Supply-side and demand-side economics are two competing explanations of the relationship between government fiscal policy and economic growth. In general, liberals and progressives tend to embrace demand-side economics, while conservatives and libertarians tend to prefer supply-side economics.
Defining Supply-Side Economics
"Supply-side economics" has two different but interrelated meanings, according to economist James Gwartney. The first refers to the idea that incomes and standards of living vary according to the production of goods and services, or "supply," with more production leading to higher incomes. This view is basically uncontested by mainstream economists. In the context of the debate between supply-side and demand-side economics, however, the term refers to the view that the best way to stimulate economic growth is to lower barriers to production, especially taxes. Specifically, advocates of supply-side economics argue that lower taxes will result in larger supplies of goods and services, thus lowering prices and improving standards of living.
Defining Demand-Side Economics
Demand-side economics argues that economic growth increases most as a function of increasing demand for goods and services rather than increasing supply. Demand-side economists like Paul Krugman argue that the best way to avert recessions and depressions is to stimulate demand by investing in large-scale infrastructure projects, such as building highways. These projects, they argue, directly increase demand for products like asphalt but also put money in workers' pockets. Workers then spend their wages, further increasing demand and encouraging businesses to increase production and hire more employees.
Marginal Tax Rates
The centerpiece of supply-side economic thinking is the view that lowering marginal tax rates is the path to prosperity. Supply-side advocates like Gwartney say higher taxes, especially on businesses, lead to inefficient investments in tax havens and discourage business investment. If a business owner expects to lose 40 percent of earnings from increased productivity to taxes, they argue, he will be less likely to increase his productivity. Thus, economic growth stagnates. Demand-side advocates dispute this view, because they see demand as the central factor driving economic growth. Krugman, for example, argues that recessions emerge from shortfalls in demand. Stimulating supply, in his view, is therefore a less effective solution than stimulating demand.
Tax Rates and Deficits
A central tenet of supply-side economics is the disassociation of tax rates and tax revenue. The counterintuitive view holds that total tax revenues can actually increase as a result of cuts in tax rates. This phenomenon is explained by the Laffer curve: If a cut in tax rates stimulates enough economic growth, the government can collect more net dollars even though its citizens pay a smaller percentage of their income. Most economists dispute the idea, however. A survey of economists by IGM Chicago found a strong majority disagreed with the claim that an income tax cut would lead to higher revenues within five years.