What Is Supply-Side Economics?
Supply-Side economics was dubbed "Reaganomics"
by the media. If you were
for Reagan, that meant you were for it. If you were
against Reagan, you were against it. That`s as far as
public understanding ever went.
Even today three decades later few
people beyond economists familiar with macro-economic
theory know what it is. Liberals think it means tax cuts
for the rich and call it "trickle-down economics."
Libertarians believe it is a variant of Keynesian
economics that fuels consumer spending with federal
budget deficits. Conservatives believe it means leaving
more money in the pockets of those who earn it. Other
people think it means that tax cuts pay for themselves.
President Reagan`s vice president, George H.W. Bush,
said it is
Supply-side economics is none of
these things. It is a
theoretical innovation in macro-economics.
The two professional economists who
had the first insights into supply-side economics were
the University of Chicago trained economist,
Norman Ture, and the Canadian economist,
Robert Mundell, a
Nobel prize-winner in economics.
I knew both. When I was a professor
of economics, I reviewed for Mundell scholarly
publication in the prestigious
Journal of Political Economy of which he was
editor. I served in the US Treasury with Ture.
Supply-side economics corrects a
fundamental mistake in Keynesian economics. Most
everyone has heard of
supply and demand, but Keynesian economics, known as
demand management, left out supply.
In Keynesian economics demand is
the important element. Supply responds to demand. The
way Keynesians saw it, demand needed to be high to
maintain full employment. The original Keynesian
economists were very sensitive to unemployment and the
human suffering associated with the
Great Depression. They attributed the depression to
insufficient aggregate demand to keep everyone employed,
and their economic policy was keyed to insuring
Keynesians believed that private
demand would tend toward insufficiency. To guarantee
full employment, Keynesians had the federal government
overspend its revenues, thus adding to aggregate demand
the amount of the budget deficit. There were two ways to
overspend revenues: keep federal spending constant and
cut tax revenues or keep tax revenues constant and
increase federal spending.
Original Keynesians regarded
monetary policy as impotent. They relied on fiscal
policy. Later Keynesians, under assault by monetarists
such as Milton Friedman, corrected this view. By the
time I entered the fray, Keynesians used monetary policy
to pump up demand to provide full employment, and they
used fiscal policy in the form of high tax rates to
control inflation. The Federal Reserve pumped money into
the economy to keep demand and employment high, and
fiscal policy took money away in taxes so that inflation
remained low. Or at least, this is how it was supposed
to work. By the mid-1970s it was obvious that it wasn`t
What supply-side economists pointed
out to Keynesians is that high tax rates did not control
inflation. Instead, high tax rates contributed to
Keynesians believed that fiscal
policy only affected demand. The government could add to
aggregate demand by cutting taxes, for example, and
running a budget deficit, thus overspending the revenues
that taxation drained from the private sector. Or, to
fight inflation, the government could raise taxes to
drain demand from the private sector and not spend the
revenues. But for Keynesians fiscal policy had no effect
on aggregate supply.
Supply-side economists pointed out
that fiscal policies, such as changes in the marginal
rate of taxation, altered relative prices and shifted
the aggregate supply curve, not the demand curve. An
increase in marginal tax rates–the rate of tax on
additional income– reduces the after-tax rate of return
(or earnings) from work and investment and results in a
lower level of supply. Lowering marginal tax rates
increases the rewards to work and investment and,
therefore, increases aggregate supply.
The Keynesian policy caused "stagflation"
and worsening "Phillips curve" tradeoffs between
employment and inflation, because high marginal tax
rates caused a reduction in labor input and a reduction
in the rate of saving and investment. What was happening
was that people and companies were responding to higher
demand by raising their prices instead of their output.
Supply-side economics established
that fiscal policy shifted the aggregate supply
schedule. In his famous economic textbook Nobel
economist Paul Samuelson included me and a diagram
showing that supply-side economics was an argument that
fiscal policy shifted the aggregate supply curve in
contrast with the Keynesian emphasis that it shifted the
aggregate demand curve. Samuelson declared that the real
argument was over the magnitude of the shift.
In other words, the most famous
American economist of the 20th century accepted the
supply-side theory and said its importance for economic
policy depended on its magnitude. Several economists
provided empirical evidence of the magnitude, but the
disappearance of worsening trade-offs between employment
and inflation settled the issue for most.
I myself debated most of the
Keynesian Nobel prize-winners before university
audiences or before annual meetings of economic
associations. When the argument was presented to them,
they understood the point and accepted it. I received a
standing ovation when I gave the annual State of the
Economy address at MIT. The story of how supply-side
economics came to be can be found in my book, The
Supply Side Revolution, published by Harvard
University Press in 1984. A concise technical statement
of the theory can be found under my entry in The
New Palgrave Dictionary of Money and Finance, the
leading reference work for economics.
There is nothing fly-by-night about
supply-side economics. It corrects a Keynesian oversight
and puts aggregate supply back into policy
considerations. As a member of the congressional staff
during 1975-78 working to bring supply-side economics to
the fore, my most important allies were three
Republicans, Jack Kemp and Marjorie Holt in the House
and Orrin Hatch in the Senate, and three Democratic
senators, Russell Long, Lloyd Bentsen and Sam Nunn.
Stagflation and worsening
trade-offs between inflation and employment resulted
from an incorrect economic policy mix that pumped up
demand with easy money while restraining real output
with high tax rates. Supply-side economics corrected
this mistake, and we have not seen the problem since.
Supply-side economics was a major
innovation in macroeconomic theory and economic policy.
It was a correction of an oversight, not a magical
formula. A quarter century ago before the days of the
high speed Internet and US
offshore outsourcing, supply-side economics
revitalized the economy`s ability to grow without having
to pay the price of rising rates of inflation. This
battle was fought and won long ago. Re-fighting it is a
waste of time and energy in an era of new serious
The George W. Bush regime was faced
with no stagflation and no worsening trade-offs between
employment and inflation. The Bush administration did
not use changes in the marginal rate of taxation to
correct a mistaken policy mix or an oversight in
economic policy. Moreover,
global labor arbitrage is causing American jobs to
be outsourced abroad. As Americans are experiencing
declining opportunities to work, the response of labor
supply to better incentives is small. Similarly, US
companies are locating their investments in plant and
equipment abroad. The substitution of foreign for
American labor and the relocation abroad of US plant and
equipment prevent reductions in marginal tax rates from
having any appreciable effect on aggregate supply in the
I am not a partisan of Dubya`s tax
cuts. Income distribution is a legitimate issue. This is
especially the case when offshore production and jobs
outsourcing are destroying the American middle class.
Just as Dubya hides behind
"freedom and democracy" to wage wars of naked
aggression, he hides behind supply-side economics in
order to reward his cronies. There seems to be no
American value or legitimate principle that the Bush
regime is incapable of despoiling.
CREATORS SYNDICATE, INC.
with Lawrence M.
for Peter Brimelow`s
Forbes Magazine interview with Roberts about the
recent epidemic of prosecutorial misconduct.