Transcript Reaganomics: The Real Story

Supply-Side Economics and
Reaganomics: The Real Story
Background, Budgets, and Results
Steven R. Cunningham
For Macroeconomics Classes
University of Connecticut
Supply-side History
 François Quesnay and the physiocrats:
 Around the year 1750.
 Emphasized the importance of property
rights in a market economy
 Argued that excessive taxation diminishes
output
 Argued that high tax rates:
 Kill growth.
 May diminish tax receipts, whereas lowering tax
rates may result in such rapid growth as to
increase tax receipts.
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History, continued
 Adam Smith in the Wealth of Nations
(1776) writes that taxes reduce the
incentive to work and firms to employ.
 Jean Baptiste Say (1821) argued:
 “high taxes impoverish the individual
without enriching the state”, and
 high taxes are “economic suicide”.
 Karl Marx in Das Kapital (1867) writes:
 Over-taxation is a principle in Europe
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Redistribution
 Keynes claimed Malthus (ca. 1820) as his
logical predecessor. Malthus feared short-run
inadequate demand as a result of over-saving:
 Profits go to owners of capital (capitalists).
 The capitalists are rich, therefore tend to save (I.e.,
they have a lot of discretionary income).
 As a larger and larger portion of income goes to the
capitalists, consumption falls.
 Deficient demand results, leading to widespread
unemployment.
 Proposed Solution: redistribute income from
the rich to the poor.
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Mundell
 Robert Mundell created modern
supply-side economics in a single
knock-out paragraph at the end of a
monograph published in 1971, then
never pursued his idea in print.
 Robert Mundell’s Webpage
 Won Nobel Prize in Economics, 1999.
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About Mundell
 By 1963, Kindelberger of MIT called him
“the foremost international economist of
his generation.” (He was barely 30 years
old then.)
 He extended Keynesian economics to
the open economy.
 He discovered classical economics and
the long run in the late 1960s, and
moved to the University of Chicago to
learn more.
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About Mundell, continued
 Before he was 40, he completely reconstructed
the modern theories of:
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Flexible vs. Fixed Exchange Rates
International Asset Market Theory
Flight of Funds Theory
The Monetary Approach to the Balance of Payments
Formal Models of Money Creation
Deficit Finance
External Imbalance
Monetary Interdependence
Inflation
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Arthur Laffer
 BA, Yale, MBA and PhD from Stanford, 1972
 Went to Chicago in 1969 as an ABD and works
with Mundell. Calls Mundell “a genius.”
 Whereas Mundell deliberately avoids the
limelight, Laffer wants fame. Uses his contacts
at Chicago and Stanford to become President
Nixon’s Chief Economist in OMB.
 Mundell visits Laffer in Washington. Laffer
introduces Mundell to George Schultz who
plays a key role in the Reagan Administration.
 The stage is set for Reagonomics.
 1974, Laffer draws a curve on a napkin.
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Laffer Curve
Tax
Revenue
45°
0%
tmax
Marginal Tax Rate
9
thigh
100%
Wall Street Journal Connection
 Jude Wanniski (WSJ reporter) reports on
the ideas of Mundell and Laffer in a
series of articles beginning in 1974.
Interest grows.
 March 1976, conference in Virginia. Herb
Stein refers to “supply-side fiscalism”.
Later this becomes “supply-side
economics.
 1978, Wanniski writes a book called The
Way the World Works.
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Theory: Incentives Matter
 Two principles from the first course in
economics:
 If you tax something, you get less of it.
 If you subsidize something, you get
more of it.
 What have we as a society been
taxing and subsidizing?
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Incentives (2)
 We have taxed:
Income
Employment and productive effort
Investment and Saving
Production of goods and services that the
population at large needs and wants, worth
more than the cost of production
 (And we’ve increase regulation of these
things.)
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 Is it any wonder we have gotten less of
these?
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Incentives (3)
 What have we subsidized?
 Unemployment and leisure
(unemployment compensation, welfare,
redistribution)
 Lack of productivity and contribution to
society (welfare, etc.)
 Is it any surprise that we’ve gotten
more of these things?
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Progressive Taxation
 Discourages employment at the
margin, where the decision is made.
 Workers are being penalized for
increasing their productivity, working
to advance themselves and society.
 Of course, any income tax reduces
the after-tax wage, reducing labor
supply.
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Growth vs. Redistribution
 Supply-siders argue that the issue is
growth vs. redistribution. They argue
that they are “growthists” while
Keynesians are “redistributionists”.
 They argue that Keynesians think that
society is “zero sum”.
 Redistribution is destructive to
incentives.
 Redistribution doesn’t work. “The
incidence of a tax is not the same as the
burden of a tax.”
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Tax Wedge
Wages
After-tax
Labor
supply
Interest Rates
After-tax
Saving
Saving
Labor
supply
Labor
demand
Investment
Employment
Saving, Investment
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What Reagan Faced:
The Economic Problems
 The inflation creep of the 1970s had
resulted in an enormous increase in tax
burden through “bracket creep”.
 Social security tax and Medicare had also
increased the personal tax burden.
 According to Boston College economist
Barry Bluestone, 31 million jobs had been
destroyed between 1978 and 1982.
 Fully one-third of all private sector jobs that
existed in 1978 had disappeared by 1982.
What Reagan Faced:
Defense Issues
 Defense spending had declined from 9.6% of GNP in
FY1962 to 5.5% of GNP in FY1981, a decline of 43%.
 More of the defense spending in 1981 was directed
toward salaries and pensions than in 1962.
 CIA reports showed that defense expenditures in the
Soviet Union were twice as high (as a percent of
output) than U.S. defense expenditures, implying that
the U.S.S.R. was spending 45% more on defense than
the U.S.
 In 1979, the Soviet Union invaded Afghanistan and
the U.S. embassy in Iran was seized.
 The questions everyone was asking was “Can we
defend ourselves? Are we ready?”
Reagan’s FY1982 Budget Proposal
Reagan’s Proposal
ERTA (What He Got)
1
30% cut in personal taxes
25% cut in personal marginal tax
rates
2
Accelerated depreciation for
capital in business
Got it!
3
9% increase in defense spending
per year for 5 years
Got it!
4
$50 billion cut in non-defense
spending in 1982, growing to
$100 billion in 1986
No!
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Additional cuts of $30 billion in
1983, $40 billion in each of the
next 3 years
No!
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Indexing of personal exemptions
and brackets, starting in 1985
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Elimination of the “marriage
penalty”
Results (1)
 Despite the tax cuts of 1981, federal tax
revenues nearly doubled in the Reagan
years. (Washington Times, 8/25/1992)
 Real inflation-adjusted manufacturing
output rose to its highest point of the postWWII period.
 In 1989, capital goods production was 38%
of total manufacturing production, as
compared with 1967 when it was 28%.
 In 1989, exports of capital goods were 45%
of total capital goods production, compared
to 20% in 1967.
Results (2)
 Domestic-based manufacturing
employment fell from 20.3 million in
1980 to 19.2 million in 1990, a
decline of 6%, probably as a result of
productivity gains.
 U.S. exports of manufacturing goods
grew by 90% between 1986 and
1992, compared with 25% for the
rest of the OECD countries.
Results (3)
 The U.S. raised its share of the
world’s manufacturing exports from
14% in 1987 to 18% in 1991.
 In 1990, the U.S.’s share of world
manufacturing exports was the same
as in 1975.
Results (4)
 More than 18 million new jobs were created
in the 1980s in the U.S.—this was more
than Japan, Britain, and Germany
combined.
 82% of the jobs created were high-pay,
high-skill managerial and technical
positions. 12% were low-skill service jobs.
 While real wages declined from $11.41 per
hour in 1978 to $10.02 per hour in 1990,
workers’ total compensation increased as
workers demanded increased benefits.
Results (5)
 Reaganomics did not gut social welfare
programs. In fact, social welfare spending
was the largest cause of the budget deficits
of the Reagan administration.
 Outlays for means-tested programs rose
19.7% from 1982-1989 (CPI adjusted). As
a percentage of GNP, this is a higher rate
than the Carter years.
Results (6)
U.S. Real Income Growth, 1983-1989
Quintile
Real Income Growth
Lowest 20%
11.1%
Second 20%
10.1%
Third 20%
10.7%
Fourth 20%
11.6%
Highest 20%
18.8%