A Walk on the Supply Side; R. Keating

THEFREEMAN IDEASON LIBERTY A Walk on the SupplySide by Raymond J. Keating I n the movie Ferris Bueller's Day Off, Ben Stein portrayed a high school teacher droning on about supply-side economics while students fell asleep and even drooled in their seats. Critics of supply-side econom ics must relish this and other pop-culture references, believing them to buttress their own view of supply-side as a kind of "pop economics. " However, supply-side economics is not just a recent fad popularized by The Wall Street Journal's editorial page and a small band of late-twentieth-century conservative economists. The historical roots of supply side theory run deep. In fact, the seeds of supply-side thought were firmly planted by such classical economists as Adam Smith and Jean-Baptiste Say, with strands of sup ply-side ideas dating back literally thou sands of years. As nations debate and em bark on economic changes taking us into the next century, it is crucial to understand what "supply-side economics" actually means.

Supply-side economics has been defined and ill-defined many times over the past two decades. Often, it seems that supply-siders themselves fail to agree on a definition. Economist Norman Ture cut through much of the morass surrounding supply-side eco nomics, compactly summarizing the sub ject as follows: "Supply-side economics is merely the application of price theoryMr. Keating, the guest editor of this month's issue of The Freeman, is chiefeconomist at the Small Business Survival Foundation, and part ner with Northeast Economics and Consulting. so-called 'microeconomics'-in the analysis of problems concerning economic aggre gates-so-called 'macroeconomics.'" 1 Though brief, Ture' s statement captured the essence of supply-side economics. I would expand the definition of supply side economics a bit to the following: Sup ply-side economics places supply over de mand in the hierarchy of economics, and therefore deals with enhancing economic production, efficiency, and growth within the context ofthe marketplace,. largely-but not exclusively-focusing on relative prices, such as incentives for working, saving, in vesting, and risk-taking. While supply-side tax policy has been highlighted for the past two decades, the supply-side school's pur view is much wider.

The Pre-Eminence of .Supply Over Demand The phrase "supply creates its own de mand" is known as Say's Law, after the nineteenth-century French economist Jean Baptiste Say, and constitutes a central tenet of supply-side economics. The idea under girding Say's Law is that supply comes before demand in the economic pecking order, if you will. The fundamental point remains that nothing can be demanded be fore it is first offered, created, or invented that is, before it has been supplied-by someone. In addition, no one can legiti mately demand something before first sup plying a product or service of value to others. 373 374 THE FREEMAN • JUNE 1995 Say, however, never actually wrote in his Treatise on Political Economy that "sup ply creates its own demand." He observed that' 'products are always bought ultimately with products.,,2 Understanding that products are bought with products, that one must produce before one can demand, any economy that empha sizes demand over supply is destined to be confronted with stagnation and relative de cline, as the size of government inevitably increases, the scope of wealth distribution efforts expand, and the economy slows as creativity, innovation, and risk-taking di minish. Say himself asserted that "the en couragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means.

Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.,,3 Say's Law not only provides a foundation for the" equilibrium in most economic mod els and a source of the stability of capital ism," as supply-sider George Gilder has noted, but also explains how economic growth occurs. 4 Gilder observed: "As the driving force of economic growth, Say's law exalts the creativity of suppliers over the wants and needs of demanders or consum ers. As entrepreneurs invent new things and learn how to make them more efficiently, unit costs and prices drop and goods become more attractive. As goods become more affordable to a wider public, more people work to acquire them by creating goods to exchange. These new suppliers both pro vide and acquire new wealth at ever lower expense.,,5 That is, supply-work, invest ment, entrepreneurship, and risk-taking drives economic growth.

Norman Ture identified the sheer absur dity of a contrary economic theory purport ing that government fine tuning or enhance ment of aggregate demand fosters economic growth. Ture laid out a devastating supply side criticism of Keynesian demand man agement: "The prevailing view that govern ment actions do directly affect aggregate income derives from perceiving these ac tions as impacting initially and directly on aggregate demand, via effects on disposable income, the changes in which are deemed to result directly in changes in total produc tion. The supply-side analysis, on the other hand, holds that government actions have no direct initial impact on real aggregate demand and, indeed, affect nominal aggre gate demand only as a consequence of changes in the stock of money. Changes in real aggregate demand, to be sure, would elicit increases in total output. The pertinent question is how changes in real aggregate demand can occur without a preceding change in total output. By definition, aggre gate demand is the sum of purchases of all types by all economic entities-govern ments, businesses, households, etc. Also, by definition, these outlays must exactly equal aggregate income which in tum, at every moment in time, must just equal the value of aggregate output. Changes in real income, therefore, occur only as changes in output occur. And changes in output occur only as a result of changes in the amount of production inputs or in the intensity or efficiencyof their use. To have a first-order effect on income, therefore, government actions would have to alter directly the amount or effectiveness of production in puts committed to production. But govern ment actions, in and of themselves, do not change the aggregate amount of production resources available in the economy or their productivity. Changes in the amount of production inputs committed to production will result only if the real rewards for their use, i.e., the real price received per unit of input, is changed.,,6 That is, as Say noted, products ultimately are purchased with products. Growth oc curs when supply-oriented incentives are enhanced.

Entrepreneurship Supply-side economics returns the en trepreneur's role to the center of econom ic theory. After all, if, as Ture asserts, "changes in output occur only as a result of changes in the amount of production inputs or in the intensity or efficiencyof their use," then the entrepreneur must take cen ter stage as he is the agent of innovation and creativity that increases inputs and/or effi ciency. The modern-day Keynesian school's fo cus on government-attempted adjustments in aggregate demand naturally ignores the critical aspect of entrepreneurship in the economy. In addition, the increasing math ematical nature of economics as an aca demic discipline has left little room for the entrepreneur's roles as innovator and bearer of risk. This focus on entrepreneurship perhaps best illustrates the difference between sup ply-side economists and industrial policy economists. A free-market economy leaves most economic decisions to individuals op erating in the private sector, rather than government bureaucrats and/or elected of ficials, as is the case with industrial policy and its more extreme cousin, socialism.

Whileboth supply-side and industrial policy economists largely concern themselves with supply-related issues (e.g., investment, pro duction, etc.), the supply-side school of economic thought operates within the wider intellectual framework of free-market eco nomics, knowing that production for the sake of production is fruitless. Production must meet current or create new demands. Value must be created. And supply-side economists recognize that the government lacks the requisite experience, knowledge, and incentives to make resource allocation decisions or to create value. The critical role of the entrepreneur in the economy is to see added value where others have failed to do so-to enhance production and/or efficiency. That is, to fulfill the es sence of Say's Law-that supply creates demand. In turn, one can identify numerous types of entrepreneurship. The Schumpet erian entrepreneur, named for economist Joseph Schumpeter and his notion of "cre ative destruction," offers innovations or inventions that can transform entire indus tries and economies. Other entrepreneurs offer improvements in the way particular A WALK ON THE SUPPLY SIDE 375 firms perform through, perhaps, different management or production structures; while still others simply see better ways of doing things and start their own businesses.

Additional entrepreneurs are at work in the investment community. For example, an investment banker or corporate raider might see added value through a proposed corpo rate merger or takeover. Then there are the venture capitalists willing to risk their own investment dollars supporting an idea, in vention, innovation, or new business. George Gilder articulated the importance of returning the entrepreneur to the econo mist's center stage: "Economic recovery depends on the resurrection of entrepre neurs. This resurrection cannot fully and durably occur until the ultimate arbiters of economic policy-the economists-resur rect entrepreneurship in their own influen tial theories. The contrary vision of capital ism without capitalists springs in part from a fundamental error of economic thought, drastically overrating the importance of physical capital formation and other quan titative measures of economic activity and drastically underestimating the decisive and controlling importance of entrepreneurial creativity. ,,7 Relative Prices and Incentives As Norman Ture noted, supply-side eco nomic analysis is largely microeconomic in nature, Le., supply side in many ways equates to price theory. Price theory deals with the allocation of resources among dif ferent uses, the price of one item relative to another. s In particular, supply-side econo mists focus on the relative prices of work .

versus leisure, saving and/or investment vs. consumption, risk-taking versus risk avoid ance, and productive, market-based activi ties versus activities based on tax avoidance or government fiat. As a result, we see the great supply-side emphasis on marginal tax rates-or the tax on the next dollar earned more so than on average tax rates. Supply-side economists argue, for exam pie, that highmarginalincome tax rates raise the cost of additional work or work effort as 376 THE FREEMAN • JUNE 1995 compared to leisure. Higher tax rates also make it cheaper for an individual to under take non-taxable, do-it-yourself work, like painting one's own house, rather than per forming income-generating, taxable work while hiring a house painter. Under these circumstances, the benefits of division of labor are lost to the economy. The returns of tax avoidance are enhanced as well. A high marginal income tax rate regime also creates a clear bias in favor of con sumption over saving and investment. Real and human capital investments become rel atively more expensive versus consump tion. Particularly worrisome, high tax rates, as well as onerous regulations, raise the relative price of such critical yet high-risk endeavors as entrepreneurship and venture capital investment. According to supply side theory, the implications under such a regime can be severe. High-risk ventures require at least the opportunity for high returns. When such opportunities are dimin ished by governmental policies, a stultified economy results, with the relative security of, for example, employment in government or in a large corporation, and investment in government securities, being enhanced ver sus the potential returns on more risky, but more productive, entrepreneurial endeav ors. Risk-taking, so crucial to economic growth, is discouraged by onerous taxes and regulations.

The full impact of relative prices on em ployment is captured in what supply-side economists refer to as the tax wedge. In essence, the tax wedge is the difference between the total cost to an employer for an employee, and the actual take-home pay of that employee. Taxes, regulations, and gov ernment mandates constitute the tax wedge. A large tax wedge significantly raises the price of labor relative to capital. Concur rently, the tax wedge can diminish incen tives for employees to accept overtime; boost employee compensation demands; and/or narrow the gap between take-home pay and government benefits (e.g., welfare or unemployment compensation) for some workers. These relative price/incentive arguments fall under the economists' label of "substi tution effects." That is, as the costs of productive endeavors-such as working, investment, and risk-taking-decline as marginal tax rates are reduced, for example, the incentives to substitute these activities for leisure, consumption, and tax avoidance are enhanced. Under such a scenario, the opportunity costs ofnot working, investing, or risk-taking increase.

Other economists have claimed that just the opposite occurs under a tax-cut sce nario, that individuals will choose to para doxically work or invest less. These econ omists essentially claim that the income effect takes precedence over the substitu tion effect. The income effect argument states that individuals have a targeted level of income, and a tax cut allows them to reach that target by working less. Substan tive problems arise with such an argument: (1) It not only nullifiessupply-side, relative price arguments, but Keynesian demand management policies as well. Keynesian arguments that more government spending increases aggregate demand and therefore economic growth, falls prey to the same income effect argument. Individuals would work less, and GDP and income would fall; (2) If the income effect were to hold in general, that would mean that ever-higher marginal income tax rates should induce ever-increasing levels of work and invest ment. Or, under the contrary scenario of tax reductions, as the price of work, saving, or investing falls, individuals choose to work, save, and invest less. In essence, as supply side economist Paul Craig Roberts has noted, income becomes an inferior good.

Roberts identified the full implication of the income effect argument: "In economics, any time the 'income effect' works counter to the 'substitution effect,' we have the relatively rare case of what is called an 'inferior good' (Le., people purchase less of it as their income rises). Since income is command over allgoods, [the income effect] argument implies that all goods are inferior goods: A tax cut will cause people to pur chase only more leisure, not more income (Le., goods)."9 It is difficult to muster a more devastating counterargument to the income-effect criticism of supply-side eco nomics than this inferior goods point made by Roberts. InRation as a Monetary Phenomenon Price stability is a paramount concern of supply-side economists. After all, inflation creates numerous economic woes. It acts as a tax by whittling away at individuals' earn ings, savings, and investments. Inflation raises interest rates. If income tax rates are not indexed, inflation pushes people into higher tax brackets without any real in creases in income. Also, inflation weakens the international value of a currency, result ingin capital flightand economic stagnation.

In the end, inflation is a clandestine tax that damages economic growth and opportunity. Supply-side economists agree with most other free-market economists on the fact that inflation is a monetary phenomenon, and not a result of too much employment and economic growth, as today's Keynesian economists argue. For supply-siders, the classic definition of inflation holds firm: too much money chasing too few goods. So contrary to Keynesian thinking, supply-side economists will argue that expanded pro duction and economic growth actually act as an inflation remedy. International Trade, Investment, and Currency Devaluation Supply-side economists are exclusively, but by no means uniquely, free traders. Like most other schools of economic thought, supply-side subscribes to the notion of Ricardian comparative advantage. From a supply-side view, the lowering of tariffs and other trade barriers expands markets and opportunities, promotes competition, and fosters economic growth.

Also, supply-side economists extol the benefits of exchange-rate stability. Why? Exchange rate volatility creates uncertainty in terms of international trade and investA WALK ON THE SUPPLY SIDE 377 ment decisions. Supply-siders would agree with Adam Smith's observation that "a commodity which is itself continually vary ing in its own value, can never be an accurate measure of the value of other commodities. ,,10 Such uncertainty discourages international investment. Supply-side economists argue that this international un certainty exerts upward pressures on inter est rates, as investors seek to compensate for added risks, most prominent being gov ernment devaluation. Mexico's recent devaluation provides a clear example of the woes of devaluation. Generally, nations willdevalue their curren cies versus other currencies in a misguided and futile effort to manipulate the terms and balance of trade. Hence exports are cheaper to their trading partners, and their own imports more expensive.

This neo-mercantilist fantasy suffers from two problems. First is that products are still purchased with other products, so any ad vantage derived from exchange-rate manip ulation will be short-lived until individuals readjust their currency terms of trade ensuring that if two bottles of wine traded for one pair of shoes before devaluation, the same trade could be made eventually after devaluation. The only way to really alter such a transaction is by increasing produc tion, improving efficiency, or changing tastes. Second, this short-term "advan tage" is obliterated by inflation, capital flight, and economic stagnation. Huge swings in the value of currencies make it difficult, if not impossible, for individuals to make any long-range decisions regarding international investment. General View of Government As already noted, supply-side economics falls under the broader category of free market economics. Therefore, supply-sid ers hold the same skepticism of government as do their free-market cousins, such as monetarists and Austrian economists.

However, various supply-siders have been criticized by some of these free-market cousins for not focusing enough attention on 378 THE FREEMAN • JUNE 1995 government spending. Such criticisms may apply to certain individuals, but cannot be applied to the general supply-side school of economic thought. In fact, devoid of proper incentives, gov ernment is viewed by supply-side econo mists as inherently wasteful. In essence, supply-siders view government as generally unable to produce anything of value. Gov ernment can redistribute; it surely can de stroy; and when functioning adequately, it can protect; but government remains unable to create. Therefore, supply-side economists con cern themselves with the overall size of government. In fact, in the supply-side view, the size of government generally takes precedence over concerns about, for exam ple, the size of a nation's budget deficit.

Supply-side economics argues that what primarily matters is the total amount of resources being diverted away from produc tive private-sector ventures to generally unproductive government undertakings. Then supply-side economists evaluate the method for financing those government ex penditures. The relative shares of borrowing versus taxing are evaluated according to the respective marginal costs to the economy. In particular, supply-side economists view government social-welfare programs with a wary eye, not only due to the amount of waste associated with such programs, but more importantly, due to the perverse in centives such programs establish. Of con cern is the fact that the welfare state breaks the key supply-side principle of supply pre ceding or creating demand. The welfare state allows an individual to demand without first supplying a marketable good or ser vice-flying in the face of the basic require ment for a prosperous economy and society according to supply-side theory, that' 'prod ucts are bought ultimately with other prod ucts." So, we have a situation where an individual being subsidized through govern ment welfare is buying products with prod ucts produced by others. This system pro vides disincentives for the individual on welfare to undertake productive activities, while also establishing disincentives for those individuals providing the welfare sub sidies, as they receive less return for their work, investment, or risk-taking. Also un der such a system, not only are producers confronted with higher taxes, but the mar ginal tax rate-including the combined loss of government benefits plus the tax rate on income-confronted by welfare recipients thinking of moving off welfare can be con siderable, even in excess of 100 percent.

Lastly, supply-side economists naturally view the government's role of protecting life, limb, and property as essential to a healthy economy and society. Devoid of such protections, absolutely no reason ex ists for individuals to move beyond mere subsistence levels of production. The SupplySide Difference What is the fundamental difference be tween economists and schools of economic thought? The late economic journalist War ren Brookes wrote: "Since economic thought first became formalized over two centuries ago, there have been essentially two different views about wealth. One view, first defined by Adam Smith and Jean Baptiste Say, is that wealth is primarily metaphysical, the result of ideas, imagina tion, innovation, and individual creativity, and is therefore, relatively speaking, unlim ited, susceptible to great growth and devel opment. The other, espoused by Thomas Malthus and Karl Marx, contends that wealth is essentially and primarily physical, and therefore ultimately finite."l1 Though I risk upsetting many economists who shun the "supply-side" label, broadly, I think the former can be categorized as supply-siders, the latter wear the blinders of demand-side economics. I do not make such an assertion lightly.

For example, it was the great Austrian economist Ludwig von Mises who observed in his Human Action: "Capital levies, in heritance and estate taxes, and income taxes are . .. self-defeating if carried to ex tremes." Mises went on to explain: It is one of the characteristic features of the market economy that the government does not interfere with the market phenomena and that its technical appara tus is so small that its maintenance ab sorbs only a modest fraction of the total sum of the individual citizens' income. Then taxes are an appropriate vehicle for providing the funds needed by the gov ernment. They are appropriate because they are low and do not perceptibly dis arrange production and consumption. If taxes grow beyond a moderate limit, they cease to be taxes and tum into devices for the destruction of the market econo my.... [T]he true crux of the taxation issue is to be seen in the paradox that the more taxes increase, the more they undermine the market economy and concomitantly the system of taxation itself. Thus, the fact becomes manifest that ultimately the preservation of private property and con fiscatory measures are incompatible. Ev ery specific tax, as well as a nation's THE MINIMUM WAGE LAW 379 whole tax system, becomes self-defeating above a certain height of the rates. 12 No supply-side economist could have put the argument better. D 1. Norman Ture, "Supply Side Analysis and Public Pol icy," Essays in SupplySide Economics, edited by David G.