What Is Supply-Side Economics?
What is it and Does it Work?
“Supply-side economics” AKA “trickle-down economics” AKA “Reaganomics”, is the economic theory that states production is the most important factor in driving economic growth.
Those who prescribe to supply-side economics believe that tax cuts on businesses will entice entrepreneurs to start new businesses and incent current businesses to invest more and increase production.
As businesses reinvest their new-found tax savings, they will hire more workers, increase wages and economic benefits will “trickle-down” from businesses to workers, and the rest of society.
Supply-side economics stands in stark contrast to Keynesian Economic theory which is a school of thought that believes government intervention is necessary to maximize economic output.
Vertical Supply Curve
Supply-siders, as the name suggests, believe that supply is more important than demand. They believe that an increase in supply will increase output and lower prices. Put simply, they believe if companies produce more of their products, prices will drop throughout the economy.
Many supply-siders believe that demand is irrelevant.
- They do not believe higher consumer demand will lead to increased output.
- They believe the only thing that will increase output is an increase in production (supply).
- This amounts to a nearly “ vertical” supply curve as illustrated below.
A vertical supply curve implies that consumer demand is essentially meaningless. Shifts in the demand curve would have little or even no impact on prices or output. This gets to the central theory behind Supply Side economics which is that only businesses can drive economic growth and that consumers have little or no impact on the economy.
Politics
The very nature of supply-side economic theory creates an unavoidable political divide. Since supply-side economics advocates for lower taxes on corporations and the wealthy along with fewer regulations supply-side economics is considered to align with right-wing ideology.
Therefore, it should be no surprise that supply-side economics was brought into the mainstream conciseness by the former Republican president, Ronald Regan. Hence, one of its nicknames being “Reaganomics”.
It should be noted that a vertical supply curve is only theoretical. Many economists believe the idea of a vertical supply curve
In general, the supply-side theory has three pillars: tax policy, regulatory policy, and monetary policy.
Does It Work
The government can impact the economy through its fiscal policy which can take two forms;
- Increased government spending
- Tax cuts
Cutting taxes is a form of fiscal stimulus, so it will have positive short-term economic impacts. However, I have not seen any evidence that compels me to believe that focusing on tax cuts for the wealthiest among us is an efficient way to stimulate the economy.
To understand why let’s quickly review the high-level equation of GDP.
GDP= G+C + I +(N-X)
Where
G= government spending
C= Consumption
I= Investment
(N-X) = Net exports (exports minus imports)
We have data that shows that 70% of U.S GDP comes from consumer spending AKA Consumption, the “C” in the GDP equation.
If we increase consumption, we stimulate the economy. Given that knowledge, I don’t believe tax buts focused on the wealthy is the most effective way to stimulate economic growth.
Tax cuts or spending targeted at low-income individuals, however, would likely do a better job at increasing consumption and therefore stimulating economic growth.
To understand why putting more money in the hands of poor people, rather than wealthy people could stimulate the economy lets review a term from Economics 101: “The Marginal Propensity to Consume” (MPC).
Basically, a person’s MPC tells us this: “If you were given an extra dollar of income, how much of that dollar would you use to buy stuff and how much would you save?”.
The MPC for rich people is much lower than that of poor people.
If you give a dollar to a rich person, they are likely to save that dollar rather than spend it because they already have their consumption needs being met.
If you give a dollar to a poor person, they are likely to spend that dollar rather than save it.
They will spend that dollar at local businesses, which will increase revenues and potential profits for that business, allowing that business to reinvest its profits by hiring new employees. Those employees take their wages and spend it at local businesses creating a virtuous cycle of economic activity.
To really dumb it down, putting money in the hands of low-income individuals will increase “C” and therefore increase GDP.
That is not to say that I believe we should increase taxes on businesses, but if the goal is to increase GDP tax cuts and spending aimed at the lower class would be an effective way to achieve that goal.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
