Economists generally fall into one of two camps: demand-side or supply-side. All economists recognize that supply and demand respond to each other in an endless effort to achive a fleeting moment of equilibrium. But what force is more of a leader that causes the other to respond? The implications of this are significant for many reasons, but I want to focus on the implications for economic growth and taxation.
The idea is that the greater force is the primary stimulus and the other is therefore primarily reactive. If you are a supply-side advocate, you would hold that supply creates its own demand, while the demand-side would argue the exact opposite-- that demand creates its own supply.
On paper, it shouldn't matter whether the tax is applied to one side or the other. If you have a $20 tax applied to an iPod, for example, either the price will be $20 higher, or the consumer has to pay that $20 through an income tax withheld -- the net effect is the same. But I will try to demonstrate in this piece that such symmetry only exists on paper-- that in the real world, one side is better able to cope with taxation than the other.
I think that supply is the greater of the two-- that supply leads to demand, not the other way around. Looking at a couple examples may help to illustrate why.
Think back to 2001. Apple is about to announce the iPod, but no one has actually seen one yet. What would a typical person say they wanted in an MP3 player? Would they ask for a "click wheel?" Would they see value in iTunes software and the ability to buy and manage music that way? Not likely. Why? Because people-- that is, the market-- had a pretty narrow definition of what an MP3 player was and how it should operate. So what was the market demanding? It was only demanding what it thought was possible-- a better version that still fit within that narrow paradigm.
A greater Apple example is probably the iPhone, though. In January of 2007, all the leading "smart phones" were actually not very smart. They could do email, but they had clunkly plastic keyboards that took up space whether you used them or not, and their internet functionality was largely a joke. You weren't going to surf most websites, and you certainly weren't going to stream video or audio. How could a potential buyer demand a "smart phone' that was outside the narrow paradigm of a Blackberry type of phone? Consumers-- that is, the market-- can't demand what they don't think is possible. The furthest a consumer might go is a generalized expression of frustration at wishing the phone worked better. But *how* should it work? What should it be capable of doing? How will I interact with it? The market cannot answer these questions on the aggregate. It relies on a specific concept to be supplied to the market and then people vote with their wallets. Touch screens, scrolling, apps, and such are so commonplace that they are de rigueur for any first-world citizen. But until Apple supplied a visionary archetype to the market, people didn't know they wanted to do things a different way.
Innovation and paradigm-shifting occur on the supply side. People didn't demand commercial aviation until the airplane was invented. Henry Ford's Model T had to be brought to market before it could actually catch on. Even the electric light wasn't widely in demand until after the big demonstration at the Chicago World's Fair made it the talk of the nation.
Time and again, the cycle is repeated-- a new idea, an innovation is brought to market by a visionary. This new supply creates a demand that, heretofore, had never existed. Competitors emerge as new supply responds to that demand. But the creative force-- the initiator of all subsequent actions-- occurs on the supply side. There is a demand for tablet devices and the supply now reflects a broad range of products from Motorla, Google, HP, and Microsoft. But the root cause of this was the iPad-- the innovation on the supply side that created the demand that generated all the other supply.
Noted entrepreneur Mark Cuban alluded to this phenomenon in an article called "Why You Should Never Listen To Your Customers." I was particularly struck when he wrote this:
Then [my company] made a fatal mistake. It asked its customers what features they wanted to see in the product, and they delivered on those features. Unfortunately for this company, its competitors didn't ask customers what they wanted. Instead, they had a vision of ways that business could be done differently and, as a result, better. Customers didn't really see the value or need until they saw the new product. When they tried it, they loved it.
Emphasis mine. Cuban is exactly right. Until the good or service is first supplied to the market, people can't see the value in something, and therefore demand cannot be generated. Productivity gains are largely driven by innovation, which I think has been shown to be a mostly supply-side phenomenon. It is precisely this reason that taxation should be moved to the other side-- the demand side.
Because the supply side is the primary driver of economic growth, it is important to minimize the encumbrance to that side as much as possible. Taxation is one such encumbrance.
When taxation occurs on the demand side, the impact is blunted. Tax a consumer 10% of his earnings, and the impact is diluted across all the products he may demand. He has many things he demands: food, transportation, shelter, entertainment, etc. Some are items he can do without or defer consuming-- the impact of the taxation is reduced.
But when the supply side is taxed, the impact is concentrated-- or can be. A worst case example might be a firm that makes computer chips like Intel. Tax Intel the same amount and all of that burden is borne by the microprocessor supply. Such products might be the key enabler to the rest of the economy, and we have hampered growth by laying excessive burden upon the supply side.
Another reason the supply side is more sensitive is the ease at which things are re-arranged. Consumers can quickly and easily revise their demand (consumption) in the way they feel best mitigates the impact of their tax burden.
But a supplier cannot readily change the business he is in or revise his product line. Responding the market changes is more expensive and time-consuming for him than for his customer.
Compliance costs are lower for a demand-side tax as well. A demand-side tax like a national sales tax are as cheap to administer as is possible. Compare that to a supply-side tax like our current income tax with the 17,000+ pages of rules, clauses, tables, and exceptions-- which must navigated at great time and expense to try and maximize compliance and minimize tax burden. Art Laffer estimates that our current system costs the economy 30% more than it needs to for the same amount of government revenue.
There is a fantastic scheme of taxation already formulated and thoroughly fleshed out: it's called the FairTax.
Because supply is what drives our economy and taxing it is more harmful, it's time to move taxation completely over to the demand (consumption) side of the ledger.
