Supply-Side Theory: Definition and Comparison to Demand-Side

The supply-side theory, or supply-side economics, is a macroeconomic concept that contends that increases in the supply of goods lead to economic growth. Supply-side economists argue that the government should increase production through tax cuts and reduced regulation.

A fiscal policy, the supply-side theory has been applied by several U.S. presidents in attempts to stimulate the economy by targeting factors that increase output and supply more goods and services.

Critics argue that supply-side economics is fundamentally flawed and that relying on supply alone does not create demand. Empirical evidence has repeatedly shown its failings in practice as policy. However, the supply-side theory remains a tool in policymaking circles, particularly in the United States and Great Britain.

Key Takeaways:

  • Supply-side economics holds that increasing the supply of goods translates to economic growth for a country.
  • In supply-side fiscal policy, tax cuts, lower interest rates, and deregulation help foster increased production.
  • Supply-side fiscal policy was formulated in the 1970s as an alternative to Keynesian, demand-side policy.

Understanding the Supply-Side Theory

Supply-side economics aims to bolster an economy by implementing policies that will lead to an increased supply of goods and services and subsequent economic growth such as:

  • Reducing corporate income tax rates to provide companies with more cash for reinvestment.
  • Decreasing capital borrowing rates to incentivize businesses to plan new projects and invest in capital assets such as buildings and manufacturing tools.
  • Loosening business or government regulations to eliminate lengthy processing times and unnecessary reporting requirements that often stifle production.

Comprehensively, all three variables have been found to provide increased incentives for expansion, higher levels of production, and increased production capacity. In some instances, supply-side economics may be part of a global plan to increase domestic supply and make domestic products more favorable over foreign products.

Trickle Down Effect

Supply-side policy proponents argue that by targeting the economic variables that boost production, a trickle-down effect occurs as companies produce more and expand, they will employ more workers, and increase wages.

History of the Supply-Side Theory

The Laffer Curve designed by economist Arthur Laffer in the 1970s supported the supply-side economic theory. The curve shows a direct relationship between tax receipts and federal spending and argues that a loss in tax revenue is matched by an increase in economic growth; thus, less money collected from businesses and consumers proves to be a better fiscal policy choice that leads to a better economic picture.

In the 1980s, President Ronald Reagan used supply-side theory to combat the stagflation that followed the recession in the early part of the decade. Reagan’s fiscal policy, also known as Reaganomics, focused on tax cuts, decreased social spending, and the deregulation of domestic markets.

3.5%

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

This supply-side fiscal policy of tax cuts to boost economic growth remained popular among U.S. presidents in subsequent decades. In 2001 and 2003, President George W. Bush also instituted wide-ranging tax cuts. These applied to ordinary income as well as dividends and capital gains.

In 2017, President Donald Trump enacted a tax bill based on supply-side economics. The Tax Cut and Jobs Act (TCJA) cut taxes, both income and corporate, to stimulate growth. The Trump administration also focused on supply-side fiscal policy through trade relations that raised tariffs on international producers to create an opportunity for U.S. businesses to increase production.

In 2022 Liz Truss took over as conservative party Prime Minister in the U.K. and quickly implemented a broad set of supply-side fiscal policies including massive tax cuts and spending plans. However, markets quickly reacted unfavorably, leading to a sudden and sharp devaluing of the British pound to historically low levels along with mounting inflation. The British public quickly voiced disdain for "Tussonomics," including negative reactions from within her party, and she was forced to change course after less than one month in office.

Supply-Side vs. Demand-Side

The supply-side theory and demand-side theory contrast two different approaches to economic stimulus.

The demand-side theory or Keynesian theory was developed in the 1930s by John Maynard Keynes. Built on the idea that economic growth is stimulated through demand, the theory seeks to empower buyers by:

  • Increasing government spending through public programs, like higher unemployment benefits or subsidies, or establishing infrastructure projects to create jobs and promote consumer demand and boost consumer spending.
  • Increasing the money supply within an economy where central banks buy or sell government securities and expand the money supply. More money in circulation leads to lower interest rates, an incentive for consumers and businesses to buy goods or invest in their businesses.

Overall, multiple studies support both supply and demand-side fiscal policies. However, studies have shown that due to multiple economic variables, environments, and factors, it can be hard to pinpoint effects with a high level of confidence and to determine the exact outcome of any one theory or set of policies.

Criticism of Supply-Side Theory

Critics often cite that supply-side tax cuts do not lead to increased economic growth, neglect the demand side of the economy, and may lead to higher deficits and currency weakness. Some also argue that supply-side economics is merely trickle-down economics, benefiting the rich and doing little for the poor and middle class.

In 2001 and 2003, Congress passed two generous tax cuts for the wealthy, and the slowest job growth in half a century followed. Evidence suggests that they did not improve economic growth or pay for themselves, but instead ballooned deficits and debt and contributed to a rise in income inequality.

Market commentators have also argued that supply-side policies are responsible for the growing trend among corporations to engage in stock buybacks. Buybacks occur when companies place the cash they gain from lower taxes back into the pockets of their shareholders rather than investing in new plants, equipment, innovative ventures, or employees. In 2018, US corporations spent more than $1.1 trillion to repurchase their stock rather than invest in new plants and equipment or pay their workers more.

What Is Supply Side Policy?

Supply Side Policy (SSP) refers to measures governments take to increase the availability or affordability of goods and services, along with generous tax reform, which refers to tax cuts and changes in tax laws that may encourage or discourage productive behavior.

What Are the Main Criticisms of Supply Side Theory?

The main criticism of the supply-side theory is that it does not take into account factors such as inflation, interest rates, and unemployment levels. Additionally, some critics argue that supply-side policies do not always lead to increased demand for goods and services and that tax cuts alone cannot achieve truly sustainable long-term growth outcomes.

How Does Supply Side Economics Compare with Keynesian Economics?

Some economists argue that supply-side theory has more in common with Keynesian economics than with classical economics because both theories focus on how aggregate demand affects economic outcomes. However, while Keynesian Economics relies heavily on government intervention (such as fiscal policy or monetary policy), the supply-side theory emphasizes market forces instead. In addition, while classical economics focuses primarily on what individuals can produce (and therefore what they can sell), the supply-side theory also takes into account what businesses can produce (and therefore what they can sell). Ultimately, then, the supply-side theory may be said to have a greater emphasis on market dynamics than Keynesian theory does.

What Are Some Implications of Supply Side Policy?

Some proponents of the supply-side argue that its principles could be used by policymakers for economies to experience faster overall growth rates without experiencing excessive inflationary pressures; others suggest that it could help reduce government debt levels over time due to increased revenue generated from higher taxes levied on high earners and capital gains made from asset appreciation. In some respects, the supply-side theory has been successful in terms of increased production – but this has not always translated into higher levels of prosperity for all. Its emphasis on deregulation may lead to financial instability in times of crisis, and its reliance on tax cuts as a mechanism for stimulating growth may exacerbate income inequality over time.

The Bottom Line

The supply-side theory is a macroeconomic theory that stresses the importance of increasing production through corporate tax cuts, deregulation, and low capital borrowing rates, to boost economic growth. Critics of the theory argue that it is based on flawed assumptions and does not address important factors such as demand-side policy efforts.

Article Sources
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  1. Center for American Progress. "The Failure of Supply-Side Economics."

  2. The Guardian. "Trickle-down Economics Doesn't Work but Build-up Does—Is Biden Listening?"

  3. The World Bank. "GDP growth (annual %) - United States."

  4. Associated Press. "UK leader in peril after Treasury chief axes ‘Trussonomics’."

  5. Center on Budget and Policy Priorities. "The Legacy of the 2001 and 2003 "Bush" Tax Cuts."

  6. Tax Policy Center. "Tackling Stock Buybacks: Too Little, Too Late from Foreign Investors."

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