Why the Reagan Tax Cut Worked in 1981 and Why It Wouldn’t Work Today

Thirty years ago today, Ronald Reagan signed into law the Economic Recovery Tax Act of 1981. It remains controversial, with Democrats blaming it for undermining the nation’s finances and contributing to the maldistribution of income, while Republicans assert that the Reagan tax cut was so stimulative it actually lost no revenue and that its reprise is just what the economy needs today.

The truth is that the Reagan tax cut never came close to paying for itself, but neither was it expected to lose as much revenue as it did. And while it was highly stimulative, that is only because the economic and financial circumstances of the time made it so. Reenacting some version of the Reagan tax cut under today’s economic conditions would not bring about similar results.

It’s important to remember that inflation was the central economic problem at the time Reagan endorsed the tax plan that had been developed in Congress by Congressman Jack Kemp of New York and Senator Bill Roth of Delaware, which proposed cutting the top income tax rate from 70 percent to 50 percent and the bottom rate from 14 percent to 10 percent.

The Consumer Price Index rose 4.9 percent in 1976, 6.7 percent in 1977, 9 percent in 1978 and 13.3 percent in 1979. At the same time, unemployment was stubbornly high, averaging 7 percent from 1975 to 1979.

One of the key problems that the Reagan-Kemp-Roth plan was designed to deal with was bracket-creep. Since the tax system was not indexed at that time, whenever workers got a cost-of-living pay raise they got pushed up into higher tax brackets even though their real income had not risen. Consequently, the average federal income tax rate on a four-person family with the median income had risen from 7 percent in 1965 to 11 percent in 1978, and the marginal tax rate – the tax on each additional dollar earned – rose from 17 percent to 25 percent.

The dominant theory at the time said that budget deficits were a key cause of inflation. Therefore, virtually all mainstream economists thought the Reagan tax cut would make inflation much worse. A Congressional Budget Office analysis of the Kemp-Roth bill in 1978 estimated that it would add 2.7 percentage points to the inflation rate by 1983.

Reagan’s economic advisers had a different view. Tax rate reductions were not inflationary because they would increase labor supply and economic output, which would reduce inflation, not increase it. Reducing inflation was primarily a function of monetary policy. If the Federal Reserve reduced the growth rate of the money supply then inflation would fall regardless of the deficit. Simultaneous tax cuts would cushion the economic cost, the economists argued.

In 1979, the Fed began targeting the money supply, which brought on a recession in 1980. But inflation only fell to 12.5 percent. Continued tight money led to another recession in 1981 and 1982, which brought inflation down to 8.9 percent in 1981 and 3.8 percent in both 1982 and 1983. Ironically, this much more rapid improvement in inflation contributed heavily to the budgetary cost of the Reagan tax cut. Since taxes are assessed on nominal incomes and tax indexing didn’t start until 1985, the sharp fall of inflation shrank the tax base and increased the tax cut’s revenue loss.

The collapse of inflation also meant that real interest rates were extremely high. In early 1982, the federal funds rate was more than 14 percent, leaving a great deal of room for easing monetary policy. By the end of 1982, the fed funds rate was down to 9 percent. Thus the economic expansion of the 1980s was powered by a combination of tax cuts, falling inflation and lower interest rates.

Today, by contrast, income tax rates are at a historical low – the top tax rate is just 35 percent and revenues are less than 15 percent gross domestic product versus 19.6 percent in 1981. The average federal income tax rate on a median family is less than 5 percent and its marginal rate is 15 percent. Inflation is nonexistent and the federal funds rate is close to zero.

Therefore, there is no possibility of replicating the experience of the early 1980s because economic and financial conditions now are virtually 180 degrees opposite from what they were then.

Making economic policy is not like making cookies and you can’t use a cookie-cutter approach. Policies need to be crafted to the circumstances. I believe Reagan’s policies were appropriate to the economic conditions of the early 1980s. Today’s economic problems require a very different set of policies.

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