Supply Side Economics(Defeats Keynesian Economics)

Jamie KadonskyElliot Boettcher

• Why should we use supply side economics?– Economic growth can be most effectively created

by lowering barriers for people• Adjusting income tax and capital gains tax rates• Allowing greater flexibility by reducing regulation

– Consumers will benefit from a greater supply of goods and services at lower prices

• Supply side economics – Higher income levels and living standards cannot

be achieved without expansion in output – Supply-side economics is used to describe the

changes in marginal tax rates• The percentage of that next dollar of income that you'll

actually be allowed to keep is 100% minus your marginal tax rate

• Marginal Tax– High marginal tax rates strongly discourage income,

output, and the efficiency of resource use– Typical policy recommendations of supply-side

economics are lower marginal tax rates and less regulation

– Reveals how much of one’s additional income must be turned over to the tax collector, as well as how much is retained by the individual

-Affects the incentive to earn

• Marginal Tax– An increase adversely affects

the output of an economy in two ways• First, the higher marginal rates

reduce the payoff people derive from work and other taxable productive activities.– Higher rate = less money for

taxpayers• Thus, when marginal tax rates

rise, some people—those with working spouses, for example—will opt-out of the labor force. Others will decide to take more vacation time, retire earlier, or forgo overtime opportunities.

• Marginal Tax– High tax rates will even drive highly productive

citizens to other countries where taxes are lower – High marginal tax rates encourage forms of tax-

avoidance taxpayers facing high marginal tax rates will spend on pleasurable, tax-deductible items • Such as plush offices, professional conferences held in

favorite vacation spots, and various fringe benefits.

– Real output is less than its potential because resources are wasted producing goods that are valued less than their cost of production

(HIGHER TAXES) (LOWER TAXES)

• Critics of supply-side economics point out that a 10 percent change in after-tax wages increases the quantity of labor supplied by only 1 or 2 percent. This suggests that changes in tax rates would exert only a small effect on labor inputs.

• These estimates are of short-run adjustments– Compare countries, such as France, that have had

high marginal tax rates on even middle-income people for a long time with countries, such as the United States, where the marginal rates have been persistently lower

• Recent work by Edward Prescott, co-recipient of the 2004 Nobel Prize in economics, used differences in marginal tax rates between France and the US to make such a comparison. Prescott found that the elasticity of the long-run labor supply was substantially greater than in the short-run supply and that differences in tax rates between France and the United States explained nearly all of the 30 percent shortfall of labor inputs in France compared with the United States.

• The supply-side economic policy of cutting high marginal tax rates, therefore, should be viewed as a long-run strategy to enhance growth rather than a short-run tool to end recession.

• Changing market incentives to increase the amount of labor supplied or to move resources out of tax-motivated investments and into higher-yield activities takes time.

• The full positive effects of lower marginal tax rates are not observed until labor and capital markets have time to adjust fully to the new incentive structure

• Because marginal tax rates affect real output, they also affect government revenue.

• An increase in marginal tax rates shrinks the tax base, both by discouraging work effort and by encouraging tax avoidance and even tax evasion. – An increase in tax rates leads to a less than

proportional increase in tax revenues.

• The bottom line is that cutting all rates by a third will lead to small revenue losses (or even revenue gains) in high tax brackets and large revenue losses in the lowest brackets. – As a result, the share of the income tax paid by

high-income taxpayers will rise.

• And to spice up the presentation….

WHY KEYNESIAN ECONOMICS IS WRONG…

• As the Keynesian perspective triumphed following WWII, most economists believed tax reductions affect output through their impact on total demand.

• The potential supply-side effects of taxes were ignored.

• However, in the 1970s, as inflation pushed more and more Americans into high tax brackets, a handful of economists challenged the dominant Keynesian view.

• Led by Paul Craig Roberts, Norman Ture, and Arthur Laffer, they argued that high taxes were a major drag on the economy and that the top rates could be reduced without a significant loss in revenue. They became known as supply-side economists.

• During the presidential campaign of 1980, Ronald Reagan argued that high marginal tax rates were hurting economic output, but contrary to what many people think, neither Reagan nor his economic advisers believed that cuts in marginal tax rates would increase tax revenue

• Keynesian continued to focus on the demand-side effects, claiming that it was irresponsible to cut taxes at a time when inflation was already high.

• They expected the rate cuts to lead to larger budget deficits, which they did, but also that these deficits would increase demand and push the inflation rate to still higher levels.

• Contrary to the Keynesian view, the inflation rate declined substantially from 9 percent during the five years prior to the tax cut to 3.3 percent during the five years after the cut.

• Furthermore…– Supply side = WIN!• Thinking about the future• Adds to deficit… BUT inflation rate decreases• Low marginal tax rates = more income, output, and the

efficiency of resource use

– Keynesian = LOSE!• Thinking only about now• Adds to deficit… AND no new money is in circulation• High marginal tax rates = less income, output, and the

efficiency of resource use

Supply Side, The Better Side