In the early 1980s supply-side economists promised that disinflation was possible without unemployment. The 1981-1982 recession punctured that hope. But supply-side economics made a partial comeback because the recovery from that deep recession was both rapid and prolonged.
Supply-side economics and its effectiveness abroad.
Supply-side economics was all the rage in the United States in 1981, the first year of the Reagan administration. And so-called supply-siders still run a very active publicity machine, proclaiming the correctness of their views in the press and in books.
Supply-side economists lay heavy stress on the incentive effects of taxation in determining the behaviour of the economy. Beyond that broad agreement there are really two separate supply-side groups. The mainstream group stresses the importance of tax incentives in promoting growth, especially by their effect on saving and investment. Similarly, it analyses the effects of tax changes on labour supply, the effects of Social security on saving and retirement decisions and a host of other important issues.
But it was the radical fringe of supply-side group that received most of the publicity during the early 1980s, when Reagan tax cut that determined fiscal policy for the entire decade was put in place. This group made exaggerated claims for the effects of tax cuts on saving; investment and labour supply and for the effects of tax cuts on total government revenue from taxation. Among the intellectual leaders of the fringe was Arthur Laffer, whose curve has become famous. Radical supply-siders were installed in the Treasury and there was an active supply-side group in Congress. The radical fringe argued that 1) tax rate reductions would have such powerful effects on work effort that total tax revenues would rise and 2) the supply-side effects of the tax cuts would have a powerful effect in reducing inflation by increasing the growth rate of output.
In 1981 the Reagan administration presented an optimistic scenario for growth with low inflation that was supposedly justified by supply-side considerations. Tax rates were to be cut significantly but, it was claimed, the rapid increase in growth would keep the budget close to balance. That at least was the public claim.
Radical supply-side economics was thus an essential part of the rhetoric supporting Reaganomics. The most important factor in these policies was the President´s determination to cut taxes. This was done in the belief that the government was too large and that government spending could be cut by denying Congress tax revenue to spend. Arguments by supply-siders that tax cuts would rapidly increase economic growth and reduce inflation were certainly welcome, but it is quite likely that President Reagan would have proceeded with his policies even had he known they would result in massive budget deficits, so long as they would reduce the size of government.
Supply-side predictions were criticised at the time by mainstream macroeconomists. The evidence is that tax reductions do affect incentives and that tax cuts increase output. But there is no evidence that the incentives would be so strong as to result in higher government revenue after a tax cut. Similarly, an increase in the growth rate of output will contribute to reducing the inflation rate-but the effects are unlikely to be powerful.
The events of two years following the Reagan tax cuts do not support the views of the radical supply-siders. Inflation was indeed reduced, but the reduction was a result of tight monetary policy and not of expansionary fiscal policy. Output fell rapidly; it did not increase. These events led to the departure of the radical supply-siders from responsible policy-making positions, but did not slow their claims that supply-side economics (of the radical branch) was the solution for the economy’s problem.
An interesting sidelight on supply-side economics comes from considering the relationship between supply-side economics and monetarism. Both approaches are often associated with conservative political positions. But the two groups of economists are critical of each other. In their policy positions, favouring tax cuts in almost all circumstances and believing also that the Fed should allow rapid money growth to foster rapid output growth, the supply-siders are closer to Keynesianism than to monetarism.
Supply side policies
An alternative or even a complementary policy to demand-side management is to increase the productive potential of an economy, irrespective of the state of aggregate demand. Policy measures, which raise the long run or potential GDP, are known as supply-side policies. Successful supply-side policies raise potential GDP faster than if were it left to the normal process of economic growth. The attractiveness of such policies is that they bypass the uncomfortable trade-off between output and inflation.
The general conclusion is that, regardless of their effectiveness, supply-side policies do not produce immediate miracles. They may increase incentive to raise production; they may be aimed at improving general efficiency; they may require some sectors to decline and free resources for other, more valuable uses. All these measures take time to work, five to ten years, or even longer.
Three broad approaches to increasing the economy’s long-run potential have been examined. First, good supply-side policy should aim to make markets as efficient as possible and when markets fail that test, government intervention can improve matters. Second, given that governments are already interfering in the market place for both good and bad reasons, they should strive to minimise the negative impact of their intervention. One example is regulation; another is taxation; yet another is subsidy policy. Third, unemployment remains a deep concern in much of Europe where roughly 10% of the labour force is out of work.
Taxation and the provision of public goods. Public goods are special because they naturally are non-rival and non-excludable. Being non-excludable, public goods cannot be charged to their users. A toll booth can be installed at a bridge´s entrance, but what price should its owners charge ? Non-rivalry means that the marginal cost of their use is very small; thus the price ought to be low. But fixed costs can be large (a bridge is very expensive to build), so how can the producer be compensated ? In addition, a bridge is a natural monopoly if it is the only one in the vicinity. If the owner charges a high price and makes large profits, market competition will lead to the multiplication of bridges next to each other, a very inefficient outcome.
Markets just cannot cope with such failures, public goods need to be provided collectively (free bridges), or their provision needs to be regulated (privately built bridges are generally subject to strict regulations, including pricing and quality of service).
Public goods are pervasive: transportation and amenities, but also justice and police, passports, defence and diplomacy etc. In each case, there is a market solution, but it is inefficient as not enough-sometimes none at all-would be privately provided. And in each case, the insufficient provision of the public goods would greatly impair economic activity, possibly leading to the breakdown of other, well-functioning markets. This is why the provision of public goods is a fundamental supply-side policy. The more efficient the provision, the more productive the economy will be. Efficiency means that public goods are produced at the lowest possible cost-which also involves issues of corruption. It also requires that resources be collected to finance the production of public services, an issue to which we now turn.
Once a society has agreed to let government perform certain public functions, public resources need to be raised in order to pay for them. This is done through taxation of final goods and services. Taxation generally distorts markets by driving a wedge between the cost of producing goods and services and the price paid by the consumers.
Non-distortionary taxes do not affect economic behaviour. An example would be lump-sum taxes levied on individuals without any reference to incomes, wealth, or spending, or taxies levied unexpectedly on past incomes and wealth so that it is too late to react. For this reason, non-distortionary taxes are appealing to governments. In practice, however, retroactive taxation is considered unfair precisely because it takes people by surprise. Lump-sum taxes are also unpopular, as Mrs Thatcher´s fateful experience with the poll tax in 1990 showed. As a result, nearly all taxes are distortionary.
Laffer curve. Because distortionary taxes move the economy away from its first-best equilibrium, it is entirely conceivable that higher tax rates actually result in lower tax yields. This effect is sometimes called the Laffer curve. This curve describes a theoretical relationship between total government tax revenues and the average tax rate (the ratio of tax receipts to GDP). The tax rate ranges from 0 to 100%; at a 0% rate, tax revenue is nil; when the tax rate reaches 100%, no one is likely to work or produce at all so tax receipts are also nil. At intermediate tax rates, tax receipts are positive. The hump-shape of the curve indicates that the tax rate distorts the economy so much that beyond some tax rate, taxable income declines faster than the tax rate increases. The threshold point corresponds to the average tax rate for which tax receipts are at a maximum. Any rate of taxation to the right of this point is inefficient because the same tax income can be raised with a lower tax rate, i.e. less distortion.
Incentives and taxation
The social safety net. The social safety net refers to the system of transfers and benefits designed to help the disadvantaged and vulnerable in society. These include unemployment benefits, social welfare, old-age pensions, early retirement, health insurance and disability benefits. A large gap divides European countries, which transfer between 20% and 30% of their national income to individuals or firms, from the USA, Japan and Switzerland, which transfer only 10-15%. This might lead a casual observer to conclude that high European unemployment is a product of the “social welfare state”, which puts weight on solidarity but at the cost of productivity and economic efficiency.
Yet it is too hasty to claim that Europeans have erred too far in the direction of social protection, in comparison to the rest of the OECD. The high level of transfers observed in Europe is to some extent a response to high unemployment, which may have other underlying causes. At the same time, these transfers-in the form of unemployment benefits, welfare and premature retirement and disability pensions-take the pressure off workers and firms to adjust to a changing world economy. The greatest danger is that the safety net becomes a trap, leading to long-term unemployment.
It is useful to think about the adverse effects of the safety net on incentives. The social systems of most countries share two institutional features. First, poor or unemployed people receive transfers-income maintenance programmes or unemployment benefits-from the state. Second, income taxes are progressive: the rate of taxation increases as income rises. Taking up a job not only means receiving a salary, but also paying taxes if the salary is high enough and thereby losing eligibility for income maintenance programmes. It is conceivable then that people can be financially worse off by taking a job, not to mention incurring a loss of leisure and possibly some activity in the underground (shadow) economy. Implicitly, these people face an effective marginal tax rate-considering the overall effect of work on their income-in excess of 100%. Recent experience of “work-to-welfare” in the USA indicates that the incentive aspect is important for bringing workers on social assistance back to work.
Labour taxation. Because labour is so important in any economy, it is natural to expect governments to tax it. Labour is one of the most highly taxed “commodities”. Not only is labour subject to income taxes paid by households, but also to a number of social security contributions by both employees and employers.
