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Voodoo Economics, A Trojan Horse, and Trickle Down: Is it time to give the supply-side a try?
AS policy is defined as any government policy designed to largely impact the AS sector. This means that the target of any AS policy is to impact costs and/or productivity. The upshot is a policy designed to raise productivity of the business sector relative to its costs. The goal of such a policy is to increase real GDP and to reduce the price level. AS policy is always one-sided – there is no situation where the AS policy would attempt to raise costs relative to productivity.
|Situation 1||Situation 2||Situation 3||Situation 4|
|offset a negative supply shock||AD policy would involve a difficult tradeoff||output problem is quite severe||Long-run economic growth and increasing the standard of living|
|if a wage shock causes business costs to rise relative to productivity||Suppose the country is in a stagflation situation—with very high prices and low real GDP||AD policy would help to increase output, but as mentioned above, has the negative side effect of raising prices.||This will be discussed more below.|
|a fitting antidote would be a policy designed to reduce costs relative to productivity||An expansionary AD policy would be able to increase output but it would make inflation worse. A contractionary AD policy would reduce inflation but it would make output worse. *See note||Combining an expansionary AD policy with an AS policy would have a double whammy on increasing output while the AS policy offset any increases in prices.|
* In such a situation, AD policy has tough policy tradeoffs, but AS policy has none. Why? Because AS policy has the effect of reducing prices and raising output. There is no tradeoff since AS policy makes progress against both the problems of stagflation.
These four situations require both short- and long-run AS tools. We turn to a discussion of supply-side policy tools below.
AS Policy Tools
In the first three situations above, AS policy was an appropriate remedy for short-term macroeconomic ills. In each of these cases, a policy designed to raise business productivity relative to business costs would have the desired impact of increasing AS, AD, and real GDP while simultaneously lowering prices.
Until the 1980 presidential election in the U.S., the idea of AS policy was not in the forefront of most people’s minds. While many elements of AS policy had clearly been used many times before then, the genre of AS policies had hardly been explicated and, therefore, AS policy was not well known or understood. With the election of Ronald Reagan in the U.S. and the conversion of Margaret Thatcher around the same time in the United Kingdom, AS policy became very well known and enunciated. Reagan and Thatcher inherited a recessionary world with very high inflation. Therefore the setting was just right to try this novel approach. Because AS was not well known – it was very controversial. When George Bush was competing against Reagan for the Republican presidential nomination in 1979, he called AS policy Voodoo economics. Others called AS policy a Trojan Horse. Others simply saw it as a way for Reagan to reward his rich friends. Trickle-down were words suggesting that the rich would get most of the rewards and the rest of the population would get some of the crumbs.
Despite the criticisms, both Reagan and Thatcher were able to push through programs that resembled AS policies. We have continued to see bits and pieces of AS policies since them in the presidencies of George H. Bush, Bill Clinton, and George W. Bush. Below we describe some examples of AS policies recalling that the unifying concept is any policy whose intention is to cause productivity to increase relative to labor costs. It is a way to reduce unit costs of output.
Deregulation of business
By deregulating such major industries as transportation, communications, or banking the government hopes to create more competition that would lead to more entrepreneurship, higher innovation, and reductions in costs and prices.
Lower tax rates on income
While lower income taxes appears on the surface to be an AD policy, Reagan explained that the emphasis on tax RATES illustrated that households have choices about how much they want to work. Entrepreneurs make choices about how much risk to take. Lowering tax rates raises the reward to work and effort and risk relative to taking leisure. In 1979 the highest tax rates in the U.S. were at about 70%. Reagan believed that by lowering them to less than 30% would greatly enhance the reward for risk and work.
Lower tax rates on high incomes
In most countries the majority of national savings come either from businesses or from high income individuals. Lowering tax rates on the people with the highest incomes (keep in mind that many proprietorships pay personal income taxes rather than business taxes) was expected to reduce the penalty on saving and thereby create incentive for more saving. Why is this an AS policy?
It is considered an AS policy because increased saving should lead to lower interest rates and more investment spending. If spent wisely that investment spending by firms could lead to gains in business productivity.
Reduced capital gains taxes
By reducing the penalty on capital gains, more investors would be willing to take more risk. This might also induce more saving.
Accelerated depreciation and various subsidies aimed at capital spending
By allowing firms to accelerate their capital depreciation they could gain faster benefits from new capital. By giving subsidies for direct purchases of capital, firms would be rewarded for buying more capital. The new and better capital should translate into higher business productivity.
Business credits and special write-offs for hiring or training
Were meant to reduce any governmental impediments that raised the cost of labor. Subsidies for worker training were meant to raise productivity.
Union busting rhetoric
Was used by Reagan to try to diminish the upward push on wages and labor costs. Reagan used air traffic controllers as his first case. In 1979 coal miners were asking coal companies for three-year contracts with increased wages of approximately 40%. A long strike ensued. Miners were not necessarily being greedy. They had lost purchasing power during the decade of the 1970s. Inflation was high and it seemed to be rising. Nevertheless, high and rising wages would be counterproductive to the AS policy. If unions would ask for more modest wage increases, that would reinforce the goals of the rest of the AS program.
An article by William Poole and Howard J. Wall argues that the U.S. has much more entrepreneurship than other countries for a variety of reasons. The implication is that supply responses are quicker and involve a greater number of companies. (“Entrepreneurs in the U.S. Face Less Red Tape,” The Regional Economist, October 2004, Federal Reserve Bank of St. Louis, pages 5-9.) Why does the U.S. have a much higher percentage of people who want to be entrepreneurs? The authors focused on four factors:
- The U.S. makes it very easy to start a business – it can take as little as four days and $210. In contrast, it takes 31 days and $3,500 in Japan . Whereas there is no stipulation that the U.S. entrepreneur have any capital, Belgium requires a minimum of 75% of per capita income. In Germany and Greece the amount of capital necessary exceeds each nation’s average per capita income.
- U.S. financial markets are competitive and allow banks and investors to take risk. In the U.S. banking laws used to be very restrictive. Today they allow banks to move across state lines and can more freely charge interest rates that compensate for increased risk,
- The World Bank believes that U.S. firms have great flexibility in hiring and firing workers. They face fewer regulations that relate to conditions of employment. In contrast, the article singles out several country practices that promote inflexibility: Belgium for prohibiting fixed-term employment contracts, France for the 35 hour work week regulation, Germany for mandatory closing times for shops, and various European countries for constraining allowable grounds for employee dismissal, third-party approval for layoffs, and high mandated severance pay.
- The authors believe that high tax rates place high financial burdens on entrepreneurial firms. They cite the OECD for total tax rates that show that only Japan (27.1%) had (in 2002) lower tax rates than the U.S. (29.6%). Tax rates of other countries included Sweden (54.2%), Denmark (48.8%), Belgium (45.5%), France (45.3%), Italy (42%), and Germany (37.9%)
Despite the much higher incidence of entrepreneurship in the U.S. the authors believe the U.S. could do more. They site several suggestions to crease an improved supply response and economic dynamism including reducing the burden of some environmental regulations, reductions in health care expenses, and tort reform.
If you are so smart, then why aren’t you rich?
That’s what my mother always said to my father. In this context the question is, if AS policy is so good, then why doesn’t it have a better reputation? There are several parts to this answer.
For one thing, Reagan’s AS policy was watered down. For another, only a partial program was legislated. In Reagan’s case, within a year or two some of the key provisions were changed. Like all history, this record is subject to several interpretations and differences of opinions. Since Reagan, we have seen piecemeal aspects of AS policy incorporated into larger more diverse fiscal programs. In short, it is hard to find clear evidence of the effects of any AS policies and even harder to find unambiguous opinions about their effectiveness.
And one thing will always haunt any politician who tries to be a forceful advocate of AS policy—the politics are terrible. As the terms Trojan Horse and trickle down attest to, the most salient aspect of AS policy is its direct impact on wealthy individuals and companies. Of course, any policy designed to raise productivity relative to business costs will have to be aimed at these groups. The unhappy political fact is that any populist will make mincemeat out of AS policies. One must have an economics course under their belt to understand or explain why AS policy is best for the country. But all it takes is the shortest sound bite to show quite vividly that some very tiny percent of the direct benefits will go to poor people. It is a tough row to hoe.
For more background on AS policy, the following reading is excellent, keeping in mind that this article was written by an advocate of AS policy. “A Walk on the Supply Side” by Raymond Keating. The original citation is The Freeman, a publication of the Foundation for Economic Education, May 1995, Vol 45, No.5.Taken from the following website