Supply-Side Theory Definition

What is supply theory?

The theory of supply is an economic concept according to which the increase in the supply of goods leads to economic growth. Also defined as supply side tax policy, the concept has been applied by several US presidents with the aim of stimulating the economy. Broadly, supply-side approaches target variables that enhance an economy’s ability to supply more goods and services.

While some economists are strong supporters of supply theory, others have opposed it. Critics argue that supply theory is fundamentally flawed (i.e., supply by itself cannot create demand), and empirical evidence has repeatedly shown its failures in practice as policy (for example, in the case of the Kansas tax cuts which failed to generate growth).

Key points to remember:

  • Supply-side economics holds that increasing the supply of goods results in economic growth for a country.
  • In supply-side fiscal policy, practitioners often focus on lowering taxes, lowering borrowing rates, and deregulating industries to foster increased output.
  • Supply-side fiscal policy was formulated in the 1970s as an alternative to Keynesian demand-side policy.
  • The validity of this theory remains disputed on both theoretical and empirical grounds, with advocates on both sides of the debate.

Understanding Supply Theory

Supply-side economic theory is commonly used by governments as a premise to target variables that enhance an economy’s ability to supply more goods. In general, supply-side fiscal policy can be based on a number of variables. It is not limited in its scope but seeks to identify the variables that will lead to increased supply and subsequent economic growth.

Supply-side theorists have historically focused on firms income tax discounts, capital loan exchange rates and more flexible trade regulations. Lower income tax rates and capital borrowing rates provide businesses with more cash to reinvest. Plus looser business regulations can eliminate long processing times and unnecessary reporting requirements that can stifle production. Overall, all three variables were found to provide increased incentives for expansion, higher production levels, and increased production capacity.

Overall, there can be a number of supply-side tax measures that a government can take. Often, supply-side fiscal policy will be heavily influenced by the current culture. In some cases, supply-side economics can be part of a global plan to increase domestic supply and make domestic products more advantageous than foreign products.

Proponents of supply-side policies believe they have a runoff effect. The theory is that by targeting the economic variables that could be most effective in stimulating production, companies will produce more and grow. By doing so, they employ more workers and raise wages, putting more money in consumers’ pockets. However, history has not confirmed this to work in practice.

Supply side vs demand side

Supply theory and demand theory generally take two different approaches to economic recovery. The demand theory was developed in the 1930s by John Maynard Keynes and is also known as Keynesian theory. Demand theory is based on the idea that economic growth is driven by demand. Therefore, practitioners of the theory seek to empower buyers. This can be done through government spending on education, unemployment benefits, and other areas that increase the purchasing power of individual shoppers. Critics of this theory argue that it can be more expensive and more difficult to implement with less desirable results.

Overall, several studies have been produced over the years that support demand and supply side fiscal policies. However, studies have shown that due to multiple variables, environments, and economic factors, it can be difficult to identify effects with a high level of confidence and determine the exact outcome of a theory or set of policies.

History of supply-side economics

The Laffer Curve contributed to formulating the concept of supply theory. The curve, devised by economist Arthur Laffer in the 1970s, argues that there is a direct relationship between tax revenue and federal spending, primarily that they substitute on an individual basis. The theory holds that a loss of tax revenue is made up of an increase in growth; thus, tax cuts are a better fiscal policy choice.

In the 1980s, President Ronald Reagan used the supply theory to fight stagflation that followed the recession at the beginning of the decade. Reagan’s fiscal policy, also known as reaganomicfocused on tax cuts, cuts in social spending and the deregulation domestic markets. Gross domestic product (GDP) under the Reagan administration averaged 3.5%; under George HW Bush (R): 2.25%; under Bill Clinton (D): 3.88%; under George W. Bush (R): 2.2%; under Barack Obama (D): 1.62%, and under Donald Trump (R): 0.95%.

3.5%

Average GDP under the Reagan administration’s supply-side fiscal stimulus.

This supply-side fiscal policy of cutting taxes to spur economic growth remained popular among U.S. presidents in subsequent decades. In 2001 and 2003, President George W. Bush also introduced sweeping tax cuts. These applied to ordinary income as well as dividends and capital gainsamong others.

In 2017, President Donald Trump signed into law a tax bill that, in principle, is based on supply-side economics. The Tax Cuts and Jobs Act (TCJA) cut taxes, both income and corporate, in hopes of stimulating growth. Since then, the provisions have disproportionately benefited high earners and hurt some working-class and middle-class taxpayers.

During his presidential tenure, Trump also focused on supply-side fiscal policy through trade deals that raised tariffs on international producers in a bid to create an opportunity for American companies to produce more. .

Critics of these types of policies point to the growing tendency for corporations to engage in share buybacks. Buyouts occur when companies put money they could make from lower taxes back into the pockets of their shareholders rather than investing in new factories, equipment, innovative companies or their workers.

According to the Tax Policy Center, in 2018, U.S. corporations spent over $1.1 trillion to buy back their shares rather than invest in new plants and equipment or pay their workers more.

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