Friday, October 10, 2008

Reaganomics Supply-Side Economics

Reaganomics Supply-Side Economics

Understanding Supply-Side Economics by David Harper,CFA, FRM (Contact Author Biography) Reaganomics (a portmanteau of "Reagan" and "economics") refers to the economic policies promoted by United States President Ronald Reagan. The four pillars of Reagan's economic policy were to:[1] reduce the growth of government spending, reduce marginal tax rates on income from labor and capital, reduce government regulation of the economy, control the money supply to reduce inflation. In attempting to cut back on domestic spending while lowering taxes, Reagan's approach was a departure from his immediate predecessors. Reagan became president during a period of high inflation and unemployment (commonly referred to as stagflation), which had largely abated by the time he left office.

Supply-side economics is better known to some as "Reaganomics", or the "trickle-down" policy espoused by former U.S. president Ronald Reagan. He popularized the controversial idea that greater tax cuts for investors and entrepreneurs provides incentives to save and invest and produce economic benefits that trickle down into the overall economy. In this article, we summarize the basic theory behind supply-side economics.

Like most economic theories, supply-side economics tries both to explain macroeconomic phenomena and - based on these explanations - to offer policy prescriptions for stable economic growth. In general, supply-side theory has three pillars: tax policy, regulatory policy and monetary policy. However, the single idea behind all three pillars is that production (i.e. the "supply" of goods and services) is the most important determinant of economic growth. The supply-side theory is typically held in stark contrast to Keynesian theory, which, among other facets, includes the idea that demand can falter, so if lagging consumer demand drags the economy into recession, the government should intervene with fiscal and monetary stimuli. This is the single big distinction: a pure Keynesian believes that consumers and their demand for goods and services are key economic drivers, while a supply-sider believes that producers and their willingness to create goods and services set the pace of economic growth. The Argument That Supply Creates Its Own Demand In economics we review the supply and demand curves. The left-hand chart below illustrates a simplified macroeconomic equilibrium: aggregate demand and aggregate supply intersect to determine overall output and price levels. (In this example, output may be gross domestic product and the price level may be the Consumer Price Index.) The right-hand chart illustrates the supply-side premise: an increase in supply (i.e. production of goods and services) will increase output and lower prices.
Starting Point
Increase in Supply (Production)

Supply-side actually goes further and claims that demand is largely irrelevant. It says that over-production and under-production are not really sustainable phenomena. Supply-siders argue that when companies temporarily "over-produce", excess inventory will be created, prices will subsequently fall and consumers will increase their purchases to offset the excess supply. As put by the Fountainhead Capital Group, "After all, what would cause consumers and businesses to stop demanding goods and services and force the economy into a recession or a depression? Keynes had no idea, and said as much…." This essentially amounts to the belief in a vertical (or almost vertical) supply curve, as shown below on the left-hand chart below. On the right-hand chart, we illustrate the impact of an increase in demand: prices rise but output doesn't change much.
Vertical Supply Curve
An Increase in Demand → Prices Go Up

Under such a dynamic - where the supply is vertical - the only thing that increases output (and therefore economic growth) is an increase in the production of the supply of goods and services. As illustrated below:
Supply-Side Theory Only an Increase in Supply (Production) Raises Output

Three PillarsThe three supply-side pillars follow from this premise. On the question of tax policy, supply-siders argue for lower marginal tax rates. In regard to a lower marginal income tax, supply-siders believe that lower rates will induce workers to prefer work over leisure (at the margin). In regard to lower capital-gains tax rates, they believe that lower rates induce investors to deploy capital productively. At certain rates, a supply-sider would even argue that the government would not lose total tax revenue because lower rates would be more than offset by a higher tax revenue base - due to greater employment and productivity.

On the question of regulatory policy, supply-siders tend to ally with traditional political conservatives - those who would prefer a smaller government and less intervention in the free market. This is logical because supply-siders, although they may acknowledge that government can temporarily help by making purchases, they do not think this induced demand can either rescue a recession or have a sustainable impact on growth. The third pillar, monetary policy, is especially controversial. By monetary policy, we are referring to the Federal Reserve's ability to increase or decrease the quantity of dollars in circulation (i.e. where more dollars means more purchases by consumers, thus creating liquidity). A Keynesian tends to think that monetary policy is an important tool for tweaking the economy and dealing with business cycles, whereas a supply-sider does not think that monetary policy can create economic value. While both agree that the government has a printing press, the Keynesian believes this printing press can help solve economic problems. But the supply-sider thinks that the government (or the Fed) is likely to create only problems with its printing press by either (a) creating too much inflationary liquidity, or (b) not sufficiently "greasing the wheels" of commerce with enough liquidity. A strict supply-sider is therefore concerned that the Fed may inadvertently stifle growth by contributing to deflation and encouraging investors to horde dollars. What’s Gold Got To Do with It?Since supply-siders view monetary policy not as a tool that can create economic value, but rather a variable to be controlled, they advocate a stable monetary policy or a policy of gentle inflation tied to economic growth - for example, 3% to 4% growth in the money supply per year. This principle is the key to understanding why a supply-sider often advocates a return to the gold standard - which may seem strange at first glance. (And most economists probably do view this aspect as dubious.) The idea is not that gold is particularly special but rather that gold is the most obvious candidate as a stable "store of value". The supply-sider argues that if the U.S. were to peg the dollar to gold, the currency would be more stable, and fewer disruptive outcomes would result from currency fluctuations. As an investment theme, supply-side theorists say that the price of gold - since it is a relatively stable store of value - provides investors with a "leading indicator", or signal for the direction of the dollar. Indeed, gold is typically viewed as an inflation hedge. And, although the historical record is hardly perfect, gold has often given early signals about the dollar. In the chart below, we compare the annual inflation rate in the United States (the year-to-year increase in the Consumer Price Index) with the high-low-average price of gold. An interesting example is 1997-98: gold started to descend ahead of deflationary pressures (lower CPI growth) in 1998.

Conclusion Supply-side economics has a colorful history. Some economists view supply-side as a half-baked economic theory - economist and New York Times columnist Paul Krugman even called its founders "cranks" in a book dedicated to attacking the theory ("Peddling Prosperity"). Other economics are so utterly disagree with the theory that they dismiss it as offering nothing particularly new or controversial to an updated view of classical economics. We have discussed the three pillars, and, based on this, you can see how the supply side cannot be separated from the political realms: if true, it implies a reduced role for government and a less progressive tax policy.
by David Harper (Contact Author Biography)In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The Bionic Turtle, a site that trains professionals in advanced and career-related finance, including financial certification. David was a founding co-editor of the Investopedia Advisor, where his original portfolios (core, growth and technology value) led to superior outperformance (+35% in the first year) with minimal risk and helped to successfully launch Advisor.
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Better Home Business said...


With the advice from former president Richard Nixon, Reagan concentrated on economic issues his first six months in office. Reaganomics was the name given to the supply-side economic theory which Reagan based his economic plans. It operated on the belief that the economy was struggling in large part because of excessive taxation. With more money going to taxes, individuals and corporations were unable to invest capital to stimulate growth. The plan called for massive tax cuts in order to stimulate investments. The economic growth would then `trickle down` to the workers. Supply-side economics also called for budget cuts to counteract the loss of revenue from the tax cuts. Reagan followed this model in creating his budget plan in 1981. Reagan put together legislation that cut government expenditures by $40 billion and created a three year tax cut plan for individual and corporate income taxes. The tax cut was the largest in history and was expected to jump start the economy. However, after the bills passed in the summer of 1981, the country fell into the worst recession since the Great Depression.


Inflation averaged 12.5 percent when Reagan entered office, was reduced to 4.4 percent when he left.


Interest rates fell six points.


Eight million new jobs were created as unemployment fell.


An eight percent growth in private wealth.

CON 4.1

According to the Statistical Abstract of the United States for 1996, the number of people (white, black, and Hispanic) below the poverty level increased in almost every year between 1981 (31.8 million) and 1992 (39.3 million).


We were $994 billion in debt in fiscal 1981, when Carter left off, and $2,867 billion when Reagan leaves office in fiscal 1989. The rough number is 2.85 times as much in 1989 as in 1981. No, it's not quite tripled, but very close. Okay, so the republicans have an argument for this: it didn't really double or triple when you take it as a percentage of either GDP or GNP. Okay, if we go with that, then it can indeed be agreed that Reagan didn't really double the debt as a percentage of either of these figures. But that doesn't really make Reagan look any better. As a historical look at the debt since before the United States entered World War II will show, the debt as a percentage of GDP never went up meaningfully for any extended period of time except for two periods: during the War itself, and starting during the Reagan years. At least President Roosevelt had the need to borrow money hand and fist to fight the Axis powers. What's Reagan's excuse? We needed to borrow money to give a tax break to the wealthy?

PRO 5.1

The primary reason the deficit grew during the Reagan years was the Cold War military buildup.

PRO 5.2

In no year following the tax cuts did revenues decline. They increased in fact in almost a straight progression from pre-Reagan years. The Cold War budgets did increase, and of course the happy fact was that this led to the end of the Cold War itself, as the Soviet Union recognized it could not outspend the U.S. But those military budgets were not significantly larger than during the 70s, and were smaller than in the Kennedy and Johnson years. No, it was domestic spending, and particularly entitlement spending, that grew enormously under the Democrat congress.


The trade deficit quadrupled.


Between 1978 and 1981 the top capital gains rate was cut from 35 percent to 20 percent and revenues soared by 90 percent in real terms between 1978 and 1985.After Congress lifted the rate to 28 percent in 1986, capital gains revenues declined by 20 percent by 1990.

CON 7.1

There are two reasons for these numbers. One is they start with a recession, the change in the economy is responsible for most of these changes. The second reason is a short term effect. During 1981 when there was talk of a Capital Gains Tax cut people held off selling their assets until the tax cut. Then people rushed to sell assets before the 1986 tax raise happened.

CON 7.2

The 1986 Tax Reform Act is widely considered to be the best piece of American tax legislation since the adoption of the income tax. It is the opposite of Reaganomics. Over its first five years, it closed more than $500 billion in loopholes and tax shelters. As a result:

Major U.S. corporations that previously had paid little or nothing in income taxes due to loopholes were put back on the tax rolls, and corporate taxes were increased overall by a net of more $100 billion over five years.
A huge wasteful tax-shelter industry for high-income individuals was shut down.
Tax rates on capital gains income were raised to the same level as on other income.
Millions of moderate-income working families got tax relief through a major expansion of the earned-income tax credit.
Taxes on most families (on average, all but the best-off tenth) were reduced. (The table shows the tax changes by income group.)
The income tax was substantially simplified for most filers.
Allied in support of the 1986 reforms were a vast array of public interest groups, labor unions and citizens groups around the country. The act was also highly praised by most economists, because it leveled the playing field for businesses and investments, and made our economy more efficient and productive. Unsuccessfully opposing the 1986 Tax Reform Act were low- and no-tax corporations, recalcitrant supply-siders and tax-shelter promoters. (Opponents included, for example, Newt Gingrich, Bill Archer and billionaire Donald Trump, who continues to criticize the act for cracking down on abusive real-estate tax shelters.)


The average annual growth rate of real gross domestic product (GDP) from 1981 to 1989 was 3.2 percent per year, compared with 2.8 percent from 1974 to 1981 and 2.1 percent from 1989 to 1995. The 3.2 percent growth rate for the Reagan years includes the recession of the early 1980s, which was a side effect of reversing Carter's high-inflation policies, and the seven expansion years, 1983-89. During the economic expansion alone, the economy grew by a robust annual rate of 3.8 percent. By the end of the Reagan years, the American economy was almost one-third larger than it was when they began.

CON 8.1

To avoid being misled by the business cycle, one must look at underlying economic growth rates. The following table accomplishes this result in two ways. First, it measures economic growth and other data from one business cycle peak to the next, rather than from a recession to a later peak. Second, it uses CBO calculations of "potential" economic growth — that is, CBO's (Congressional Budget Office) estimate of the size of the economy in any year if unemployment were at normal levels, rather than abnormally high or low levels. In effect, CBO directly calculates the size of the underlying economy, ignoring the business cycle. Both approaches give the same answer: economic growth rates have slowed from decade to decade; if income tax rates have made any difference to economic growth, that difference has been too small to be obvious. Specifically, the CBO data show that the underlying rate of annual economic growth was lower in the 1980s than the 1970s. It averaged 3.4 percent from 1969 to 1980, then slipped to 2.7 percent in the 1980s (not the 3.8 percent that comes from measuring from the depths of the recession in 1982), and is now projected at 2.1 percent. It is plausible that the underlying annual growth rate might have been slightly less than 2.7 percent in the 1980s were it not for the 1981 tax cut, but surely only slightly.


When Reagan took office in 1981, the unemployment rate was 7.6 percent. In the recession of 1981-82, that rate peaked at 9.7 percent, but it fell continuously for the next seven years. When Reagan left office, the unemployment rate was 5.5 percent.

PRO 10

Real median family income grew by $4,000 during the Reagan period after experiencing no growth in the pre-Reagan years; it experienced a loss of almost $1,500 in the post-Reagan years.

CON 10.1

The savings rate did not rise in the 1980s, as supply-side advocates had predicted. In fact, in the 1980s the personal savings rate fell from 8 percent to 6.5 percent. If the median family was better off why did their savings go down?

CON 11

In 1993 Clinton raised the taxes on the rich, the opposite of Reaganomics, opponents argued that this would stop the growing economy. That did not happen.

PRO 11.1

It is entirely disingenuous of the "cons" to suggest that the fact that the tax increase of the first Clinton budget (after he had promised, you will recall, a tax cut) did not harm the economy proves that the Reagan tax increase was a mistake. Not factored into any liberal equation is that at the time Clinton took office (in fact, long before the election) the economy was growing briskly again, the brief Bush recession having ended in March 1992. Moreover, the end of the Cold War led to massive cuts in military and Defense Department budgets, a reduction in the size of government that Clinton and Gore now have the audacity to claim as their achievements