The Reagan administration's supply-side fiscal policy, instead of promoting economic growth and balancing the budget as its proponents claimed, has done exactly the opposite. Supply-side economics has resulted in massive unemployment and ever-mounting budget deficits. The new buzz-word is "structural" deficits, but in fact these are supply-side deficits that are the logical outcome of supply-side fiscal policy.
Supply-side economics combines large cuts in taxes with smaller cuts in government spending. The tax cuts have a weak stimulative impact on demand throughout the whole economy. But the cuts in government spending have a much larger negative impact on demand.
The net effect is to raise the deficit while depressing aggregate demand, production and incomes.
As production and income fall, tax receipts do too, and transfer payments, such as unemployment compensation, rise. This further increases the deficit, so that the original deficit feeds on itself, becoming ever-larger as the economy continues to weaken.
The concept of the income multiplier is a useful way to understand the dynamics of supply-side deficits. As the government buys goods and services, makes transfer payments or cuts taxes, recipients spend these dollars in turn on other items --cars, refrigerators, doctor visits, etc.--stimulating further production and generating additional income. The multiplier is simply the number of times the original government payment is recycled throughout the economy.
The multiplier effects of different deficit-increasing measures vary widely. In particular, the propensity to spend, or recycle, dollars received from tax reductions, in a depressed and uncertain economy, has been quite low. There appears to have been very little consumption response to the recent Reagan tax cuts, as wary consumers have used the extra take-home pay to repay debts and add to savings. This means that the multiplier effect of these tax cuts has been fairly low, certainly below 1.
On the other hand, the multiplier effect of cutbacks in expenditure programs has been higher. In the case of direct government purchases, of course, there is an initial infusion of spending equal to the amount of the purchases. Thus, even if there were no further spending by the recipients of these dollars, the "multiplier" would be at least 1. (Theoretically, the tax cut multiplier could be zero, if recipients saved all the increase in their disposable income or used it to repay debt.)
Moreover, the Reagan administration has cut back spending on transfer programs that have largely affected low-income families. These families were already operating under severe budget restraints, and are unlikely to be able to maintain previous consumption levels by borrowing. Hence, they will be forced to cut back on their spending. This time, the multiplier works in reverse, reducing aggregate spending by a multiple of the original cutback in government purchases and transfer payments. Because the negative multiplier is larger than the positive multiplier, it is easy to see how a policy that increases the deficit can also depress the economy.
Think about the following simple numerical example. Suppose the expenditure multiplier is 2 and the tax multiplier is 1/2. (The exact numbers are not important, as this is merely an illustration.) If taxes are cut by 100, spending would increase by 50 (100 times the multiplier, 1/2). If, at the same time, government outlays are cut by 50, spending would fall by 100 (50 times the multiplier, 2). The net effect is to increase the deficit by 50 and to reduce income by 50. The decline in income, in turn, further increases the deficit by about 25 cents for every dollar that income falls, due to lower tax receipts and higher transfer payments on the reduced income base. Hence, the deficit rises by an additional 12.5, bringing the total to 62.5. And of course, with a lower level of income and production, unemployment has risen.
Now, consider the impact of a more traditional form of deficit spending that involves increasing government outlays with no tax cuts. Suppose the government increases budget outlays by 50. The deficit increases by 50, as in our earlier example, but this time income increases by 100 due to the multiplier effect. As income increases by 100 and the tax expands, the deficit falls by 25, reducing the earlier increase to 25. Unemployment is down, income is growing, and the deficit is only 25, compared with a supply-side deficit of 62.5 (21/2 times as large) that produced a recession and higher unemployment.
It should be clear from these examples that the tendency for supply-side fiscal policy to drag the economy down and the deficit up is a phenomenon quite independent of the Federal Reserve's monetary policy, although it is certainly true that restrictive monetary policy and high interest rates exacerbate the problem. Moreover, there is nothing in the "structure" of the economy that is producing deficits. Rather, the deficits are the result of large but weak tax cuts combined with small but powerful spending cuts that, on balance, weaken the economy, erode the tax base, and further raise the deficit.
Deficit spending, properly designed, has the potential for reducing unemployment and expanding the tax base. Supply-side fiscal policy is a perverse form of deficit spending that works the other way.