Supply-side economics assumes that lower tax rates boost economic growth by giving people incentives to work, save, and invest more. A critical tenet of this theory is that giving tax cuts to high-income people produces greater economic benefits than giving tax cuts to lower-income folks.
Essentially, the more money the rich are able to keep, the more the whole economy will grow. But the evidence reveals two fundamental problems with this story. First, its primary prediction is wrong—giving tax cuts to the rich does not increase economic output or create new jobs.
Instead, tax cuts for middle- and low-income taxpayers are much more effective at boosting macroeconomic activity. Second, supply-side theory misunderstands the actual mechanism by which tax rates influence macroeconomic activity. These empirical findings carry an important lesson for our tax policy: Rather than increasing inequality by throwing away revenue on tax cuts for the rich, we should ensure that middle- and lower-income Americans have enough after-tax income to maintain strong consumption levels, especially during economic downturns.
Moreover, by perpetually fetishizing tax cuts for the top rates, conservatives have disregarded other policies that are more effective at spurring economic growth. Supply-side economics starts with a reasonable intuition: If you let people keep more of the income they earn, they will have an incentive to earn more income. Based on this intuition, supply-siders predict that lowering tax rates will encourage people to work, save, and invest more by increasing the after-tax returns from these activities.
And they conclude that all this additional working, saving, and investing will generate faster economic and job growth. One reason is that rich people can afford to work less when tax rates are high, whereas lower-income people need to work enough to make ends meet regardless of the tax rate. Giving tax cuts to the rich therefore should generate a bigger uptick in work.
According to that logic, incentivizing a CEO to work a few more hours a week is thought to be more economically beneficial than incentivizing a janitor to work the same number of extra hours.
A third reason is that rich people can afford to save most of their tax cuts, which in turn will increase investment. In contrast, lower-income people often need to spend the extra dollars. In fact, hourly earnings after accounting for inflation fell during the s, and were flat during the one in the s. But during the s, after the tax hikes, real hourly wages grew by about 1 percent a year.
This assertion, as with the others, is not supported in the data. Not only did government revenues fall during the supply-side era, but the bottom line deteriorated noticeably, too. Publicly held debt rose during both supply-side eras, and fell substantially during the higher-tax period. Bush work? Did they boost investment, spur growth, and cause prosperity to trickle down?
The data says no. And when President Clinton raised taxes in , did the economy suffer a slowdown, as was predicted by those who believe in supply-side economics? Again, the data says no. This data does not mean that higher taxes are always better and lower taxes are always worse for the economy.
That would be making the same mistake that many supply-siders make, but in reverse. Indeed, there were obviously other forces at work in our economy besides tax policies over this year period.
The numbers in this brief have been updated with the latest data, and thus differ slightly from that original paper.
For more information on methodology and a deeper discussion of supply-side theory, please refer to the original publication. Michael Linden , Michael Ettlinger. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights.
Measure content performance. Develop and improve products. List of Partners vendors. Supply-side economics is better known to some as " Reaganomics ," or the "trickle-down" policy espoused by 40th U. President Ronald Reagan. President Reagan and his Republican contemporaries popularized the controversial idea that greater tax cuts for wealthy investors and entrepreneurs provide them with incentives to save and invest, and produce economic benefits that trickle down into the overall economy.
He often quoted the aphorism "a rising tide lifts all boats" to explain his take on the theory. Like most economic theories, supply-side economics tries to explain both macroeconomic phenomena and—based on these explanations—offer policy prescriptions for stable economic growth. In general, the supply-side theory has three pillars: tax policy, regulatory policy, and monetary policy. However, the single idea behind all three pillars is that production i. The supply-side theory is typically held in stark contrast to the Keynesian theory which, among other facets, includes the idea that demand can falter, so if lagging consumer demand drags the economy into recession, the government should intervene with fiscal and monetary stimuli.
This is the single big distinction: a pure Keynesian believes that consumers and their demand for goods and services are key economic drivers, while a supply-sider believes that producers and their willingness to create goods and services set the pace of economic growth.
In economics, we review the supply and demand curves. The chart below illustrates a simplified macroeconomic equilibrium: aggregate demand and aggregate supply intersect to determine overall output and price levels. In this example, the output may be the gross domestic product, and the price level may be the Consumer Price Index. The below chart illustrates the supply-side premise: an increase in supply i. Supply-side actually goes further and claims that demand is largely irrelevant.
It says that overproduction and under-production are not sustainable phenomena. Supply-siders argue that when companies temporarily "over-produce," excess inventory will be created, prices will subsequently fall and consumers will increase their purchases to offset the excess supply. This essentially amounts to the belief in a vertical or almost vertical supply curve, as shown in the chart below. In the below chart, we illustrate the impact of an increase in demand: prices rise, but output doesn't change much.
Under such a dynamic—where the supply is vertical—the only thing that increases the output and therefore economic growth is increased production in the supply of goods and services as illustrated below:. Relatively few economists have received the Presidential Medal of Freedom. Most of them could also boast a Nobel Prize in economics, and all of them had deep records of distinguished academic work or public service, neither of which pertains to Laffer.
He sold the country on the idea that tax cuts were magic. He contended tax cuts would lead to so much investment and economic growth that they would end up generating at least as much government revenue as they cost. In other words, he said tax cuts would pay for themselves. The magical thinking sold to the American people was that giving tax cuts to the rich would improve the lives of the majority. When that idea becomes the basis for government policy, it can have disastrous consequences.
President Ronald Reagan accepted the Laffer Curve hook, line, and sinker. He convinced Congress to enact deep tax cuts in , and tax revenue plummeted.
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