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 "voodoo economics."

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 contributions for 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 sufficient demand.

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 working.

What supply-side economists pointed out to Keynesians is that high tax rates did not control inflation. Instead, high tax rates contributed to inflation.

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 problems.

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 US.

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.


Paul Craig Roberts [email him] is the author of Alienation and the Soviet Economy and Meltdown: Inside the Soviet Economy, and is the author with Lawrence M. Stratton of The Tyranny of Good Intentions : How Prosecutors and Bureaucrats Are Trampling the Constitution in the Name of Justice. Click here for Peter Brimelow's Forbes Magazine interview with Roberts about the recent epidemic of prosecutorial misconduct.