Archive for the ‘e488-supplyside’ Category

A Response to Bosworth’s Tax Incentives and Economic Growth

Friday, February 15th, 2008

Bosworth notes that supply-side economics is used in two different instances.  One is in the broad sense where the “volume and quality of the capital and labor inputs” determine the aggregate supply and the other is a narrower focus that emphasizes that tax reductions “increase the supply of saving, investment, and labor.”  Supply-side economics received a lot of attention in the late 1960s and 1970s due to high inflation rates.  The classicals didn’t view demand management as a problem and thought that prices would adjust as a result of disequilibriums in the market, especially in the labor market, and as a result of the quick changes in prices, the market would clear.  Keynesian economists came along next and observed that a decrease in demand in one market would lead to unemployment.  This unemployment would cause reductions in other markets because their incomes would fall and thus, they would consume less.  Therefore, where the Keynesians and classicals differed was in the speed of prices adjusting to changes in the market.  Whereas the classicals thought that price levels adjusted quickly, Keynesians observed sticky prices, and consequently, it was those sticky prices that created a gap between supply and demand.  Up until the 1960s, it was a general consensus that government policy did little in the way of changing the short-run path of potential GDP.  (For individual markets, the potential GDP can be changed because resources can be shifted from one market where the returns aren’t maximized to the market where the resources are used to their fullest potential.)  However, the overall economy is different in that supply is limited by the growth rate in both labor and capital.  Thus, since demand management was seemed as ineffective in combating high rates of inflation and unemployment in the late 1960s and 1970s, supply-side economics became the focus.  The new economic thought, however, had its own problems–political in nature–because supply-side economics deals with changes in taxes.

At first, though, people weren’t too receptive to the idea of supply-side economics because they felt that the government went too far in redistributing taxes and thus eroding people’s incentive to work.  Bosworth does note here that neo-Keynesians cannot be blamed for all these problems centered around inflation because demand management had greatly increased during the Vietnam War and the disruption of oil from the Middle East in the early 1970s created domestic economic problems.  The neo-Keynesians did, however, try to curb the recession in the 1970s by inducing mild recessions, but at the expense of higher unemployment.  Therefore, due to the fact that the public was dissatisfied with the roller coaster ride of the inflation-unemployment trade off, new theories to guide macroeconomic policies emerged.

It was an observed trend of the 1970s that the overall economy and worker productivity both slowed down (and between 1977-1982, worker productivity failed to grow at all).  At first this was perceived as temporary, but it soon became realized that this may be the new status of the economy–since people were used to an average of 3 percent growth since the end of WWII.  The frustrations came when workers perceived that their real wages were falling due to the high inflation rates.  More importantly, the notice of the lack of productivity growth in the economy made people realize that there would be few extra resources to put towards other social programs, and consequently, this laid the groundwork for increased social conflict among the various races and ethnic groups in America.

Out of the foreseeable social conflict came the notion that greater emphasis needed to be placed with the supply side of the economy.  At the current time, there was little or no consensus as to the “sensitivity of wages and prices to changes in demand and the responsiveness of supply to changes in wages, prices, taxes, and government benefits.”  Economists agree that “fixprice” markets represent the short run where prices are rigid and don’t respond to changes in the money supply due to lagged effects whereas “flexprice” markets represent the long run where prices are positively related to changes in the money supply.  (The only grey area, however, is the definition of the short- and long-run.)  In answer to the second question, people haven’t been able to quantify the magnitudes of the effects of changes in supply due to changes in the rates of return or relative prices when deciding on saving and investment choices.

Supply-side economists concur with the American neoclassicalists that supply (i.e. capital and labor) is largely effected by changes in the price level, which can be viewed as tax reductions because then people have more take-home income.  What supply-side economists feel is that more money in the economy via tax reductions will create an increase to entrepreneurial innovation, and thus, a greater work effort.  (This differs from earlier thoughts that concluded that tax reductions would ultimately reduce work effort because someone would wonder why they would have to work as hard as they did before if they end up with the same after-tax income as a result of the new tax break.)  Supply-side economists criticized Keynesian economics on the grounds that Keynesians believed in the “involuntary unemployment” due to mismatches the aggregate supply and demand.  However, the supply-side economists observed that the only reason to “involuntary unemployment” was as a result of information lags and errors in forecasting models developed by firms.  Some even went as far to state that fiscal policy has little or no effect on aggregate demand if the public wasn’t affected at all by interest rates.  Thus, these individuals favored monetary policy to affect the rates of change of GDP.

All in all, the supply-side view credits the increase in both capital and labor to the 1964 tax reduction because without this increase in after-tax incomes, there wouldn’t have been increased spending, which would never have led to increases in “production, employment, investment, and income.”  The rise in after-tax incomes had a significant impact on worker productivity.  With a lower tax bracket, employees offered to work more hours in return for a higher after-tax wage.  Where the criticism comes into play with the supply-side view is the magnitude and absolute effects that these supply changes (i.e. capital and labor) really had on productivity and output.  Were people responding strictly to economic incentives (i.e. lower tax rates) or did the improvements in technology have a larger impact?  Of course, there are numerous factors at play that cannot be controlled outside of a laboratory setting.  On the one hand, the substitution effect would say that people would work more hours at the expense of leisure due to higher after-tax incomes, but others would cite the income effect and claim that people would want more leisure, and therefore, give up work hours.  The impact on savings is another area of question.  Some would argue that the increased after-tax income would encourage people to save more, but there are those who feel that people consume based on present and future streams of income, and as a result, would consume more at the present time, which indicates that the net change in savings is ambiguous.  The effects on capital investments are also uncertain because an increased after-tax income would make capital cheaper relative to labor, but “cheaper” capital wouldn’t alter the production process that measurable because firms make decisions based on combinations of both capital and labor.

Source: Bosworth, Barry P.  1984.  Tax Incentives and Economic Growth.  Washington DC: The Brookings Institution.