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May 1981

An Econometric Model Incorporating the Supply-Side Effects of Economic Policy

by Michael K. Evans

Michael Evans discusses the implications of the supply-side macroeconometric model he recently developed. According to Evans, stimulating investment is a key to supply-side policy because it will both increase real growth and moderate inflation. Evans finds that investment would be significantly stimulated by reductions in tax rates, regardless of whether the tax cuts apply to corporate income, personal income, or capital gains. He believes that a change in the corporate tax rate has the most powerful effect on investment, and an increase in the investment tax credit has the least impact. Evans also examines in considerable detail the influence of personal tax cuts, cuts in capital gains taxation, and a variety of other plans to stimulate saving. These tax reductions raise the after-tax real rate of return and increase saving; the increased saving in turn increases demand for assets, lowering interest rates and stimulating investment. In the labor market equations, Evans finds important effects of tax rates on both labor supply (participation rates and hours worked) and on wage gains. The effect of taxes on wage gains is particularly important because it permits tax declines to moderate inflation.