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uNIVERSITY OF ARIZONASupply Side Economics: Taxes, Labor and Income
How economic theories of the Classical and Neoclassical Schools make societies better off in practice
LASC 393 Sylvia Mioduski
Jordan
TABLE OF CONTENTS
TABLE OF CONTENTS 2
TABLE OF FIGURES 3
Introduction and Thesis 4
Summary of Two Competing Theories: Supply Side Economics (SSE) vs. Demand Side Economics (DSE) 5
Digging deeper into J.M. Keynes’ Demand Side Economics (DSE) 6
Digging deeper into Supply Side Economics (SSE) 9
How TAX REVENUE increased using SSE in the 1980s with lower TAX RATES 10
SSE IN THEORY: RELATIONSHIP OF LABOR, UNEMPLOYMENT AND FEDERAL REVENUES 12
SSE IN PRACTICE: RELATIONSHIP OF LABOR AND FEDERAL REVENUES 12
SSE Theory: the INTEREST RATES drive economic growth through lower INFLATION 14
SSE in Practice: how tax policy caused higher WAGES in 1980s America 16
SSE in Theory: How tax policy can raise INVESTMENT 18
SSE in Practice: how tax policy caused higher INVESTMENT in 1980s America 19
SSE Theory: how Laffer’s curve demonstrates successful application in 1980s America 21
CONCLUSION: SSE in Theory and Practice in 1980s America 21
WORKS CITED 25
TABLE OF FIGURES
Figure 1a: Income Tax Rates vs. Federal Tax Receipts 11
Figure 1b: Regression of Income Tax Rates vs. Federal Tax Receipts 11
Figure 2a: Income Tax Rates vs. Unemployment 13
Figure 2b: Regression of Income Tax Rates vs. Unemployment 13
Figure 3a: Income Tax Rates vs. Inflation Rates 15
Figure 3b: Regression of Income Tax Rates vs. Inflation Rates 15
Figure 4a: Income Tax Rates vs. Real Wages 16
Figure 4b: Regression of Income Tax Rates vs. Real Wages 17
Figure 5a: Income Tax Rates vs. Real Investment 19
Figure 5b: Regression of Income Tax Rates vs. Real Investment 20
Introduction and Thesis
Since 1930 many economic beliefs rested on the supposition that the practice of Demand Side Economics (DSE) is the most effective method of raising the real wealth of nations, businesses, and households. Also called Keynesian economics after the 20th century British economist John Maynard Keynes, stimulating the economy in the 1940’s, 1960’s, and 1970’s using Keynes’ DSE methods may have worked to a degree. Since then it has been considered by some of the following : academic economists, members of the federal government and Federal Reserve System, leaders in the financial and banking industry, Big Business and Small Business leaders, and even members of the voting public to be the most effective policy in both the short-run and the long-run. Government spending assists a languishing economy, they believe. However, there are consequences to such thinking and actions of DSE that diminish the real wealth of nations, businesses, and households. Short-term spurts that result from DSE intervention come at high expense because taxes must be raised to finance this government spending and such taxes lower real wealth for businesses and households. Consumption being a function of income, households must pay taxes, given by the formula (1/1-b)*-t[1]. Spending will decrease and society will be worse off, say opponents of DSE.
Supply Side Economics (SSE) is the antithesis of Keynes’ DSE. Advocates of SSE believe taxes should be reduced in order to increase federal revenue: reducing taxes increases the incentive to work, spurring business investment and higher household income and therefore aggregate demand (Y). Supply Side Economics is the dominant theory and I will use it throughout this paper to show SSE is relatively more effective than DSE in practice. I think that interventional government-based demand is inauthentic and causes mispricing in the key variables of a healthy economy: labor, investment, savings, and wages become distorted. My thesis is that Supply Side Economics (SSE) makes society better off as measured by improvements in the six key economic variables of tax rates, federal tax receipts, labor employment, inflation rates, real wages, and real investment.
I will show there is ample data which prove that Supply Side Economics is effective in the long run as interpreted by and used by the Reagan administration in the 1980s in the United States. I will also mention the similar effects of Supply Side Economics in the United Kingdom during the Margaret Thatcher Administration.
Summary of Two Competing Theories: Supply Side Economics (SSE) vs. Demand Side Economics (DSE)
Understanding the relationships of the many variables of an economy is crucial in economics. Such variables include the following: tax rates, federal tax receipts, labor employment, inflation rates, real wages, and real investment[2]. The relationship one variable has on another, whether its effect is positively or inversely related, is important in dissecting models and understanding economic logic.
Advocates of the two competing theories have been debating which economic prescription is best for a given situation. Given an economic situation, should the free-market approach of the SSE be taken or the intervention approach of the DSE, they ask. During recessions, many DSE advocates believe that spending to induce aggregate demand will stimulate the economy in the short run.
In the 1930’s and 1950’s, DSE policies caused increased total demand in the short run at the expense of long-term economic growth in the long run. Since DSE economics were first practiced in 1930’s America, the nation has been saddled with increasing fiscal deficits from intervention and unnecessary unemployment, ultimately resulting in stagnant real wages for consumers and decreased purchasing power.
SSE incorporates the theories of the Classical and the Neoclassical schools. These two theories together assert economic growth is the result of supply side factors including capital—both human and financial, both labor and land. Changes in prices are the crux of the matter for the SSE. The change in prices influence labor supply and real wages. The process behind this price mechanism is extremely important. It is the interest rate which dictates an adequate amount of money must exist in the economy for production to exist; production exists because the amount of labor is ample. That is, nothing can be consumed if the general population is not employed. To create or increase income, workers offer to firms their labor in the form of time and skill. Subsequently, firms are able to create goods. Because the price of money is the interest rate and the interest rate is non-volatile and always known, both prices and wages are flexible. The current wage can purchase the amount of goods available at the prevailing price. Flexible prices allow consumers to purchase at a given price; shortages and surpluses are short lived and in some circumstances never take place.
Supply Side advocates attack J.M. Keynes’ theory which incorporates unnecessary government intervention and unnecessary fiscal spending. In effect, spending creates larger deficits which consequently reduce economic growth in the long run. In contrast, SSE theorizes saving, investment, interest rates, labor supply and tax rates are pivotal in economic decisions, among firms and households.
Digging deeper into J.M. Keynes’ Demand Side Economics (DSE)
During the Great Depression, Keynesian policies were implemented. Government programs were created and an expansionary policy was put in place to stimulate a lagging economy. With prices rising as a result of government deficits fueled by fiscal spending, taxes were increased. With wages falling as a result of increased government spending, deficits increased. The classical school will claim the cause of the Great Depression was a tight monetary policy, government intervention and an increase in taxes. Businesses were dissuaded by increased costs and taxes. With rising prices, falling wages and inadequate demand, unemployment rose. Contesting Keynes’ theory, Reagan intentionally put a restrictive monetary policy in effect reducing investment and saving; however, in 1982, investment increased in response to a decrease in saving creating a tax revenue increase. These increases are mainly a response of the top 5% income earners who paid more taxes, as a result of the top marginal income tax being decreased from 70% to 28% (Feldstein). This led to an increase in high income earners which resulted in higher tax revenues; more individuals in the top tax bracket being taxed at 23% created $313 billion in government revenue in 1988 versus being taxed at 70% which created only $33 billion in revenue.
Contrast Supply Side results with Keynesian economics. Keynesians believed and to a certain extent are correct, at least in theory, that stimulating the economy by spending fiscally will stimulate aggregate demand, also known as GDP. In response to government spending, labor supply increases; wages will increase but only nominally. This is inflationary. A declining interest rate stimulates investment and consumption ultimately leading to higher output. However we must acknowledge a distinct difference; consumption is a function of income, according to John Maynard Keynes. Persons will consume more as their wage increases. Consumption, in the classical system depends on the interest rate; it dictates wages and output.
MV=PY[3] (or M^d=kPY) are known as the equation of exchange and determine output in the classical system. SSE policies adhere to a self-regulating economy and this equation. The macroeconomic picture builds on the foundation and pillars of supply side economics and its effect on microeconomic activity. There is a direct correlation with taxes, revenues and the Laffer Curve. Arthur Laffer promoted that decreasing the marginal income tax rate has an effect on the size of the labor force, the willingness to work and tax revenue.
Crowding out effect – combating an inadequate investment and saving, an injection of government funds “crowds out” private investment because the private sector lacks funds to spend. Using the formula which determines government investment S+T=I+G (or Savings + Taxes = Investment + Government Spending), a reduction in saving will occur if taxes are increased; rearranging the equation S=-T+I+G. As T becomes larger, as it did in the late 1970’s, consumer income decreases given the formula (Varian). proves as tax rates increase, t, both firms and workers lose income. The government has “crowded out” private investment.
A reduction in taxing high income earners increased saving and capital; increasing the tax base by a flat tax across all workers will offset any leakages and increase federal revenue. These increases are mainly a response of the top 5% income earners who paid more taxes. In response to this reduction, high income earners increased from 116,757 who paid $19,003,420 in taxes to 723,697 high income earners and brought in $99,742,040 as a result of the top marginal income tax being decreased from 70% to 23% (CATO). What Laffer and other proponents proved was the elasticity of the tax rate was high enough to encourage workers to offer labor as a result of reductions in tax rates, increasing the tax base and number of workers. The long run effect of alleviating the federal deficit by cutting spending and increasing the tax base. The tax base, if increased, provides more government revenue. A Positive relationship between the population taxed and the tax base substantiates Supply Side economic theory through increased tax revenues. Laffer proves a positive relationship with the tax base and federal receipts, mainly among the upper class, since they were affected the most by cutting marginal income tax rates from 90 percent to 50 percent and decreasing the capital gains tax. (Laffer).Elasticity between tax rates and tax base determine whether decreasing the rates induce spending and increase the labor supply. A number less than one indicates an inelastic relationship; a group or person does not respond to changes in price, hence demand does not change.
Elucidating his theory more fully, John Maynard Keynes believed as government spending takes place interest rates are driven down. Consider Figure 1 below and the model (1/1-b)*t. S+T=I+G, where b = ?, S = ?, T = ?, I= ?, and G = ?. The variable r (=?), decreasing, becomes more attractive for consumers. Businesses and consumers increase their borrowing. Essentially, the value of their incomes have increased: money is cheaper for household consumption and demand for money increases. Production increases in response to more household demand (Y), or output increases. Keynes was willing to trade off increased demand (Y) from government spending and higher taxes for households.
Digging deeper into Supply Side Economics (SSE)
Broadening the picture of how and why supply side economics does work, we’ll analyze policy decisions made during President Ronald Reagan’s two terms in office and economic impact as a result of these policies. In addition to the U.S. Ireland using the same policies received the same feedback by cutting tax rates from 30% to 12.5% (CATO). Federal Reserve Chairman Paul Volcker, attempting to control inflation, sold bonds, thereby tightening the money supply, while the Administration reduced spending. Volker’s decision accomplished two things. Interest rates rose and saving increased while investment fell temporarily.
The enactment of the 1986 tax cut legislation accomplished this (Gwartney). Inflation was reduced from 9.6 percent to 3.3 percent in just 5 years, through a reduction in government spending (Gwartney).
Classical and Keynesian economics depart from each other in several areas. Only two are important. Keynes attacked, for better or worse, the assumption that interest rates determine consumption; he contested it is impossible to predict the future and therefore consumption could not meet the supply of goods. Perfect information is an unreasonable assumption, closely related to disagreement regarding interest rates. His belief was government intervention was necessary to revitalize aggregate demand to expand an economy. Keynesian’s attack on supply side economics, adamantly stating that tax cuts, especially during an economic downturn will only exacerbate the recession. Inability to finance government spending is counterproductive. Keynes believed liquidity of money was not important and therefore was relatively inelastic; Money demand was not important.
Money plays a vital role in supply side economics. Money demand was elastic after Paul Volcker, in 1983, restricted the money supply causing interest rates to rise sharply. The inverse relationship between interest rates and investment was crucial and validated or debunked whether supply side economics was in theory viable. This reduction in investment by businesses and government caused a recession. CPI fell to 12.5% from 13.29%. (Inflation.eu) Many believe this policy move was unnecessary and catastrophic. Under President Franklin D. Roosevelt, the Federal Reserve performed the same action which exacerbated the Great Depression. Unemployment increased and prices rose during that time. When inflation is kept in check, full output can be maintained without upward pressure of prices causing output to fall and unemployment to occur. Our economy was, at least for a short time, in a recession. Eventually, falling prices would stimulate investment and decrease unemployment.