The Supply-Side Economics: Features and Policy Prescription

The Supply-Side Economics: Features and Policy Prescription!


Supply-side economics is a relatively new term which came into use in the mid-1970s as a result of the failure of Keynesian demand-side policies in the US economy which led to stagflation. The term is new but its basic principles are to be found in the works of the classical economists. According to J.B. Say, supply creates its own demand.


The very act of supplying goods implies a demand for them. If there is an imbalance between demand and supply, it is corrected automatically by changes in prices and wages and the economy always tends toward full employment.

The main emphasis of the classical economists was on economic growth for which they advocated non-interference with the market mechanism. It was the “invisible hand” which led to the maximisation of national wealth.

They believed that entrepreneurs, investors and producers were the prime movers on which the economy depended. It was the increase in the supplies of capital and labour and increase in their productivities that determined growth. Of course, free trade and capital movements internationally were instrumental in a faster growth rate of the economy.

Main Features of Supply-Side Economics:

Modern supply-side economics lays emphasis on providing all types of economic incentives to raise aggregate supply in the economy. According to Bethell, “The essential argument of supply-side theory is that adding to supply unlike adding to demand is not a zero-sum task. In order to make something,… a producer does not need to be given any money. Instead, he has to be given an incentive.” Incentives to producers are essential to invest, produce and employ. Similar incentives are to be given to individuals to work and save more.


The government plays a limited role in liberalising markets, reducing taxes and freeing the labour market. The main objectives of supply-side policies are to keep inflation at a low level, achieve and maintain full employment and attain faster economic growth. Supply-side economists suggest the following policy measures in order to achieve these objectives.

Tax-induced Change in Aggregate Supply:

Supply-siders regard tax cuts as an effective means of raising the growth rate of the economy. To assess the likely effects of tax reductions, they distinguish between income and substitution effects of a cut in the marginal rate of income tax.

The substitution effect of a wage cut induces people to work more and have less leisure, and the income effect causes people to work less and enjoy more leisure. It is only when the substitution effect of a tax cut is larger than the income effect that there will be an incentive to work more, thereby leading to reduction in unemployment.

A reduction in personal tax rates increases the incentive of people to work and save more. High savings reduce short-term interest rates and lead to increased investment and thus to an increase in the economy’s capital stock. Reduction in marginal tax rates by improving the work effort of the people also increases their productive capacity and the level of output and employment in the economy.


Thus supply-side tax cuts by raising work, effort, saving and investment, increase the supplies of labour and capital and shift the aggregate supply curve to the right. The effect of a. supply-side tax cut is illustrated in Fig. 1 where AS is the aggregate supply curve and AD is the given demand curve.

Real output or GDP is measured along the horizontal axis and the price level on the vertical axis. AS and AD curves intersect at point T and determine OP price and OQ real output of the economy. Suppose there is a tax cut both on persons and firms. This increases work effort and saving on the part of workers and investment by firms.

The Effect of a Supply-Side Tax Cut

As a result, supplies of labour and capital increase which shift the aggregate supply curve AS to the right as AS1. Now the AS1 curve cuts the AD curve at point C. As a result, the price level falls to OP1 and the real output increases to QQ1 as a result of a tax cut.


Similarly, reduction in corporate tax rates, by giving incentives to the corporate sector in the form of increasing tax credit for larger investment and providing higher depreciation allowance, encourage investment. Higher investment leads to the production of more goods and services per unit of labour and capital.

Supply-siders also advocate an additional tax relief for firms employing researchers because R&D help in increasing productivity. They also favour reduced estate taxes for small farmers which will induce them to spend more on inputs so as to increase production.

Further, tax cuts reduce diversions to “shelter” (protected) industries and minimise or eliminate the need for accountants, investment consultants and tax-lawyers. Moreover, tax reductions reduce ‘underground’ (black market) activity where exchange is not recorded in the books and no taxes are paid.

Increasing Growth Rate:

According to supply-side economists, tax cuts increase the disposable income of the people who raise additional demand for goods and services. On the other hand, the faster growth in productivity leads to the production of additional goods and services to match the additional demand.

This leads to balanced growth in the economy without shortages. When the economy is moving towards balanced growth, the rate of inflation is low. This, in turn, leads to an increase in the real disposable income of the people which raises consumption, output and employment.

Low inflation leads to increase in net exports which strengthen the value of national currency in relation to foreign currencies. The increase in productivity increases the production of more goods for export, thereby further strengthening the country’s currency.

Thus supply-side economists advocate reduction -in tax rates in order to increase the incentives to work, save and invest and to get more tax revenue by the government. Increase in investment leads to an increase in the economy’s capital stock, to increase in productivity, to larger output, low inflation, high level of employment and high growth rate of the economy.

These policy prescriptions shift the aggregate supply curve of the economy to the right. This is illustrated in Fig. 2 where AS is the aggregate supply curve and AD is the given aggregate demand curve. They intersect at point E which is the initial equilibrium point of the economy with OP price level and OQ real output.


Suppose the supply-side policies increase the total supply of factors like labour and capital due to tax policies, incentives, etc. They increase real output and shift the AS curve to the right as AS1. The new equilibrium is at where the AS1 curve cuts the AD curve. Now real output increases to OQ1 and the price level falls to OP1 thereby increasing the growth rate of the economy.

Policy Prescriptions of Supply-Side Economics:

Following are the policy prescriptions of supply-side economics:

1. The Laffer Curve: Tax Rate Vs. Tax Revenue:

The most popular aspect of supply-side economics is the Laffer curve named after its originator Prof. Arthur Laffer. The Laffer curve depicts the relation between tax rate and tax revenue. It is based on the assumption that a cut in the marginal rate of tax will increase the incentives to work, save and invest. This tax cut, in turn, will increase the tax revenue. The Laffer curve shows two extremes of tax rates: A 0% tax rate and a 100% tax rate.

Both yield no tax revenue. If the tax rate is 0%, no revenue will be raised. If the tax rate is 100%, people will have no incentive to work, save and invest at all because the whole income will go to the government. Thus the tax revenue will again be zero. As the tax rate increases from 0% to 100%, tax revenue correspondingly rises from zero to some maximum level and then starts declining to zero. Thus the optimum tax rate is somewhere between the two extremes.

Figure 3 shows the Laffer curve where the tax rate (0%) is taken on the horizontal axis and the tax revenue on the vertical axis. As the tax rate is raised above zero, the tax revenue starts increasing. The Laffer curve is upward sloping. At the relatively low tax rate, it is upward sloping. At the relatively low tax rate T1, the tax revenue is R1.

The Laffer Curve

As the tax rate rises to T, the tax revenue continues to increase and the curve reaches the peak, P where the tax revenue R is the maximum. Thereafter, further rise in the tax rate will reduce revenue to the government. Thus T is the optimum rate of tax.

According to Laffer, “Except for the optimum rate, there are always two tax rates that yield the same revenue.” In the figure, the revenue R1 at the high tax rate T2 is the same as the revenue collected at the low tax rate T1. If the government wishes to maximise tax revenue, it will choose the optimum tax rate T.

An important feature of the Laffer curve is that it has a normal range and a prohibitive range. The normal range is to the left of the optimum tax rate T and the prohibitive range is to its right. In the normal range, increases in the tax rate bring more revenue to the government.

But in the prohibitive range, when the tax rate becomes high, it reduces the incentives to work, save and invest. Consequently, the fall in output more than offsets the rise in tax rate. When the tax rate reaches 100%, the revenue falls to zero because no one will bother to work.

Thus high tax rate stifles economic growth and results in high unemployment. Therefore, a reduction in the tax rate will actually increase revenue by encouraging the incentives to work, save and invest. People not only produce and earn more but also switch money out of low-yielding “tax shelters” and untaxed “underground” economy into more productive and socially desirable investment. The result would be higher employment and economic growth leading to high tax revenue.

2. Reduction in Government Spending:

To achieve full employment, low inflation and high growth rate of the economy, the supply-side economists emphasise reduction in government expenditure accompanied by tax cuts. They are against monetization of budget deficit which the Keynesians advocate.

But the reduction in government expenditure should be more than or equal to tax cuts so that savings increase to finance larger investments. This will increase employment, income and growth rate of the economy.

3. Monetary Policy:

Another plank of supply-side policy is to have restrained monetary expansion in order to keep the inflation rate low.

4. Increased Depreciation:

To encourage more investment, supply-siders suggest increased investment allowance and/or higher depreciation on buildings, machines vehicles, and other capital goods.

5. Reduction in Welfare Benefits:

To reduce unemployment, supply-side economists emphasise reduction in welfare benefits, especially unemployment allowance. This will encourage workers to accept jobs at lower wages, thereby reducing unemployment in the economy.

6. Reducing Trade Union Power:

Supply-siders also advocate reduction in the power of trade unions through legislation which will make the labour market more competitive. Trade unions raise wages above the competitive level which the employers cannot afford. Thus they destroy jobs and increase unemployment. When the government restricts union power, unemployment and cost-inflation are reduced.

7. Deregulation and Privatisation:

Deregulation and privatisation are important supply-side policies. They are used to encourage more competition within the economy. Removal of public sector monopolies and sale of public sector enterprises and transfer of public utilities in private hands lead to increase in productive efficiency, wider consumer choice and lower prices.

8. Free Trade and Capital Movements:

Free trade and free capital movements among countries are another policy measure of supply-siders. The removal of exchange controls and free inflow and outflow of both short- term and long-term capital lead to the maximisation of output and growth by widening markets and checking monopolies.

Criticisms of Supply-side Economics:

The above prescriptions of supply-side economics have been criticised by economists on the following grounds:

1. Laffer Curve Controversial:

The Laffer curve is an interesting but a controversial concept. No one knows with certainty either the location of the optimum point or the exact shape of this curve. The curve may peak at 40% or 90% tax rate, or it may peak in-between these rates.

For instance, if we take the curve which peaks at point A in Figure 4, the present tax rate-T should be cut to T1 to maximise revenue. On the other hand, if another curve peaks at point B, the tax rate T should be increased to T2. Without the knowledge of either the peak or the shape of the curve, it is not possible to know the effect of reducing (or increasing) the tax rate or tax revenue and economic activity. In fact, nobody knows the exact shape of the Laffer curve or the relationship between tax rate and tax revenue.


2. Tax Cuts do not bring High Growth Rate:

Economists do not agree that cutting tax rates will lead to high growth rate and more tax revenue. They point out that high growth rate generates higher incomes which, in turn, generate higher tax revenue. Therefore, it is not reduction in tax rates that leads to the high growth rate of the economy.

3. Tax Cuts do not measure Work Effort:

It is not possible to measure work effort specifically as a result of tax cut. No doubt, increased work effort leads to higher incomes and to increase in tax revenue. But the increased tax revenue may not be sufficient to compensate the government for the decrease in revenue due to the lower tax rate. Moreover, it is possible that people may work less when their disposable income increases with the lower tax rate.

4. Tax Cuts do not affect Target Incomes:

Critics argue that some persons have ‘target’ real income. When taxes are reduced, they will work less and have more leisure to maintain their target income.

5. State Intervention Necessary:

Supply-siders have been criticised for their policy of non-intervention by the state. But there are many contradictions in the working of the capitalist system which cannot sustain balanced growth of the economy. When the economy reaches full employment, a number of distortions and imbalances develop which fail to maintain full employment. Therefore, state intervention is necessary to remove them.

6. Supply-side Policies fail to bring Social Justice:

Supply-side economists emphasise reduction in social spending, subsidies, grants and budget deficit with reduction in taxes. But such a policy has actually led to huge budget deficits in the United States. Further, the policy of reducing social spending, subsidies and grants adversely affects the poor and unemployed and fails to bring social justice.

No comments yet.

Leave a Reply