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Supply-side economics (Part I)

Supply-side economics came into vogue in the early 1980s when Ronald Reagan assumed the presidency. Supply-siders felt that the economic role of the federal government had grown much too large and that high tax rates and onerous government rules and regulations were hurting the incentives of individuals and business firms to produce goods and services. President Reagan suggested a simple solution: get the government off the backs of the American people. How? By cutting taxes and reducing government spending and regulation.

The objective of supply-side economics, then, is to raise aggregate supply, the total amount of goods and services the country produces. The problem, said the supply-siders, is that high tax rates are hurting the incentive to work and to invest. All the government needs to do is cut tax rates, and voila: up goes production.

Many of the undesirable side effects of high marginal tax rates are explained by the work effect, the savings and investment effect, and the elimination of productive market exchanges, which we shall take up in turn.

The Work Effect

People are often confronted with work-leisure decisions. Should I put in that extra couple of hours of overtime? Should I take on a second job? Should I keep my store open longer hours? If you answer yes to any of these, you'll have to give the government a pretty big slice of that extra income.

At what point do you start working for the government? When it takes 20 cents out of each dollar of extra income (a marginal tax rate of 20 percent)? When it takes 30-cents? Or 40 cents? Each of us makes his or her own decision about the cutoff point. If you are a wage-earner, you will have to pay Social Security tax, federal income tax, and, possibly, some state income tax. Back in 1980, before the passage of the Kemp-Roth tax cut and the tax cuts that came under the Tax Reform Act of 1986, people earning more than $30,000 a year often had marginal tax rates of more than 50 percent. If you paid more than half of your overtime earnings in taxes, would you consider yourself to be working for the government?

Facing high marginal tax rates, many people refuse to work more than a certain number of hours of overtime or take on second jobs and other forms of extra work. Instead, they opt for more leisure time. In sum, high marginal tax rates rob people not only of some potential income but of the incentive to work longer hours. People working shorter hours obviously produce less, so total output is lower than it might have been with lower marginal tax rates. This and the saving-investment argument (considered next) are the two key points made by supply-siders for lower marginal tax rates.

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SUPPLY - SIDE ECONOMICS

(Part II) The Saving and Investment Effect

The supply-side economists really make two arguments against high marginal tax rates. The first is the work effect. Next is the saving and investment effect. When people save money, they earn interest on their savings. But a high marginal tax rate on interest income will provide a disincentive to save, or at least to make savings available for investment purposes.

Similarly, people who borrow money for investment purposes - new plant and equipment and inventory - hope that this will lead to greater profits. But if those profits are subject to a high marginal tax rate, once again there is a disincentive to invest.

If people are discouraged from working, total output will be reduced. And if they are discouraged from saving and investing, the economy will be stagnant. Supply-side economists point to the economic stagnation of the late 1970s and early 1980s as proof of the basic propositions of their theory. On the other hand, the economic record during the Reagan years, particularly with respect to saving, investment, and economic growth, was nothing to write home about either.

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