What Is Supply-Side Theory?

Supply-side theory is an economic theory built on the concept that increasing the supply of goods leads to economic growth. Also defined as supply-side fiscal policy, the concept has been used by several U.S. presidents in fiscal policy stimulus. Comprehensively, supply-side approaches seek to target variables that bolster an economy’s ability to supply more goods.

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 rather seeks to identify variables that will lead to increased supply and subsequently 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. Oftentimes, 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.

Supply-side policies have also been known to have a trickle-down effect. With this economic effect, what is good for the corporate world trickles down through the economy benefiting all. As such, the economic environment can influence which variables might be most effective in targeting supply production for both companies and consumers. Broadly, as companies produce more and expand, they employ more workers and increase wages, putting more money in the pockets of consumers.

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.

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 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 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 - primarily that 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 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. Reagan’s supply-side fiscal policy saw positive results with the inflation rate reduced to 4%, the unemployment rate reduced to 6%, and average annual gross domestic product (GDP) growth of 3.51%. In 1984, GDP under the Reagan Administration increased 7.20% for a record post-1980 high.

7.20%

The GDP growth rate in 1984 under the Reagan Administration’s supply-side fiscal stimulus.

In 2001 and 2003, President George W. Bush also 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.