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Vivek Dehejia: Rise of the 'supply side'

Narendra Modi's rhetoric around governance seems closer to Mundell's ideas than Keynes' that focus on managing demand

Vivek Dehejia 

Vivek Dehejia

Following last week's address by President Pranab Mukherjee, in which the Narendra Modi government unveiled its policy priorities for the coming five years, it has been opined by some, including this writer, that we might just be witnessing the rise of "supply-side" economics in India.

But what exactly is "supply-side" economics?

A term originating in US policy debates in the late 1970s, at its core, it is nothing other than a rediscovery of the primacy of the production - supply - of goods and services, as determined in the "real" economy, in contrast to the emphasis of Keynesian economists on "aggregate demand" for goods and services. The latter is susceptible to manipulation by government policies, both fiscal and monetary, in a world in which prices are "sticky" and so the economy may veer away from its long-run, or "potential", level of output.

Put another way, "supply-side" economics emerged from the failure of Keynesian-style demand management policies to cure "stagflation" - a combination of high inflation and stagnant output - which gripped the US and other economies after the oil shocks of the 1970s.

Since Keynesian policy focuses almost exclusively on managing demand, it assumes, either explicitly or implicitly, that the supply of goods and services - the economy's potential level of output - is largely unaffected by government policy, and is mostly a function of the economy's underlying technological capabilities, resources and consumer preferences. What is more, if prices are sticky and aggregate demand is deficient, so that actual output lies below its potential level, a concern with raising the level of potential output itself is of secondary importance at best for the Keynesians.

The supply-siders, taking a leaf from classical macroeconomists such as Friedrich von Hayek, argued instead that the Keynesian emphasis on stabilising demand as a cure for the business cycle was misguided, and that policy ought instead to focus on boosting the economy's long-run output level directly. Such policy proposals, most controversially at the time, focused on large cuts in personal and corporate taxes, and an emphasis on deregulation, to free up entrepreneurship and reduce the government's drag on the private economy.

The pioneers of "supply-side" economics included my own great teacher, Robert Mundell, the economist Arthur Laffer, and a group of journalists, academics and private sector folks who at the time (and even today) were disdained by the entrenched Keynesian economists in the major east coast universities such as Harvard and MIT. Mundell, a professor then as now at Columbia - a university whose economics department has a history intimately tied to the "Chicago School", despite its geographical location - was to win the Nobel Prize in Economics in 1999, although principally for his theoretical contributions to economics rather than the role he played as a supply-sider.

The one concept most famously (or infamously, depending on your point of view) associated with the supply-siders is the "Laffer curve", an inverted U-shaped mapping between the tax rate on the horizontal axis and tax revenues on the vertical axis. There is an oft-repeated story told, a version of which I have heard from Mundell himself, of a dinner at a restaurant in the fashionable Georgetown neighbourhood of Washington DC, in which Mundell, Laffer and others were discussing how a cut in the tax rate could actually increase - rather than decrease, as conventionally believed - total tax revenues. Someone drew an inverted "U" on a paper napkin, and the Laffer curve was born. (But, as Mundell told me with a characteristic glint in his eye, this fancy restaurant would more likely deploy starched cotton, rather than paper, napkins.)

The logic behind the Laffer curve accords entirely with conventional economic theory. At a zero tax rate, revenue, obviously, is zero. At a 100 per cent tax rate, revenue, likewise, will be zero since no one has an an incentive to work, save, or produce income. There must, therefore, be an "optimal" point in between - the peak of the inverted "U" - at which tax revenues are maximised. An economy that has slipped beyond this point could, therefore, increase revenues by bringing tax rates back down to the optimal level - in effect, because the revenue-raising impact of a larger tax base dwarfs the revenue-reducing impact of a lower tax rate.

The debate, then as now, is not on the logic behind the Laffer curve, and "supply-side" economics more generally - which are founded on impeccable insights from economic theory - but on their actual policy relevance. Keynesians believed that the incentive effects of lower taxes - both to boost government revenue and economic activity itself - were small in practice, while supply-siders contended that the beneficial effects would be large and materialise relatively quickly.

Even today, the debate rages on, partly because a disagreement on economic policy often reflects not just one's preferred theory of the economy, but equally one's ideological disposition for, or against, a smaller role for government.

Either way, given his mantra of "maximum governance, minimum government", it is clear that Modi's rhetoric, at the very least, is closer to Mundell than it is to Keynes.

The writer is an economics professor at Carleton University in Ottawa, Canada, and is co-author of Indianomix: Making Sense of Modern India (Random House India, 2012)
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First Published: Mon, June 16 2014. 21:48 IST