of investment, a country’s capital stock wears out and is not replaced, raising costs of production and shifting short-run (and maybe even long-run) aggregate supply leftward. If investment remains sufficiently low, over time an economy’s output could even begin to shrink.

In the article below, The Economist’s Free Exchange explores the relationship between tax rates and long-run economic growth. The Economist takes the position of “supply-siders” who study the impact of tax rates on the level of output. The idea of supply-side economics is that lower taxes encourage more investment and thus higher growth rates.

Here’s the gist of the supply-side argument:

Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

On the other hand…

…we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years.

In the case of the Laffer Curve, which shows the relationship between tax rates and tax revenue, the article concludes that:

Tax cuts don’t exactly “pay for themselves”, but they also don’t diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the origina cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.

Supply-side economics, folks. Understanding the effects of fiscal and monetary policies on not only aggregate demand, but on aggregate supply (both short-run and long-run) is a crucial skill in  answering AP free response questions.

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

19 responses so far

19 Responses to “Supply – side economists: “lower taxes, more growth, more tax revenue!””

  1. James Tsaoon 04 Apr 2008 at 10:08 pm

    In many ways… the idea of supply-side economics makes sense. Though how does the government make sure that a sufficient amount of this increase in disposable income goes to investment? And how long does it take for wealth to 'trickle down?' There is no right or wrong between supply-side economics and demand-side economics, it is a matter of a right balance between the two. If Republicans become too extreme with supply-side economics and do not handle the policies well, it can widen the gap between rich and poor.

  2. optional.xuon 06 Apr 2008 at 9:24 pm

    Of course, if investment were always to increase when tax cuts happened and GDP kept going up and up then supply-side would be great! But I feel skeptical that a decrease in taxes always leads to a three-fold in GDP. So why don't we just have lower taxes every year if the revenue always come back eventually to their original amount? Not reasonable one would say but I feel like it works to some extent but it isn't guaranteed to happen.

    One of those ideal things that don't happen.

  3. Jessica Ngon 07 Apr 2008 at 11:28 am

    In a way, this theory of supply side economics by cutting taxes to promote investment makes sense. But there is a possibility that in an even longer term, the effects will be offset by the increase in aggregate demand. Tax cuts obviously produce increases in aggregate demand as investment increases. However, this may lead to huge inflation, higher than the "healthy" growth rate. Restrictive monetary and fiscal policies will be implemented in order to combat the inflation. This leads to an increase in interest rate and investment will decline, again reducing tax revenue.

    But yet again, this is also theoretical. These theories kind of just goes around in a circle; it's hard, and I'd say it's practically impossible, to determine which one is more appropriate to an economy.

  4. Angel Liuon 07 Apr 2008 at 9:39 pm

    I thought the supply-side economic view is to shift aggregate supply rightward so there's increase in GDP and little inflation, but tax cuts aiming to increase investment is actually shifting aggregate demand. Then after increase in capital stock will aggregate supply shift to the right. Doesn't that take a long time and the result unpredictable?

  5. Chan Min Parkon 07 Apr 2008 at 10:47 pm

    As we said in class, tax cuts don't necessarily lead to more investment and more growth. It may stimulate investment because people have more disposable income. However some people might just work less because they can make the same amount of money since there are tax cuts. Then, investment won't grow as much as anticipated and the economic growth might not be as great.

  6. kevinyehon 08 Apr 2008 at 12:06 am

    In a certain way tax cuts do benefit society from the supply side, but really how much difference is that going to make as opposed to, say, government spending in demandside economics? It's really a matter of politics, then, where the Republicans are just trying to keep the government out of the economy.

  7. kxc.024on 08 Apr 2008 at 6:58 pm

    I'm more of a democrat so of course my views will also be kind of biased. But I personally think that these tax cuts don't benefit as much. While it is true that by cutting taxes, investment and all that will increase, leading to an outward shift of AS, wouldn't it be easier to shift AD outwards? The mathematics do show that there is a larger increase in real GDP when government spending increases, as opposed to tax rebates…

  8. Helenon 08 Apr 2008 at 10:53 pm

    Republicans advocate minimum government intervention in the economy and thus lower taxes, all for the ultimate purpose of encouraging firms to invest. It looks as if supply-side economics cannot stand alone by itself because a weak AD, caused by low investments, cannot stimulate long run economic growth because as we have learned recently, an increase in AS has to be accompanied by an increase in AD for actual long run economic growth to occur.

    Republicans and Democrats alike are giving all these economic rationale for why they support lower (or higher taxes), less (or more) government spending, but I think all of this is just a facade over the fact that the politicians are using the economy as another tool to achieve their political ends.

  9. Kristie Chungon 09 Apr 2008 at 12:30 am

    Well both demand-side economics and supply-side economics can be used, and I don't really think there's really one right way to approach the problems in the economy. Like people have already said, I think the choice of which to implement is influenced by politics.

  10. MichaelChowon 09 Apr 2008 at 8:32 pm

    The quote "Investment is the main engine of economic growth, price level stability, and low unemployment" is reasonable in many ways. And I see a good argument on the overall aspect of the incentive for firms to invest. With the reduction in taxes, the incentives will without a doubt increase. However the argument made in relation to the Laffer Curve shows us that there is a relationship between tax cuts and tax revenues which then "stuns" investment.

  11. Jeewonon 09 Apr 2008 at 9:45 pm

    It makes sense that lower tax rates will provide incentives for firms to invest more, but is it really guaranteed? The supply-side argument that a "tax cut of one percent of GDP increases real output by approximately three percent over the next three years" is probably based on the assumption that the increased disposable income from lower taxes will be spent on investment, which will compensate for the lower tax revenues. Also, like Jessica said, increasing aggregate demand could cause inflation.

  12. kevinmaon 12 Apr 2008 at 6:50 pm

    i agree that this theory makes sense that if we lower tax more people should be investing. However, this doesn't always happen because investors also look at other factors in that country. Also like some previous people said, increasing aggregate demand could also cause inflation which could cause less people to invest.

  13. serenatuon 13 Apr 2008 at 5:02 pm

    Tax cuts do benefit the society, with a tax cut, firms have more incentive to invest and thus causing the supply curve to shift outward to the right. I think demand-side economics and supply-side economics will both be useful, however to determine which polity to use really depends on the politics and the government.

  14. Mondon 14 Apr 2008 at 12:58 am

    I agree with what is being said, both of them work. There is no right or wrong way, as long as it achieves the goal, then who cares which one you choose?

  15. christianoon 02 Sep 2009 at 10:20 pm

    So a tax cut increases the firms' incentive to invest which would shift AD out and which could also shift out aggregate supply in the long run as investments in new technology for example increase the quality of the firms' resources therefore lowering their costs of production and makes them more productive. This would cause real GDP to increase which means that there is more income/ profit for the government to tax. If the increase in GDP is proportional to the tax cut, then government's revenue wouldnt change. This shows that a tax cut does not necessarily cause a decrease in government's tax revenue and a positive thing is that it lowers the burden on firms and households.

  16. Marc Lemannon 03 Sep 2009 at 8:06 am

    Laffer's and supply-side economists' theory is certainly intereseting, and would work in a large concept, but in the real world… would people actually have more of an incentive to work if their taxes are slightly cut, or would they realize that they have to work less to receive the income they need? Research should be done to find out; questioning taxpayers would generate trustworthy responses.

  17. Alexon 09 Nov 2010 at 11:51 am

    I feel as though cutting taxes is necessary to bring a country out of recession…as fiscal policy states. The government will need to intervene, however, in order for this to work. I also agree that investment spending spurs economic growth. However, the investments must be maintained. Today we discussed in my economics class that when GDP increases and the economy is doing well that more competition is created (again another good thing)…BUT this leads to quite a high inflation rate because of the fact that businesses are willing to spend more to keep up with demand for their products. Also, their machinery (I) will become worn-down quicker because of greater usage; therefore, they will spending money in greater quantities because malfunctions are almost not possible for businesses when competition is fierce in a growing economy.

  18. AGon 09 Nov 2010 at 11:52 am

    I feel as though cutting taxes is necessary to bring a country out of recession…as fiscal policy states. The government will need to intervene, however, in order for this to work. I also agree that investment spending spurs economic growth. However, the investments must be maintained. Today we discussed in my economics class that when GDP increases and the economy is doing well that more competition is created (again another good thing)…BUT this leads to quite a high inflation rate because of the fact that businesses are willing to spend more to keep up with demand for their products. Also, their machinery (I) will become worn-down quicker because of greater usage; therefore, they will spending money in greater quantities because malfunctions are almost not possible for businesses when competition is fierce in a growing economy.

  19. Steven Bergeron 09 Sep 2011 at 12:25 pm

    Who's blog software are you using on the site? Hoping I can try to get my own website's feedback appearing more like this format, my design is acceptable but, I've been working on it attempt to get it looking quite as clean as yours.