Economic Report of the President

equired. To the extent that its supply response is less than the additionaldemand it creates, any tax reduction adds to the pressures ofdemand on the rate of inflation.But there are two ways in which such tax cuts can be made whilestill restraining demand. First, tax reductions may offset increases inother taxes. As discussed earlier, inflation pushes taxpayers intohigher tax brackets, so that the average effective tax rate—the ratioof tax revenues to GNP—rises. Consumption is depressed and economicgrowth reduced. In the years ahead, periodic tax reductionswill therefore be both possible and necessary to keep aggregatedemand from falling. Second, a tax reduction accompanied by Federalspending reductions of roughly the same magnitude will notchange aggregate demand; hence, even if the supply response to atax cut is smaller than the demand response, inflationary pressureswill not be generated.Thus, it is clear that the design and timing of supply-oriented taxcuts depend importantly on the specific relationship between thedemand-side and supply-side responses. If such tax reductions fail togenerate enough supply to offset the additional demand theycreate—and the evidence discussed below suggests this to be thecase, particularly for personal tax reductions—they must then be integratedlike any tax cut into policies of demand management.THE SUPPLY-SIDE RESPONSE TO PERSONAL TAX CUTSA 10 percent reduction in marginal tax rates on individuals (approximatelya $30-billion personal tax cut in 1981) would increasethe total demand for goods and services by $60 billion, or 2 percentof GNP. It could also lead to increases in individual work and savingin response to the lower tax rates and thereby increase potentialGNP. How much of the increase in demand would be matched bysuch increases in supply?The Supply of LaborThe additional production that results from lowering taxes onlabor income depends both on changes in the quantity of labor supplied(i.e., the total number of hours worked) and on changes in theaverage productivity of labor.Higher after-tax wages make work more attractive. This encouragesnew entrants to join the labor force and those already employed towork longer hours. Since after-tax incomes have risen, however,people can also afford to work less—to take longer vacations or toshorten their workweeks. Whether the former effect would or wouldnot exceed the latter effect is hard to predict. A preponderance ofthe evidence suggests that for adult men the two effects approximatelyoffset each other; that is, a cut in income taxes increases the80