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Supply-side Economics
Supply-side economics is a branch of economics based on classical theory. Supply-side
economics arose in the 1970s as an alternative to the dominant Keynesian economic theory.
Supply-side economics emphasizes long run economic growth rather than short run economic
stability. Supply-side economics argues that long run economic growth can best be achieved by
maximizing the incentives that producers have to increase production. In other words, by
encouraging the supply side of the economy.
Supply-side Fiscal Policy versus Keynesian Fiscal Policy
Keynesian fiscal policy theory emphasizes using fiscal policy to manipulate aggregate demand in
order to achieve economic stability (full employment) in the short run. But supply-side economists
assert that fiscal policy will also affect the supply side of the economy, both in the short run and in
the long run. Supply-side economists argue that Keynesian fiscal policy has had a harmful effect
on the supply side of the economy.
Keynesian theory has made deficit spending politically acceptable. Since Keynesian theory was
introduced, deficit spending has become the norm for fiscal policy. As mentioned earlier in the
chapter, the federal government has had budgets deficits in all but 12 years since Keynesian
theory was introduced. Deficit spending has led to a growing federal government. It is politically
easier to increase government spending if taxes are not increased at the same time that the
government spending is increased. Deficit spending makes this possible.
Example 7A: In 1929 (before Keynesian theory made deficit spending politically acceptable),
federal government expenditures were equal to about 2.5% of GDP. In recent decades, annual
federal government expenditures have generally been about 20% of GDP. From 2009 through
2011, annual federal government expenditures were over 23% of GDP.
Example 7B: In 1929, federal government expenditures were $3.1 billion. In 2014, federal
government expenditures were $3,504.2 billion. After adjusting for inflation, federal government
expenditures increased by over 80-fold.
The growing federal government has led to higher marginal tax rates in order to finance (most) of
the government spending. According to supply-side theory, high marginal tax rates have a
harmful effect on the supply side of the economy, both in the short run and in the long run. High
marginal tax rates reduce the incentive to earn higher income in the short run. Thus, high
marginal tax rates will tend to reduce SRAS.
High marginal tax rates also reduce the incentive to increase the productive capacity of one’s
resources in the long run. Thus, high marginal tax rates will tend to reduce LRAS. High marginal
tax rates will likely affect LRAS more than SRAS, as illustrated in Example 8 below.
Example 8: If the top marginal income tax rate were increased from 39.6% (the rate in 2015) to
70% (where it was before the tax cuts of the 1980s), not very many surgeons, research scientists,
software designers, etc. would give up their high income careers for something less demanding.
But how many young people would decide that the sacrifice and cost of training to become a
surgeon, research scientist, software designer, etc. was no longer worth the effort?
The importance of incentives is discussed in an appendix at the end of this chapter.
Supply-side economists support lowering marginal tax rates. Lower marginal tax rates will
increase incentives to earn higher income in the short run and to increase the productive capacity
of one’s resources in the long run. Thus, lower marginal tax rates will increase production in both
the short run and the long run.
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Fiscal Policy 9 - 6