Reagan took office in 1981 amidst a plethora of economic crises. Inflation soared in the double-digits at 13.5%, the unemployment rate stood at 7.5%, and energy prices were rocketing in the aftermath of the Iranian revolution. By the end of his two terms, inflation had fallen to 4.1%, unemployment down to 5.5%, and the US became far less heavily dependent on oil imports. An imposing legacy, Reagan’s supply-side policies paved the way for unprecedented, sustained economic growth, burying the tumultuous years of the stagflation years of the 1970s and marking the start of the Great Moderation – a period of record growth and prosperity.
Tax Reform
Reagan’s election in 1980 marked an end to the New-Deal consensus that birthed an unsustainable welfare state and put the US on the path to uncompetitiveness and stagnation. The return of classical liberal economic policies in the 1980s came to be redefined as neoliberalism.
As a former actor, Reagan understood the damaging effect of punitively high marginal tax cuts more than most. Frequently citing the counterproductive, disincentive mechanism that punitively high rates induce before his transformation into a Californian politician, the Reagan administration sought to reduce these high rates – learning from the lessons of Chief Secretary Mellon in the 1920s. As the latter experienced cutting high marginal tax rates from 73% to 24% during the period, which has since been termed the Roaring Twenties, cutting punitively high rates reduces the deadweight welfare loss from taxation, increasing tax revenues as shown by the Laffer Curve.
This is because the labour supply for higher earners is highly elastic, as a tradeoff exists between leisure and work for those earning comfortably high salaries. An excessively high marginal tax rate on this income disincentivises work, pushing more high earners into choosing leisure. As such, cutting these rates increases GDP by pushing higher earners into further work, thereby increasing tax revenues. In the Economic Recovery Tax Act of 1981, Reagan cut the top marginal tax rate from 70% to 50%. In the coming years following this bill, tax revenue from this income group increased – despite a lower marginal tax rate, as per the supply-side effect of increasing the labour supply.
Welfare Reforms
Reagan’s welfare reforms similarly boosted the productive potential of the US economy. The Omnibus Reconciliation Act of 1981 placed time limits on the duration an individual could receive government benefits. The Family Support Act of 1988 required non-disabled individuals to participate in job training and work activities to receive benefits. This increased the labour supply of the US economy, helping reduce unemployment by pushing more individuals into the workforce. Coupled with the income tax cuts for lower-income individuals, this incentivised more individuals to choose work over welfare. The ERTA of 1981 increased the standard deduction, and personal exemptions and expanded the earned income tax credit (EITC) for low-income individuals. This contributed to record GDP growth during the 1980s when GDP growth across the West slowed. Between 1981 and 1989, GDP growth averaged 3.5% in the US, compared to 2-3% for developed Western economies.
Common sense economic reforms through cutting taxes for lower-income households combined with welfare reforms rewarded Reagan with an election victory in 1984 that saw Reagan win all but one state.
Business Reforms
Reagan pursued aggressive deregulation to increase competition within markets. For example, the deregulation of the Natural Gas industry removed price controls, increasing competition and lowering prices for consumers by increasing the supply available on the market. Similarly, financial reform allowed banks and mutual funds to invest in new markets, increasing the number of financial products available and marking the birth of mortgage-backed securities. This increased competition within US markets forced firms to produce higher quality products and lower prices. It led to more jobs, contributing to the dramatic fall in unemployment under his Presidency.
Corporate tax reform similarly increased jobs and competition. The corporate tax rate was lowered from 46% to 34% in 1981 as part of the ERTA. This increased the number of small businesses by 3.5 million under his two terms as regulatory, and tax cuts made it easier to start and maintain a business, creating a favourable environment for small businesses to grow and create jobs. The argument that Reagan’s tax cuts overwhelmingly favoured large businesses is also made redundant because the number of small businesses as a percentage of all firms increased from 89.6% in 1982 to 92.6% in 1989. Corporation taxes harm small businesses far more than larger firms, the latter of which can afford to absorb the higher costs from higher tax rates. This increased competition for larger firms put them under greater pressure to deliver high-quality products at competitive prices, leading to greater prosperity as US consumers benefitted.
Ultimately, the Reagan administration oversaw a period of high economic expansion coupled with falling inflation and unemployment rates through supply-side reform. Cutting high taxes increased revenues by boosting the labour supply, allowing individuals to keep more of their hard-earned income and incentivising work over leisure. Welfare reform encouraged self-sufficiency and reduced the dependency culture rampant in the US during the 1970s, pushing more individuals into employment. Finally, business reform through deregulation and corporate tax cuts increased the number of small businesses, rewarding entrepreneurship and reducing the government wedge from taxation, making large companies more accountable by increasing competition, lowering prices and increasing quality. Reagan’s legacy has been so powerful as to completely reshape the opposition Democratic Party, culminating with the election of Democrat Bill Clinton in 1992, who further continued Reagan’s legacy with welfare reform and supply-side tax cuts.
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