Supply-side policy measures: improving incentives to work and invest

Government and the Macro‑economy – Supply‑Side Policy

Lesson Objective

Identify and evaluate the supply‑side measures that improve incentives for households to work and for firms to invest, and assess their likely impact on economic growth, unemployment, inflation and income distribution (AO1‑AO3 of the Cambridge 0455 syllabus).

1. What is Supply‑Side Policy?

Supply‑side policies are government macro‑economic interventions that aim to increase an economy’s potential output (the level of output that can be produced when all resources are fully employed). They do this by improving the determinants of aggregate supply (AS) – labour, capital, technology and the institutional framework – and therefore shift the long‑run aggregate‑supply (LRAS) curve to the right.

2. Why Focus on Incentives?

Incentives influence the decisions of the two key agents in the supply side of the economy:

• Households – whether they choose to supply labour (work).
• Firms – whether they decide to invest in capital, research, or new enterprises.

When the net return to work or to invest rises, the supply of labour and capital expands, raising the economy’s productive capacity.

3. Improving Incentives to Work

• Lower marginal income‑tax rates – Reduce the tax deducted from each additional pound of earnings, raising the after‑tax wage and encouraging a larger labour‑supply.
• Welfare‑to‑Work programmes – Conditional benefits that require claimants to look for work or undertake training, turning passive receipt into active job‑search.
• Education, training and skills development – Expansion of vocational colleges, apprenticeships, adult‑learning schemes and university places raises human‑capital productivity and makes employment more rewarding.
• Labour‑market reforms – Flexible working hours, reduction of statutory leave, removal of occupational licensing, easier part‑time contracts and “right‑to‑work” rules increase labour‑market efficiency.
• Minimum‑wage adjustments – A floor set at or near the productivity level can raise the incentive to supply labour; if set too high it may discourage hiring.
• Childcare subsidies – Lower the opportunity cost of work for parents (especially women), encouraging higher labour‑force participation.

4. Improving Incentives to Invest

• Corporate‑tax cuts – Lower the statutory tax on profits, raising after‑tax profitability and stimulating expansion of the capital stock.
• Accelerated depreciation / investment allowances – Allow a larger proportion of investment costs to be written‑off in the first year, reducing the effective user cost of capital.
• R&D tax credits – Grant tax relief for expenditure on research and development, encouraging innovation and technological progress.
• Deregulation and reduction of red tape – Simplify planning permissions, licensing and other administrative procedures, cutting the time and cost of starting or expanding projects.
• Privatisation of state‑owned enterprises – Transfer assets to the private sector where profit motives can increase efficiency and investment.
• Public investment in infrastructure – Build or upgrade transport, energy, broadband and other networks; this lowers transaction and transport costs for businesses and improves the productivity of both firms and households.
• Lower direct taxes on capital – Reduce taxes on capital gains, dividends, interest or property income, raising the after‑tax return on savings and private investment.

5. Summary Table – Supply‑Side Measures

6. How the Measures Work – Simple Models

Labour supply: \(L_s = f\bigl[w(1-t)\bigr]\)
A fall in the marginal tax rate t raises the after‑tax wage \(w(1-t)\), shifting the labour‑supply curve outward.

User cost of capital: \(c = r + \delta - \frac{\tau_i}{1-\tau_i}\)
where \(r\) = real interest rate, \(\delta\) = depreciation rate, \(\tau_i\) = tax allowance rate. Increasing \(\tau_i\) (e.g., via accelerated depreciation) lowers \(c\), encouraging firms to expand the capital stock \(K\).

7. Advantages and Disadvantages of Supply‑Side Incentives

1. Advantages
   • Expand potential output → sustainable long‑run growth.
   • Can widen the tax base, reducing the fiscal burden over time.
   • Improve international competitiveness and productivity.
   • Generally exert less upward pressure on prices than demand‑side stimulus because they increase supply rather than demand.
2. Disadvantages
   • May create short‑run fiscal deficits if tax cuts are not offset.
   • Benefits can be skewed toward high‑skill workers and large firms, widening income inequality.
   • Rapid deregulation or privatisation can cause short‑term job losses or market instability.
   • Effectiveness depends on existing conditions; in an economy already near full productivity, further tax cuts may have limited impact.

8. Suggested Diagram

9. Key Points to Remember

• Supply‑side policies target the determinants of potential output, not just short‑run demand.
• Incentives to work affect the labour market; incentives to invest affect the capital market and technology.
• Policy effectiveness hinges on the existing tax structure, labour‑market flexibility, and the level of public investment.
• Evaluation must consider four criteria: economic growth, unemployment, inflation and distributional effects (who benefits and who may be disadvantaged).
• Use the LRAS diagram to link definition (AO1) with impact (AO2) and to structure essay answers (AO3).

10. Potential Exam Questions (IGCSE 0455)

1. Explain how a reduction in the marginal income‑tax rate can increase the level of employment in an economy.
2. Discuss the likely impact of accelerated depreciation allowances on a country’s long‑run aggregate supply.
3. Evaluate the advantages and disadvantages of welfare‑to‑work programmes as a supply‑side policy.
4. Assess how labour‑market reforms (e.g., flexible working hours, removal of occupational licensing) can affect unemployment and potential output.
5. Analyse the possible distributional effects of corporate‑tax cuts and R&D tax credits.
6. Using a diagram, explain how public investment in infrastructure can shift the LRAS curve.
7. Compare and contrast the macro‑economic effects of lower direct taxes on capital with those of lower corporate‑tax rates.