James D. Gwartney
The Concise Encyclopedia of Economics

Supply-Side Economics

by James D. Gwartney
About the Author
Supply-side economics provided the political and theoretical foundation for a remarkable number of tax cuts in the United States and other countries during the eighties. Supply-side economics stresses the impact of tax rates on the incentives for people to produce and to use resources efficiently. A person's marginal tax rate—the tax rate she pays on an additional dollar of income—determines the breakdown between taxes, on the one hand, and income available for personal use, on the other. Since they directly affect the incentive of people to work, to save and invest, and to avoid and evade taxes, marginal tax rates are central to supply-side analysis.

An increase in marginal tax rates reduces the share of additional income that earners are permitted to keep. This adversely affects output for two major reasons. First, the higher marginal rates reduce the payoff that people derive from work and from other taxable productive activities. When people are prohibited from reaping much of what they sow, they will sow more sparingly. Thus, when marginal tax rates rise, some people, those with working spouses for example, will opt out of the labor force. Others will decide to take more vacation time, retire earlier, or forgo overtime opportunities. Still others will decide to forgo promising but risky business opportunities. These reductions in productive effort shrink the effective supply of resources and thereby retard output.

Second, high marginal tax rates also encourage tax shelter investments and other forms of tax avoidance. As marginal tax rates rise, investments that generate paper losses from depreciable assets become more attractive. So, too, do business activities that present opportunities to deduct expenditures on hobbies (for example, collecting antiques, raising horses, or traveling) and personal amenities (luxury automobiles, plush offices, and various fringe benefits). Thus, people are directed into activities because of tax advantages rather than profitability. Similarly, they are encouraged to substitute less desired tax-deductible goods for more desired nondeductible goods. Waste and inefficient use of valuable resources are a by-product of this incentive structure.

It is important to distinguish between a change in tax rates and a change in tax revenues. Because higher tax rates discourage work effort and encourage tax avoidance and even tax evasion, the tax base will shrink as the rates increase. When something is taxed more heavily, you will get less of it. Therefore, an increase in a tax rate causes a less than proportional increase in tax revenue. Indeed, economist Arthur Laffer (of "Laffer curve" fame) popularized the notion that higher tax rates may actually cause the tax base to shrink so much that tax revenues will decline.

This inverse relationship between a change in tax rates and the accompanying change in tax revenues is quite likely when marginal tax rates are high, but unlikely when rates are low. An analysis of the incentive effects for different tax brackets illustrates why this is true. Suppose that a government with progressive income tax rates ranging from a low of 15 percent to a high of 75 percent cuts tax rates by one-third. The top tax rate would then fall from 75 percent to 50 percent. After the tax cut, taxpayers in the highest tax bracket who earn an additional $100 would get to keep $50 rather than $25, a 100 percent increase in the incentive to earn. Predictably, these taxpayers will earn more taxable income after the rate reduction, and the revenues collected from them will decline by substantially less than a third. In fact, given the huge increase in their incentive to earn, the revenues collected from taxpayers confronting such high marginal rates may actually increase.

The same 33 percent rate reduction will cut the bottom tax rate from 15 percent to 10 percent. Here, take-home pay per $100 of additional earnings will rise from $85 to $90, only a 5.9 percent increase in the incentive to earn (compared to the 100 percent increase in the top bracket). Because cutting the 15 percent rate to 10 percent exerts only a small effect on the incentive to earn, the rate reduction has little impact on the tax base. Therefore, in contrast with the revenue effects in high tax brackets, tax revenue will decline by almost the same percent as tax rates in the lowest tax brackets. The bottom line is that cutting all rates by a third will lead to small revenue losses (or even revenue gains) in high tax brackets and large revenue losses in the lowest brackets. The share of the income tax paid by high-income taxpayers will rise.

The inflationary seventies created a receptive environment for the supply-side view. As inflation pushed numerous taxpayers into higher and higher marginal tax brackets, supply-side economists argued that high taxes were a major drag on economic growth. Furthermore, according to the supply-side view, the top rates could be reduced without a significant loss in revenue.

During the great tax debate of 1975 to 1986, the opponents of the supply-side view argued that it was unrealistic to expect lower tax rates to lead to increased tax revenues. According to the critics an increase in the tax base that was large enough to increase revenues would require an unrealistically large elasticity of labor supply (increase in hours worked due to higher after-tax wages). In response the supply-side proponents stressed that reductions in tax avoidance activities, as well as labor-supply effects, would enlarge the tax base when the rates were reduced. According to the supply-side view the combination of a decline in tax avoidance and increase in business activities would permit lower rates with little or no loss of revenues in the top tax brackets. At the same time, most supply-side economists, though perhaps not all, noted that reductions in low tax rates would lead to revenue losses.

Empirical studies of tax cuts that happened during the twenties and sixties buttressed the supply-side position. Prodded by Secretary of the Treasury Andrew Mellon, three major tax cuts reduced the top marginal tax rate from 73 percent in 1921 to 25 percent in 1926. In addition, the tax cuts eliminated or virtually eliminated the personal income tax liability of low-income recipients. The results were quite impressive. The economy grew rapidly from 1921 through 1926. After the rates were lowered, the real tax revenue (in 1929 dollars) collected from taxpayers with incomes above $50,000 rose from $305.1 million in 1921 to $498.1 million in 1926, an increase of 63 percent. In contrast, the real tax liability of those with less than $50,000 of income declined by 45 percent. Thus, as the tax rates were cut, the revenues collected from high-income taxpayers rose, while those collected from lower-income taxpayers declined. The tax cuts of the twenties substantially increased the percent of taxes paid by the wealthy.

The results of the Kennedy-Johnson tax cuts of the midsixties were similar. Between 1963 and 1965, tax rates were reduced by approximately 25 percent. The top marginal tax rate was cut from 91 percent to 70 percent. Simultaneously, the bottom rate was reduced from 20 percent to 14 percent. For most taxpayers the lower rates reduced tax revenues. In real 1963 dollars the tax revenues collected from the bottom 95 percent of taxpayers fell from $31.0 billion in 1963 to $29.6 billion in 1965, a 4.5 percent reduction. In contrast, the real tax revenues collected from the top 5 percent of taxpayers rose from $17.2 billion in 1963 to $18.5 billion in 1965, a 7.6 percent increase. As in the case of the tax cuts of the twenties, the rate reductions of the sixties reduced the tax revenue collected from low-income taxpayers while increasing the revenues collected from high-income taxpayers.

Major tax legislation passed in 1981 and 1986 reduced the top U.S. federal income tax rate from 70 percent to approximately 33 percent. The performance of the U.S. economy during the eighties was impressive. The growth rate of real GNP accelerated from the sluggish rates of the seventies. U.S. economic growth exceeded that of all other major industrial nations except Japan.

The critics of the eighties tax policy argue that the top rate reductions were a bonanza for the rich. The taxable income in the upper tax brackets did increase sharply during the eighties. But the taxes collected in these brackets also rose sharply. Measured in 1982-84 dollars, the income tax revenue collected from the top 10 percent of earners rose from $150.6 billion in 1981 to $199.8 billion in 1988, an increase of 32.7 percent. The percentage increases in the real tax revenue collected from the top 1 and top 5 percent of taxpayers were even larger. In contrast, the real tax liability of other taxpayers (the bottom 90 percent) declined from $161.8 billion to $149.1 billion, a reduction of 7.8 percent. These findings confirm what the supply-siders predicted: the lower rates, by increasing the tax base substantially in the upper tax brackets, caused high-income taxpayers to pay more taxes. In effect, the lower rates soaked the rich.

Probably the most detailed study of the tax changes in the eighties was conducted by Lawrence Lindsey of Harvard University. Lindsey used a computer simulation model to estimate the impact of the eighties' tax-rate changes on the various components of income. He found that after the tax rates were lowered, the wages and salaries of high-income taxpayers were approximately 30 percent larger than projected. Similarly, after the rate cuts capital gains were approximately 100 percent higher than projected, and high-income taxpayers' business income was a whopping 200 percent higher than expected. Lindsey concluded that the main supply-side effects resulted from (a) people paying themselves more in the form of money income rather than fringe benefits and amenities, (b) increases in business activity, and (c) a reduction in tax shelter activities. His findings undercut the position of those supply-side critics who had assumed that substantial supply-side effects were dependent on a large increase in labor supply.

Studies linking rate changes with changes in tax revenue measure the short-term effects of tax policy. But because taxpayers take time to adjust, revenues are even more responsive to rate changes in the long run. James Long and I conducted a study that found that taxpayers in states with lower marginal tax rates had much lower deductions and much lower expenditures on tax shelters than taxpayers in states with higher marginal rates. We found that when the combined federal-state marginal tax rate rises above 50 percent, the government's tax revenues decline. Lindsey estimates that the government's revenue begins declining at even lower tax rates, approximately 35 percent.

Supply-side economics influenced tax policy throughout the world in the late eighties. Of eighty-six countries with a personal income tax, fifty-five reduced their top marginal tax rate during the 1985-90 period, while only two (Luxembourg and Lebanon) increased their top rate. Countries that substantially reduced their top marginal tax rates include Australia, Brazil, France, Italy, Japan, New Zealand, Sweden, and the United Kingdom.

Reflecting the dominant Keynesian view at the beginning of the eighties, most economists thought that tax changes influenced output and revenue primarily by changing the demand for goods and services. Both research and the tax policy changes of the eighties, however, indicate that supply-side incentive effects are quite important. While controversy continues about the precise magnitude of the supply-side effects, the view that marginal tax rates in excess of 40 percent exert a destructive influence on the incentive of people to work and use resources wisely is now widely accepted among economists. This was not true prior to the eighties. An important piece of evidence for the shift in thinking is a 1987 statement by the Congressional Budget Office (CBO), which had been critical of the supply-side claims and had always assumed in its revenue projections that taxpayers did not respond at all to changes in tax rates. The CBO wrote: "The data show considerable evidence of a very significant revenue response among taxpayers at the highest income levels." This change in thinking is the major legacy of supply-side economics.

About the Author

James D. Gwartney is a professor of economics at Florida State University. He was previously chief economist of the Joint Economic Committee of the U.S. Congress.

Further Reading

Canto, Victor A., Douglas H. Joines, and Arthur B. Laffer. Foundations of Supply-Side Economics. 1983.

Federal Reserve Bank of Atlanta. Supply-Side Economics in the 1980s. 1982.

Henderson, David R. "Are We All Supply-Siders Now?" Contemporary Policy Issues 7, no. 4 (October 1989): 116-28.

Lindsey, Lawrence. The Growth Experiment: How the New Tax Policy Is Transforming the U.S. Economy. 1990.

Long, James, and James D. Gwartney. "Income Tax Avoidance: Evidence from Individual Tax Returns." National Tax Journal 50 (December 1987): 517-32.

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