Reaganomics in Reagan’s Economy

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           As discussed elsewhere, the entire past 30 years has proven that what didn’t make logical sense was, indeed, wrong.  Over that period, perpetually low taxes for the rich and corporations served to increase income inequality and depress the economy on a massive scale.  Back in the first few years of the Reagan Administration, however, the false supply-side argument got some traction from the recovery of 1983.  For this reason, that period deserves some discussion. 

          Recall what Reagan said in his farewell speech:

“[F]rom the recession of ’81 and ’82 to the expansion that began in late ’82 and continues to this day, we’ve made a difference. * * *  In [1981], we began the actions we felt would ignite an economic comeback: Cut taxes and regulation, started to cut spending.  Soon the recovery began.”

          Could the Reagan tax cuts have stimulated the expansion in 1983?  Here is a graph [1] of the top tax rate, the rate on all income above the top bracket.     (Today, for example, the top bracket begins at $373,650, so the top tax rate is the rate at which income above $337,650 is taxed.) 

            As the table shows, the top tax rate was 70% when Reagan took office, and it was quickly reduced to 50%, and was brought down to 28% for the last couple of years of his administration.  Reagan attributed an “expansion that began in late ’82 and continues to this day (1/12/89)” to his policies. 

           This graph shows the annual percentage change in gross domestic product (GDP) from 1970 to 2008.  It was the sudden and sharp recovery in 1983 from the double-dip recession at the beginning of the Reagan years that gave rise to Reagan’s argument that tax cuts ignited the expansion. 

          That expansion turned back around rather quickly, however, rather than continuing until 1989 as Reagan claimed.  By 1991 another recession had set in and the country was back to zero growth.  Still, this sharp 1983 spike has kept the Reaganomics “supply-side” ideology alive. [2]  There has been a lot of what I would call “folk” debate about supply-side theory, and some of it is reviving today. 

          Because the supply-side concept ignores the dictates of the profit motive, and because those with the highest incomes spend a low percentage of marginal increases in income, we should be surprised if income tax cuts lowering the highest tax bracket would create more economic activity or growth. [3]

          A closer look at the circumstances of the time does not upset that logic.  There were several major factors prior to and during the 1983 spike that contributed to the recovery and go a long way toward explaining its magnitude.  During 1978-1981 the price of American crude oil spiked, more than doubling, and between 1981 and 1983 that price had fallen again by one-third.  That stimulated the economy. 

          Also, the Carter Administration had been plagued with a serious inflationary spiral, and interests rates had been forced to extremely high levels.  The effective federal funds rate had risen from 6% in 1977 to over 19% in mid-1981. Home mortgage rates were still over 15% in 1982.  As you may recall, once inflation died away and the recession hit rock bottom, interest rates were soon falling again, and the easier credit would have contributed to recovery.  

          Reagan’s increased military spending was also an important factor in the recovery.  Although spending for military products and equipment is a drag on growth and prosperity over time, it does produce income.  Reagan had substantial budget deficits each year of his administration, and “deficit spending” is the classical Keynesian demand-side approach to stimulation.  The federal borrowing stimulated the economy, basically off-setting the the depressing effects the tax rate reductions (which removed money from the economy) would otherwise have had. [4] 

          There are instances, too, when results that supply-side Reaganomics would have predicted did not materialize.  For example, the 1978 reduction in the capital-gains tax rate from 39% to 28%, a major cut for the rich, was followed by a plunge into recession.  Conversely, the periods of GDP growth in the Clinton years followed an increase in the highest income tax rate.  

          In short, there has been nothing in actual experience to show that what failed to make intuitive sense to begin with might somehow be right.  Cutting taxes for the wealthy is basically nothing more than a wealth transfer mechanism.   

JMH – 4/2/11

_________

1] Numerous sources.

[2] The explanation for supply-side “faith” grows out of the “conservative” aversion to social spending, and therefore to Keynesian economics.  Reaganomics is ideologically attractive to “conservatives,” because it is exactly the opposite, serving the interests of the wealthy and not the interests of the people.  What’s more, it provides a veneer of legitimacy as a cover for wealth transfers to the rich. 

[3] As I suggested in “The Reaganomics Tax Argument,” I see no reason to expect that lower taxes would be more likely to encourage people to work harder than to slack off.  Regardless, it would be a stretch to expect work effort to increase revenues by enough to offset the full effect of lower tax rates. 

[4]  Our traditional perspective that Reagan borrowed money to finance his military expansion is misleading, therefore, because of the increases in borrowing needed to off-set the loss of revenues from the tax cuts.

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