Anyone who has studied some economics has likely heard of what is called supply-side economics. However, there seems to be a big misconception over just what supply-side economics actually is. I have heard it defined by quite a few as the following:
The idea that when you cut taxes for the rich, they will spend the money and it will "trickle-down" to the middle-class and the poor.
It has also been defined as:
The idea that when you cut taxes for the rich and business, that they will be so inspired to work harder that they will produce a assive amount of new wealth and increase tax revenues.
Both of these are wrong. Example #1 is often nicknamed (deridingly) "Trickle-Down Economics" and many on the Right throughout the years have fallen hook, line, and sinker for this definition as well it seems. But no economist anywhere (from what I understand) has ever made this claim about supply-side economics.
Example #2 is based on a misconception of the Laffer Curve, which is also a concept misunderstood by many, both folks on the Left and the Right.
There's also a third definition for supply-side economics as well:
The idea that when the economy is in a recession, you cut taxes.
Example #3 is really prominent among people and politicians these days. It seems every time a recession occurs, Republicans say, "Tax cuts! Deficit spending by the government doesn't work." And then Democrats go, "Stop with that ridiculous supply-side economics. We need deficit spending and the reason deficit spending historically hasn't worked is because we have never spent enough."
So I will address these fallacies each in some detail. To start, there's generally two ways of thinking about the economy: demand-side and supply-side. Demand-side focuses on demand. Supply-side focuses on supply. Keynesian economics, named after the economist John Maynard Keynes, is demand-side. Keynes called for demand-side stimulus in recessions. When private-sector aggregate demand drops off, the government needs to step in to make up for the drop-off in demand. There are generally three ways of doing this:
1) Government deficit spending - This in itself has different variations. It means the government runs a deficit in order to spend money to make up for the drop-off in aggregate demand in the private sector. Government can try spending on infrastructure, it could try buying all sorts of stuff to prevent companies from having to cut back on production, also there is what is called military Keynesianism, basically gun up the defense budget to stimulate the economy. Whether or not deficit spending works or not is hotly debated in economics (and would require a whole other blog post to address on its own). The media, generally leaning to the far-Left, will try to make out as if anyone critical of deficit spending as a form of stimulus is some ultra-rightwing crackpot, but the reality is that many economists are skeptical of deficit spending as a form of stimulus.
For example, Harvard economist Greg Mankiw is a skeptic: http://gregmankiw.blogspot.com/2009/01/krugman-on-stimulus-skeptics.html
Paul Krugman, the Nobel Prize-winning economist, on the other hand, is a huge proponent.
(there are other good economists who are skeptics and proponents)
2) Demand-side tax cuts - This shatters myth #3, the idea that supply-side economics calls for tax cuts as a form of stimulus. Demand-side tax cuts are not supply-side, they are throughly Keynesian, they just take an opposite view, that is, instead of have the government run a deficit by spending the money on its own to create demand, just cut people's taxes and let them spend the money instead.
Which works better is again hotly debated. Spending proponents say that if given tax cuts, there is no guarantee the people will spend the money. They may hoard it instead, so then no stimulative effect occurs. Whereas with bureaucrats spending it, you can be absolutely positive it will get spent. This view also relies on what is called the Keynesian Multiplier Effect, basically, that government spending money will increase the GDP, which means people will make more money, which means their aggregate demand will increase, which means that the GDP will expand even further from thir additional spending. According to the spending advocates, the multiplier effect means that for every dollar of government spending, you get more than a dollar of economic growth (in practice, this is very questionable however).
Tax cut proponents say that bureaucrats do not know how to spend the money, that the people know a lot better what to purchase to increase their well-being than bureaucrats do (certain public works projects may create economic growth in terms of the statistics, but do little to nothing to improve the people's well-being), and that deficit spending is too slow. Yes, the money is guaranteed to be spent, but how long will it take? Whereas with tax cuts the money goes immediately to the people.
3) Helicopter Technique - This is basically kind of the same thing as tax cuts, except instead of cutting taxes, the government spends money, but it spends it by sending everyone a huge check in the mail, in the hopes that the people will then spend the money and stimulate the economy. Unemployment benefits are in a sense a form of this.
These are in general the three ways to stimulate the economy to increase demand. All of them have some merti and all of them are open to criticisms as I see it. None of them should be seen as a 100% full-on solution for economic problems. There are also some other ways as well, but they are controversial (for example, unemployment benefits, and raising the minimum wage).
Some say that increasing unemployment benefits will increase aggregate demand and thus help move the economy out of the recession, and thus unemployment benefits need to be continued in this recession for example (according to this belief). You give people money and they will spend it (usually the same people claiming this are the ones who claim the people will hoard the money if it is given in tax cuts it seems!).
Critics point out that maintaining high unemployment benefits and for too long will artificially keep the unemployment rate high (people will sit on their rears on unemployment until their benefits are going to run out, upon which they then start looking for work). Thus, while unemployment benefits for a certain length of time represent a good form of social safety net, keeping them in place too long can inadverdently end up extending a recession.
Both of these views hold merit I think but again both need to be taken with a grain of salt because the criticisms of both of them are pretty valid too.
Another form of economic stimulus is raising the minimum wage. Here again it's the same arguments. The proponents say that raising the minimum wage will give people more money to spend, thus increasing aggregate demand, and thus stimulating economic growth. The critics contend that raising the minimum wage only increases the unemployment rate, because of the laws of supply and demand, i.e. artificially increase the price of something and you create a surplus of it.
And again, there's a form of irony. With something such as gasoline, the same people proposing a "living wage" recognize that artificially raising the price of fuel will get people to buy less. It is one of the best ways to stop people from buying SUVs and pickup trucks and switching to more fuel-efficient vehicles (BTW I am not saying I advocate such a policy). But when it comes to employment, these same people then think that one can raise the price of labor for businesses and not have any side effects.
On this, I would say that the critique of a higher minimum wage is pretty valid. Most employers in America are small businesses, and small businesses have a limit on what they can pay their employees. Increase the costs of those employees and something must give. Each full-time job with benefits may be converted into two part-time jobs with zero benefits, pay can be cut, what the owners pay themselves may be reduced, or prices may have to raised, offerings of goods and services may have to be cut, offerings of the quality of goods and services may cut (less meat on the sandwich), etc...or some combination of the above.
Big Businesses can handle a higher minimum wage better, and I believe it is for this reason that Wal-Mart supports a higher minimum wage.
Also the economist Paul Krugman wrote an article some years ago pointing out the nasty effects to employment of a higher minimum wage as well; he described a way to do the things a "living wage" seeks to do, but with a different policy mechanism. However, this article was written back around 1990. I have the link somewhere, but do not know where it is now. Also, I would not be shocked if Krugman has since changed his mind on this issue. A higher minimum wage also protects the trade unions by pricing workers out of the market.
Now a little on supply-side economics. As pointed out, demand-side economics focuses on demand. Supply-side economics, by contrast, deals with the supply of goods and services in the economy. So for example in dealing with excessive inflation, a demand-sider will look at the problem and reason, "The economy has an excess of demand in it. We need to increase taxes or reduce government spending." (by demand-side economics, if tax cuts are done for stimulus, once the economy recovers, they must be increased back to where they were, or the economy will become overwhelmed with demand according to the theory and skyrocket inflation).
Whereas a supply-side looks at the situation and reasons, "There are not enough goods and services to meet the demand in the economy. We need to see if we can increase the supply of goods and services to meet this demand."
This can be accomplished if taxes on business and investment are too high and also if sectors of the economy are so excessively regulated that it unnecessarilly hamstrings economic growth.
Thus supply-side economics calls for cuts to investment and business taxes. There's only one problem with this: the politics. Because many taxes for investment and businesses are "for the rich." Not too many Americans make money through investments. Only the higher-earners who also devote substantial time to investing, or rich people who make a lot of money from investments, earn money this way. I may be mistaken, but I believe middle-class people can earn money indirectly this way if their pensions or mutual funds receive money via investments. For example, if a big corporation pays out money in dividends, mutual funds, pension funds, etc...that own large chunks of that company's stock, will make money in that sense. However, explaining all of this to the general public as a politician can be a bit tricky.
So in general, cutting investment taxes can be seen as cutting taxes for the rich. Business taxes would be the corporate tax rates, for corporations of course (and nothing tricker for a politician than giving corporations tax cuts!), and the tax cuts that affect small businesses. Small businesses come in various forms, LLCs, LLPs, C-Corporations, S-Corporations, etc...S Corporations are taxed at the individual marginal income tax rates. Actually, the business itself is not taxed at this rate, the income the business makes is passed onto the shareholders who then pay taxes on it at the individual rate.
So business tax rates are the corporate and income tax rates. Only a portion of small businesses are taxed at the highest marginal income tax rates, so a reduction in the highest marginal rates in the hopes of stimulating small business investment and job creation will probably only apply to a limited number of small businesses (although I do not know how many exactly). Interestingly, a reduction in lower marginal tax rates, while a demand-side tax cut, could also, to a degree, be supply-side if it helps a business owner invest in their business more.
The thing to keep in mind however with supply-side economics is that the immediate benefit of any tax cuts for businesses, provided they increase investment, will likely go to the middle-class. This is because the business will hire additional employees. The business does this in the hopes of making more money for the shareholders in the future, but the immediate benefit goes to the workers who were hired.
With an economy hamstring by excessive regulations and/or very high business and investment taxes, slashing these tax rates usually will lead to such a boom in investment and business growth and creation, that a massive number of jobs are created, and with it, a huge boost in tax revenue (along with a huge increase in income and standard-of-living for the middle class). The thing to keep in mind though is that investment and business taxes need to already be pretty restrictive for this to happen. If they are fairly low already, then lowering them further likely won't do much. Another key point to remember: no one gets a job from a poor person or a broke business.
So to get to our examples now:
Example #1
The idea that when you cut taxes for the rich, they will spend the money and it will "trickle-down" to the middle-class and the poor.
As said, no economist has ever made this claim about supply-side economics. Politicians and media pundits, on both the Left and the Right, have made it throughout the years, but it is wrong. That is not to say that such a trickle-down effect cannot happen. It probably could. But that isn't the idea. The idea, as stated, is that when business and investment taxes are cut, you stimulate investment and thus create more goods and services and jobs for the economy. And provided this happens, the immediate benefit is to the middle-class, not the rich.
Example #2
The idea that when you cut taxes for the rich, that they will be so inspired to work harder that they will produce a massive amount of new wealth and increase tax revenues.
As described above, this is based on a misunderstanding of the Laffer curve. Basically, the Laffer curve, by economist Arthur Laffer, says that as you raise taxes, you increase revenues. But eventually you reach a point where taxes are so restrictive that as you raise them higher, you actually start to see tax revenues decline. And the inverse holds true (PAY ATTENTION REPUBLICANS): Lowering taxes that are too high and too restrictive will increase revenues, but eventually you reach a point where when you lower the tax rates, you lower the revenues as well. (this isn't to argue against lowering taxes, just to point out that after a certain point, lowering taxes must also be accompanied by reductions in government spending as well!).
Most economists agree with the Laffer curve in general, but they disagree on what the exact rates are at which revenues start to decline as taxes are increased. This really also depends on the tax itself as well. For example, historically, cutting the capital gains tax rate, in the short-term at least, has increased tax revenues. And raising the capital gains tax rate, in the short-term again, has decreased revenues. But this is because the capital gains tax is a unique tax and what happens in the long term with raising or lowering it is more debatable.
Different taxes behave differently.
As noted above, supply-side economics is based on incentivizing businesses to invest more and create jobs, and for this to happen, the tax rates must already be excessively high. A business isn't just going to invest more because of a minor cut in their taxes. But a major slash can definitely do the trick. For example, in the United Kingdom, when Labour party raised investment tax rates to around 90% I think it was, not much investment occurred. Slash those rates down to 40% though, and watch investment and job creation explode.
Example #3
The idea that when the economy is in a recession, you cut taxes.
Again, as explained above, this is a misconception of both the Left and the Right. When the economy is in recession, provided one wants to try some form of stimulus (Austrian economists hold the view that no stimulus is needed), a stimulus can be either supply-side or demand-side, and a demand-side stimulus can be a combination of deficit spending and tax cuts. One can also combine a supply-side stimulus with a demand-side stimulus.
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