Supply-side Economics - Historical Origins

Historical Origins

Supply-side economics developed during the 1970s in response to Keynesian economic policy, and in particular the failure of demand management to stabilize Western economies during the stagflation of the 1970s, in the wake of the oil crisis in 1973. It drew on a range of non-Keynesian economic thought, particularly the Chicago School and Neo-Classical School. An advocate of supply-side economics traced the school of thought's intellectual descent from the philosophers Ibn Khaldun and David Hume, satirist Jonathan Swift, political economist Adam Smith, and even Founding Father Alexander Hamilton.

However what most separates supply-side economics as a modern phenomenon is its argument in favor of a low tax rate for primarily collective and notably working-class reasons, rather than traditional ideological ones. The difference is an important one. Classical Liberals opposed taxes because they opposed government, taxation being the latter's most obvious form. Their claim was that each man had a right to himself and his property and therefore taxation was immoral and of questionable legal grounding. Supply-side economists, on the other hand, argued that the alleged collective benefit (i.e jobs) provided the main impetus for tax cuts.

As in classical economics, supply-side economics proposed that production or supply is the key to economic prosperity and that consumption or demand is merely a secondary consequence. Early on this idea had been summarized in Say's Law of economics, which states: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." John Maynard Keynes, the founder of Keynesianism, summarized Say's Law as "supply creates its own demand." He turned Say's Law on its head in the 1930s by declaring that demand creates its own supply. However, Say's Law does not state that production creates a demand for the product itself, but rather a demand for "other products to the full extent of its own value." A better formulation of the law is that the supply of one good constitutes demand for one or more other goods. This requires that the original good has some value to another party and it is through willingness to trade this value that the producer of the new good can express his demand for another good.

In 1978, Jude Wanniski published The Way the World Works, in which he laid out the central thesis of supply-side economics and detailed the failure of high tax-rate progressive income tax systems and U.S. monetary policy under Nixon in the 1970s. Wanniski advocated lower tax rates and a return to some kind of gold standard, similar to the 1944-1971 Bretton Woods System that Nixon abandoned.

In 1983, economist Victor Canto, a disciple of Arthur Laffer, published The Foundations of Supply-Side Economics. This theory focuses on the effects of marginal tax rates on the incentive to work and save, which affect the growth of the "supply side" or what Keynesians call potential output. While the latter focus on changes in the rate of supply-side growth in the long run, the "new" supply-siders often promised short-term results.

The supply-siders were influenced strongly by the idea of the Laffer curve, which states that tax rates and tax revenues were distinct—that tax rates too high or too low will not maximize tax revenues. Supply-siders felt that in a high tax rate environment, lowering tax rates to the right level can raise revenue by causing faster economic growth.

This led the supply-siders to advocate large reductions in marginal income and capital gains tax rates to encourage allocation of assets to investment, which would produce more supply. Jude Wanniski and many others advocate a zero capital gains rate. The increased aggregate supply would result in increased aggregate demand, hence the term "Supply-Side Economics".

Furthermore, in response to inflation, supply-siders called for indexed marginal income tax rates, as monetary inflation had pushed wage earners into higher marginal income tax brackets that remained static; that is, as wages increased to maintain purchasing power with prices, income tax brackets were not adjusted accordingly and thus wage earners were pushed into higher income tax brackets than tax policy had intended.

Supply-side economics has been criticized as essentially politically conservative. Supply-side advocates claim that they are not following an ideology, but are reinstating classical economics. Yet, supply-siders such as Jude Wanniski have argued for lower tax rates to increase tax revenues, and that redistribution of income through taxation was essential to the health of the polity—a view that is anathema to traditional conservatives.

Some economists see similarities between supply-side proposals and Keynesian economics. If the result of changes to the tax structure is a fiscal deficit then the 'supply-side' policy is effectively stimulating demand through the Keynesian multiplier effect. Supply-side proponents would point out, in response, that the level of taxation and spending is important for economic incentives, not just the size of the deficit.

The Reagan administration and the Kennedy administration both justified such changes in socioeconomic terms by invoking the old saying that "a rising tide lifts all boats".