Reaganomics

Why It Wouldn't Work Today

© The Balance 2018

Reaganomics is President Ronald Reagan's conservative economic policy that attacked the 1981-1982 recession and stagflation. Stagflation is an economic contraction combined with double-digit inflation.

Reagan's position was dramatically different from the status quo. Prior presidents Lyndon Johnson and Richard Nixon had expanded the government's role. Reagan pledged to make cuts in four areas:

  1. The growth of government spending
  2. Both income taxes and capital gains taxes
  3. Regulations on businesses
  4. The expansion of the money supply

What Reaganomics Is

Reaganomics is based on the Laffer Curve. Economist Arthur Laffer developed it in 1974. The curve showed how tax cuts could stimulate the economy to the point where the tax base expanded. 

The Laffer Curve showed how Reaganomics could work.

Tax cuts reduce the federal budget, dollar-for-dollar, immediately. These same cuts have a multiplier effect on economic growth. Tax cuts put money in consumers' pockets, which they spend. That stimulates business growth and more hiring. The result? A larger tax base.

Reaganomics is consistent with the theory of supply-side economics. It states that corporate tax cuts are the best way to grow the economy. When companies get more cash, they should hire new workers and expand their businesses. It also says that income tax cuts give workers more incentive to work, increasing the supply of labor. That's why it's sometimes called trickle-down economics

Key Takeaways

  • Reagan's economic policies were nicknamed Reaganomics
  • They were based on supply-side economics which prioritized tax cuts
  • Reaganomics reduced tax rates, unemployment, and regulations
  • Inflation was lowered through monetary policy
  • Reaganomics worked in the 1980s because it lowered record-high taxes

Did It Work?

President Reagan delivered on each of his four major policy objectives, although not to the extent that he and his supporters had hoped. That's according to William A. Niskanen, a founder of Reaganomics. Niskanen belonged to Reagan's Council of Economic Advisers from 1981 to 1985. Inflation was tamed, but it was thanks to monetary policy, not fiscal policy. Reagan's tax cuts did end the recession.​

But government spending wasn't lowered. It just shifted from domestic programs to defense. The result? The federal debt almost tripled, from $998 billion in 1981 to $2.857 trillion in 1989.

Tax Cuts

Reagan cut tax rates enough to stimulate consumer demand. By Reagan's last year in office, the top income tax rate was 28% for single people making $18,550 or more. Anyone making less paid no taxes at all. That was much less than the 1980 top tax rate of 70% for individuals earning $108,300 or more. Reagan indexed the tax brackets for inflation.

Reagan offset these tax cuts with tax increases elsewhere.

He raised Social Security payroll taxes and some excise taxes. He also cut several deductions.

Reagan cut the corporate tax rate from 46% to 40% in 1987. But the effect of this break was unclear. Reagan changed the tax treatment of many new investments. The complexity meant that the overall results of his corporate tax changes couldn't be measured.

Slow Spending Growth

Government spending still grew, just not as fast as under President Jimmy Carter. Reagan increased spending by 9% a year, from $678 billion at Carter's final budget in Fiscal Year 1981 to $1.1 trillion at Reagan's last budget for FY 1989. Carter increased spending by 16% a year, from $409 billion in FY 1977 to $678 billion in FY 1981.

Under Reagan, defense spending grew faster than general spending.

Military spending increased 11% a year, from $154 billion in FY 1981 to $295 billion in FY 1989.

Reagan made minor cuts to other discretionary programs in his first few budgets. These included the departments of Commerce, Education, Energy, Interior, and Transportation. Reagan did not cut Social Security or Medicare payments since they were protected by the acts that created them.

Reduce Regulations

In 1981, Reagan eliminated the Nixon-era price controls on domestic oil and gas. They constrained the free-market equilibrium that would have prevented inflation. Reagan also deregulated cable TV, long-distance telephone service, interstate bus service, and ocean shipping. He eased bank regulations, but that helped create the Savings and Loan Crisis in 1989.

Reagan increased, not decreased, import barriers. He doubled the number of items that were subject to trade restraint from 12% in 1980 to 23% in 1988. He did little to reduce other regulations affecting health, safety, and the environment. Carter had reduced regulations at a faster pace.

Tame Inflation

Reagan had campaigned on ending galloping inflation. That's when inflation rates reach 10% or more. In 1980 the inflation rate was 12.5%. These rates hurt the economy because money loses value too fast. Business and employee income can't keep up with rising costs and prices.

Galloping inflation was already being addressed by Federal Reserve Chairman Paul Volcker.

He used contractionary monetary policy, despite the potential for a recession. In 1979, Volcker began raising the fed funds rate. By December 1980, it had reached 20%.

These high rates choked off economic growth. Volcker's policy triggered the recession of 1981-1982. Unemployment rose to 10.1% and stayed above 10% for 10 months. This painful solution was necessary to stop galloping inflation. Had inflation not been tackled in this way the economy would have fared far worse. Volcker's policies knocked inflation down to 3.8% by 1983.

Reaganomics Would Not Work Today

Today's conservatives prescribe Reaganomics to make America great again. President Donald Trump and other Republicans advocate it as the solution the economy needs. But the theory behind Reaganomics reveals why what worked in the 1980s could harm growth today.

The effect that tax cuts have depends on how fast the economy is growing when they are applied. It also depends on the types of taxes and how high they were before the cut. The Laffer Curve shows that cutting taxes only increases government revenue up to a point.

Once taxes get low enough, cutting them will decrease revenue instead. Cuts worked during Reagan's presidency because the highest tax rate was 70%. They have a much weaker effect when tax rates are below 50%.

For example, President George W. Bush cut taxes in 2001 and 2003 to fight the 2001 recession. The economy grew and revenues increased. Supply-siders, including the president, said that was because of the tax cuts. 

Monetarists pointed to lower interest rates as the real stimulator of the economy. The Fed lowered the fed funds top rate from 6% at the beginning of 2001 to 1% in June 2003.

Reaganomics would not work today because tax rates are already low compared to historical levels of 70%. 

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