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Supply-side Simplified

Hello kind reader! Thanks for stopping visiting Pianomics!

With the 2012 Presidential race picking up momentum, I'd like to address an economic idea that I can guarantee will be discussed amongst the candidates and analysts alike. This has entirely nothing to do with my political views and neither am I taking a side. As an economist, I simply state the theories and facts.

Supply-side economics refers to the reform of the supply side of the economy- companies and institutions that produce the goods and services that we, the people, consume. Supply-siders are those who would like these companies to be freer and more efficient with lower barriers (taxes) to produce these goods and services. This means less regulation and a greater supply of goods and services at a lower cost.

Since the 1980's, 'supply-side economics' has tended to refer more specifically to arguments favoring cutting high tax rates, an idea championed by American economist Arthur Laffer in the late 1970's. Laffer argued, that the more people have to pay in taxes, the greater their incentive will be to avoid paying them or work less hard.

According to Laffer, if a government levied no taxes, it would receive no revenue and on the other extreme, if the government levied 100% taxes, it would still receive no revenue (because no one would have any reason to work, Uncle Sam would be taking the entire check). He drew a bell-shaped curve showing that there was a point somewhere between 0 and 100% where a government could get maximum revenues. His argument: lower taxes could actually increase government revenues, economic trade, and investment. President Ronald Reagan and Margaret Thatcher both admired and implemented such thinking into their policies.

In the supply-side point of view, taxes represent barriers to business. High taxes discourage people to work hard and do business. On the other hand, low tax rates encourages workers and businesspeople to work hard, invest, and thus, expand the economy and their own bank accounts.

The theory focuses on the marginal tax rate- the tax rate paid on an additional unit (hour) of income. This is very different from average tax rate. I look at it this way, depending on deductions, a taxpayer might pay the average tax based on their income, yet face a 28-35% marginal tax on activities that could increase income such as overtime, investment, entrepreneurship, or education. Businesses investing their capital into other ventures or running day-to-day operations would also benefit from reduced marginal tax rates.

High tax rates could damage the economy. Workers could be discouraged to work overtime, take ownership of a business, or hit the college halls. On the flip side, when tax rates are low, it encourages people to do just the opposite: work overtime, start a business, or go to college. The Laffer Curve illustrates that the government has to find a balance between the two.

Exactly where the government should draw the line is the debate that continues to rage today. Some left-leaning economists propose the ceiling should be over 50%, while those on the right of the political spectrum suggest it should be below 40%.

Laffer's argument makes great sense, but most studies show it is ineffective. Only in extreme cases, such as rates being extremely high, can cuts in taxes bring in higher revenues. Evidence shows that the Reagan and President George W. Bush cuts in 2001-2003 reduced government revenues and pushed the budget deficit higher. Supply-siders argue that what both administrations got wrong was which specific taxes to cut, rather than deciding to reduce the overall level of taxation.

In summary, higher taxes means lower growth.

Thanks for reading and God Bless.


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