Understanding Supply-Side Economics

DURING THE RECENT DEBATE in our nation’s capital over how best to get the U.S. economy moving, two opposing camps coalesced.

The first, and larger, camp emphasized more government spending, accompanied by tax rebates and temporary tax cuts geared primarily at low-income earners. These were the Keynesians, and their emphasis was on consumption. The second camp emphasized the need for permanent tax relief that boosts incentives for working, investing and risk taking, and helps the economy in both the short run and over the long haul. These were the supply-siders, and their emphasis was on production, subject to the free market.

Economist John Maynard Keynes once declared: “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.” Unfortunately, the defunct economist that continues to enslave many economists, academics, policymakers, elected officials, the media, and Wall Street today is Keynes himself.

While Keynesian economics has long proven a complete failure, with its mistaken emphasis on government fine tuning of the economy (or more specifically, aggregate demand), such thinking continues to hold considerable sway.

The government-centered Keynesian view of the economy certainly has had substantive critics over the years. However, perhaps no other school of economics so audaciously contradicted establishment Keynesian thought and policy as has supply-side economics.

Supply-side economics has been attacked and caricatured by its opponents over the years. In actuality, though, supply-side merely brings the economics discipline back to its microeconomic roots. While Keynesian economics largely concerns itself with government attempts at fine tuning demand and the economy, supply-side emphasizes individual economic decision-making and how government policies impact those decisions.

In summary, supply-side economics is built on the following tenets:

● Incentives matter. Individuals naturally respond to incentives. For example, the relative prices, or costs, of consumption versus investment, or risk avoidance versus risk taking, influence the behavior of individuals, families, and businesses.

● Markets work. The free, unfettered market provides clear incentives – through price and profit signals – that assure that resources are allocated to their most efficient and beneficial uses. So while supply-side economics emphasizes production (see next bullet), it is production within the context of the free market. In order to be of value, production must meet or create a demand. After all, the end point of the entire economic process is consumption.

● Supply comes before demand in the economic process. There are two aspects to the idea that supply takes precedence over demand in the economic hierarchy. First, in the marketplace, one must supply a marketable good or service before one can legitimately demand or consume. That is, as the 19th-century supply-side economist Jean-Baptiste Say noted, “products are always bought ultimately with products.” One must supply something in order to be able to exchange to meet one’s own needs and desires. Or more plainly, you can’t get something for nothing.

Second, supply creates demand. Indeed, no general demand existed for televisions, home computers, or most other products or services, until someone invented and improved upon such products and services.

● The engines of economic growth – working, saving, investing, risk taking, innovating, inventing, and creating– are all supply-side endeavors. Economic growth can only occur through a boost in resources used for production purposes and/or greater efficiencies, innovations, and inventions.

● The entrepreneur – not the government – drives the economy. Supply-side economics recognizes the critical economic role played by the entrepreneur. As the source of new products, services, inventions, and innovations, the entrepreneur serves as the ultimate source of economic growth.

● A healthy economy depends upon sound money. Price instability and inflation are monetary phenomena that increase the risks and costs of saving, investing, and risk taking. Sound money – knowing that a unit of currency will maintain its value months, years, and decades from now – is the necessary foundation upon which an economy can prosper.

Supply-Side Policies

Once one understands the foundation upon which supply-side economics rests, then supply-side economic policies become quite apparent.

Supply-side policy is driven by two “policy levers.” The first is the fiscal lever – tax, regulatory, and spending policies geared toward establishing a pro-growth economic environment. The second is the monetary lever – monetary policy geared to establish price stability upon which an economy can function and flourish. Under the supply-side economics model, economic growth and price stability are not at odds with one another, but are actually complimentary. After all, the most accurate definition of inflation remains “too much money chasing too few goods.” Therefore, economic growth, or the production of more goods and services, is anti-inflationary.

As for the fiscal policy lever, the following policy prescriptions are deeply rooted in supply-side economic thinking:

● Low marginal tax rates. Marginal tax rates – i.e., the tax rate on the next dollar of income earned – influence economic decisions. For example, the marginal tax rate helps determine the relative price of work vs. leisure, investment vs. consumption, risk taking vs. risk avoidance, and so on. Naturally, therefore, supply-side economics places significant importance on reducing marginal income tax rates in order to boost incentives for working, investing and risk taking.

In addition, supply-side recognition that supply comes before demand in the economic order leads to a preference for taxing consumption rather than production. This also makes sense, as consumption is the eventual end point of all economic activity and serves as the most logical point in the economic process to reflect the total cost of government. Of course, as is the case with all taxes, taxing consumption too heavily most assuredly cripples an economy.

● A light regulatory burden. Regulation is simply another form of taxation – though largely hidden from consumers’ eyes. Regulations raise the costs of investment and entrepreneurship, and thereby restrain economic growth and job creation.

● Small, limited government. Under supply-side economics, the primary emphasis is on the total size of government. That is, what are the total resources being diverted from more productive private-sector ventures to less productive government endeavors, whether through borrowing or taxing.

After all, government operates under an abysmal set of incentives. Without the disciplines of prices, profits, losses, and private ownership, government is inherently wasteful, and, therefore, should be quite limited in its duties.

On the secondary level, the relative mix of how government is then financed gains supply-side attention. For example, the relative economic costs of borrowing versus taxing must be considered. Of course, in the long run, most government expenditures are eventually paid for with taxes and fees (or through inflation). However, the mix, timing, levels, and types of taxation help determine the size and growth of the economy.

● Free trade. From a supply-side point of view, eliminating international barriers to trade lowers costs, expands and opens markets and opportunities, enhances incentives for production, boosts competition, improves quality, reduces consumer costs, and expands consumer choices.

As for the monetary policy lever, the only objective of monetary policy should be price stability. A sound currency and stable prices create an environment where investment and the economy can flourish.

Anchoring the dollar to gold – as was the case, to varying degrees, from the end of the 1870s to the late 1960s – still serves as the surest path to price stability.

Some supply-siders call for a gold price rule, where the Federal Reserve targets a certain gold price range, and varies monetary policy accordingly (e.g., price of gold goes above the targeted range, then tighten policy; if the price drifts below the target, then loosen monetary policy). A few others call for a return to a classical gold standard. Either way, the point is to establish a market-based discipline by which to guide monetary policy. Without such discipline, government runs monetary policy according to the whims and often-dubious economic theories of central bankers.

The Supply-Side Record

The record of supply-side economics has come under considerable assault in recent years, particularly as it relates to supply-side policies in the 1980s. Such attacks have been largely motivated by politics and by those favoring continued government micromanagement of the economy. An honest assessment of the results scores quite favorably in supply-side’s favor.

For example, the prominent periods of supply-side tax policies during the twentieth century – 1900 to 1912, 1922 to 1929, 1964 to 1968, and 1983 to 1989 – all show above average rates of economic growth. In addition, economic growth received a big boost in the late 1990s in part due to the 1997 capital gains tax cut, which reduced the tax costs related to investing and entrepreneurship.

Growth during the 1980s also benefited from a decline in the overall federal regulatory burden. According to economist Thomas Hopkins of the Rochester Institute of Technology, the real federal regulatory burden was on a steady decline from the late 1970s through 1988.

As for the size of government, economist Richard Rahn has performed in-depth, informative analyses of the size of government and its effect on economic growth over the years. In 1986, while at the U.S. Chamber of Commerce, Rahn and a group of economists examined the relationship between the total size of government and economic growth in 22 nations. They estimated that government maximized economic growth when it claimed between 15 percent and 25 percent of GDP. Today, government in the United States gobbles up more than 30 percent of GDP.

A more recent study by Rahn and Harrison W. Fox, Jr. (“What is the Optimum Size of Government?” sponsored by the Business Leadership Council and the Vernon K. Krieble Foundation) examined the relationship between economic growth and the size of central governments for the period of 1951 to 1993 for 57 nations. They concluded that growth is maximized when the central government’s share of GDP registered between 10 percent and 15 percent. The U.S. federal government revenues currently capture more than 20 percent of GDP.

As for trade, one of the most costly anti-supply-side measures taken within the past century was the Smoot-Hawley Tariff Act of 1930. As Smoot-Hawley crawled through Congress, it played a major part in the stock market crash of late 1929. Its passage set off a trade war, collapsing international markets, and igniting the Great Depression. In contrast, post-World War II efforts at reducing barriers to trade have been fairly successful, and contributed to both U.S. and global economic growth.

On the monetary policy front, once the final remnants of the dollar’s link to gold disintegrated in the late 1960s (with the gold window officially being closed in 1971), inflation and inflation expectations have loomed as real threats ever since, though to varying degrees. Of course, inflation expectations reflect themselves in interest rates.

Interest rates remained quite low while the dollar was somehow linked to gold until the late 1960s. Once the gold-dollar link was abandoned, they subsequently skyrocketed, and generally have hovered above the levels that were maintained while the dollar was linked to gold.

A Supply-Side Economics Reading List

An Inquiry into the Nature and Causes of the Wealth of Nations (1776) by Adam Smith
A Treatise on Political Economy (1803) by Jean-Baptiste Say
Taxation: The People’s Business (1924) by Andrew Mellon
The Way the World Works (1978) by Jude Wanniski
Wealth and Poverty (1981) by George Gilder
The Economy in Mind (1982) by Warren Brookes
The Supply-Side Revolution (1984) by Paul Craig Roberts
The Growth Experiment (1990) by Lawrence Lindsey
The Seven Fat Years (1992) by Robert Bartley
Money Meltdown (1994) by Judy Shelton

A Supply-Side Agenda for the 21st Century

After reviewing basic ideas, policies, and results, the supply-side economics agenda for the coming century is clear:

Plow expected budget surpluses into pro-growth, supply-side tax reduction.

In the short run, vastly accelerate the implementation of the President’s across-the-board reductions in income tax rates – preferably also deepening those rate cuts – and immediately eliminate two specific taxes that diminish investing, risk-taking, and entrepreneurship: the capital gains tax and the death tax.

Eventually replace our current messy, counter-productive tax system with a low-rate, simple, consumption-based tax. Either a low flat tax or a low-rate national retail sales tax makes sense.

A massive deregulation effort must be undertaken. This means not only rolling back current onerous regulations, but also establishing a system that helps to prevent the imposition and continuation of wrongheaded and costly regulations.

Dramatic reductions in the size of government – federal, state, and local – must occur. Privatization, competitive contracting, and cutbacks in and elimination of wasteful programs must be implemented in order to cut government spending and free up resources for more productive private-sector uses. Shifting Social Security, for example, to a system of privately owned and controlled investment accounts would boost individual returns and free up resources for pro-growth, private-sector investments.

Efforts to tear down trade barriers both at home and in other nations must be stepped up.

Re-linking the dollar to gold would reduce inflation and inflation expectations, cut interest rates dramatically, and as other nations returned to gold, exchange rates would stabilize, reducing risks of international investment and trade.Despite relentless attacks by opponents, supply-side economics not only makes economic sense, but it works. The supply-side emphasis on incentives, free markets, economic growth, the entrepreneur, and sound money claims a long, honored and successful history.

Mr. Keating serves as chief economist for the Small Business Survival Committee (SBSC), a columnist with Newsday, and co-author of U.S. by the Numbers: Figuring What’s Left, Right, and Wrong with America State by State (Capitol Books, 2000). This article is excerpted from “Understanding Supply-Side Economics: The Principles, the Policies, and the Future,” published by the Small Business Survival Committee in May 2001.