Effectiveness of policy options to meet all macroeconomic objectives

Supply-side policies aim to raise an economy's productivity and productive capacity, shifting the LRAS curve to the right. They are usually divided into market-based and interventionist approaches.

Market-based supply-side policies aim to free up markets and improve incentives by reducing government interference. Examples include cutting income and corporation tax (to improve incentives to work, save, invest and take risks — the Laffer-curve argument that lower rates can even raise revenue and effort), deregulation (removing rules to increase competition and efficiency), privatisation (transferring firms to the private sector for a profit incentive), and reducing benefits or trade-union power to make labour markets more flexible. These raise capacity by making markets work more efficiently. Their advantage is that they harness incentives and are relatively cheap; their drawback is that some (cutting benefits, reducing protections) can increase inequality.

Interventionist supply-side policies involve government investment to correct under-provision by the market. Examples include spending on education and training (raising human capital and labour productivity, and improving occupational mobility to cut structural unemployment), infrastructure (transport, energy, communications that lower firms' costs), support for research and development, and regional policy to revive declining areas. These directly build the human and physical capital that markets tend to under-provide. Their advantage is that they tackle market failures and build long-term capacity; their drawbacks are that they are costly (an opportunity cost) and slow to take effect.

How each improves performance. Both shift LRAS right, raising potential output (growth), allowing growth without inflation, lowering the natural rate of unemployment (especially via training/mobility), and improving international competitiveness (helping the current account). So supply-side policies can advance several objectives at once. The choice between the two reflects a judgement about the role of the state and a trade-off between incentives/cost (market-based) and tackling market failure/equity (interventionist) — and in practice a combination is often used.

A government has three main policy types — fiscal, monetary and supply-side — each more suited to some objectives than others. Their effectiveness depends on the objective, the cause of the problem, and the state of the economy.

Fiscal policy (government spending and taxation) is effective for managing AD: expansionary fiscal policy raises output and employment in a recession (especially when monetary policy is weak at the zero bound), and capital spending also raises long-run capacity. The Laffer curve suggests tax cuts can even raise revenue if rates are very high. However, fiscal policy has time lags, can cause crowding out, enlarges the deficit/debt, and causes inflation near full capacity. Used to cut inflation (contractionary), it raises unemployment — a conflict.

Monetary policy (interest rates, money supply, QE) is the main tool for controlling inflation and managing AD, being flexible and credible (independent central bank). However, it is a blunt instrument with time lags, is weak at the zero bound (hence QE, whose effects are uncertain and can inflate asset prices/inequality), and is useless against cost-push inflation.

Supply-side policy (market-based and interventionist) is the most effective for long-run growth, lowering the natural rate of unemployment, and improving competitiveness/the current account, because it raises capacity (LRAS right) and so advances several objectives without inflation. However, it is slow and costly, and market-based measures can raise inequality; crucially, the extra capacity is wasted without adequate demand.

Conflicts and government failure. All these policies create conflicts (e.g. inflation vs unemployment, growth vs the BoP) and are subject to government failure — poor information (the output gap and natural rate are unobservable), time lags that can make policy pro-cyclical, unintended consequences, and political motives. So no policy is reliably effective in isolation.

Judgement. Effectiveness is objective- and situation-specific. Demand-side policy (fiscal and monetary) is most effective for short-run stabilisation — managing the cycle and demand-pull inflation — with monetary policy the usual first choice and fiscal policy vital in a deep recession. Supply-side policy is most effective for long-run growth, the natural rate and competitiveness, advancing multiple objectives without inflation, but it works slowly and needs adequate demand. The most defensible conclusion is that the policies are complementary: a government should use demand-side policy to stabilise the cycle and supply-side policy to raise long-run capacity, matching each policy to the objective and the cause of the problem, while weighing the risk of government failure. No single policy can achieve all objectives, so the optimal approach is a well-judged combination rather than reliance on one tool.

This outcome can be explained by the Laffer curve, which shows how total tax revenue varies with the tax rate: revenue is zero at a 0% rate and at a 100% rate, rising to a maximum at some revenue-maximising rate (t*) in between.

A 70% top rate is very high, and the fact that cutting it to 50% raised revenue suggests the economy was on the downward-sloping (right-hand) side of the Laffer curve — i.e. the original 70% rate was above t*. At such a high rate, the government was actually collecting less revenue than it could, because the high rate discouraged work, investment and enterprise among high earners, and encouraged tax avoidance, evasion and emigration (so less income was declared/earned to tax).

When the rate was cut to 50%, these disincentives were reduced: high earners had more incentive to work, invest and declare income, and less incentive to avoid tax, so the tax base expanded. The larger amount of taxable income, even at a lower rate, produced higher total revenue — moving back up toward t*.

The implication is that, beyond the revenue-maximising rate, cutting tax rates can raise revenue (a market-based supply-side argument). However, this only holds if the rate was genuinely above t*; if a rate is below t*, cutting it would reduce revenue. The exact position of t* is disputed and country-specific, so this result does not mean tax cuts always raise revenue.

Government failure in macro policy occurs when intervention worsens outcomes or fails to justify its cost. Whether this risk means a government should avoid active policy must be weighed against the benefits of intervention.

The case for avoiding active policy. Active (discretionary) policy is prone to failure. The government cannot observe the output gap or natural rate precisely, so it may mis-set policy (e.g. stimulating an economy already at capacity → inflation). Time lags (recognition, decision, implementation) mean policy may act too late, even pro-cyclically (stimulating just as the economy recovers). The multiplier is uncertain, so the policy may be the wrong size; there are unintended consequences (debt, crowding out, asset bubbles from QE); and political motives may distort decisions. These suggest that rules-based policy (e.g. an inflation target) and automatic stabilisers (which act immediately, without lags) may be safer than active discretionary intervention.

The case against avoiding active policy. Doing nothing also has costs. In a deep recession, relying only on automatic stabilisers may be insufficient — active fiscal/monetary stimulus is needed to prevent prolonged unemployment and lost output, as in major downturns. Supply-side policy (active intervention) is essential for long-run growth and lowering the natural rate. And market economies are not self-correcting quickly enough in all cases, so passivity can let problems persist. The benefits of well-judged intervention can clearly exceed the risks.

Judgement. The risk of government failure means a government should be cautious and well-informed, not that it should avoid active policy altogether. The most defensible approach is to rely on rules and automatic stabilisers in normal times (minimising government-failure risk from lags and discretion), but to use active policy when the problem is large — for example, discretionary stimulus in a deep recession, or supply-side intervention for long-run growth. Active policy should be timely, evidence-based and weighed against government-failure risks. So government failure is a reason for better-designed, more cautious policy, not for inaction — because the failure to act can be as costly as misguided action.