Presidents and Economics: Ronald Reagan and the Laffer Curve
When Ronald Reagan became President in 1981 he inherited an economy marked by double-digit inflation, very high interest rates, oil shortages, and slow economic growth. During his predecessor Jimmy Carter's last year in office, inflation averaged 12.5% (compared with 4.4% during Reagan's last year in office in 1988). During Reagan's administration, the unemployment rate dropped from 7.5% to 5.4%, after reaching a high of 10.8% in 1982. In formulating a strategy for economic recovery, Reagan was inspired by the work of an economist named Arthur Laffer (shown sharing a laugh with Reagan in the picture below), who had developed something called the Laffer Curve.
The Laffer Curve is a hypothetical representation of the relationship between government revenue raised by taxation and all possible rates of taxation. The Laffer curve theorizes that no tax revenue will be raised at the extreme tax rates of 0% and 100%. If both a 0% and 100% rate of taxation generate no revenue, there must be some intermediate tax rate which generates the maximum tax revenue. Reagan believed that the United States had reached the point on that curve in which further tax increases would actually result in a decrease in government revenue, and that tax cuts were needed to increase revenues and stimulate the economy.
Reagan's theory was implemented through the "Kemp-Roth Tax Cut," a federal law passed early on in Reagan's term. It was an act to amend the Internal Revenue Code. It provided for an across-the-board decrease in the marginal income tax rates by 23% over three years, with the top rate falling from 70% to 50% and the bottom rate dropping from 14% to 11%. This act slashed estate taxes and trimmed taxes paid by business corporations by $150 billion over a five year period.
The Act's sponsors were Representative Jack Kemp of New York (who later ran for Vice-President in 1996) and Senator William V. Roth, Jr. of Delaware. They had hoped for more significant tax cuts, but settled on this bill after a great debate in Congress. It passed Congress on August 4, 1981 and was signed into law on August 13, 1981 by President Ronald Reagan at Rancho del Cielo, his California ranch.
Years later, in his autobiography An American Life, Reagan wrote (at page 231):
"Simply put, I believed that if we cut tax rates and reduced the proportion of our national wealth that was taken by Washington, the economy would receive a stimulus that would bring down inflation, unemployment and interest rates, and there would be such an expansion of economic activity that in the end there would be an increase in the amount of revenue to finance the important functions of government.
"Excessive tax rates were at the heart of the problem. Back in the fourteenth century, a Muslim philosopher named Ibn Khaldoon wrote something about taxes in ancient Egypt: 'At the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.' In other words, when rates were low, the revenue was great; when rates were high, the revenue was low."
Reagan had his critics. For example economist John Kenneth Galbraith believed that the Reagan administration actively used the Laffer curve "to lower taxes on the affluent." Other critics called Reagan's theory "trickle down economics" because they were based in part on the belief that tax policies that benefit the wealthy will create a "trickle-down" effect that would benefit the poor. His critics claimed that Reagan's policies benefited the wealthy more than those living in poverty. In support of this criticism, his opponents pointed to the fact that Reagan froze the minimum wage at $3.35 an hour, he cut federal assistance to local governments by 60%, he cut the budget for public housing subsidies in half, and he eliminated the antipoverty Community Development Block Grant program.
Along with Reagan's 1981 cut in tax rates, he also reduced the maximum capital gains rate to 20%. This was later revised by Reagan, who set tax rates on capital gains at the same level as the rates on ordinary income, with both topping out at 28%.
Although many modern day conservatives Reagan viewed as an antitax champion, in fact he raised taxes eleven times over the course of his presidency. According to historian Bruce Bartlett, Reagan's tax increases over the course of his presidency took back half of the 1981 tax cut.
During the Reagan Administration, Reagan's theory proved correct when it came to lower taxes corresponding with increased revenues. During his time in office federal receipts grew at an average rate of 8.2%. Unfortunately government spending also increased and the net result was an net loss of about 1% in revenues. In order to cover increased federal budget deficits, the United States borrowed heavily both domestically and abroad, raising the national debt from $997 billion to $2.85 trillion. Reagan would later describe the increased debt as the "greatest disappointment" of his presidency.
Another of the criticisms of Reagan is that he cut the budgets of non-military programs including Medicaid, food stamps, federal education programs and the Environmental Protection Agency. However he protected entitlement programs, such as Social Security and Medicare.
Some economists, such as Nobel Prize winner Milton Friedman, argue that Reagan's tax policies invigorated America's economy and contributed to the economic boom of the 1990s. In the final analysis, it is difficult to objectively pass judgement on the economic policies of Ronald Reagan, especially in the current climate of hyper-partisanship. On the one hand it is true that the national debt expanded significantly during the Reagan administration. One must consider whether (a) this was preferable to continuing on the path of runaway inflation and 20% interest mortgage rates, and (b) whether this was a reasonable price to pay for ending the cold war. This is something that Democrats and Republicans or liberals and conservatives will probably never agree on.
The Laffer Curve is a hypothetical representation of the relationship between government revenue raised by taxation and all possible rates of taxation. The Laffer curve theorizes that no tax revenue will be raised at the extreme tax rates of 0% and 100%. If both a 0% and 100% rate of taxation generate no revenue, there must be some intermediate tax rate which generates the maximum tax revenue. Reagan believed that the United States had reached the point on that curve in which further tax increases would actually result in a decrease in government revenue, and that tax cuts were needed to increase revenues and stimulate the economy.
Reagan's theory was implemented through the "Kemp-Roth Tax Cut," a federal law passed early on in Reagan's term. It was an act to amend the Internal Revenue Code. It provided for an across-the-board decrease in the marginal income tax rates by 23% over three years, with the top rate falling from 70% to 50% and the bottom rate dropping from 14% to 11%. This act slashed estate taxes and trimmed taxes paid by business corporations by $150 billion over a five year period.
The Act's sponsors were Representative Jack Kemp of New York (who later ran for Vice-President in 1996) and Senator William V. Roth, Jr. of Delaware. They had hoped for more significant tax cuts, but settled on this bill after a great debate in Congress. It passed Congress on August 4, 1981 and was signed into law on August 13, 1981 by President Ronald Reagan at Rancho del Cielo, his California ranch.
Years later, in his autobiography An American Life, Reagan wrote (at page 231):
"Simply put, I believed that if we cut tax rates and reduced the proportion of our national wealth that was taken by Washington, the economy would receive a stimulus that would bring down inflation, unemployment and interest rates, and there would be such an expansion of economic activity that in the end there would be an increase in the amount of revenue to finance the important functions of government.
"Excessive tax rates were at the heart of the problem. Back in the fourteenth century, a Muslim philosopher named Ibn Khaldoon wrote something about taxes in ancient Egypt: 'At the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.' In other words, when rates were low, the revenue was great; when rates were high, the revenue was low."
Reagan had his critics. For example economist John Kenneth Galbraith believed that the Reagan administration actively used the Laffer curve "to lower taxes on the affluent." Other critics called Reagan's theory "trickle down economics" because they were based in part on the belief that tax policies that benefit the wealthy will create a "trickle-down" effect that would benefit the poor. His critics claimed that Reagan's policies benefited the wealthy more than those living in poverty. In support of this criticism, his opponents pointed to the fact that Reagan froze the minimum wage at $3.35 an hour, he cut federal assistance to local governments by 60%, he cut the budget for public housing subsidies in half, and he eliminated the antipoverty Community Development Block Grant program.
Along with Reagan's 1981 cut in tax rates, he also reduced the maximum capital gains rate to 20%. This was later revised by Reagan, who set tax rates on capital gains at the same level as the rates on ordinary income, with both topping out at 28%.
Although many modern day conservatives Reagan viewed as an antitax champion, in fact he raised taxes eleven times over the course of his presidency. According to historian Bruce Bartlett, Reagan's tax increases over the course of his presidency took back half of the 1981 tax cut.
During the Reagan Administration, Reagan's theory proved correct when it came to lower taxes corresponding with increased revenues. During his time in office federal receipts grew at an average rate of 8.2%. Unfortunately government spending also increased and the net result was an net loss of about 1% in revenues. In order to cover increased federal budget deficits, the United States borrowed heavily both domestically and abroad, raising the national debt from $997 billion to $2.85 trillion. Reagan would later describe the increased debt as the "greatest disappointment" of his presidency.
Another of the criticisms of Reagan is that he cut the budgets of non-military programs including Medicaid, food stamps, federal education programs and the Environmental Protection Agency. However he protected entitlement programs, such as Social Security and Medicare.
Some economists, such as Nobel Prize winner Milton Friedman, argue that Reagan's tax policies invigorated America's economy and contributed to the economic boom of the 1990s. In the final analysis, it is difficult to objectively pass judgement on the economic policies of Ronald Reagan, especially in the current climate of hyper-partisanship. On the one hand it is true that the national debt expanded significantly during the Reagan administration. One must consider whether (a) this was preferable to continuing on the path of runaway inflation and 20% interest mortgage rates, and (b) whether this was a reasonable price to pay for ending the cold war. This is something that Democrats and Republicans or liberals and conservatives will probably never agree on.