What is Supply-Side Economics?

by John R. Hendrickson

Supply-side economics and the supply-side theory became popular with the election of Ronald Reagan as President in 1980. President Reagan, who championed limited-government and free- enterprise economic policies, believed that not only did the scope and size of the federal government have to be reduced, but also the national economy desperately needed tax reform. President Reagan inherited a severe recession with high unemployment and inflation, and one of the fiscal policy tools that Reagan used to bring about economic recovery was using tax reform based upon supply-side economic theory. Supply-side economics refers to utilizing “marginal tax rate reductions as a means of stimulating economic growth.”[1]

The supply-side theory of economics was supported by a number of academic economists and politicians who believed in and were advocates of limited government and classical economics. The founder of classical economics was Adam Smith, who wrote The Wealth of Nations, which challenged the mercantilist economic system which had dominated Europe:

The main feature of classical economics, which began with Adam Smith, was its focus on the price system. Prices embodied all available knowledge about the supply and demand for goods and services and would instantly adjust to take account of new information. Thus, maintaining price flexibility through free markets was essential to allocate scarce resources efficiently and to maximize social welfare. Governments played no major role in the classical system, other than enforcing property rights and guaranteeing the value of the currency.[2]

Supply-side economics “was not a fully integrated school of economic thought, but rather a new way of presenting forgotten truths of classical economics.”[3] Other schools of economic thought such as the Chicago school, as influenced by the ideas of the late economist Milton Friedman, also advanced the theories of classical economics through free markets.

Some of the economists who championed the supply-side theory include Arthur Laffer, Larry Kudlow, Paul Craig Roberts, Robert Mundell, among others.[4] In addition journalists such as conservative columnist Robert Novak and writers of The Wall Street Journal such as Robert Bartley and Jude Wanniski, who “wrote the first book explicitly devoted to supply-side economics, The Way the World Works, were all influential in advocating supply-side ideas and policies.”[5] This also included numerous politicians who shared a similar view of the benefit of free markets and low tax rates on an economy.

The supply-side theory also challenged the prevailing Keynesian theory, named after the British economist John Maynard Keynes, which argued for “deficit spending to stimulate aggregate demand in the economy; in other words, to provide purchasing power to allow consumers to buy goods, thereby stimulating additional production.”[6] Keynesian economic theory dominated economic thought during the Great Depression of the 1930s and into the post-World War II era of national economic policy. President Franklin D. Roosevelt’s New Deal, as an example, advocated Keynesian-style economics through its many public works programs such as the Works Progress Administration (WPA) and the Civilian Conservation Corps (CCC) among others. President Barack Obama is currently using Keynesian-style policies most notably with his $850 billion economic stimulus package and his additional call for more stimulus in the American Jobs Act.

Supply-siders were highly critical of President Roosevelt’s New Deal policies and blamed the severity of the Great Depression on the government interventionist policies of not just Roosevelt, but also President Herbert Hoover, who in the eyes of supply-siders, committed the  gravest sin of all by signing into law the infamous Smoot-Hawley Tariff, which raised tariff rates. Supply-siders also share in the view of Milton Friedman that the Depression was caused by the Federal Reserve, which contracted the money supply.

Supply-siders also give credit to the successful economic policies in the 1920s under Presidents Warren G. Harding and Calvin Coolidge, both of whom slashed government spending and tax rates. Secretary of the Treasury Andrew Mellon, who served in both Administrations, was one of the chief architects of the Harding and Coolidge economic policies, and he argued that lower tax rates would lead to economic growth. In fact the Harding-Coolidge policies led to substantial economic growth as well as reductions in government spending and the national debt. Although, Harding, Coolidge, and Mellon share a similar conservative economic philosophy with the supply-side theory, it can be debated if they were in fact early proponents of supply-side economics. The reason for this includes their support for protective tariffs and their belief in the moral necessity of balanced budgets.

The heart of supply-side theory focuses on the importance of low tax rates to stimulate economic growth. This aspect of the supply-side theory was explained by Arthur Laffer and the Laffer Curve, which is still a major part of tax policy debates today. The Laffer Curve demonstrates “that government revenue declines if tax rates are too high and rise if such rates are reduced.”[7] In other words high tax rates will hinder “the incentive to work, save, and invest,” while a “tax-rate reduction, therefore, would restore incentives and stimulate production.”[8] Therefore supply-side tax reductions create economic growth by providing the economy with incentives for growing.

The first major example of a supply-side tax cut occurred under President John F. Kennedy, who was a liberal Democrat, but realized the need to push for tax reductions to stimulate the economy. President Kennedy’s tax cut “slashed the top income tax rate from 91 to 70 percent.”[9]  The Kennedy tax cut also lowered the bottom income tax rate “from 20 percent to 14 percent.”[10] Arthur Laffer, Stephen Moore, and Peter Tanous in The End of Prosperity: How Higher Taxes Will Doom the Economy — If We Let It Happen argue that the Kennedy tax cuts led to a period of economic growth and the benefits included:

• Those tax cuts spurred economic growth and job creation. Total national employment grew by more than 1 million jobs in the four years after the enactment of the Kennedy tax cuts. The economic growth rate climbed from 4.3 to 6.6 percent.

• Those tax cuts generated an increase in tax revenues, which helped balance the budget. Total income tax receipts grew from $48.7 billion in 1964 to $68.7 billion by 1968.

• After tax rates were cut, Americans increased their work effort, businesses increased their investment spending, and the economy accelerated into a higher gear of economic growth…[11]

Although Kennedy has received credit for his tax reduction plan it was not until Ronald Reagan became President that the supply-siders had an actual supporter in the White House. Reagan called for a return to constitutional limited-government along with a free-market economic policy which challenged directly New Deal and Great Society policies that had dominated government since the 1930s. In fact Reagan’s economic policies became known as “Reaganomics,” which also was another term for supply-side economics. The policy objectives of Reagan’s economic plan included:

• Reduce personal income tax rates.

• Eliminate inflation and restore a strong dollar.

• Downsize the government and balance the budget.

• Deregulate key industries like energy, financial services, and transportation.

• Expand free trade and embrace globalization.

• Win the Cold War by rebuilding the military.[12]

President Reagan met his policy objectives by “reducing the top income tax rate from 70 percent to 50 percent,” and later “the top rate was further reduced to 28 percent — its lowest level since the 1920s.”[13] The Reagan economic program, largely driven by the across-the-board tax reductions generated a period of long-term economic growth.

President George W. Bush followed suit in pushing for Reagan-style tax cuts, which Congress agreed to and were actually recently renewed by Congress. As economic historian Burton Folsom wrote:

In 2003, President Bush promoted a series of tax cuts: the capital gains tax was cut from 20 to 15 percent; the dividend tax from 39.6 percent to 15 percent; the top income tax rate from 39.6 percent to 35 percent; and the tax on business machinery and equipment was lowered.[14]

The Bush Tax Cuts led to a period of “economic growth and created eight million jobs from 2003-2007.”[15] Folsom credits the tax cuts to be President George W. Bush’s greatest accomplishment.[16] The debate over the future of the Bush Tax Cuts will be vital to the economy, because even though President Barack Obama reluctantly agreed to renew the cuts, his rhetoric and policies have not been friendly to supply-side policies.

The supply-side economic theory has made a lasting impact not only on the intellectual side of economic thought, but also in formulating substantial policies that lead to economic growth. Most of the current Republicans who are seeking the party’s presidential nomination are advocating policies rooted in the tradition of supply-side theory. History has demonstrated that across-the-board tax reductions have led to periods of economic growth and prosperity.  Supply-side economics along with limited-government policies are a solid blueprint to not only reverse the current economic malaise, high unemployment, and out-of control spending, but also provide incentives for economic growth and expansion. 

John R. Hendrickson is a Research Analyst at Public Interest Institute. 

The views expressed herein are those of the author and not necessarily those of Public Interest Institute or Tax Education Foundation.  They are brought to you in the interest of a better-informed citizenry.