Supply-Side Economics and Trickle-Down Economics

A primary benefit of learning economics is that government policies can be evaluated according to scientific principles. Government policies are often set by political agendas that usually favor the wealthy, because they have the most influence with politicians and most politicians are also wealthy. However, in democracies, politicians must rationalize their self-serving policies, so that voters will, at least, acquiesce. Naturally, many of the wealthy want lower taxes on themselves, so to justify why they should receive most of the tax breaks, they embraced what has become known as supply-side economics.

What exactly constitutes supply-side economics is nebulous; different people have different ideas. The nebulosity of supply-side economics arises from the fact that it is not really an economic theory, but rather a political argument for lowering taxes, particularly for the wealthy, and decreasing regulation. By its name, one would think that supply-side economics means an increase in the aggregate supply of the economy. A market equilibrium exists as an equalization between supply and demand. Increasing supplies reduces prices, which will increase demand, but it can also reduce revenue to the suppliers, which in turn, reduces supply. Demand increases with lower prices, but whether the increased demand increases revenue for the suppliers depends on the elasticity of both supply and demand. The market equilibrium is the point where suppliers are maximizing their profits. If they could make more money by increasing the supply, then they would do so.

Supply-side economics, as a political argument, focuses on increasing the supply of labor, a necessary input for the production of any good or service. Reducing taxes on labor will increase the supply of labor, because the workers will receive a higher disposable income, which is equivalent to a higher supply price, thereby increasing the supply of labor. This will lead to a stronger economy, but only if all of the labor is utilized. But increasing the supply of labor will be of no benefit unless it also leads to increased demand. And as I will argue later, this increased demand depends on the tax breaks and who receive them.

So supply-side economics argues that higher tax rates on labor will reduce disposable income, thereby lowering the incentive to work. People may decide to retire earlier, to stay at home, take more vacation time, forgo overtime opportunities, or even move to another country, or avoid taking excessive risk in business.

Arthur Laffer was a major exponent of supply-side economics, both becoming prominent during the 1970s. Ronald Reagan was a big fan, even basing his tax policy, implemented in the 1980s, on it, which is why supply-side economics was often called Reaganomics. Laffer argued that increasing taxes can actually reduce tax revenue, because it will disincentivize work. He illustrated this by drawing a curve on the napkin, what later became known as the Laffer curve, showing the relationship between work and the tax rates on work, arguing that tax revenue would, at 1^st, increase with increasing tax rates. But when the tax rate got high enough, fewer people would work or they would work less, which would decrease tax revenue. When the tax rate reached 100%, then tax revenue would decline to 0, equivalent to the same situation when the tax rate itself was 0%. Thus, there was some point on the curve that would yield the maximum tax revenue. Although Laffer’s curve was symmetrical, the real curve is most certainly asymmetrical, because most people must work to earn a living, so the supply of labor is inelastic, especially at lower incomes.

The Republicans, especially, have latched onto supply-side economics to justify lowering taxes on wealthy people. They argue that lower taxes would stimulate the economy, and that increased economic growth would help to pay for the tax cuts, because, although the tax rates are lower, the tax base would increase through economic growth. To increase public support for lowering taxes on the wealthy, supply-side economics is often coupled with trickle-down economics. Giving the tax breaks to the wealthy, it is argued, will stimulate investments, saving, and even incentivize wealthy people to work harder by creating more businesses. Then their wealth will trickle down to lower-income people.

The Economics of Supply-Side Economics

Supply-side economics fails as a political argument for reducing taxes on the wealthy because it contradicts a few simple economic principles. Supply-side economics actually works best by giving the tax breaks to the poor. The main problem with supply-side economics as a political argument is that it starts with the political goal of reducing taxes on the wealthy, then tries to justify this goal by deriving economic benefits for society as a whole. But by considering a few fundaments of economics, a different conclusion is reached.

One aspect of the economy that seems clear is that consumption drives the economy. While supply is obviously necessary, no good or service will be supplied if it cannot be sold. So if an entrepreneur starts a business, then the business can only thrive if it has customers. If a product or service is demanded by the public, then some entrepreneur will figure out how to produce or provide it. That consumption is the main driver of the economy can also easily be seen by considering the fact that people, as biological beings, have demands that arise from their biology. These demands existed before there was any economy. Civilizations simply provided a better means to satisfy these demands.

Another fundament of the economy is that marginal utility declines with increasing consumption of any particular good or service. When you are hungry, you eat. As you eat more, you become less hungry, until you are no longer hungry. If you continue to eat, then you will get sick. What is true of eating, is true of all consumption of goods and services. Since money is used to purchase goods or services, money itself also has a declining marginal utility. In other words, the marginal utility of money is inversely proportional to the wealth of the individual. Why is that? Poor people must spend all of their money for the goods and services that are needed to survive. On the other hand, the wealthy have far more money than what is required even for a splendid living, so having more money does not increase their standard of living by much. This would suggest that tax breaks to the poor would be far more effective in stimulating consumption, and therefore, stimulate the economy more than giving tax breaks to the wealthy. And if the tax breaks to the wealthy are paid for by reducing social welfare programs, then the negative impact of reducing the income for the poor on the economy will exceed any stimulatory effect of giving tax breaks to the wealthy, because overall consumption will be reduced.

Another fundament of the economy is that the marginal propensity to consume is inversely proportional to wealth. This is related to the declining marginal utility of money. Because the wealthy already have everything they need or want, they spend less of their additional income. Instead, they invest it, mostly in secondary financial markets, such as the stock market, or they buy collectibles, like art.