Supply-side economics is an innovation in macroeconomic theory and policy. It rose to prominence in congressional policy discussions in the late 1970s in response to worsening Phillips Curve trade-offs between inflation and unemployment. The postwar Keynesian demand management policy had broken down. The attempts to stimulate employment brought higher rates of inflation, and attempts to curtail inflation resulted in higher rates of unemployment.
In other words, the Phillips curve (named after economist A. W. Phillips) trade-offs between inflation and unemployment were worsening. Each additional job created had to be paid for with a higher rate of inflation, and each reduction in inflation had to be paid for with a higher rate of unemployment.
The Phillips curve met its nemesis in stagflation, a new term that entered economics in the late 1970s. Milton Friedman summed up the demise of the Phillips curve with his article, “More Inflation, More Unemployment.”
The appearance of stagflation—simultaneous inflation and unemployment—was a serious problem for Congress, as I pointed out in the late 1970s in an article in The Public Interest, “The Breakdown of the Keynesian Model.” Simultaneous inflation and unemployment meant that the federal budget would soon be out of control. In those days, Congress actually worried about such an outcome.
The Keynesian economic establishment could offer Congress no solution other than an “incomes policy.” An incomes policy was wage and price controls. Inflation would be controlled by suppressing wages and prices, while expansionary monetary and fiscal policies boosted aggregate demand to raise employment. Even Congress understood that aggregate demand could not rise if wages were suppressed.
Congress looked for a different solution, and I, being on the scene as a member of the congressional staff, gave them the solution. In Keynesian economics, monetary and fiscal policies only affect aggregate demand. If these policies were expansionary, aggregate demand increases, thus boosting employment and inflation. If these policies were restrictive, inflation and employment would fall with consumer spending. The fault in Keynesian theory and policy was the assumption that fiscal policy had no impact on aggregate supply.
I was able to explain to members of Congress, both Democrats and Republicans who were concerned about stagflation, that some forms of fiscal policy directly increase or decrease aggregate supply. High tax rates mean that leisure is cheap in terms of forgone current earnings—thus there is less labor supply—and current consumption is cheap in terms of foregone future income streams—thus less savings for investments. Keynesian demand management had run into trouble because the high tax rates on income reduced the response of supply to demand stimulus. Thus, prices rose instead of output.
The solution, I said, was to reduce the marginal income tax rates across the board. This would increase the responsiveness of supply to demand and cure stagflation.
Both political parties listened. In the House, it was the Republicans who took the lead—Jack Kemp and Marjorie Holt. In the Senate, Republicans Orrin Hatch and Bill Roth stepped forward. However, in the Senate the lead was taken by Democrats, especially Russell Long, chairman of the Senate Finance Committee, Lloyd Bentsen, chairman of the Joint Economic Committee of Congress, and my Georgia Tech fraternity brother, Sam Nunn.
As a result of Rep. Jack Kemp being the first congressional spokesman for a supply-side policy and President Reagan’s adoption of the policy, supply-side economics is associated with Republicans. However, Republicans almost lost the issue to Democrats. The first official government endorsement of supply-side economics was in the late 1970s by the Joint Economic Committee of Congress under the chairmanship of Democratic Senator Lloyd Bentsen of Texas.
The Joint Economic Committee under Senator Bentsen’s leadership put out Annual Reports two years in a row calling for a supply-side policy. As the presidential election approached that put Ronald Reagan in the White House, the majority Democrats in the Senate had a meeting to decide whether to pass the supply-side tax rate reductions prior to the presidential election, thus pulling the rug out from under Reagan on his main plank. The Senate Democrats were inclined to move forward with the tax rate reductions, but the Senate Majority Leader convinced them that it would look like an endorsement of Reagan over their own party’s candidate (Jimmy Carter). The Senate
Majority Leader said that immediately after the election, the Democrats would take control of the issue and pass the marginal tax rate reductions. The great surprise of the election was that the Democrats lost control of the Senate.
There was more opposition to Reagan’s tax bill from Republicans than from Democrats. Republicans believed that budget deficits ranked with the Soviet threat and were more willing to raise taxes than to reduce them. The Republican opposition was so strong that I had a hard time getting the tax bill out of the Reagan administration so that Congress could vote on it. In those days, the great bogyman for Republicans was budget deficits, and deficits were what Treasury’s projections showed. Although the Treasury was, for the most part, committed to the President’s policy and believed that some part of the lost revenues from marginal tax rate reduction would be recovered, which is also what Keynesians believed, the Treasury’s revenue forecast was based on the traditional static revenue model that every dollar of tax cut would lose a dollar of revenue.
OMB director David Stockman and his economist Larry Kudlow covered up the revenue loss by assuming a higher rate of inflation. In those days, the income tax was not indexed for inflation. Nominal income gains pushed taxpayers into higher tax brackets. The higher was inflation, the higher was nominal GDP and tax revenues. In order to raise the revenue forecast, Stockman only needed to raise the inflation forecast.