What Is Supply-Side Theory?

The supply-side theory is an economic concept whereby increasing the supply of goods leads to economic growth. Also defined as supply-side fiscal policy, the concept has been applied by several U.S. presidents in attempts to stimulate the economy. Comprehensively, supply-side approaches target variables that bolster an economy’s ability to supply more goods and services.

Key Takeaways:

  • Supply-side economics holds that increasing the supply of goods translates to economic growth for a country.
  • In supply-side fiscal policy, practitioners often focus on cutting taxes, lowering borrowing rates, and deregulating industries to foster increased production.
  • Supply-side fiscal policy was formulated in the 1970s as an alternative to Keynesian, demand-side policy.

Understanding Supply-Side Theory

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

Supply-side theorists, historically, have focused on corporate income tax reductions, capital borrowing rates, and looser business regulations. Lower-income tax rates and lower capital borrowing rates provide companies with more cash for reinvestment. Moreover, looser business regulations can eliminate lengthy processing times and unnecessary reporting requirements that can stifle production. Comprehensively, all three variables have been found to provide increased incentives for expansion, higher levels of production, and increased production capacity.

Overall, there can be any number of supply-side fiscal actions a government can take. Often, supply-side fiscal policy will be heavily influenced by the current culture. 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.

Proponents of supply-side policies believe that they have a trickle-down effect. The theory is that by targeting the economic variables that might be most effective in boosting production, companies will produce more and expand. As they do so, they employ more workers and increase wages, putting more money in the pockets of consumers. However, history has not borne this out to work in practice.

Supply-Side vs. Demand-Side

The supply-side theory and demand-side theory generally take two different approaches to economic stimulus. The demand-side theory was developed in the 1930s by John Maynard Keynes and is also known as Keynesian theory. The demand-side theory is built on the idea that economic growth is stimulated through 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 spending power of individual buyers. Critics of this theory argue that it can be more costly and more difficult to implement with less desirable results.

Overall, multiple studies have been produced through the years that 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.

History of Supply-Side Economics

The Laffer Curve helped formulate the concept of supply-side theory. The curve, designed by economist Arthur Laffer in the 1970s, argues that there is a direct relationship between tax receipts and federal spending—primarily that they substitute on a one-to-one basis. The theory argues that a loss in tax revenue is made up by an increase in growth; thus, tax cuts are a better fiscal policy choice.

In the 1980s, President Ronald Reagan used supply-side theory to combat stagflation that followed the recession in the early part of the decade. Reagan’s fiscal policy, also known as Reaganomics, focused on tax cuts, decreasing social spending, and the deregulation of domestic markets. Gross domestic product (GDP) under the Reagan Administration averaged 3.5%; under George H.W. 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 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 among others.

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

During his presidential term, Trump also focused on supply-side fiscal policy through trade relations that raised tariffs on international producers with the aim of creating an opportunity for U.S. businesses to produce more.

Critics of these types of policies point to the growing trend among corporations to engage in stock buybacks. Buybacks occur when companies place the cash they may gain from lower taxes back into the pockets of their shareholders rather than investing in new plants, equipment, innovative ventures, or their workers.

According to Tax Policy Center, 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.