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Supply-Side Economics

Updated on January 31, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Supply-Side Economics Definition

Supply-side economics claims that an increase in goods supply leads to long-term economic growth. It is a macroeconomics theory. The supply-side economics theory recommends the implementation of expansionary fiscal policies to enhance production.

Supply-Side Economics Graph

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The concept emphasizes the factors of production—capital, land, labor, and entrepreneurship. Supply-side fiscal policies include the curtailment of borrowing rates, tax reduction, and deregulation of industries. The theory claims that Increased production results in excess supply over demand; consequently, goods prices plummet, and goods demand rises.

Key Takeaways

  • Supply-side economics is a macroeconomics concept that advocates the increase in supply or production to achieve long-term sustainable growth.
  • The theory was introduced in the 1970s by Arthur Laffer—an American economist. He presented a relationship between tax rate and tax revenue using the Laffer Curve.
  • This theory suggests that reduced taxes encourage producers, industries, businesses, and entrepreneurs to invest more and produce more.
  • Keynesian economists criticize supply-side theory for lacking proven examples. Also, this approach does not visibly benefit the lower-and-middle-income group.

Supply-Side Economics Explained

In the 1970s, Arthur Laffer proposed the concept of supply-side economics to dispel the demand-side theory. Arthur is an American economist. He presented the Laffer curve to represent the relationship between the tax rates and the tax revenue.

Laffer suggested that when governments reduce taxes, businesses are motivated to produce more goods and services. Consequently, when the market gets flooded with commodities, prices automatically go down—goods demand increases. When taxes are low, wealthy individuals invest more—the economy gets a boost—more jobs are created.

The supply-side fiscal policy boosts factors of production like land, capital, labor, and entrepreneurship. This is achieved by reducing taxes, industrial regulation, and borrowing rates. The supply-side theory claims that controlling inflation results in sustainable economic progress—in the long term. Further, higher production means increased labor requirements; thus, more jobs are created.

However, Keynesian economists have always criticized the supply-side theory for lacking proven examples. Also, this kind of growth does not show any positive impact on the lower-and middle-income group. On the one hand, this concept promises long-term outcomes, but at the same time, it is costly at present.

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Fundamental Elements

The free trade Supply-side economics approach aims to boost a nation’s production and economic activities for sustainable growth. The theory hinges on three fundamental pillars:

  1. Monetary Policy: Governments increase the circulation of money by implementing expansionary measures—like reduced borrowing rates.
  2. Tax Policy: Governments curtail income tax and marginal taxes to motivate entrepreneurs, producers, investors, suppliers, and workers. Entrepreneurs, in turn, increase investment and economic activities.
  3. Regulatory Policy: The deregulation of industries is equally important to witness a free-market scenario. This way, governmental control or intervention in economic activities is minimal.

Examples

Now that we understand the basics and a few intricacies of the concept, let us also understand the practicality through the examples below.

Example #1

Alex was a small business owner facing economic challenges in the 1980s. Frustrated with high taxes impacting his ability to invest and expand, Alex encounters the principles of supply-side economics. Influenced by economists like Arthur Laffer, he learns that reducing tax rates, particularly on businesses and high-income individuals, can lead to economic growth.

Inspired by this idea, Alex witnessed the Reagan administration implementing supply-side policies, including substantial tax cuts. As a result, Alex finds relief in lowered taxes, enabling him to invest in his business, hire more employees, and contribute to overall economic revitalization. Through Alex’s experience, free trade supply-side economics comes to life as a theory promoting economic growth through strategic tax policies.

Example #2

Real-world data do not entirely back Laffer’s supply-side theory. In 1981, to implement the tax cuts, President Ronald Reagan introduced the Economy Recovery Tax Act (SERTA). Reagan promised these policies in his campaigns.

This law curtailed marginal tax rates for individuals from 70% to 50%. Reagan believed that reducing taxes would encourage people to produce more goods and services. This policy anticipated the speedy growth of the economy and business activities. Reagan’s policies are referred to as ‘Reaganomics.’

Supply-Side Examples

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By 1986, the US witnessed the creation of 10.5 million new jobs and a GDP growth of 1.1%. Even so, the supply-side policies did not live up to the expectations. Despite significant reductions in tax rates, US tax revenue collection did not increase all that much.

In hindsight, Reagan’s supply-side ideas failed because the tax savings offered to the rich did not lead to the anticipated amounts of job creation. Rather, tax savings were accumulated—the rich became richer.

Importance

Let us understand the importance of supply-side economics theory through the points below.

  • It focuses on reducing tax burdens, especially on businesses and high-income individuals, with the aim of fostering increased investment, production, and job creation.
  • Lower tax rates incentivize entrepreneurship by allowing individuals and businesses to retain a higher share of their income.
  • By reducing taxes on capital gains and corporate profits, supply-side policies aim to stimulate business investment in equipment, technology, and infrastructure, contributing to economic expansion.
  • Lowering tax rates is believed to lead to increased hiring as businesses have more resources to expand their operations and workforce, ultimately reducing unemployment.
  • Supply-side policies aim to make the domestic economy more competitive globally by attracting investment, fostering innovation, and positioning the country as an attractive business environment.
  • Supply-side economics seeks a balance between providing incentives for economic growth and ensuring a fair and efficient tax system that benefits a broad range of individuals and businesses.

Pros and Cons

The effectiveness of the free trade supply-side economics often depends on the specific economic and social context in which they are implemented. Let us understand its pros and cons through the points below.

Pros

  • Advocates argue that reducing tax rates, especially on businesses, incentivizes investment, leading to increased production, economic growth, and job creation.
  • Lower taxes on capital gains and corporate profits are believed to encourage entrepreneurship and innovation by providing individuals and businesses with greater financial flexibility.
  • Supply-side policies aim to enhance a country’s global competitiveness by attracting foreign investment, fostering a dynamic business environment, and stimulating economic activity.
  • Proponents assert that as the economy expands, overall tax revenue may increase, even with lower tax rates, potentially improving fiscal conditions.

Cons

  • Critics argue that supply-side policies may exacerbate income inequality by disproportionately benefiting high-income individuals and corporations.
  • Skeptics contend that lowering tax rates may not always result in increased government revenue, potentially leading to budget deficits and limiting public resources.
  • Critics claim that the benefits of supply-side policies may not directly reach lower-income individuals, as they may not have significant capital to invest or substantial business income.
  • Supply-side economics has been criticized for a “trickle-down” effect, suggesting that benefits to the wealthy may not necessarily translate into improved conditions for the broader population.

Supply-Side Economics Vs Demand-Side Economics

Let us understand the distinctions between supply-side and demand-side economics through the comparison below.

Supply-Side Economics

  • Centers on policies that stimulate production and supply of goods and services.
  • Advocates for reducing tax rates, especially for businesses and high-income individuals, to incentivize investment, job creation, and economic growth.
  • Encourages entrepreneurship by providing individuals and businesses with financial incentives to invest, innovate, and take risks.
  • It often favors limited government intervention and may benefit the wealthy more directly.
  • Believes that benefits to businesses and the wealthy will eventually “trickle down” to benefit the broader population through increased job opportunities and economic prosperity.

Demand-Side Economics

  • Centers on policies that stimulate consumer spending and demand for goods and services.
  • Advocates for policies like progressive taxation and social welfare programs to redistribute income and improve the purchasing power of lower-income individuals.
  • Supports increased government spending, especially during economic downturns, to boost demand and stimulate economic activity.
  • It aims to address income inequality through measures like progressive taxation.
  • Believes that increasing consumer spending will lead to higher demand for goods and services, prompting businesses to expand and create more jobs.

Supply-Side Economics vs. Keynesian

Laffer’s supply-side theory is in stark contrast to the Keynesian demand-side theory. Let us understand the distinction in detail:

BasisSupply-Side EconomicsKeynesian
DefinitionThe supply-side theory claims that an increase in commodity supply boosts the economy.Keynesian economics claims that an increase in demand is the major factor behind economic growth.
Proposed byIt was introduced by Arthur Laffer in the 1970s.It was proposed by John Maynard Keynes in the 1930s.
Tax Cuts forTax relaxation is offered to producers and suppliers.It reduces tax liability for lower and middle-class sections.
AimIt encourages producers, investors, suppliers, and industries to invest more.It motivates the lower and middle-class sections to buy more.
Focus Should be onProducers and suppliersConsumers
Consumers BenefitsAbundant choices in goods and servicesHigher purchasing power to spend income on products and services
Suitable ScenariosSuits high inflation markets.Suitable for recession scenarios.

Frequently Asked Questions (FAQs)

What is supply-side economics?

The supply-side theory assumes that an increased supply of goods leads to long-term economic growth. It focuses on factors of production—land, capital, labor, and entrepreneurship. It recommends the creation of favorable business environments by introducing supply-side fiscal policies—reduced taxes and reduced industrial regulation.

What is the fundamental element of a supply-side economy?

The fundamental elements of this theory are relaxation of industrial regulation, curtailed taxes, and borrowing rate discounts.

Do supply-side theories work?

Supply-side theories are suitable in scenarios where the government wants to control inflation, generate job opportunities or ensure long-term sustainable growth. However, it fails to deal with adversities like a recession—when aggregate demand is already low, and supply is high. Also, these policies cannot be applied as a quick fix to solve economic problems.

Who created supply-side economics?

In the 1970s, the American economist Arthur Laffer proposed the supply-side theory. The Laffer Curve illustrated a relationship between tax rates and tax revenue.

This has been a guide to Supply-Side Economics & definition. Here, we explain its examples, importance, pros, and cons and compare it with the demand side. You may learn more about economics from the following articles –