The Supply-Side Challenge

The supply-siders, as their name suggests, argued that by emphasizing demand Keynesians had neglected the factors that encourage investment.

They claimed that productivity had slowed because government policies reduced the incentive to produce. Regulation had business owners filling out forms rather than doing business. High, progressive income taxes reduced the reward for working harder or investing more.

One version of this tendency, represented by the editors of the Wall Street Journal, emphasized reduction of what they deemed unproductive public spending:

Income transfers conducted through the federal budget are seriously eroding savings and capital formation…. In other words, it is money transferred from people who are working to people who are not, lowering the incentives of both for productive labor .^[17]

The Journal's editors believed that the welfare state had broken the link between work and reward. This side of the analysis was congenial to oldline Republicans who disapproved of nearly all government activity except maintaining public order and security. Another side, exemplified by Representative Jack Kemp, was willing to maintain most existing governmental activities (an important difference) while emphasizing the positive effects of tax cuts. Economist Arthur Laffer claimed that high taxes so discouraged economic activity that a large cut, by increasing incentives to work and invest, would generate much economic growth. In a reasonably short time, therefore, even the government would be better off because the smaller tax cut would come from a much larger economic pie. This was the (in)famous "Laffer Curve."

The supply-side analysis essentially ignored the demand problem that preoccupied Keynesians. Also it paid little attention to interest rates, which surely, if to an unknown degree, influenced rates of investment and economic growth. Yet, in spite of these analytic weaknesses, supply-side proponents had two practical advantages: in proposing tax cuts they were suggesting something that politicians like to do; they also were proposing to manipulate an instrument of policy—tax rates—that, unlike interest rates or personal consumption, the government could directly control.

Laffer used the Keynesians' tax cut during the Kennedy administration as an example of how lower taxes could increase economic growth. Keynesians, however, had argued that tax cuts stimulate demand and thus, potentially, inflation. With inflation already high, supply-siders needed a counterargument. They found it by allying with the monetarists, who held that monetary, not fiscal, policy affected prices.