Chapter10 - Chapter 10 Supply-Side Economics The...

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© Sanjay K. Chugh 119 Spring 2008 Chapter 10 Supply-Side Economics The backward-bending labor supply curve of the consumption-leisure model is one basis for a school of macroeconomic policy thought known as “supply-side economics.” 58 Its basic premise is that tax cuts would unlock a tremendous increase in the quantity supplied of productive resources (labor and capital) to the economy, thereby dramatically raising GDP. In this section, we will focus on the theoretical mechanism by which it may do so and also discuss the practical problems with such policies. Taxes and the Backward-Bending Labor Supply Curve Recall the basic backward-bending labor supply curve of the consumption-leisure model, reproduced in Figure 43, which we derived using the underlying indifference curves and budget constraint of the individual. Recall that the labor tax rate t explicitly appears in the budget constraint of the model, (1 ) (1 ) 168(1 ) Pc t W l t W + = . (1.13) If we hold the price of consumption P and the pre-tax wage rate W constant, then changes in the tax rate t clearly lead to changes in the slope of the budget constraint and hence to changes in the optimal choice of consumption and leisure. Such is the way that we traced out the backward-bending labor supply curve. The claims of supply-side economies lies hinges on the assumption that the economy is usually in the upward-sloping portion of the labor supply curve, somewhere near 1 n or 4 n , say – the region in which increases in the after-tax wage would lead to a higher quantity of labor supplied. Thus, if the government were to lower the tax rate t , then the real after-tax wage rate ((1 ) / ) t W P would rise (with P held constant). 58 This school of thought rose to prominence during the Reagan Administration and is generally associated with the Republican Party, though even within it it is often viewed as an extreme set of positions. Recently, the economic policy advisers of the current George Bush have been essentially leaning again towards “supply-side” views. For an interesting (and scathing) review of the rise of the supply-siders during the 1970’s and 1980’s, see Peddling Prosperity by Paul Krugman.
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