Reaganomics: Why Ronald Reagan's 1981 Tax Cut Did Not Cause the 1983 Recovery or Boost Tax Revenues

by Bernard Sherman

Revised May, 2006 Feel free to let me know of any (civil) critiques you might have - I'm always ready to listen and rethink. tax-paper is my address. My provider is hotmail. It is a .com.

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Contents

1. Why the 1981 tax cut does not deserve credit for the 1983-89 expansion - and five factors that do deserve credit

2. Why the results of the 1981 tax cut do not support "supply-side theory"

3. Why the 1981 tax cut reduced tax revenues and increased the Federal budget deficit

PART ONE: Why Reagan's 1981 tax cut was not what caused the 1983 recovery

You've read it in The Wall Street Journal: Ronald Reagan's economic agenda "ignited the boom." You've seen it on the Web: "Shortly after the tax cuts were enacted, the economy took off for an unprecedented period of peacetime growth." It's a great story, but too simple to be true. When A precedes B, we can't assume that A caused B; the 1981 tax cut preceded the 1983 recovery, but didn't ignite it. Here are five actual causes:

1. Business cycles go down and up David Stockman, Reagan's first director of the Office of Management and Budget, was a key architect of Reaganomics, but he didn't believe that the tax cut caused the boom. He wrote, "There was nothing new, revolutionary, or sustainable about [the growth of 1983-89]. The cycle of boom and bust had been going on for decades and ...its oscillations had reached the high end of the charts. That was all." [Stockman, The Triumph of Politics, p. 377.]

The growth-bust cycles Stockman referred to - business cycles - have been part of American life since the mid-19th century, when manufacturing began to overtake agriculture in economic importance. The cycles swung more widely than usual during Ronald Reagan's first term, which began with one of the worst recessions since World War II. But as we'll see, most economists agree that what caused and then resolved this recession was Fed policy. Stockman has good reasons to say that the recession would have ended without the 1981 tax cut.

A look at business cycles also shows why we should not be impressed by the 7.5% growth in 1983, the year of the rebound. The quickest growth has typically come right when a recovery starts, as idled factories and laid-off employees get to work again. Because the 1981-82 recession was so deep, the rebound was likely to be exceptionally strong with or without a tax cut.

Considering business cycles helps us avoid the mistake of thinking that something ordinary is remarkable. It can also orient us to how to approach the question. Economists have argued about business cycles for decades (see this excellent survey), and increasingly agree that there is not one single cause - problems with both "supply" and "demand" can jar the economy. As we'll see, both contributed to the downs and ups of the Reagan cycles.

2. Oil prices come back to earth The recession Reagan inherited had two "dips," the first of which struck in 1978 because of a "supply shock" - an explosion in the price of oil. Since World War II, whenever oil prices have risen by 60% or more, a recession has almost always followed, and research has shown that other forces can't account for this effect. Oil is a key ingredient in making and/or transporting a huge range of products.

3. Paul Volcker slays inflation, then slashes interest rates I mentioned a "double dip" recession: the economy really tanked in 1981, after Reagan had taken office. The reason was not anything he did, however, but another "supply-slide" cause: the Federal Reserve drastically curbed the growth of the money supply. As a result, interest rates hit levels not seen since the Great Depression. The "effective Federal Funds Rate" soared from below 6% in 1977 to over 19% in mid-1981. According to a recent textbook, this Fed policy was the "well understood" cause of the second dip.

Why did Paul Volcker, chair of the Fed from 1979 through 1987, take such a draconian approach? Because he was convinced that his main duty was to "slay the dragon" of inflation. For most of the 1970s, inflation was indeed fire-breathing, with rates hovering between 5 and 10% and hitting double-digits twice. As Volcker said, the economy could have better prospects only if it regained the now-lost condition of "price stability," in which "ordinary people do not feel that they have to take expectations of price increases into account in making their investment plans or running their lives."

Volcker's tight money slew the inflationary dragon but at a cost, an economic slowdown then called the "Volcker Recession." With interest rates so high, banks rationed credit, businesses wouldn't borrow to invest, and residential investment fell by 40%. (Real residential investment fell to its lowest point in thirteen years. Who would buy a house when a 30-year fixed mortgage cost 18.5%, as it did in late 1981? ) Housing starts dropped by about half between 1978 and 1982. Unemployment reached almost 11%, and consumer spending on "durables" (like appliances and cars) plummeted.

In mid-1982, with inflation down and unemployment too high, the Fed changed its policy. The Fed Funds Rate dropped below 9% by the end of 1982, and below 6% by fall of 1986. As mortgages became more affordable (the 30-year fell to single digits by 1986), people bought housing - so much of it that residential investment rose by a stunning 46% during the first year of the recovery. And Volcker's policy gave America the price stability he'd sought. Inflation settled in at around 3%. America's renewed sense of stability, says Volcker, laid "the essential base" for the recovery of the 1980s.

Thus the Reagan expansion "should be called the Volcker expansion." Volcker was appointed not by Reagan, but by Jimmy Carter. Admittedly, Reagan deserves credit for letting Volcker do what he wanted. But Reagan's admirers have to admit that the lower inflation and renewed money growth were not caused by the 1981 tax cut but by a tough-minded Carter appointee acting on his own at the Fed.

4. A "financial revolution" makes it easier to fund and grow a business Another factor contributing to growth in the 1980s was what the economists Raghuram Rajan and Luigi Zingales call "a veritable revolution in finance." Getting funding for a good business idea became significantly easier, and far more likely to be at "arms-length" - where previously it had depended more on personal contacts, business connections, or family advantages. The financial revolution especially benefited small and young midsize firms. And once again, Reagan was not behind it.

Instead, this revolution was well in progress before Reagan and his tax cuts. Consider a 1975 act that abolished fixed commissions on the New York Stock Exchange. The NYSE now had to allow quantity discounts for large trades, making it much more feasible for pension and mutual funds to invest in small public equities. Or consider a 1979 ruling by the Bureau of Labor, allowing pensions and endowments to put parts of their portfolios in risky investments. This led to an explosion in what is called the "private equity market" (it increased from $5 billion to $175 billion over the next 20 years), which gives small and midsize firms much more access to finance. Another advance was in the economics of lending - the development of new methods of isolating, calibrating, and sharing risk. These made it far easier for lenders to take risk on, and thus for businesses to borrow.

5."Demand-side" factors boost demand Many other factors contributed to the growth of the 1980s, such as the "demand-side effects" of the tax cut (people spending more because they had extra dollars in their wallets after April 15), which I'll discuss next.

Increased defense spending by the Federal government also boosted "aggregate demand" in the US economy.

Conclusion: I don't deny that tax laws needed some of the reforms made in 1981. Top marginal rates needed to be cut (from 70% for investment income and 50% for wages and salaries). And tax brackets had to be indexed to inflation - ordinary people were being pushed into high tax brackets by nominal price increases. On the other hand,the 1981 law had serious flaws of its own, as it added or expanded tax loopholes, a problem that needed fixing in 1986 (see below). Regardless of how you evaluate the 1981 law, though, it didn't cause the recovery. As I hope I've shown, it played a small part as economic stimulus, not a leading role.

Modern economies are so diverse and complex that all claims about a single cause for an economic recovery are dubious on their face. A local subsistence agrarian economy could be explained in single-cause terms - a drought or an early frost - but a modern economy can't. The recovery of 1983 is an example of why.

To insist that the 1981 tax cut was the thing that got the economy going - and to ignore everything else - is to take a leap of faith into a belief system called "supply-side economics" by its proponents. Yet as Stockman says, "What economic success there was had almost nothing to do with our original supply-side doctrine."

Considering that doctrine clarifies the matter further. Even with the positive forces at work on the economy, we could still claim that a major share of credit for the recovery goes to the supply-side effect of the tax cut. But a close look at the theoretical claims for the cut settles at least part of the issue: it didn't do what Stockman calls "our original doctrine" insisted it would, as I'll explain next.

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PART TWO: Why the Reagan years undermine supply-side claims - an introduction

I've sprinkled the term around, so let's look more closely at supply-side economics.

You might have heard that tax cuts stimulate the economy by allowing people to spend the extra money they now have in their pockets. There's no question that this has sometimes happened; but it does not illustrate supply-side economics. Instead, it's a classic example of Keynesian "demand-side" economics. When it happens, people who have more money to spend, spend more, and thereby get the economy humming. The 1981 tax cut did have some impact on the economy this way.

But true supply-siders shouldn't take that as evidence for their arguments, which revolves around increasing not demand, but supply. Now few people disagree that increasing the ability to "supply" goods and services increases long-term economic growth. But demand also has an effect. The gist of supply-side thinking is a dislike of demand-boosting through government spending. Instead, supply-siders emphasize the ability of the government to increase supply and boost growth rates. Was Reagan's 1981 cut the classic illustration of what they mean? To put this more specifically, the Reagan tax cuts were supposed give people the incentive to work longer hours, save more money, and be more productive (that is, produce more per hour of work) - each of which would indeed increase long-term economic growth if it happened. But did any of them happen?

No. If it were so, the Reagan tax cut would have been followed by increases in how much people saved, how many hours they worked, and how productive they were. None of these spikes happened. America's savings rate began a historic decline during Reagan's term, in spite of significantly increased tax incentives for saving. Overall, it's not clear in general that tax cuts boost saving rates. As for longer hours, even people who got huge tax cuts did not work longer - a finding replicated in several major independent studies. Most full-time primary earners are working as many hours as they can; cuts on labor taxes seem to affect only marginal workers, people who could choose not to, and they are too few to have much effect on the economy.

How about productivity? It also failed to cooperate with theory: productivity growth remained sluggish. In fact, the numbers from 1951 to 1995 show the opposite of what supply-side theory predicts. During this era, productivity growth dropped pretty much in lockstep with marginal tax rates. Productivity growth took off in the mid-1990s after Clinton's tax hike. I'm not arguing for cause and effect - research shows that high technology was the single biggest cause of the late 90's productivity leap (not the delayed effects of the Reagan tax cuts, by the way) - but it does show that supply-side thinking is too simple to fit the real world. By an honest supply-sider's standards, then, the 1981 tax cut doesn't support their claims.

I'll return to the growth question below. But perhaps the central claim of supply-siders (made famous in the so-called "Laffer Curve") was that - because of all the above claims - cutting taxes would actually increase government revenues. Let us examine that question in more detail.

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PART THREE: Why the Reagan tax cut reduced tax revenues and increased the deficit
"The [1981 Reagan] tax cut did not cause tax revenue to rise... tax revenue fell... the government began a long period of deficit spending... the largest peacetime increase in the government debt in U.S. history. Fads can make experts seem less united than they actually are." N. Gregory Mankiw, a head of George W. Bush's Council of Economic Advisers, in his 1998 book Principles of Economics (New York: Dryden. pp. 29-30, in the section "Thinking Like an Economist: Why Economists Disagree: Charlatans and Cranks")

The 1981 tax cut didn't cause the 1983 recovery. But there's one other key supply-side claim: that Reagan's tax cut actually increased federal tax revenues. Thus the tax cuts payed for themselves; they were, in economics lingo, "self-funding." Some Republicans in office today treat this assertion as an article of faith. What do economic researchers say?

By and large, they deny that the Reagan tax cuts were self-funding. True, tax revenues per person did increase in the 1980s, but that was not unusual - in fact, it was sub-par. After adjusting for inflation and population growth, tax revenues per person increased far less in the 1980s (18%) than they had in the 1970s (25%) or would in the 1990s (40%) - details here. Yet the 1990s, which had the largest growth per person, began with tax increases from Bush I and Clinton.

Worse for supply-siders, individual income tax revenues didn't increase during the Reagan era relative to the economy, but declined, from 9.6% of GDP in 1981 to only 8 percent in 1984. Similarly, overall federal tax revenues declined from 20.8% of GDP in 1981 to 18.5% in 1983. (I'm getting this from the Congressional Budget Office.) By 1990, the first Bush administration's Treasury department estimated that the 1981 tax cuts were costing it $164 billion a year in lost income tax revenues. So the 1981 tax cuts led to reductions in government revenue, not increases.

Still, do economic models suggest that tax cuts are self-funding? A recent paper by Mankiw (former head of George W. Bush's Council of Economic Advisers) and Matthew Weinzierl argues that using a standard economic model to make "back of the envelope" calculations suggests that cuts in labor taxes will pay for only about 17% of themselves, while cuts in capital tax cuts will pay for about 50% of themselves. The authors note that real-world research will be needed to find out how true some of its assumptions are; but they do not support the claim that tax cuts are self-funding. At best, capital tax cuts are halfway self-funding, and labor tax cuts only one-sixth self-funding.

Worse, economist Brad DeLong notes that the model that Mankiw and Weinzerl use would be derailed if the government runs persistent large budget deficits - as in fact it did under Reagan and has under George W. Bush (more on that later).

The claim of self-funding is further undermined by a December, 2005 paper by the nonpartisan Congressional Budget Office. It concludes that under the most optimistic assumptions about economic behavior, tax cuts would fund at best only 28% of themselves. With less utopian assumptions, the paper shows, tax cuts could fail to fund themselves at all, or even reduce their own funding.

The case against the self-funding claim is further damaged when we look more closely at the first Reagan term. One tax revenue stream actually did increase relative to GDP - payroll taxes (the tax taken out of your paycheck to pay for Social Security and Medicare), which increased by an average 4.3%. Yet for Reaganomics, the problem is that what caused this rise was not a tax cut but a big tax increase, the Social Security Reform Act of 1983, which accelerated social-security tax increases, and also taxed social-security income on the rich for the first time.

Another nail in the coffin of the "self-funding" claim is that corporate tax revenues plummeted after Reagan's tax cut - in contradiction to the "cut taxes, increase revenue" ideal. They increased slightly in 1983, but surged only after effective corporate tax rates were increased by a third in 1986. The 1986 tax-reform law cut the nominal corporate tax rate for big firms from 46% to 34% but it increased the effective rate - that is, the rate that corporations actually paid - from 21% to 28%. It did this by getting rid of "investment tax credits" created in 1981, and by limiting depreciation deductions; together these 1981 provisions had allowed half of the largest companies to avoid paying any federal taxes at all in at least one year before 1986. The 1986 reform also strengthened the Alternative Minimum Tax, to make sure the profitable corporations paid at least something.

Thus the claim that Reagan's 1981 tax cut funded itself fails to stand up.

Distortion, Corporate Taxes, and the 1986 Reform

Still, is there any reason to think that tax cuts could increase government revenues? We've discussed the claims that people would work more and save more, both of which are unsupported. But there are other good reasons for the claim. One recent paper, Kopczuk, 2004 , summarizes research on marginal income tax rates and government revenues. Raising marginal tax rates can reduce government tax revenues - but not because lower taxes inspire good economic behavior, but because higher taxes increase the tendency to evade taxes illegally, or reduce the amount of income people report, or cause people to shift income to untaxed forms. This happens mostly among the wealthiest (who have both more incentive to cheat and much greater ability to do so; middle-class earners usually earn their income through wages, so their taxes are withheld, like it or not).

Did Reaganomics reduce such distortions? A case can be made, following Kopczuk, that Reagan's cut on the top marginal rate might be expected to help. The runaway inflation we talked about earlier was pushing too many people into higher brackets, and the top marginal tax rate was so high that it inspired many fruitless "distorted" investment schemes that sapped vitality from the economy. (And it explains why few people actually paid 70% marginal rates on their investment income, regardless of what was in the code; they spent a lot of money figuring out creative ways to get around it.) Reducing distortion could be a plausible explanation of how the tax cut jump-started the economy. But no - in fact, the 1981 law did not reduce tax-caused distortion, because it added special preferences and exceptions to the tax code. Indeed, Reagan resisted the efforts of his budget director, Stockman, to get rid of such special preferences as the oil-gas exploration deduction and the unlimited home-mortgage deduction. The tax-shelter industry grew markedly after 1981. Moreover, "investment tax credits" for corporate investment distorted the corporate sector's investing. The cut did not cause the 1980s boom through reducing distortion.

In 1982 some beginning efforts were made to reduce tax shelters, with little effect. And part of the 1981 cut was effectively reversed, through a scaling back of some corporate credits and deductions. Why? Because the budget deficit was scaring Congress - and even the President. According to Martin Feldstein, head of Reagan's Council of Economic Advisers from 1982-84, Reagan "agreed grudgingly to the need for tax increases in 1982, 1983, and 1984 because he did not like the looming budget deficits." (in Feldstein's American Economic Policy in the 1980s, p. 21) More on the deficit in a moment. But back to the distortion story: things improved dramatically in 1986.

John W. Sloan, in his The Reagan Effect, notes that "the irony of the 1986 tax reform is that it was designed to close many of the loopholes" created by the 1981 Reagan law. And the 1986 act was undeniably bipartisan in origin. According to Feldstein, Reagan's chief of staff had the bill drawn up in response to a bill proposed by Democrats Bill Bradley and Dick Gephardt - Reagan's staffer didn't want to let the Democrats "seize the tax reform issue from the Republicans." Feldstein notes that Bradley and Gephardt were influenced by "academic public finance economics." Thus, the tax law changes of 1986 can't really be attributed to the consistent vision of Ronald Reagan. What is praiseworthy about him, instead, was his pragmatism in working with the Democrats. Admirers of Reagan should point to this example of working with the opposite party for the common good - cleaning up the tax code, something that is sorely needed again two decades later. Alas, in today's polarized Washington it is impossible to imagine this example being followed. Instead, Reagan is evoked for a simplistic focus purely on cutting tax levels, when the real problem is the economic distortion caused by today's corrupted tax code.

That pesky deficit

Hovering over my discussion has been "the large, persistent budget deficit" Reagan brought on. The loss of income tax revenue after the 1981 tax cut explains why the lunch wasn't free: Reaganomics created budget deficits bigger, says Volcker, than "anyone had really intended" (p. 177). 5 At its peak in 1983, the annual deficit topped 6% of GDP - more than twice its usual level in the Carter years. The typical Reagan supporter blames the Democratic Congress, but both Republican and Democratic congressmen were into pork; and Congress added only an average of 2.8% to Reagan's annual budget proposals. And Reagan's proposed budgets were not frugal: they cut social programs, but not the much costlier entitlement programs. More to the point, they increased defense spending by 38% in his first two years.6 During Reagan's eight years, defense spending increased by $806 billion, which is more than the increase in the deficit ($779 billion). You may regard the defense buildup as a good thing, but you can't deny that it cost money. Overall, Reagan didn't reduce Federal spending - he shifted it from social programs to defense and to paying interest on Federal debt. Meanwhile, federal revenues decreased relative to GDP because of Reagan's tax cut. The inevitable result was a deficit.

(That nobody imagined the deficit was also partly because Volcker tamed inflation better than anyone expected him to. The purpose of the 1981 tax cut was partly to fight "bracket creep" - people finding themselves paying higher tax rates purely because of inflation - so controlling inflation reduced government tax revenues below what had been expected.)

The 1986 tax law helped reduce annual debt, but not enough, because all that annual debt continued to build up. Relative to the GDP, the size of the accumulated debt almost doubled in the Reagan years, going from 27% of the total US economy to over 40% by the end of the Reagan presidency and to almost 50% by 1993.

A persistent deficit creates a vicious cycle. Put lunch on a credit card year after year and soon the interest payments will cost more than the food. By the early Clinton years the government was actually spending within its means; what was causing the massive deficit by then was the huge and mounting interest on the preceding debt.

Conclusion If you still believe in Reaganomics, remember what supply-siders predicted in 1993, when Bill Clinton raised the top marginal tax rate (the one on the wealthy) to 39.6% - an increase of 40% over Reagan's final 28% rate. Newt Gingrich told us the tax increase would "kill jobs and lead to a recession," The Wall Street Journal told us the budget deficit would soar sky high, and Forbes told us the stock market was doomed to a deadly crash, so take your money out now. The predictions couldn't have been more wrong - America actually got an expansion longer than Reagan's, a stock-market boom, and a budget surplus. But if supply-side economics were true, the predicted disasters are exactly what should have happened. Supply-siders who nowadays try to credit the Clinton boom to "delayed effects" of the Reagan tax cuts conveniently forget their projections from 1993, and more to the point, ignore the many, many causes, large and small, that played out during the 1990s. (For example, tax-shifting by the wealthy in the year before the cut temporarily allowed them to avoid the higher tax rate.) Besides, they overlook the partial reversal of Reagan's cuts by the first George Bush (who raised marginal tax rates on the top bracket from Reagan's 28% up to 31%) as well as Clinton, as well as increases in payroll taxes during Reagan's term. To claim that these tax increases choked off economic growth is a denial of the obvious.

The Reagan 1981 tax cut neither caused the 1983 recovery - other factors deserve the credit - nor boosted tax revenues. It did cause a significant increase in the Federal budget deficit. And it doesn't prove supply-side theory. Whether the increased deficit was a serious problem or not is another question, and an interesting one (I'll post some thoughts on this eventually). But the clear lesson of the Reagan era is that if you want tax cuts, you need to be honest about their consequences. Unless you start out with stupendously high taxes, tax cuts do not turbocharge the economy, and they will eventually force you to shrink the size of the government. You can't have it both ways - slashing taxes while still maintaining a powerful military and expensive entitlement programs like Social Security and Medicare. You have to choose. That's because the bill for lunch, no matter how long you defer it, always comes due sooner or later.

P.S. It's also worth noting that in 1978 Congress produced a tax cut that supply-siders should regard as a crucial application of their theory: they cut capital-gains taxes from 39% to 28%, the first tax cut on the rich in 15 years. The double-dip recession that followed is more evidence that supply-side policy doesn't hold magical powers. And if you insist that this capital-gains tax cut did produce major results, you have to admit that it happened under Carter.

- Bernard Sherman (Footnotes to be added as author's time allows - they do exist- but scroll down for some of them)

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See also: http://pages.stern.nyu.edu/~nroubini/SUPPLY.HTM (Nouriel Roubini) and http://www.pkarchive.org/economy/TaxCutCon.html

FOOTNOTES (at least, the beginning of them):

Business cycles: Todd Knoop's book Recessions and Depressions: Understanding Business Cycles (Praeger, 2004) for an excellent discussion of business cycles. The standard definitions of when business cycles began and end can be found at National Bureau of Economic Research http://www.nber.org/cycles.html. Data on quarterly real GDP growth is online at http://research.stlouisfed.org/fred2/series/GDPC96/downloaddata See also Joel Slemrod and Jon Bakija, p. 97 of Taxing Ourselves; data taken from the U. S. Bureau of Economic Analysis.

For the Federal funds rate: http://federalreserve.gov/releases/H15/data/m/fedfund.txt or http://www.economagic.com/em-cgi/data.exe/fedbog/fedfund As to why inflation was so bad in the 1970s, see this article: www.j-bradford-delong.net/pdf_files/Peacetime_Inflation.pdf

Volcker and Toyoo Gyohten, Changing Fortunes, p. 177-79

"Volcker expansion": Paul Krugman, in his book Peddling Prosperity, p. 122. While inflation-adjusted interest rates (the ones that matter to businesses) remained high until the mid-1980s, partly because of the high borrowing by the US government discussed in the paper, rates did drop enough to make a difference earlier.

Oil shocks and recessions: nine out of ten recessions between World War II and 2002 were preceded by sharp rises in the price of oil. See James D. Hamilton "Oil and the Macroeconomy Since World War II," Journal of Political Economy, 91 (1983): 28-248; and James Hamilton and Anna Maria Herrera, " Oil Shocks and Aggregate Macroeconomic Behavior" (forthcoming), Journal of Money Credit and Banking.

For crude oil prices: See http://www.wtrg.com/prices.htm for detailed graphs and numbers.

The evidence on the 1981 tax cut and entrepreneurship is slight and still murky. One study found that self-employed people were more likely to invest in their existing businesses after the 1986 (not 1981) tax cut than before: Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen, "Entrepreneurs, Income Taxes, and Investment," in Does Atlas Shrug? ed. Joel Slemrod, Harvard University Press, 2000. Another study concluded that people are slightly less likely to make the jump into going solo when marginal tax rates are (for them) relatively higher: William Gentry and Glenn Hubbard, "Tax Policy and Entrepreneurial Entry," American Economic Review 90 no 2, May 2000, pp. 283-287. But commentary on both, with skepticism about the economic benefits, and about data on entrepreneurship: Slemrod and Jon Bakija, Taxing Ourselves (3rd. edition), Massachusetts Institute of Technology Press, 2004, pp. 135-37. And Julie Berry Cullen and Roger Gordon found that "a cut in personal tax rates reduces entrepreneurial activity."

Finance revolution: See the excellent book Saving Capitalism from the Capitalists (New York, 2003) by Raghuram Rajan and Luigi Zingales.

Niskanen; Joskow and Noll, all in American Economic Policy in the 1980s (ed. Martin Feldstein; Chicago: 1994), Joskow and Noll: p. 372; Niskanen, p. 446.

Technological, institutional, and regulatory changes interacting: For example, as Rajan writes, "Information technology improved the ability of banks to lend and borrow from customers at a distance" - a development which forced states to rescind regulations protecting local bank monopolies, starting in 1972. New financial realities also led to the collapse the system of government-controlled international exchange rates, the Bretton Woods agreement, in 1971. In 1973, US policy began to favor free cross-border capital transactions, which had proved impossible to control in any case. The resulting freer international flow of capital made it more difficult for governments to support cartels or subsidize large incumbent firms - as they previously had done, with policies that reduced competition.

Milton Friedman (in the Wall Street Journal, June 11, 2004) shows that the number of pages added to Federal regulation declined sharply in Reagan's years. But statutory deregulation was more significat in the 1970s.

Examples of pre-Reagan governmental changes that contributed to the financial revolution: Consider a 1979 ruling by the Bureau of Labor, allowing pension funds and endowments to put parts of their portfolios in risky investments. This led to an explosion in what is called the "private equity market" (it increased from $5 billion to $175 billion over the next 20 years). In various ways, this market gives access to finance to startups and young midsize firms. Or consider a 1975 act of Congress that abolished fixed commissions on the New York Stock Exchange, allowing quantity discounts for large trades. This changed the economics of large pension and mutual funds, making it much more feasible for them to invest in public equities. And starting in 1972, American states began a long process of opening local banks to interstate competition. States that did so had significantly higher growth rates - 30 to 80% faster growth in the year after deregulation - while states that did not actually declined in growth. Also, states that deregulated banks showed a significant rise in the creation of new enterprises.

Government expenditures (defense and non-defense), revenues, and much more: http://www.bea.doc.gov/bea/dn/nipaweb/SelectTable.asp?Selected=N#S

What the heck IS a supply-sider? Here's a good post on the topic: http://www.j-bradford-delong.net/movable_type/2003_archives/000837.html

Savings drop after tax cutsion: Jane Gravelle, The Economic Effects of Taxing Capital Income (MIT Press, 1993) for detailed discussion.

Productivity statistics: According to the Bureau of Labor Statistics (http://www.bls.gov), the annual average productivity growth rates have been

1950-1963: 3.5%;

1964-1980: 2.2%

1981-1986: 2.1%

1987-1992: 1.7%

1993-2002: 2.1%

According to Stephen Oliner and Daniel Sichel, "The Resurgence of Growth in the Late 1990s: Is Information Technology the Story?" Journal of Economic Perspectives, 2000, 14: pp. 3-22. - the "multifactor productivity" (or output growth that cannot be explained by growth in inputs) was: 0.33 from 1974-1990; 0.48 from 1991-1995; and 1.16 from 1996-1999. In the third period, the contribution to this growth from the Computer and Semiconductor Sector was three times what it had been in the previous periods.

No connection internationally between economic growth rates and tax levels: see the excellent book, Taxing Ourselves by Joel Slemrod and Jon Bakija (MIT Press: Second ed, 2001). The particular study I mentioned is summarized on pp. 99-103

The tax cuts did not increase labor supply: Nada Eissa 1996 found that high-income men worked only 2% more hours in response to big reductions in their marginal tax rates - "Tax Reform and Labor Supply," In Tax Policy and the Economy, vol. 10, ed. James Poterba, National Bureau of Economic Research and MIT Press. Robert Moffitt and Mark Wilhelm, 2000, found just a 3% increase in labor supply - '"Taxation and Labor Supply Decisions of the Affluent" in Does Atlas Shrug? ed. Joel Slemrod, pp. 193-234; James P. Ziliak and Thomas Knieser 1999 found no effect, even among people whose marginal tax rate fell from 50% to 28% "Estimating Life Cycle Labor Supply Tax Effects," Journal of Political Economy 107, no. 2 (April): 326-259. To be sure, Eissa found that the wives of rich men did work significantly more after the 1986 tax cut, but she also found that this group is so small that it has only a tiny effect on the overall economy.)

Quote from N. Gregory Mankiw (1998), Principles of Economics (New York: Dryden). pp. 29-30: "An example of fad economics occurred in 1980, when a small group of economists advised presidential candidate Ronald Reagan that an across-the-board cut in income tax rates would raise tax revenue. They argued that if people could keep a higher fraction of their income, people would work harder to earn more income. Even though tax rates would be lower, income would raise by so much, they claimed, that tax revenue would rise. Almost all professional economists, including most of those who supported Reagan's proposal to cut taxes, viewed this outcome as too optimistic. Lower tax rates might encourage people to work harder, and this extra effort would offset the direct effects of lower tax rates to some extent. But there was no credible evidence that work effort would rise by enough to causes tax revenues to rise in the face of lower tax rates. George Bush, also a presidential candidate in 1980, agreed with most of the professional economists: He called this idea 'voodoo economics.' Nonetheless, the argument was appealing to Reagan, and it shaped the 1980 presidential campaign and the economic policies of the 1980s.... Congress passes the cut in tax rates... but the tax cut did not cause tax revenue to rise... tax revenue fell... government began a long period of deficit spending... largest peacetime increase in the government debt in U.S. history. Fads can make experts seem less united than the actually are... when the economics profession appears in disarry, you should ask whether the disagreement is real or manufactured... [by] some snake-oil salesman who is trying to sell a miracle cure... " --Thinking Like an Economist: Why Economists Disagree: Charlatans and Cranks

Some other resources:

Crude oil prices: See http://www.wtrg.com/prices.htm

Economic data galore: http://research.stlouisfed.org/fred2/

GDP data: See http://www.swcollege.com/bef/econ_data/unemployment/unemployment_data.html.

The Office of Tax Policy Research: http://www.otpr.org/

Business cycles - see Todd Knoop, Recessions and Depressions: Understanding Business Cycles (Praeger, 2004)

Paul Krugman;s critiques of supply-side tax cuts: http://www.nytimes.com/2003/09/14/magazine/14TAXES.html?ex=1071378000&en=7518baae53cb75b0&ei=5070

A William Niskanen article on Reagaonomics

See also www.wikopedia.org/wiki/Reaganomics, for a presentation of opposing viewpoints.

Economics research: A great summary is the book Re-Inventing the Bazaar: A Natural History of Markets by John McMillan (Norton, 2002).

More detail. Regarding a long-term change in the amount of financing available to small and middle-size businesses, and indeed to consumers. This had many causes. One was a change in what gave a firm competitive advantage. In the days of the industrial revolution, big, vertically integrated companies like GM were protected from competitors because their key advantage was expensive infrastructure. It would cost a fortune for a competitor to replicate this. But in the last third of the century, other competencies grew in importance, notably the knowledge in worker's heads. This long-term trend by itself reduced barriers to entry.

The trend was greatly facilitated by changes in the finance field. For one thing, banks had been monopolies highly protected by the states. A local bank didn't have to worry about other banks coming in from out of state to compete. This stranglehold reduced access to capital for new businesses and for individuals. Customers got lower returns on money deposited, and those who managed to get loans got them on unfavorable terms. In 1972, states began deregulating banks; by the mid 1990s the trend was complete. States that deregulated experienced significantly faster growth than states that didn't.

Other reforms also led to more capital being available to smaller businesses. In 1979, the Bureau of Labor clarified the "Prudent Man" rule on what pension funds and endowments could invest in. Before, they could put money in nothing more risky than a dividend-paying stock. Now, the Bureau accepted the argument (proved by academician Harry Markowitz) that in the context of a total portfolio, risky assets can reduce overall risk. The ruling had a dramatic effect: much more money was now available for the high-risk, high-return "private equity" market. This allowed much more financing for small and medium businesses. These changes also allowed the derivative market to develop; the academics had developed the mathematical basis, but now the money was available and big funds could use them. This allowed business and state projects to proceed that wouldn't have before, since now the risk could be effectively hedged.

Money for public equity also grew. In 1975 Congress ended a confiscatory tradition of fixed commissions at the New York Stock Exchange. It allowed brokerage firms for the first time to offer quantity discounts to clients. This greatly reduced the trading costs of pension funds and mutual funds. By improving the economics of trading by large funds, they made a great deal more money available for financing public equity. It was a part of why the number of mutual funds increased by 16 times between 1980 and 2000. Another, more subtle effect was that the amount of company shares owned by institutional (rather than individual) investors doubled - 60% of public equity in 2000, compared to 30% in 1980. The result, although it is obscured by recent corporate scandals, was better corporate governance, a fact demonstrated by research.

OUTTAKES

zero sum game idea -- government versus markets.

Abstract of the article:
Did the Reagan tax cut of 1981 cause the economic boom of 1983-89? This article argues otherwise. The evidence shows that other factors played far more significant roles. These include: (1) Business cycles (I end by quoting David Stockman, Reagan's first budget director, who wrote, "The cycle of boom and bust had been going on for decades and ...its oscillations had reached the high end of the charts. That was all"); (2) The "slaying of the dragon" of inflation by Paul Volcker, the tough-minded chairman of the Fed; (3) The lowering of Fed rates once Volcker felt inflation had been slain. To whip inflation he had raised interest rates so stratospherically that the rates themselves caused a recession in the early Reagan years; as I show, the ensuing drop in interest rates unleashed residential investment, which led the recovery; (4) The end of a severe oil shock. Events in Iran and Iraq had caused oil prices to double from 1978-81. The return of oil prices thereafter to normal ranges was an economic plus, and clearly was not the result of Reagan's tax cuts; (5) The results of "a financial revolution" - which greatly increased access for small and medium-sized businesses to financing and to markets. This revolution had resulted from a variety of changes in law, regulations, markets, research, and financial tools - most of which had taken place before Reagan, in the 1970s. (6) Other elements discussed below. (And if in spite of all the above you still believe that the 1981 tax cut gets the credit, you must explain why the somewhat hidden tax increases of 1982, 1983, and 1984 didn't kill the recovery.)

I also look at the near-tripling of the Federal budget deficit during Reagan's term; the evidence shows that his tax cut was a major cause. I also look at "supply-side" economics to see if the economic events of the Reagan era support its ideas about how tax cuts cause growth; a close examination shows that they do not (to quote Stockman again, "What economic success there was had almost nothing to do with our original supply-side doctrine").

I know someone who practices long-distance healing. She believes that by concentrating her thoughts (from a safe distance) she can cure your health problems. Imagine running into her when you're on the fifth day of a nasty cold. "I'll start praying!" she promises; two days later, your cold is gone. How much credit should you give her? It's obvious: colds last seven days. When A ("healing") precedes B ("no more sneezing") it doesn't prove that A caused B.

How about the broader argument that the tax burden on individuals and businesses fell in late-20th century America, and that this explains the growth of the economy in that era? Again, data undermine these claims. For one thing, the total tax burden in the US - that is, including all taxes, such as payroll, state, and local, as well as Federal income tax - has not changed much since 1950, hovering around 25-30%. As for income taxes, research raises doubt about the simple claim that higher tax burdens reduce growth. One major study found that US income tax revenue as a percentage of the total economy rose from 2 percent in 1913 to 15 percent in 1942 - but that this increase had no effect on the average growth rate of the economy. And it is worth noting that the periods of highest economic growth in the 20th-century US have been exactly those periods with the highest marginal tax rates, such as the 1950s. Again, this is not cause and effect, but it does not fit supply-side thought, or any other simple assertions about how taxes affect the economy. Stronger evidence against the supply-side mantra - "cut taxes, watch the economy grow" - comes from looking at a much larger sample of countries than just the US. Economists Joel Slemrod and Jon Bakija compared eceonomic growth rates with tax levels in the 25 major countries from the years 1970 to 1990. They found no relationship between overall tax levels and growth rates. (They also found no link between tax rates and the size of the economy.) Some of the lower-tax countries had fast growth - but so did some of the most heavily taxed countries. And some low-tax countries had low growth.