Supply-side economics or New Classical Economics has gained distinct prominence in the early 1980s with the election in the U.S.A of a conservative government under President Reagan. These ideas have been labelled as "Reaganomics". These ideas represent a revival of classical economics and its latest form called New Classical Macroeconomics. The structure of President Reagan's economic program is based on the four pillars, broadly known as lower tax rates, reduced government spending, encouragement of monetary restraint and easing of regulatory burden on businesses. President optimistically announced that his 4-point economic program, if enacted, would result in higher level of output and employment and a lower inflation rate. The extension of this program was the Economic Recovery Act of 1981 passed during his administration.
The effect of the act was that, there were substantial changes in the nation's tax laws. The personal income tax rates dropped by 25% with 5% reduction on October 1, 1981, and there was subsequent 10% reduction on July 1, 1982 and July 1, 1983. The reduction in the maximum rate on capital gains from 28% to 20% was the resultant of the reduction in the rate of maximum personal income tax on investment income, which had a steep fall from 70% to 50% on 1st January, 1982. Added to the above mentioned reduction, there are many other provisions of the Act which aim to achieve increase in incentives to work, save and invest.
As things stood on Jan 1, 1982, any wage earner can invest up to $2,000 a year in a personal pension plan called an Individual Retirement Account (IRA). No taxes are paid on the contribution or the interest it earns until the person starts withdrawing funds from the plan. The other features of the Act are that there is a wide scope for the personal income taxes to be indexed to the consumer price index (CPI) starting in 1985. Under the provision tax brackets, personal exemptions and standard deductions will be adjusted each year to take inflation into account. Consequently, the taxpayers who receive wage increases that merely keep pace with inflation will have a constant real tax payment.
President Reagan's Economic Recovery Act of 1981 also contain many provisions which are designed to favor business. Effective from January 1st, 1981, business depreciation schedules were simplified and redesigned to accelerate the write off of investment in plant and equipment. In addition, firms received a 6% investment tax credit for the purchase of new cars, small trucks and research equipment and a 10% credit for other equipment. These changes reduce the cost of capital, thereby providing an incentive for firms to invest in new plant and equipment. Furthermore, corporate tax rates were reduced for corporations with profits of less than $50,000. Single proprietorships and partnerships benefit from the reduction in personal income tax rates.
As seen above, President Reagan's program is viewed as a program based on supply-side considerations of an incentive package. However, the program has been criticized on several grounds:
The incentives may have little or no effect on labor supply, saving and investment spending;
Aggregate expenditure or demand may increase more rapidly than aggregate supply, aggravating inflationary tendencies, and
In the absence of the large cuts in government spending, the combination of expansionary fiscal policy and contractionary monetary policy will result in high interests which in turn discourage investment spending in the economy. Further, the program has also been criticized for its adverse impact on social programs and distribution of income. Because of the hike in defense expenditures, social programs had to be cut more drastically to achieve a net decrease in government spending. With regard to the personal income tax reductions, they resorted to proportional reductions in tax rates so that those with high incomes benefit the most. Attempts were made in U.S. Congress to limit the tax reductions and to restructure the tax structure to give more relief to those at lower range in income levels.
However, the protagonists of supply-side economics argue that large cuts in marginal tax rates are essential to provide incentives to work, save and invest. This in turn is expected to boost the output and employment and decrease in inflation to the benefit of the nation. As referred earlier, most of these supply-side measures, especially the tax cuts and deregulation of the economy, are currently being pursued to give a 'push' to the recession-ridden economies in most of the developing economies, including India.