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Some Thoughts on Supply-side Economics

Mises Daily: Tuesday, March 02, 2010 by

Laffer Curve

[Libertarian Forum, 1980]

When Keynes's General Theory was published in 1936 there was no reason to believe that it would soon serve as the framework for 40 years of economic theory and policy. Almost to a man, every important economist of that era condemned the book and its message as confused, inconsistent and dangerous.

Joseph Schumpeter compared Keynes's proposals with the types of economic policies pursued by France's Louis XV, which led to the bloodshed of the French Revolution.[1] Friedrich Hayek angrily insisted that Keynes was asking us to abandon 200 years of economic theory and return to the crude and naive idea that somehow the more money you create the wealthier you become.[2]

And Kenneth Boulding declared that

Mr. Keynes' economics of surprise, like Hitler's, may be admirable in producing spectacular immediate success. But we need Puritan economists like Dr. Hayek to point out the future penalties of spendthrift pleasures and to dangle us over the hellfire of the long run.[3]

Yet, by 1946, only ten years after the appearance of The General Theory, all that had changed. Keynesian economics had swept the field and those who refused to accept the new vision were considered as out of date and antiquated as those who still believed that the sun revolved around the earth.

Paul Samuelson could prayerfully give thanks that Keynesian system had given economists, "a Gospel, a Scripture, a Prophet."[4] And Gottfried Haberler, who had once been one of Ludwig von Mises's most promising students in the 1920s and early 1930s, could insist that, "Only a dullard or a narrow minded fanatic could fail to be moved to admiration by Keynes' genius."[5]

Promising price stability, Keynesian monetary policy produced 30 years of ever worsening inflation; pledging an era of full employment, Keynesian contra cyclical manipulations created severe fluctuations and distortions in employment and output, particularly in the last ten years; and assuring the public that the secret to ever greater investment and productivity lies in the government's fiscal ability to stimulate aggregate demand, the last 20 years has seen productivity increases falling rapidly and capital investment become ever more erratic.

With such a widening margin between promise and performance, a revolt against the Keynesian system was inevitable. The first step in this revolution was the rediscovery of the quantity theory of money. Both Austrian and Chicago economists hammered away at the public and their fellow economists that a prolonged and accelerating rise in prices could never happen without an ever increasing expansion of the supply of money and credit.

How successfully has this truth been learned? James Meade, a leading British Keynesian and Nobel Laureate, gave a lecture in Vienna last year in which he said that a "system of uncontrolled [trade union] monopoly power" combined with a "Keynesian governmental undertaking that, whatever happens to the level of money wages, demand will be stimulated sufficiently to avoid any General Unemployment," has created a "set of institutions which might well have been expressly designed to set in motion and maintain [a] process of explosive inflation."[6]

When one of the leading intellectual advocates of the British Welfare State and the Keynesian system begins to show such grave doubts, we can hope that the era of naive but highly dangerous rationalizations for monetary expansion may be coming to an end.

Another major blow against the Keynesian paradigm is now being leveled by those who call themselves the "supply-side" economists.

Pointing to the low rate of savings in the United States (approximately 3 percent), and the low rate of (real) investment and productivity increases, the "supply-siders" have lifted from a bookshelf long neglected by the Keynesians, the old 19th century classical works that had so cogently argued that only that which has been produced can be consumed and only that which has been saved is available to be invested. With great articulation they have helped bring back to Say's Law the respect it always deserved and should never have been denied.

All exchange has as its purpose the fulfillment of human wants and desires. We offer to trade something we possess for something held by another because we believe that that which the other person presently has title to would give us greater satisfaction than that which we presently own. Yet, unless we have been the beneficiary of a magnanimous gift giver, the only way to acquire what we want is first to produce or participate in the production of something that other individuals might possibly desire.

That too much of one thing and too little of another might be produced is almost inevitable in a world where the future is uncertain and present productivity must be guided by anticipations of future wants. But through the process of profit and loss, incentives are always being created for producers to supply greater quantities of some goods and less of others. Thus, while a perfect balancing of supply and demand may never exist at any moment in time, that is the tendency that is always at work in the system.

The "supply-side" economists have not only repeated these arguments, but have also attempted to analyze under what conditions it is worthwhile to trade or not to trade, work or not to work, and save or not to save. Individuals, they point out, must compare the relative advantages of doing one thing rather than another, and the alternative that offers the highest anticipated gain will be the one chosen.

In the market place, relative advantages come to be expressed in terms of prices. We enter the supermarket and, given our income, we allocate our expenditures so as to maximize utility or achieve the highest level of satisfaction possible.

If the relative prices of some goods change, we reevaluate our estimations of them and most people will tend to buy a relatively smaller amount of the products that have risen in price and a relatively larger amount of those that have gone down in price. Relative prices, and any changes in them therefore, influence and guide the allocation of income on the part of consumers and the allocation of production on the part of producers.

The same tools of analysis, the "supply-siders" argue, can also be applied to a study of fiscal policy. Tax rates, for example, represent some of the relative prices that an individual has to take into consideration when making a decision.

If an individual is considering working additional hours or is contemplating a new investment or a new device for improving productivity, he must compare the additional revenue or gain that he would receive from carrying out this plan with the additional costs — including taxes — involved.

Thus, "supply-siders" conclude, progressively rising marginal tax rates that take a greater and greater proportion of one's income will tend to dissuade work, create incentives to move into barter or cash transactions that can avoid the leering eye of the tax collector, and diminish the incentive for saving and investment.

How could work, productivity, saving, investment and greater division of labor be stimulated? By lowering the marginal tax rates, so that at every level of income the proportion remaining in the hands of workers and producers would be larger. Then the relative cost of making a work or saving or investing decision would have fallen and these activities over time would probably be expanded.[7]

Now, if the "supply-side" argument was left at that, the main thrust of their argument could be considered unobjectionable in its general outline, with few grounds for major disagreement. They would have only more or less supplied the basic tools of price theory to some aspects of fiscal policy.[8]

An additional ingredient in the tool kit of some "supply-side" theoreticians, however, is the concept of the "Laffer Curve," named after Arthur Laffer, a USC economist.

Laffer argues that there are two possible tax rates that will generate the same level of government revenue. If taxes are zero, government revenue is zero and the people retain 100 percent of their income. If taxes are l00 percent, government revenue would again be zero because, Laffer says, nobody would bother to work if they were not allowed to keep any of what they had earned and produced.

If the rate of taxation is lowered from l00 percent, individuals would have an incentive to work, since they could now keep some of what they had produced and government revenue would rise from zero to some positive number. Every lowering of the tax rate would continue to induce more and productivity, with greater government revenue besides.

Greater government revenue, that is, until some point at which any further lowering of the tax rate would, in fact, generate less of a government take rather than more. Hence, the "Laffer Curve."

What, then, is the goal to which economists and politicians should direct their efforts? In The Way The World Works, Jude Wanniski, one of the leading gurus of the "supply-side" school of economics, gives as an answer, the discovery of the actual shape of the "Laffer Curve."

That part of "The Curve" at which government revenue is maximized should be pinpointed and fiscal policy implemented to assure that the economy is moved to that point without further delay.[9]

The obvious question is, how do we ever find out the actual shape of "The Curve" and where we are on it?

If, for sake of the argument, we accept that such a "Curve" exists somewhere out there, it is important to realize that it would be nothing more than the cumulative subjective estimations of a multitude of individuals about the relative advantages of work vs. leisure, consumption vs. savings, etc.

"The Curve" would be no more fixed or stable than the expectations and preferences of the individuals in a particular community. Changes in people's valuations, revisions in expectations about the political, social or economic climate and new discoveries of cost-saving production techniques would all work to make any hypothecated "Laffer Curve," a shifting, shadowy entity whose position and shape would be as fluid and erratic as the imaginative minds of the individuals who comprise the elements living under "The Curve."

But even more important than the theoretical difficulties of determining the position and shape of "The Curve" is the assumption that the goal of fiscal policy should be the maximizing of governmental revenues.

The primary trade-off is not seen as that between income kept and income seized via taxation from the public. That analysis is incidental to the main purpose of discovering the tax structure that generates the most revenues for the state coffers, i.e., the incentive structure that entices and induces the slaves to produce the output that assures the maximum booty for the slave-masters and their lackey underlings.

Indeed, the in-fighting and emotional hysteria in Congress over the Kemp-Roth Bill is nothing more than the politicians and the special interests arguing over whether the proposed tax cut will or will not supply the government with ever greater sums to dole out to the friends and favorites of the political court.[10]

"Supply-side Economics," as it has developed over the last few years and as it is usually presented when its case is being made, is not a vehicle for diminishing the size of government or expanding the economic liberty of the general public.

Having reached a dead-end in attempts to stimulate the economy on the side of "aggregate demand," the macroeconomic manipulators have now discovered there is a new set of economic equations that can be massaged on the "aggregate supply" side as well.

Already the economic model builders are busy at work revising their equations and adding more variables. Michael Evans, the designer of two of the leading Keynesian econometric models, has changed over to the "supply-side" school. Having opened a new economic forecasting business, he is designing a new "supply-side" model and is already estimating how much of a percentage cut in tax rates will produce what percentage increase in savings and work effort.[11]

And after having slowly been shown the light, the economic forecasters working for Congress are licking their chops calculating what tax levers should be pulled, and by how much, to generate revenue and production where the government considers it worthwhile.

Rather than a means for freeing the economy from the fiscal tax burdens of the state, "supply-side" economics may very well serve as the vehicle for what in France has long been called "indicative planning." Instead of directly ordering the movement of labor and resources from one area of the economy to another, indicative planning operates through a system of tax incentives and subsidy programs to entice business enterprises into certain parts of France and into certain lines of production that the government considers "socially desirable."[12]

Supply-side economics could open the door for systematic government manipulation of tax rates as a means to assure the "socially desirable" level of saving and investment and the "socially desirable" combination of work and leisure.

Just as the old Keynesian macroeconomics has been a mechanism for distorting the economy through "aggregate demand" tools, the new "supply-side" macroeconomics will almost certainly result in economic distortions through the use of "aggregate supply" tools.

Tax cuts and lowering of tax rates are desirable. But they are desirable because they would allow those who have earned the income the right to keep and spend it as they see fit. Would savings and investment be greater if personal and corporate tax levels were lower? Probably they would, since existing fiscal actions have set up disincentives for both activities.

But individuals, themselves, should be left free to decide how much to work or not and how much to consume and save. And equally important, entrepreneurial and business activities should be free from regulations and fiscal gimmickry so production can be organized and resources can be allocated to reflect the preferences and desires of income earners in their role as consumers.

There is no "socially desirable" level of work or of saving and investment other than what individuals freely choose as desirable. And unless the case for "supply-side" economic reform is modified to reflect an argument for individual freedom, it may very well serve as a means for even greater state control over the economy and not less.


[1] Joseph A. Schumpeter, "Review of The General Theory of Employment, Interest and Money by John Maynard Keynes," Journal of the American Statistical Association (Dec., 1936), p. 794.

[2] Friedrich A. Hayek, The Pure Theory of Capital (London: MacMillan & CO., Ltd., 1941), pp. 409-410.

[3] Kenneth E. Boulding, "Review of The Pure Theory of Capital by Friedrich A. Hayek," Journal of Politcal Economy (Feb., 1942), p. 131.

[4] Paul Samuelson, "The General Theory", in The New Economics, ed. by Seymour E. Harris (New York: Alfred A. Knopf, 1946), p. 147.

[5] Gottfried Haberler, "The General Theory," in The New Economics, ibid., p. 161.

[6] James E. Meade, "Stagflation in The United Kingdom," Atlantic Economic Journal (Dec., 1979). p. 6

[7] Jack Kemp, An American Renaissance: A Strategy for the 1980's (New York: Harper & Row, 1979), pp.32-76.

[8] See Murray N. Rothbard, Power and Market: Government and the Economy (Menlo Park: Institute for Humane Studies, 1970) pp. 63-123, who draws similar conclusions, though with important qualifications.

[9] Jude Wanniski, The Way the World Works (New York: Simon and Schuster, 1978), pp. 97-1 15.

[10] Arthur B. Laffer & Jan P. Seymour, eds., The Economics of the Tax Revolt (New York: Harcourt Brace Jovanovich: 1979), pp. 45-68.

[11] Michael E. Evans, "The Bankruptcy of Keynesian Econometric Models," Challenge Magazine (Jan.-Fep.., 1980) pp. 13-19.

[12] Vera Lutz, Central Planning for the Market Economy, An Analysis of the French Theory and Experience (London: Longmans, Green and Co. Ltd., 1969).