SUPPLY SIDE ECONOMICS

Government and Aggregate Supply The stagflation of the 1970s led to the realization that all economic problems could not be solved by focusing solely on aggregate demand. Supply-side economists focus their attention on government policies such as high taxation that impede the expansion of aggregate supply.

Government and Aggregate Supply Tax policies can improve the unemployment/inflation trade-off A reduction in taxes on capital gains (profit from investment spending) and/or corporate income will increase business profit expectations and increase investment.  This increase in investment means greater capital stock which leads to increased productivity and an outward shift of both the SRAS and the LRAS

Government and Aggregate Supply A reduction in taxes on personal income leads to higher levels of savings  More savings leads to lower interest rates = more investment = more capital stock = SRAS and LRAS shift out. A reduction in taxes on personal income creates an incentive to work and to work harder.  An increase in labor force participation = SRAS and LRAS shift out.  An increase in productivity shifts SRAS and LRAS outward

Government and Aggregate Supply PL RGDP LRAS 2 AS 2 PL2PL1 LRAS 1 AS 1 AD 2 AD 1 Q1Q1 Q2Q2

THE LAFFER CURVE The Laffer Curve relates tax rate levels to levels of tax revenue and suggests that, under some circumstances, cuts in tax rates will expand the tax base (output and income) and increase tax revenues.

0 100 l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

0 100 m l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

0 100 m n l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent)

0 100 m m n l THE LAFFER CURVE Tax revenue (dollars) Tax rate (percent) Maximum Tax Revenue

The Laffer Curve and Reaganomics In the 1980s, as part of President Reagan’s move to prove that less government is better, Arthur Laffer’s ideas were put in play. Taxes were cut with the expectation that tax revenues would increase. The result was the opposite – tax revenues fell. Today most economists believe that we are in the range of Laffer curve where tax rates and tax revenues move in the same, not opposite, direction.