Monday, January 21, 2013

Supply Side Economics

            The phrase “supply side economics” brings to mind Arthur Laffer, Ronald Reagan and tax cuts, but the concept is much broader and more important than that.  The fundamental principle underlying supply side economics is that incentives matter and that the most important of all incentives are those to work and improve oneself.  Remember that national output is just the product of the number of people working times their average productivity.  For the economy to grow, and the standard of living to rise, there must be some combination of more people entering the work force or those already working becoming more productive.  Supply side economics is ultimately about providing the right incentives to reward labor force participation and self-improvement.

            To be sure, taxes are part of the story.  Given a certain revenue target, the government should attempt to collect the necessary taxes in a fashion that interferes the least with incentives for individual productivity.  As noted in an earlier post, our immensely complex income tax system comes nowhere near meeting that goal.  There is even a language barrier.  In the recent dispute over taxes, President Obama continually referred to higher taxes on the wealthy.  But we have an income tax, not a wealth tax.  A more appropriate phrase would have been to say that his goal was to increase taxes on the highly productive.  Such language makes the trade-off more clear and gives appropriate credit to the highly productive for their contribution.

            Beyond taxes, all government programs have incentive effects.  As those programs age they can become obsolete (can you imagine using a 10-year old cell phone?) and unintended consequences with associated perverse incentives can come to the fore.  Richard Vedder provides some good examples with regard to employment.  The point is that government programs need to be constantly reinvented, just like cell phones, with an eye toward creating proper incentives for employment and self-improvement.  Unlike cell phone manufacturers, however, governments face almost no competition and, there in, lies a problem that I will explore more in future posts.

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