Supply-Side Economics and the Price Level Elasticity of Aggregate Demand

Abstract

A concept that has been largely ignored in the economic literature is the price level elasticity of aggregate demand. The purpose of this article is to integrate this concept into supply-side economic theory and demonstrate the conditions under which decreased tax rates induce higher tax revenues. Within a standard aggregate demand, aggregate supply reduced form model, it is found that the relationship between tax rates and tax revenues depends on two factors: the tax rate elasticity of aggregate supply and the price level elasticity of aggregate demand. More specifically, it is found that a tax decrease that increases the aggregate supply of goods and services is more likely to also increase tax revenue when the price level elasticity of aggregate demand is greater. Alternatively, for a tax rate decrease to increase tax revenue, the tax rate elasticity of aggregate supply must be greater when the price level elasticity of aggregate demand is lower.