By Aidan Hackett. Edited by Arjun Chandrasekar.
In stark opposition to the ideas of Keynes, demand side theorists, large government advocates, and those pushing for higher tax rates, supply side economic theory posits lower taxes, more business freedom, and incentivising growth through production, investment and saving, rather than just “spend, spend, spend”.
As Keynesian economic theory took hold over much of the world in the wake of the Great Depression and World War II, proponents of classical economic ideas – those of Adam Smith, sought to make a modern revitalisation of his work. Much of this work was done by member of the famed “Chicago School”, which boasted members such as Friedrich Hayek and Milton Friedman.
What is Supply Side Theory?
Supply side theorists want the government to cut taxes for practical reasons backed up by sound economic theories and models. This is opposed to classical liberal ideas of wanting to cut taxes because of the ideological stance that government should not be overreaching. While the two rationalisations of why taxes should be cut are often complimentary, they are not necessarily linked.
Supply side theory seeks to drive economic growth through investment in business and saving, and not by spending as Keynes would have it. The argument follows in four initial logical progression, and then seeks to enter a positive feedback loop.
- Tax rates are reduced
- This can be on the business or individual level, in facets from income tax, to property tax, to capital gains tax.
- Money saved because of lower taxes is invested/reinvested
- When a business has more money, they tend to do things with that money to expand their business. When people have more money, they will spend it, but up to a threshold. After that threshold is crossed, they tend to save (meaning the bank will loan out that money – a good for the economy) or invest themselves. We saw this in action in the wake of stimulus checks in the Covid-19 pandemic.
- Investment leads to more jobs and higher wages
- When business expand, they are forced to hire more people. In the event a business cannot/does not want to expand, what they do with that money is still generally good. They will either pay out dividends to investors, do stock buybacks, give bonuses to employees, or the business may even invest the cash into the stock market.
- The average consumer has more money, which they will spend.
- When previously unemployed people have jobs, when employees get bonuses, and when investors get dividends or see the stock price rise because of buybacks, everyone in that system gets more money in their pocket.
- Money spent and circulating in the economy is at a level such that taxes at the lower rate are higher in total value to those of taxes under the old system.
- 25% of $100 is $25, which is higher in total value than $24.50 – 35% of 70. The tax man gets a smaller piece, but of a larger pie, meaning that at the end of the day, he is taking home more money.
And this system would then go full circle. The government can now lower taxes again, and business can expand, and people can get richer and spend a little more, and so on and so forth.
Criticisms of the Supply Side Theory
There are two main criticisms of the supply side theory, one of which is more viable than the other.
Firstly, we have the idea of taking our positive feedback loop from above, and then taking it to the nth degree. If the logic for lowering taxes to overall increase economic output works from lowering taxes from, say, 30% to 25%, then if the argument is sound, it should work from lowering the taxes from 2% to 1%. Now, obviously this would not work, as the population of an economy is finite, and time is finite, so thinking we could produce on forever is a stupid idea.
This argument rests on the idea that business will only ever take extra money earned and use it to produce more things, and in turn, producers will always buy those things. This doesn’t work in practice. Consumers don’t want to buy more than what they need of a product – this is the idea of marginal utility. So, if a business outproduces demand, then they will need to lower prices to entice people to buy things, which, at a point, means they will lose money. Firstly, consumers would never buy that much, and secondly, even if they did, producers would stop producing at the point they lose money by producing it. After a point, businesses will just take the money and redistribute it to investors.
We can now tell that this reduction in taxes cannot go on forever, but that is not because the idea of supply side theory is wrong. It just means that there has to be some point along the tax rate/economic prosperity curve where the system has been optimised. The lowering of tax rates is not good in all situations, so the growth in economic prosperity is marginal, and stops, and then reverses (lowering taxes is worse for society) at some point.
The second criticism of supply side theory is quite a strawman and is usually used in political ideology debates rather than empirical economic theory ones. The strawman being constructed is that supply side theory (often called “trickledown economics” or “Reaganomics” in these contexts’) is when you cut taxes for the rich only, and then expect that to “trickle down” to the poorer classes. Thomas Sowell, a prominent member of the Chicago School, has challenged people for decades now for people to find him a legitimate economist who has ever seriously said that, and no one has gotten back to him with an answer to the challenge. While supply side theory can often seem like it benefits rich people the most, it does not aim to make the poor richer by doing things to help the already rich – that would be illogical – why not just give the tax cuts to the poor? While this argument usually comes from a good place of wanting to help people less fortunate than yourself, it is ill informed, and created by people who may not have good intentions.
Why Doesn’t Government Use It?
Control. Supply side policies are incentives – when a government lowers taxes, they hope that business and individuals invest and turn the cogs of the economic machine. They can’t do anything to actually make sure that happens. Government employ demand side policies due to the large amount of control they have over them. They want more economic activity in sector XYZ? They spend some money in sector XYZ. There is no hoping with that, they are influencing the economy in an extremely hands on way, and for them to achieve their goals, demand side is the way they can achieve them most effectively.
Supply side theory is a widely accepted economic theory and is used by most liberal democracies in the world today, to some extent. It aims to increase economic prosperity by encouraging saving and investing rather than spending. It posits that increased money flow in the economy will ultimately offset any potential lost government revenue due to the sheer quantity of money moving in the economy.