Evaluation of supply-side policy
Syllabus: Evaluate the effectiveness of supply-side policies through consideration of factors including:
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.
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]
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]
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]
Supply-side policies are government attempts to increase productivity and shift aggregate supply (AS) to the right.
- Free-market supply-side policies involve policies to increase competitiveness and competition. For example, privatisation, deregulation, lower income tax rates, and reduced power of trade unions.
- Interventionist supply-side policies involve government intervention to overcome market failure. For example, higher government spending on transport and communication.
Benefits of Supply-Side Policies
In theory, supply-side policies should increase productivity and shift long-run aggregate supply (LRAS) to the right.
1. Lower Inflation
Shifting AS to the right will cause a lower price level. By making the economy more efficient, supply-side policies will help reduce cost push inflation.
2. Lower Unemployment
Supply-side policies can contribute to reducing structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment. See: Supply-side policies for reducing unemployment
3. Improved economic growth
Supply-side policies will increase the sustainable rate of economic growth by increasing LRAS; this enables a higher rate of economic growth without causing inflation.
4. Improved trade and Balance of Payments.
By making firms more productive and competitive, they will be able to export more. This is important in light of the increased competition from an increasingly globalised marketplace. See also: Economic Importance of Supply-Side Policies
Examples of supply-side policies
This involves selling state-owned assets to the private sector. It is argued that the private sector is more efficient in running businesses because they have a profit motive to reduce costs and develop better services. See more on Privatisation.
This involves reducing barriers to entry to allow new firms to enter the market. This will make the market more competitive. For example, BT used to be a monopoly in telecommunications, but now several firms compete for our business. Competition tends to lead to lower prices and better quality of goods/service.
- The difficulty is that not all industries are amenable to competition. For example, power generation and water supply is a natural monopoly. Privatising and deregulating these industries tends to create a private monopoly who can charge higher prices.
3. Reducing income tax rates
It is argued that lower income increase the incentives for people to work harder, leading to an increase in labour supply and more output. Similarly, a cut in corporation tax gives firms more retained profit they can use for investment.
- However this is not necessarily true, lower taxes do not always increase work incentives (e.g. if income effect outweighs substitution effect). Firms may not invest the increased profit but give to shareholders or save. See: Cutting corporation tax.
5. Deregulate Labour Markets
Labour markets can be deregulated through policies such as
- Make it easier to hire and fire workers. Abolish redundancy pay or right of appeal
- Reduce maximum working weeks and minimum holiday pay.
- Enable zero hour contracts which allow firms to employ workers when demand is greater.
If it is cheaper to hire and fire workers, the argument is that it encourages firms to take on workers in the first place, creating more employment opportunities.
- However, more flexible labour markets can cause increased uncertainty and lower productivity. See also: Flexible labour markets
5. Reducing the power of trades unions
This can involve legislation which reduces the ability of trade unions to go on strike. This should:
- Increase efficiency of firms e.g. less time lost to strikes.
- Reduce real wage unemployment. (if labour markets are competitive)
6. Reducing unemployment benefits.
Lower benefits may encourage the unemployed to take jobs. Lower means-tested benefits for those in work may increase the incentive to work longer hours.
7. Deregulate financial markets.
For example, building societies were allowed to become for profit-making banks. Deregulation should allow more competition and, in theory, lead to lower borrowing costs for consumers and firms.
7. Increase free-trade
Lower tariff barriers this will increase trade and provide an incentive for export firms to invest.Increasingly important are non-tariff barriers. For example, EU Single market has harmonisation over regulations, which enables more frictionless trade. Negotiating frictionless trade-deals
9. Removing unnecessary red tape
Planning restrictions can make it difficult for firms to expand and invest in new capacity. Reducing red tape and levels of bureaucracy reduce firm’s costs and encourage an environment conducive to encouraging investment.
10. Encourage immigration
Free-movement of labour can enable firms to fill labour shortages – whether they are skilled jobs, in construction and engineering or low-skilled jobs such as fruit picking. Liberal immigration policies make labour markets more flexible and in boom times help firms keep up with growing demand. For countries with relatively low wages, they may lose out on most skilled labour who move abroad to get higher paying jobs.
Interventionist supply-side policies
1. Increased education and training
Better education can improve labour productivity and increase AS. Often there is under-provision of education in a free market, leading to market failure. Therefore the government may need to subsidise suitable education and training schemes.
- However govt intervention will cost money, requiring higher taxes, It will take time to have effect and government may subsidise the wrong types of training
2. Improving transport and infrastructure
With transport, there is usually a degree of market failure – congestion and pollution. Government spending on improved transport links can help reduce congestion and overcome this market failure. Improved transport provision helps reduce the cost of transport and will encourage firms to invest. Transport bottlenecks on the road, rail and air – are often cited as a major stumbling block for the UK economy.
- However, in a crowded country like the UK, it can be difficult to increase transport capacity, especially in London.
3. Build more affordable homes
Building affordable council homes in expensive areas can make it easier for workers to move and find jobs in expensive areas, reducing geographical immobility. Firms can suffer from labour shortages in areas that have become very expensive to live in.
4. Improved healthcare
Business can face substantial costs from time lost to ill-health. Health care spending which improves a nation’s health can improve labour productivity. Improved health can also come from discouraging unhealthy habits. For example, tax on cigarettes, alcohol and sugar can reduce health care costs associated with drunkenness, obesity and polluted environments.
Limitations of supply-side policies
- Productivity growth depends largely on private enterprise and trends in technological innovation. There is a limit to which the government can accelerate the growth of technological change and improvements in working practices.
- Supply-side policies can be counter-productive. For example, flexible labour markets may reduce costs for business – but if they cause job-insecurity, workers may become demotivated and labour productivity stagnates. Since 2009, the UK has seen a fall in structural unemployment due to more flexible labour markets – but productivity growth is almost stagnant.
- In a recession, supply-side policies cannot tackle the fundamental problem which is lack of aggregate demand.
- Time. All supply-side policies take a long time to have an effect. Some policies, such as education spending may not influence the economy for 20-30 years.