The need for Supply Side Policies

The European economies are facing significant challenges in their attempts to rebound from recent inflationary and energy crises. Although the European Central Bank (ECB) is working to tame inflation, it is unlikely that price stability will be restored anytime soon. Eurozone governments have been implementing fiscal measures to alleviate pressure from the general increase in the price level, but these measures have focused more on the demand side than on the supply side of the equation. This, coupled with the hike in real interest rates, could become more inflationary along the way, hindering the ECB’s work of trying to decrease aggregate demand.

In contrast, the U.S. economy has experienced excessive demand and spending growth, and aggregate supply is in a much better shape compared to the Eurozone. Although the ECB was late to realize that it had to start tightening its monetary policy, the Eurozone countries are facing a bigger supply-side problem compared to the U.S. This is due to most European countries experiencing economic stagnation for decades, causing the gap between the U.S. and the EU to widen, all the while emerging markets are catching up. Unfortunately, the current energy crisis and the EU’s anti-growth policies can further exacerbate these problems, leading to permanent productivity and innovation decline, with a real chance of de-industrialization. These are problems that monetary policy cannot help alleviate, and national governments should seek a radical shift in economic policy to improve economic performance and decrease inflationary pressures.

Picture 1: Nominal wage growth in the Euro Area

Source: tradingeconomics.com

One potential tool for improving economic performance is growth-oriented tax cuts. Although some may argue that an expansionary fiscal policy runs the risk of overheating the economy and increasing inflation, the story is more complex. Central banks not only should but have a duty through their mandate to offset any possible overheating, and tax cuts could reduce the costs of wages and goods and services in the short run. The long-term benefits to the economy are even greater since productivity gains are deflationary and can improve living standards. If nothing else, the data clearly shows that high corporate taxes discourage business and foreign investments, harming productivity and overall GDP on its path.

Although on the surface, in a simple ceteris paribus model that might be the case, it ignores two main factors: 1) central banks not only should, but have a duty through their mandate to offset any possible overheating. After all, inflation is a monetary phenomenon, and 2) tax cuts could reduce, in the short run, the costs of wages, and goods and services. The long-run benefits to the economy are even greater since productivity gains are deflationary and can improve living standards. The only sound argument against tax cuts is that they could significantly worsen the fiscal profile of the Eurozone countries that are already heavily indebted. After all, it is very unlikely that tax cuts would be accompanied by spending cuts as well. On the other hand, Eurozone governments have benefited from the inflationary spike which has reduced their real debt obligation. Moreover, it has also increased their tax revenues as a result of people being pushed into higher income brackets as a result of their nominal wages increasing.

Cutting taxes doesn’t necessarily result in a major decrease in state revenue, as the Laffer curve shows. The basic premise of the curve is that both at a 0% and 100% tax rate the state will collect the same revenue – zero. Thus, there has to be an optimal point along the curve where revenue is maximized. This point varies depending on time and place, and of course, the taxes in question. Furthermore, economists also disagree on what tax rate we reach the declining revenue area, the wrong side of the curve.

There is plenty of evidence that European countries may have already reached or are very close to reaching the tipping point, unlike the U.S. It is also important to point out that the biggest insight of the curve, one that is oftentimes ignored, is that the Laffer curve doesn’t deal only with tax revenues but economic growth as well. In other words, at the optimal rate at which income and wages grow, so does the pie. In turn, so do tax revenues – in the terms that matter, absolute.

Picture 2: Laffer curve

Higher taxes do not only reduce economic activity only because individuals have a bigger incentive to substitute their labor for leisure but also because producer and consumer surpluses are now reduced because less is left to save and invest from their total income. Thus, policymakers should aim for growth maximization rather than maximized tax revenues.  

Picture 3: Average OECD countries corporate tax rates and revenue,

Source: OECD

Politicians should start paying more attention to the supply side rather than the demand side of the economy. In the long run, a country’s prosperity is tied to its ability to produce goods and services. While it is true that tax reform by itself won’t fix the economy it is a useful tool that improves its future prospects.