"Supply Side" and the Evolution (and Abuse) of Economic Ideas

Though one must be wary of any claim that there is "a new consensus among economists on how to look at the national economy," (former Reagan and Bush official) Bruce Bartlett's op-ed in today's New York Times, "How Supply Side Economics Trickled Down" raises a number of interesting issues.
The basic idea of "supply side" economics is that, by altering incentives to work and save, changes in marginal tax rates will change the quantity of labor and capital supplied in the economy. This is in contrast to the traditional "Keynesian" focus on the effects on aggregate demand. Bartlett argues that supply side "has become a frequently misleading and meaningless buzzword that gets in the way of good economic policy." He continues:

But today it is common to hear tax cutters claim, implausibly, that all tax cuts raise revenue. Last year, President Bush said, “You cut taxes and the tax revenues increase.” Senator John McCain told National Review magazine last month that “tax cuts, starting with Kennedy, as we all know, increase revenues.” Last week, Steve Forbes endorsed Rudolph Giuliani for the White House, saying, “He’s seen the results of supply-side economics firsthand — higher revenues from lower taxes.”

This is a simplification of what supply-side economics was all about, and it threatens to undermine the enormous gains that have been made in economic theory and policy over the last 30 years. Perhaps the best way of preventing that from happening is to kill the phrase “supply-side economics” and give it a decent burial.

Mark Thoma has an extensive response, framed in terms of the contemporary academic debate between Real Business Cycle (RBC) models vs. New Keynesian models. RBC models are the modern incarnation of classical economics, and rely on the optimal response of utility maximising consumers and profit maximizing firms to productivity shocks - shifts of the production function - to generate economic fluctuations. Everything is driven by supply, and aggregate demand is irrelevant. In New Keynesian models, as in old Keynesian models, aggregate demand matters, though for different reasons. The New Keynesians use microeconomic frictions like menu costs and coordination failure to generate an upward sloping aggregate supply curve. Thoma writes:

Why does NK policy tend to focus on demand shocks rather than supply shocks? The answer is that although it would be ideal if we could use supply-side polices to smooth short-run fluctuations in output arising from supply shocks, the reality is that we cannot do this. As Bartlett notes, supply-side polices are very blunt, slow-acting policies that can affect output in the long-run, but they are all but useless in dealing with short-run fluctuations in the economy (thus, RBC theorists tend to focus mainly long-run growth).

Since supply cannot be managed in the short-run, that leaves demand management policies, i.e. monetary and fiscal policy. As we learned in the 1970s, demand side tools are not very effective instruments for offsetting supply-side shocks - trying to use demand side policy to offset supply shocks helped to generate the stagflation we saw at the time. We've learned since then, but practically we are still somewhat powerless to offset supply side shocks in the short-run - all we can do is manage demand to match changes in supply. That is, if a hurricane wipes out supply, we can use policy to reduce demand to match, but we can't do much to increase supply back to its initial level in the short-run.

Thoma picks up many of the important points that Bartlett seems to miss, but as Bartlett points out in his response to Thoma, RBC and New Keynesian models were developed in the 1980's, while the original debate over "supply side" started in the 197o's.
If there is any kind of "consensus" - or at least a "synthesis" - it is methodological. The work of Robert Lucas, among others, has convinced academic economists to build their macroeconomic models with more careful microeconomic foundations. Both the RBC and New Keynesian schools take utility maximization and expectations seriously.
On the specific issue of "supply side" tax cuts, if you are taking utility maximizing behavior seriously, then the effect of marginal tax rates on incentives should matter - in theory. Whether it does in practice is an empirical question that is difficult to resolve. For example, consider a cut in the marginal tax rate on labor income: whether this increases or decreases labor supply would depend on whether the income effect, which would cause people to work less (if leisure is a normal good, as your income rises you want more of it) is outweighed by the substitution effect (the opportunity cost of leisure increases). The supply-siders think the substitution effect is extremely strong. Perhaps if we follow Bartlett's wish and ditch the term "supply side" we should replace it with "substitution effect economics."
Incidentally, one of Reagan's supply side revolutionaries, David Stockman is back in the news.