By passing the Economic Recovery Tax Act of 1981, the U.S. Congress enacted supply-side tax cuts to stimulate the economy and enhance revenues.
The Economic Recovery Tax Act of 1981 had its origins in a movement called supply-side economics that gained momentum in the early 1970’s. Arthur Laffer, a young economist out of the University of Chicago, had worked as a budget analyst for the U.S. Office of Management and Budget and made a set of daring economic predictions based on incentives in the tax system. He introduced the “Laffer curve”
Laffer estimated that the tax rate that would maximize revenues was about 15-20 percent for the top income earners, much lower than the rates of 40-60 percent then in place. He pointed out that his theory supported the tax cuts enacted by President John F. Kennedy
Laffer was dubbed the father of the supply-side tax cuts by Jude Wanniski
The federal budget started to grow dramatically during the presidency of Jimmy Carter.
Kemp and other Republicans in Congress already had started to forge a tax reduction package, but their efforts had been blocked by Carter. Early in 1979, however, the Joint Economic Committee, under the leadership of Democratic senator Lloyd Bentsen
The drain on the economy caused by high tax rates was clear to Reagan, who had been a Democrat until the 1960’s. Reagan’s familiarity with the Kennedy tax cuts (and his personal witnessing of the effects of the Coolidge-Mellon cuts) convinced him that reducing marginal tax rates would accomplish two objectives. First, it would give individuals more money to invest. Reagan believed that individuals could make better decisions than could the government concerning investment. Second, lowering tax rates would reduce the government’s claim on individuals’ resources in relative terms. Even though his economic advisers pointed out that individuals’ tax payments might increase in dollar amount, the proportion of income devoted to government would in most cases decline.
Upon election, Reagan immediately pushed for a Kemp-type tax cut of 30 percent, to be implemented in 1981. Even before the economic proposals could be presented, budget director David A. Stockman
President Ronald Reagan meets with the press after signing the tax cut bill into law at his ranch near Santa Barbara, California.
Laffer and other supply-side advocates noted that the main effects of the tax cuts would not occur immediately. The tax cuts were expected to affect investment, and investment plans take time to formulate and implement. In addition, some businesses might be prompted to postpone some of their new investment to take advantage of the even lower tax rates to come.
Measuring the effects of the tax cuts on business is difficult because many factors influence business activity and such activity can be measured in various ways. Several statistics, however, are indicative of the success of the tax cuts. Real GNP (GNP adjusted for inflation) rose 3.6 percent in 1983, the first year that the full tax cut went into effect, and 6.8 percent in 1984. The rate of inflation, which was in the high teens during the Carter years, fell to 3.2 percent in 1983 and 4.3 percent in 1984. The unemployment rate dropped from 7.1 percent in 1980 to 5.5 percent by the end of Reagan’s term. The employment effects from the tax cuts were more impressive than the unemployment rate reflected, since millions of women had entered the workforce in the 1980’s. The decreased unemployment rate reflected those millions of people finding jobs in addition to previously unemployed people going back to work.
As predicted in George Gilder’s Wealth and Poverty
Per-capita after-tax income rose by approximately 25 percent from 1980 to 1988, even including the effects of the 1982 recession. Real GNP rose from $3.1 trillion to $4 trillion during the same period. The average level of prices, which almost doubled during the four years of the Carter administration, rose approximately 20 to 40 percent (depending on the measure used) during Reagan’s eight years in office.
Critics claimed that such astounding improvements were “consumption driven” and that American industrial capability had suffered. They refuted the notion that the tax cuts on the wealthy had resulted in investments in plant and equipment. That claim was refuted by American productivity increases, especially in manufacturing. U.S. industries such as steel used the 1980’s to downsize as well as to invest in new plant and equipment to replace outdated machinery.
Critics of the Reagan tax cuts and supply-side philosophy argued that an economic boom would have occurred even without the policy changes. Economic indicators, however, showed improvements beyond those typical in a recovery. Clearly, the business community approved of and responded to the tax cuts.
Supply-side economics changed the American economy in the 1980’s, essentially rescuing it from a decade of complacency and high-tax malaise. It also restored the role of investment and incentives to center stage in the economic debate. The success of supply-side tax cuts was questioned by liberals, who traditionally were opposed to smaller government and lower taxes, and even by some conservatives. Reagan’s vice president, George H. W. Bush,
The primary criticism against the performance of the economy after the supply-side tax cuts focused on federal deficits, which reached record levels (before being adjusted for inflation), and the national debt. Reagan was assailed as being the architect of the “twin towers of debt” that is, the domestic debt and the foreign trade deficit that rose during the 1980’s. Critics maintained that the United States was borrowing to finance consumption and that the supply-side cuts had ushered in a rash of leveraged buyouts on Wall Street and the popularity of junk bonds. Businesses, they claimed, used the tax cuts as incentives not to invest in real plants and equipment but instead to make paper profits through buying and selling existing companies.
At the height of the Vietnam War and as the Great Society programs peaked, federal spending stood at 19.8 percent of GNP. Ten years later, as Reagan took office, the federal government’s spending as a share of GNP had risen to more than 22 percent, and at the time the tax cuts went into effect, the figure had risen to almost 24 percent. Spending, rather than decreases in tax revenue, apparently caused rising government budget deficits. In addition, each year after 1983, the deficit as a proportion of GNP fell. Increases in the deficit reflected the fact that the American economy had grown and prices had risen; removing those factors showed that the relative burden of the deficit was smaller. By the time Reagan left office, the federal deficit as a share of GNP was smaller than it was in 1975 by almost 1 percent and almost exactly what it was when Reagan took office in 1980.
Another criticism of the supply-side tax cuts’ effect on business held that the United States had become a net importer of foreign capital, which was used by Americans to finance a consumption binge rather than to invest in U.S. businesses. Evidence against that argument shows that the supply-side cuts made investing in American business and manufacturing so rewarding that banks and individual investors kept their money home for the first time in a decade. Banks, however, began to write off loans to Argentina, Mexico, and other Latin American nations. This caused changes in the capital account, but the real events behind those changes actually had been occurring over a long period of time. The trade deficit was thus illusory, and, to the extent that a capital inflow existed, it occurred only because U.S. investors, like everyone else, realized that the tax cuts had made the United States a much more profitable place to do business.
The last area in which the supply-side tax cuts were criticized came in the appellation “decade of greed.” Critics suggested that the tax cuts encouraged personal consumption at the expense of charitable giving, since the tax deduction for a charitable contribution of a given size now reduced taxes by a smaller amount than previously. Charitable contributions by individuals actually grew faster in the 1980’s than in the late 1970’s.
In short, the achievements of the supply-side tax cuts were clear and substantial. The American economy showed its greatest boom since the 1920’s, employment soared, small businesses thrived, American manufacturing staged a resurgence, and the wealthy paid more in taxes, invested more, and gave away more than in the previous decade or under higher tax regimes. Analyses of government budgets showed that total tax revenues rose after the cuts, especially after the third installation of the cut. Nevertheless, the incentives created by lower tax rates raised U.S. productivity to its highest levels in a decade, levels that matched those of the closest foreign competitors.
Lost in the debates were the increases in the tax burden for most Americans in the tax “reform” package of 1986 and the “deficit reduction package” of 1990. The net effect of the two groups of laws was to increase the actual taxes most Americans had to pay. The 1986 laws eliminated numerous tax deductions, and the subsequent deficit reduction package increased taxes on a variety of items. Overall, the negative effects of the two tax increases dampened the economy to such an extent that full-fledged recession set in by 1990 and would not be alleviated until years later.
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Fink, Richard H., ed. Supply-Side Economics: A Critical Appraisal. Frederick, Md.: University Publications of America, 1982. Collection of essays by proponents and opponents of supply-side tax cuts includes debates on most of the crucial issues but does not address any of the economic effects of the Reagan program. -
Gilder, George. Wealth and Poverty. New York: Basic Books, 1981. The “bible” of early supply-siders. As incoming president, Reagan reportedly handed out copies of this book to his entire staff as a guide for public policy. Offers perceptive and clear analysis but has been dismissed by some supply-side writers as “journalistic” or “unscholarly.” -
Krugman, Paul. Peddling Prosperity: Economic Sense and Nonsense in an Age of Diminished Expectations. New York: W. W. Norton, 1994. Demonstrates how politicians often adopt poor economic policies. Severely criticizes proponents of supply-side economics. -
Nau, Henry R. The Myth of America’s Decline. New York: Oxford University Press, 1990. Thorough and convincing, if somewhat restrained, analysis of American economic performance since 1960 by a former State Department official who offers an insider’s view of policy making while applying his economic and quantitative skills to issues of international growth. Concludes that the resurgence of the U.S. economy during the 1980’s resulted from policies enacted between 1982 and 1985. -
Puth, Robert C. American Economic History. 3d ed. Fort Worth, Tex.: Dryden Press, 1993. Standard economic history covers the modern period. Informative, although it repeats some of the deficit/debt fallacies. -
Raboy, David G., ed. Essays in Supply Side Economics. Washington, D.C.: Institute for Research on the Economics of Taxation, 1982. Collection of scholarly essays by economists and historians examine various aspects of supply-side economics, including the rational expectations model, the theoretical heritage of supply-side economics, and the distortions of taxation and savings that can develop. -
Roberts, Paul Craig. The Supply-Side Revolution: An Insider’s Account of Policymaking in Washington. Cambridge, Mass.: Harvard University Press, 1984. Former Kemp adviser who served in the Treasury Department under Reagan provides an excellent insider history of the tax cut battle. Criticizes Laffer and those in the administration who had broader goals for the economic program. -
Wanniski, Jude. The Way the World Works. 4th ed. Washington, D.C.: Regnery, 1998. One of the earliest published advocacy pieces for supply-side tax cuts also provides one of the first published analyses of the causes of the Great Depression that links the Hawley-Smoot Tariff Act of 1930 to the stock market crash. Presents clear and persuasive discussion of the positive effects of low tax rates.
United States Suffers Its First Trade Deficit Since 1888
Reagan Is Elected President
Bush Is Elected President