RONALD REAGAN’S PRO-MARKET REFORMS IN THE US
P. 86 - 91 Ronald Reagen
In 1981, around 60 Democrats voted with the Republican minority in Congress to pass Reagan’s Economic Recovery Tax Act, which phased in a 25% cut in marginal individual tax rates over three years along with introducing incentives for small businesses and personal savings. The bill also included a provision to index tax rates from 1985 onwards to avoid bracket creep (the process by which inflation pushes income into higher tax brackets, resulting in higher taxation but no increase in real purchasing power). Democrats had also proposed tax cuts of their own, spread over four years instead of three, but experts calculated that if inflation remained at 8% over the four-year period, 98% of the 25% cut would be lost to bracket creep unless tax rates were adjusted in response to inflation.
These were the most drastic tax cuts in American history to date, and they would save American taxpayers a total of USD 718 billion between 1981 and 1986 according to a prognosis by the US Treasury. However, Reagan hoped that they would in fact help him to keep his election promise of raising tax revenue by stimulating growth. At a press conference in October 1981, he quoted the 14th-century Muslim philosopher Ibn Khaldūn’s foreshadowing of the Laffer Curve theory, as this effect is called in economic jargon: “In the beginning of the dynasty, great tax revenues were gained from small assessments. At the end of the dynasty, small tax revenues were gained from large assessments.” Reagan added: “And we’re trying to get down to the small assessments and the great revenues.” And that’s exactly what he did.
The economists William A. Niskanen and Stephen Moore have analysed ten key supply-side indicators to compare the economic record of the Reagan years with the periods immediately preceding (1974 to 1981) and following (1989 to 1995) his two terms in the White House. Following are their conclusions.
Economic growth during the Reagan years was 3.2% per year, compared to 2.8% during the Carter–Ford years and 2.1% during the Bush–Clinton years. Niskanen and Moore emphasize that the growth rate for the Reagan years includes the recession of the early 1980s, a side effect of reversing Carter’s high-inflation policies. From 1983 to 1989, GDP grew by 3.8% a year, and by the end of Reagan’s second term the US economy was almost one third larger than when he first took office.
This growth was a direct consequence of Reagan’s deregulation and tax reform policies in conjunction with falling oil prices. The growth rate in the 1980s was higher than in the 1950s and 1970s, though substantially below the growth rate of 5% following John F. Kennedy’s 1964 tax rate cuts of 30%.
Median household incomes grew by USD 4,000 from USD 37,868 in 1981 to USD 42,049 in 1989 after having stagnated during the preceding eight-year period. Under Reagan’s successor, George W. Bush Sr., they fell by USD 1,438.
Unemployment stood at 7.6% when Reagan took office, rising to almost 10% during the 1981–1982 recession. It then continued to fall to 5.5% by the end of his second term. Between 1981 and 1989, 17 million new jobs – roughly 2 million a year – were created.
Inflation was in double digits when Reagan arrived at the White House. By his second year in office, it had fallen by more than half, to 6.2%. By the end of his second term, it stood at only 4.1%, largely due to the prudent monetary policy of Paul Volcker, who was chairman of the Federal Reserve from 1979 and 1987. Although well aware that it would cause a temporary recession, Reagan explicitly supported Volcker’s strategy. Contrary to the dire predictions of many of his critics, his drastic tax cuts did not lead to further increases in inflation.
As a November 1981 article in the Wall Street Journal explained, this combination of fiscal restraint and drastic tax cuts was precisely the secret to Reagan’s later successes: “You fight inflation with a tight monetary policy. And you offset the possible recessionary impact of tight monetary policy with the incentive effects of reductions in marginal tax rates. Since we are now having a recession, you could claim the formula has failed, except for one detail: We’ve had tight money all right, but dear friends, we haven’t had any tax cut.” The tax cuts took effect on 1 January 1983, marking the beginning of an era now remembered as the ‘Seven Fat Years’.
Interest rates fell sharply during the Reagan years. Interest rates on a 30-year mortgage fell from 18.9% in 1981 to 8.2% in 1987, while the Treasury Bill rate fell from 14% in 1981 to 7% in 1988.
These achievements are only slightly overshadowed by less positive figures in three areas of analysis. Productivity grew by only 1.5% a year, which was lower than in the three decades preceding Reagan’s presidency, though significantly higher than the 0.3% annual growth achieved under Bill Clinton. The personal savings rate fell from 8% to 6.5% during the 1980s.
Reagan’s critics like to point to one statistic in particular to show what was wrong with his economic policy: the budget deficit, which in 1981 stood at USD 101 billion and 2.7% of GDP, rose to USD 236 billion and 6.3% of the GDP by 1983. When Reagan left the White House, he left a USD 141 billion deficit (2.9% of the GDP). National debt doubled from USD 1,004 to USD 2,026 billion during his presidency – a dramatic growth rate compared to the previous years, though relatively modest in comparison to the growth rates under Bush Sr. and Barack Obama.
Reagan had campaigned on a platform that included the promise to create new jobs, fight inflation, lower taxes and promote economic growth, while increasing military spending and reducing the budget deficit. Achieving all of this at the same time proved impossible even for him – not least because his administration had promised to protect ‘core safety net programs’ including social security, unemployment benefits, cash benefits for the elderly poor and the veterans programme, which accounted for two thirds of federal transfer payments. Along with the cost of his ambitious plans to accelerate defence spending, these expenses added up to 70% of the total budget for 1981, which left him very little room for manoeuvre to reduce the level of spending.
The attempt to establish a direct link between the growing debt and Reagan’s tax cuts flies in the face of the facts. Despite – or rather because of – the lower tax rates, tax revenue grew by 58% from USD 347 billion in 1981 to USD 549 billion in 1989. The growth in tax revenue during his time in office was only slightly below that achieved by his successors Bush Sr. and Clinton, who both raised taxes whereas Reagan cut them.
The growing accumulation of debt was caused by Reagan’s large military expenditures, which saw the defence budget almost double from USD 158 billion in 1981 to USD 304 billion in 1989. Niskanen and Moore show that the cumulative increase in defence spending even outpaced the cumulative increase in the budget deficit. If not for this massive increase in military expenditure, Reagan would have succeeded in cutting taxes and debt while creating jobs and getting inflation under control.
However, the second key issue confronting the Reagan administration – the Cold War, which the president proposed to end by massively escalating the arms race – made this impossible to achieve. The NATO ‘Double-Track’ Decision in December 1979 (parallel courses of nuclear forces modernization and arms control) immediately preceded the Soviet invasion of Afghanistan. With the Soviet Union already experiencing serious economic troubles during the 1980s, Reagan was determined to bring about the collapse of the communist superpower he liked to call the ‘Evil Empire’. As Niskanen and Moore point out, this raises a key policy question: “If the entire accumulation of debt in the 1980s went to finance the Reagan defense build-up, the key policy question would shift to whether it was appropriate to borrow for those large military expenditures. Was the Reagan administration justified in paying for this one-time increase in ‘public investment’ spending through debt rather than taxes?Or, put another way, was it appropriate to have asked our children and grandchildren to help defray the cost of defeating the Soviet menace?”
Equally unsubstantiated by evidence is the assumption that the economic upswing during the Reagan years was achieved by means of brutal welfare cuts. In fact, total federal spending on welfare programmes rose from USD 339 billion in 1981 to USD 539 billion in 1989. Adjusted by population growth and inflation, this represents an annual growth rate of 0.9% – lower than in any other period in post-war American history. Incomes rose for every income quartile, from the richest to the poorest, during Reagan’s time in office.
The American Dream of income mobility, which for many today has turned into a nightmare of discontent, was alive and well in the 1980s: 86% of households that were in the poorest income quintile in 1981 were able to move up the economic ladder into a higher quintile by 1990. The percentage of poor households that moved all the way up to the richest income quintile between 1981 and 1990 was even slightly higher than the percentage of those who remained in the poorest quintile. The number of Americans earning less than USD 10,000 a year fell by 5% during the 1980s, while the number of those earning more than USD 50,000 rose by 60% and the number of those whose annual income exceeded USD 75,000 rose by a staggering 83%. Among the fables Niskanen and Moore debunk, the claim that wealthy whites were the sole beneficiaries of Reagan’s policies at the expense of poorer African Americans is one of the most persistent and pernicious. In fact, African American households saw even stronger growth in real take-home pay between 1981 and 1988 than their white peers.
Among the most striking achievements of the Reagan administration is the fact that he successfully implemented these sweeping pro-market reforms in the face of the Democratic majority that dominated Congress for most of his two terms in office. That he was able to do so was largely due to two key factors: first of all – as is often the case – the political changes had been preceded by changes in the cultural and intellectual climate that were reflected in the public discourse on economics. Proponents of the once dominant Keynesian views (even Nixon was a self-confessed Keynesian) found themselves at a loss to explain the simultaneous rise in inflation and unemployment. In January 1977, the Wall Street Journal ran an editorial titled “Keynes is Dead”. By contrast, uncompromising pro-market thinking – as espoused by Milton Friedman’s Chicago School in particular – was in the ascendancy.
The public mood had changed, and even Democrats were now in favour of tax cuts. As alluded to above, their main initiative in 1981 was a bill to reduce marginal tax rates for those in the highest tax bracket by 25% over four years.380 This was the second reason for Reagan’s success: he was able to achieve bipartisan support for many of his reform proposals.
After a decade of price controls and government intervention in the 1970s, Americans now started to put their faith in the market again. The optimistic mood helped to boost the economy, and the economic upswing helped to boost optimism. The 1980s witnessed a revolution in communications technology. From only 1% in 1980, the proportion of American households that owned a VCR skyrocketed to 58% by the end of the decade. The 1980s also saw the number of personal computers explode from just over 2 million in 1981 to 45 million in 1988, around half of them in private homes. The 1980s’ greatest economic success stories included Microsoft (which issued its first public stock in 1986), Apple and Sun Microsystems. Young, innovative companies raised capital from venture capitalists or IPOs. At the same time, a fitness revolution swept the country, with health clubs springing up everywhere and Arnold Schwarzenegger – himself a great admirer of Friedman and Reagan – kicking off a craze for physical exercise.
Poll data from 1977 show that 53% of respondents ranked inflation as the most important problem facing the US, followed by recession or unemployment at 39%. In 1981, a staggering 70% of Americans were most concerned about inflation. By 1987, that number had fallen to 13%, with 11% citing the deficit as their largest concern.
Reagan’s economic advisers during his two terms in the White House included Friedman, who in his memoirs gives a very positive overall assessment of Reagan’s political legacy, praising him for his unprecedented “adherence to clearly specified principles dedicated to promoting and maintaining a free society”. However, Friedman does take Reagan’s administration to task for deviating from pro-market principles by negotiating a protectionist agreement with Japan to impose a ‘voluntary’ quota on exporting cars to the US. Reagan’s second term in office, Friedman goes on to say, was “much less productive than the first” because his second presidential campaign in 1984 lacked any “specific commitments for action”.
Despite these minor reservations, Reagan’s reforms proved compellingly that a return to its traditional capitalist free-market values was the way to make America strong again. Unfortunately, his successors failed to adhere to this lesson and persevere with his reforms. Instead, the reforms were little more than a short hiatus on the road towards increasing government intervention and a burgeoning welfare state. Samuel Gregg’s Becoming Europe describes 5 the likely outcomes of the progressive ‘Europeanization’ of the US economy in drastic terms, while William Voegeli’s Never Enough warns that, for all he accomplished, not even Reagan was able to reverse the disastrous slide towards a welfare-state system – although he did succeed in keeping the growth in inflation-adjusted federal welfare spending below 1%.
Reagan, Thatcher and Erhard were the most significant and most adamant proponents of free-market capitalism among the 20th century’s Western political leaders. All three rejected the social democratic welfare state along with socialism in its undiluted Marxist form. And all three made significant contributions to a growth in prosperity for the nations they governed.
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