My time with supply-side economics.

• Author: Roberts, Paul Craig
• Position: Memoir & Defense

Supply-side economics is a major innovation in economics. It says that fiscal policy works by changing relative prices and shifting the aggregate supply curve, not by raising or lowering disposable income and shifting the aggregate demand curve. Supply-side economics reconciled micro- and macroeconomics by making relative-price analysis the basis for macroconclusions. The argument is straightforward: relative prices govern people's decisions about how they allocate their income between consumption and saving and how they allocate their time between work and leisure.

The cost to the individual of allocating a dollar of income to current consumption is the future income stream given up by not saving and investing that dollar. The present value of that income stream depends on marginal tax rates. The higher the marginal tax rate, the lower is the value of the income stream, and the cheaper is the price of current consumption. Thus, high marginal tax rates discourage investment and thereby lower the rate of economic growth.

The cost to a person of allocating additional time to leisure is the forgone current or future earnings. The value of the forgone income depends on the rate at which additional income is taxed. The higher the marginal tax rate, the cheaper the price of leisure. Tax rates thus affect the supplies of labor and entrepreneurship, the investment rate, the growth rate, and the size of the tax base.

Supply-side economics presented a fundamental challenge to Keynesian demand management. Keynesian multiplier rankings, which showed government spending to be a more effective stimulus to the economy than tax-rate reduction, had turned demand management into a ramp for government spending programs. Powerful vested interests organized in support of this policy. All Republicans could do was to bemoan the deficits necessary to maintain full employment.

Keynesian economists objected to the fiscal emphasis on relative price effects. They claimed that people have targeted levels of income and wealth regardless of the cost of acquiring them. A tax cut would let them reach their targeted levels of income and wealth sooner, resulting in a reduction of work effort or labor supply. Lester Thurow at MIT used this reasoning to argue that a wealth tax is a costless way to raise revenue because the income effect runs counter to and dominates the substitution effect. A wealth tax would cause a rise in labor supply as people worked harder to maintain their desired after-tax...