1. Illustrate the rationale of tax cuts as a supply side policy (SSP)

As we now know, the SSP is supposed to increase the output produced by a disengagement from the governments in the economics affairs. These SSPs, all decided and improved by the government, include privatization, competition increasing, reduced monopoly and trade union power, reduced benefits to unemployed, increased labour mobility and reduced taxation. We illustrate the rationale of tax cuts in the following paragraphs.

In order to make everything as easy as possible to understand, we suggest following everything with a look at the graphs shown at the end of this paper. We start with an equilibrium situation (Graph 1), and the vertical strait line represents the situation of the supply side at this exact moment. This vertical line states that the AS curve is not elastic to a change in prices, assuming then that a AD policy (fiscal or monetary) would not have the discounted effect on unemployment.

On the first step (Graph 2), the reduction in the tax level will have a positive impact on the aggregate demand curve, shifting from AD1 to AD2. This is because less tax means more money to spend in the economy. On the short term, the output produced shifts from Y1 to Y2. We can see from the graph that the price doesn’t change – on the short term at least – meaning that the economy is not working at full capacity and then, firms can hire more employees without having to increase wages. This condition is necessary to our theory, since the SSP aims to increase the employment rate.

On the second step (Graph 3), the aggregate supply curve shifts also to the right, but much less than what has been seen from the AD. The new price is P2, and the new output, on the long term, is Y3. This shift is explained by the fact that for any price, firms are now willing to produce more output because their price is lower (by the tax decrease amount). However, given the fact that an increase in production can’t be done immediately, this explains why we wait on step two to see the shift of AS. Furthermore, the increase in the price level is explained by the fact that the AD curve shifts more than the AS one and a shift of AS reduces the amount of unemployed citizens, pushing up gradually the price of labour.

The decrease in the tax rate is supposed to be, according to the supply-siders, compensated by the bigger expenses and new revenues generated by the new output production (more income taxable). At this subject, it’s important to note the "Laffer Curve" (Graph 4), which shows the rationale in the supply-sider’s heads. That is, there is a certain level of tax rate that maximize the total tax revenues, and another level (that has not to be different from the first one) that maximize the GDP growth rate. For instance, if the initial situation shows a tax rate of TI, it’s easy to prove (according to the Laffer’s model) that we can both increase tax revenues and GDP growth rate by reducing tax rate to TC for example.

 

2. America now faces huge deficits with regard to the federal budget and the balance of payments. What seems to have gone wrong with the supply side miracle?

Obviously, the problem is that the revenues from the bigger taxable income didn’t show up as planed! That is, since the American government was committed on a certain level of expenses (welfare, national defence, etc), and the revenues were not there, the government had to borrow money outside of the country, worsening the balance of payments with all the interest to be paid outside, especially to Japan.

The problem is that the supply side theory works properly on a short-term basis, as shown in the Graph 2. That is, the income rises, without any inflation (and so without any interest rates rise). However, on a long term, the Graph 3 tells us what is going to happened! On Graph 3, we see that the increase in output leads also to an increase in prices, as the labour factor starts to ask for better pay. This increase in price gives also an increase in interest rates, which most possibly leaded to a partial crowd-out. We then have to believe that Keynesians were right, after all. That would explain the collapse in local investment.

The main result of the supply side operation in the United States has been, over a five years term, a decrease in real savings and investment relatively to the GNP.

One problem of the theory was to take the American society’s behaviour for granted. That is, the government believed that the decrease in the tax level would lead to more savings from citizens. However, if citizens do something else than saving (consuming more, for instance), the calculation then goes wrong, and we see the money multiplier change its value.

 

4. Are we likely to see a return to the emphasis on the demand side of macroeconomics policy that characterised Keynesian economics up until late 1960?

The results of the American experiment would suggest that yes, but since the government is not ruled by economists but by politicians to whom the first priority is to get re-elected, noting is certain. That is, the population (or at least the public figures) is asking for more tax reductions, in the petroleum for example, national debt reduction, a better government, less involved in doing business, a competitive market, etc. These are example of supply side policies, so we can’t fully expect to see a come back to the old good Keynes theory.

Moreover, it looks like the government has much less power to exert a Keynesian policy now than before: the capital market has been growing so much that it’s not sure if it’s possible for the government to influence the interest rates by buying bonds, for example! The latest failure of the G7 central banks to support the Euro is a good example of this reduced power over the economic situation. The solely Iraqi government (Saddam), is expected to have more effect on the Euro exchange rate that the G7 operation only for its decision to tale payment of oil sold to Western countries in Euro instead in American dollar (Financial Times, Wednesday 1^st of November)

6. What are the lessons for the UK from the US experience?

First we must see what is the lesson. The American experience in the 80’s tells us that a short-term goal in economics is not such a good idea. The short-term is decided by politics. Whatever is going on in politics is not necessary the best for the whole economy. If the same theory was to be tried in UK, as it was under the Conservative Party’s reign, the rulers would have to remember that there is to be an increase in prices, and that this will lead to an increase in interest rates, unless something else is done. For instance, the government could reduce its expenses by different way, just to make sure the decrease in tax revenues doesn’t result in a budget and balance of payments deficit. We must not forget that a decrease in tax should mean also, according to the supply-siders, a decrease in government’s role in and out the market. One problem of the USA attempt was to rely only on tax reduction, even if many other supply-side policies could have been used more efficiently.