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Evaluation of supply-side policy


Syllabus: Evaluate the effectiveness of supply-side policies through consideration of factors including:

  • time lags,

  • the ability to create employment,

  • the ability to reduce inflationary pressure,

  • the impact on economic growth,

  • the impact on the government budget,

  • the effect on equity, and

  • the effect on the environment.

Supply-side policies - strengths

Supply-side policies may be targeted at particular sections of the economy raising efficiency there.

Successful application on the economy, as a whole, will shift the LRAS to the right and have a double effect, increasing the level of real output and lowering the price level.

Achievement of the major macro-economic goals of economic policy may be achieved if LRAS is shifted to the right. Such a shift:

  • Represents an increase in the productive potential of the economy (economic growth)
  • Will lower the price level (thus helping to reduce inflation)
  • Will increase the level of real output and, more than likely, the level of employment as the two are closely correlated.
  • Will help to improve the balance of payments if the improved efficiency represented by greater LRAS transmits itself through to increased competitiveness for firms engaged in exporting.

Policies that cut the rate of income tax, in addition to increasing the incentive to work and to be entrepreneurial are considered by some economists to lead to an increase in tax revenue. As employment and incomes increase they generate more tax revenue, albeit with lower tax rates. This is demonstrated by the Laffer curve. However, there is some dispute as to the precise rate of tax which maximizes potential tax revenue.

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More interventionist supply-side policies may, in addition to increasing productive efficiencies, have the effect of injecting money into the circular flow of income and setting up a multiplier process leading to an increase in output, employment and income. The benefits, or otherwise, of this expansionary fiscal effect can be further considered by reviewing Section 2.4.

Supply-side policies - weaknesses

As we have seen, while some supply-side policies represent a more interventionist approach, most supply-side policies are associated with neo-classical, free market or supply-side economists. There is considerable disagreement between free market economists and economists who favour an interventionist approach, as to how best the economy should be managed.

Some interventionist objections to particular free market oriented supply-side policies are as follows:

  • Education and training - few would disagree with the wisdom of committing government spending to these areas, but such expenditure may be insufficient in itself to guarantee permanent jobs without ensuring an adequate level of aggregate demand in the economy; in supply-side policies they need to be accompanied by appropriate fiscal and/or monetary policies.
  • Reduction in unemployment benefits - apart from the economic objection, that such a policy would lower the spending power of such recipients and therefore reduce aggregate demand, output and employment, such a policy can be questioned on moral and political grounds. Is it right to make a group of people who are likely to be amongst the poorest in society, even poorer, while at the same time making the rich richer through tax cuts? Moreover, the idea that 'taking a stick' to the unemployed to force them back to work, presupposes that all unemployment is of a voluntary nature. In practice, people may be involuntarily unemployed, due to lack of demand in the economy or as the result of scarce employment opportunities in their geographic area.
  • Reduction in direct taxes - while low income individuals and families are given the 'stick' to improve their incentives (via cuts in welfare benefits), the better-off are given the 'carrot' in the form of tax cuts. Apart from the morality of such policies, which make life more unpleasant for the least fortunate and make society more unequal, the alleged incentive effects of lower taxes have little empirical basis. A number of studies have shown that cutting income tax does not make people work harder and longer; with a minority being fully aware of the reality of their marginal tax rate. Indeed, it has been found that lower taxes may encourage some employees to take more leisure time as they can now gain the same disposable income by working fewer hours.
  • Reduction in the power of trade unions - for those economists who are not of the free market persuasion, this is simply viewed as another measure to shift wealth, income and the balance of power away from the less well-off to the better-off. The individual employee is always weaker than the individual employer, especially where the employer is a large multinational corporation, and trade unions act as a counterbalance to those unequal power relations. Trade unions may reduce the firm's costs by acting as a channel for communication between employers and employees - it is likely to be cheaper for the firm to negotiate with one organisation through 'collective bargaining', rather than employers talking with individual employees.
  • Deregulation - over recent years the world financial system has been largely deregulated with a 'free' market being largely establishedThis lack of regulation that has widely been blamed for the recent credit crunch and the world - wide economic crisis that followed. It is only the subsequent government intervention, in the form of nationalisation and re-regulation that avoided total economic melt-down.
  • Privatisation - this has been at the heart of supply-side, free market economies since the early 1980s and has been a central component of the structural adjustment programmes imposed on less developed countries by the IMF and the World Bank. Click on QUOTES to get a flavour of the degree of opposition privatisation has caused.

In particular, privatisation has been criticised on the following grounds:

  • Political arguments - for those who believe that socialism represents a superior form of society to capitalism, the movement towards privatisation of the means of production will inevitably lead to greater class conflict, greater exploitation of workers and a more unequal and unfair society in general.
  • Management of the economy - a privatised laissez-faire economy, as opposed to one with varying degrees of government control, is likely to be particularly prone to the vagaries of the market, the violent swings of the trade cycle and the movement in an out of the country of speculative capital flows.
  • Natural monopolies - the case against the privatisation of utility industries such as gas, water and electricity rests upon the enormous potential for private monopoly abuse in terms of high prices, poor quality service for consumers, worsened conditions and redundancies for employees, with high dividends for shareholders and high salaries for senior managers (the 'fat cat' syndrome).
  • Fraud - while claiming that 'popular capitalism' has returned industries to the public, the opposite has been the case. When an industry is nationalised, in theory it is jointly owned by everyone in the country. Privatisation, therefore, represents a process of selling shares or assets to people, who may already own those assets, a confidence trick which if carried out by any individual would carry a stiff custodial sentence! At the same time, those individuals, who are either unable or unwilling to purchase shares are, in effect compelled to relinquish their assets.
  • Deregulation - this has also been a central plank of supply-side policy and its advantages are based on the general arguments for a freely operating price system, e.g. the promotion of competition and enterprise, greater efficiency, lower prices and wider choice for consumers and 'getting the state of the backs' of businesses by the removal of 'red tape' and bureaucracy. However, like privatisation, it has been fiercely criticised. Follow the criticisms of deregulation link to see these.
Past Paper Essay Questions

May 2013 TZ1

4. (a) Explain how labour market reforms may be used to promote economic growth. [10 marks]

    (b) “Market-oriented supply-side policies will always be more effective in promoting economic growth than                 demand-side policies.” To what extent do you agree with this statement? [15 marks]

Nov 2010

2. (a) Explain how supply-side improvements to an economy may be achieved through the use of taxes and government     spending. [10 marks]

    (b) Evaluate the use of supply-side policies to reduce unemployment. [15 marks]

Nov 2007

2. (a) Using one or more diagrams, explain the difference between the equilibrium level of national income and the full employment level of national income. [10 marks]

(b) Evaluate the policies a government may use to increase the full employment level of national income. [15 marks]