Is An Incentive The Good Macroeconomic Policy?

A first theme of supply side economics is the key role played by incentives, which denote adequate returns to working, saving, and entrepreneurship. Supply sides point to the miracles performed by unfettered free markets and seek to avoid the disincentives due to high tax rates; moreover, they argue that Keynesian in their excessive concern with demand management, have ignored the impact of tax rates and incentives on aggregate supply.

What is the hypothesized relationship between tax policy and overall economic activity? In the context of aggregate supply and demand analysis, lowering tax rates would raise the post tax return to capital and labor; higher post tax returns would induce greater labor and capital supply, along with the higher rates of innovation and productivity growth; and the increase of inputs and innovation would increase the growth of potential output and thereby shift aggregate supply to the right.

The macroeconomic impact of this supply side measure depends upon the shape of aggregate supply curve. If the economy is in a recession with the relatively flat aggregate supply curve the impact of the supply shift on actual output will be relatively modest.