What Is Supply-Side Theory?

The supply-side theory is an economic theory built on the concept that increasing the supply of goods leads to economic growth. Therefore, 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.

Also defined as supply-side fiscal policy, the idea has been used by several U.S. presidents in fiscal policy stimulus. Overall, supply-side fiscal policy often focuses on reducing corporate taxes, increasing labor market opportunities, and deregulating industries to provide for greater business production.

Understanding Supply-Side Theory

Supply-side theorists argue that corporate income tax reduction, capital borrowing rates, and looser business regulations are three important variables that can be adjusted to stimulate economic growth. Adjusting these three variables in favor of businesses supports stimulus by targeting core business activities and business analysis.

The idea is relatively simple because businesses seek to operate with efficiency. Taking supply-side fiscal policy steps to reduce taxes and borrowing rates provides businesses with more cash which creates an incentive to produce more and earn more. Freeing up more money at a corporate level also leads to greater investment in research and human resources, which theorists also suggest leads to greater production and earnings.

Supply-side economics can also be associated with trickle-down economics which states that what is good for the corporate world will trickle down through the economy benefiting all. As companies produce more and expand, they employ more workers and increase wages which puts more money in the pockets of consumers. Increased production can also make domestic products more competitive and favorable over foreign products.

Key Takeaways

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

Supply-Side vs. Demand-Side

Supply-side theory and demand-side theory generally take two different approaches to economic stimulus. Demand-side theory was developed in the 1930s by John Maynard Keynes and can also be known as the Keynesian Theory. Demand-side theory is built on the idea that economic growth is stimulated through demand. Therefore, practitioners of the theory seek to more greatly empower buyers. This can be done through government spending for 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 to 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.

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, meaning they substitute on a 1-to-1 basis. The theory argues that a loss in tax revenue is made up by an increase in growth so, therefore, the argument suggests tax cuts are a better fiscal policy choice.

In the 1980s, President Ronald Reagan used supply-side theory to combat pricing issues that followed the recession in the early part of the decade. Reagan cut the top tax rate and the corporate tax rate. While the economy was dragged out of recession, national debt under Reagan surged. 

In 2001 and 2003, President George W. Bush instituted wide-ranging tax cuts. These were applicable to ordinary income as well as dividends and capital gains among others. The top one percent were the main beneficiaries of his cuts. Bush's tax cuts came after President Clinton's tenure, during which he had already cut taxes by 28%. Economic growth entered the fast lane in 2003 and onwards up until the 2008 financial crisis.

In 2017, President Donald Trump enacted a tax bill that, in principle, is based on supply-side economics. The bill cut taxes, both income and corporate, in the hope to stimulate growth. President Trump has also focused on supply-side fiscal policy through trade relations which have raised tariffs for international producers creating incentives for U.S. businesses to produce more.