A Supply Side Tax Cut

A key point is that Supply Siders propose to cut the tax rate, that is, the proportion of each dollar of income taken by taxes. That's different from cutting tax revenue. The Supply Siders have hoped that, by cutting the tax rate, they could increase production by so much that tax revenues would hold steady, or even increase. Let's see if we can visualize this in one of our AS/AD diagrams:

Figure 8: A Supply Side Tax Cut

The diagram is set up as usual, with the addition of taxes. Production is Y₁, with a price level of p, so p*Y₁ is the nominal Gross Domestic Product. The tax rate is such that t₁ is taken out of every p dollars of nominal income. That is, the tax rate is t₁/p. Thus the total tax take is t₁ times Y₁. In the diagram, the tax take is shown by the sum of the area shaded like this:

and the area shaded like this:

Now the tax rate is cut to t₂/p. This stimulates investment, increasing productivity and shifting the LAS rightward to LAS₂. We assume that aggregate demand also shifts to AD₂, so that the price level is steady at p. (This shift in Aggregate Demand could partly be a result of the tax multiplier impact of the tax cut itself. If that's not enough, we suppose that the Federal Reserve system "accommodates" the shift in Aggregate Supply by increasing the money supply). We have a new equilibrium with price level p and real GDP at Y₂. The tax take is the sum of the area shaded like this: and the area shaded like this: .

How are we doing? There have been both an increase and a decrease in tax revenues. Tax revenues on Y₁ of real GDP have decreased by the rectangle shaded like this: ; but they have increased by the tax on the increased production the area shaded like this: . If the second area is greater than the first, then tax revenues will actually have increased.

Here is the conclusion: it is logically possible, in the AS/AD model, for a tax cut to increase, rather than decreasing, total tax revenues. For the Supply Siders, this is more than a possibility -- it is a promise. They propose to increase tax revenues by cutting tax rates.

But will it really work?

Worries