Silver as an investment


Supply-Side Economics Explained

Paul Craig Roberts

Supply-Side economics burst onto the economic policy scene in Washington, D.C., on September 21, 1975 in the Sunday Washington Star in an article I had written for US Representative Jack Kemp that provided a supply-side economic basis for his capital formation bill. Subsequently, I generalized the supply-side approach when I realized that changes in marginal tax rates altered relative prices and could shift the aggregate supply side curve. Until that time, economists assumed that fiscal policy only impacted the aggregate demand curve.

Today 42 years after this article and 36 years after the passage of the Economic Recovery Tax Act that constituted the supply-side economic policy of President Reagan, there is still scant understanding of the economics that cured stagflation and enabled Reagan to pressure the Soviets to end the Cold War.

For example, in Wikipedia’s account Supply-Side economics is presented as a claim that cutting tax rates increases tax revenues. This is ignorant nonsense.

As the Assistant Secretary of the Treasury for Economic Policy, I had the central role in the implementation of Supply-Side economics. On US Representative Jack F. Kemp’s staff as economic counsel and in the House of Representatives as Chief Economist for the Republicans on the House Budget committee, I wrote the Kemp-Roth bill that addresses stagflation and that President Reagan adopted as presidential policy. As staff associate of the Joint Economic Committee in the US Senate I convinced some Republicans and the most important majority Democratic committee chairmen that Supply-Side economics was the way out of the stagnation trap. The first Joint Economic Committee annual reports endorsing Supply-Side economics came from committee chairman Lloyd Bentsen, a Texas Democrat. My book, The Supply-Side Revolution, peer-reviewed and published by Harvard University Press in 1984, explains the theory of Supply-Side economics and provides empirical evidence and the history of Reagan’s policy.

A few years ago Harvard University Press informed me that China had published a Chinese language edition of The Supply-Side Revolution. I have a copy on my bookshelf. On my wall hang letters from President Reagan thanking me for the implementation of the Supply-Side economic policy. On another wall is a letter from President Reagan to the French Ambassador and Finance Minister on the occasion of the ceremony that presented me with the French Legion of Honor for my services to economics. In his letter Reagan says “Craig is the architect of the economic policies of my administration.” I have the US Treasury’s Meritorious Service Award for “outstanding contributions to the formulation of US Economic Policy.”

Yet the Wikipedia account of Supply-Side economics excises both me and the content of Supply-Side economics. In our place are the accumulation of decades of propaganda against “Reaganomics.”

The missing subject matter becomes even stranger when we take into account the fact that I wrote the peer-reviewed New Palgrave Dictionary of Money and Finance (Macmillan, London, 1992) entries on Supply-Side Economics and the Laffer Curve. The New Palgrave is the premier economic encyclopedia. It is extraordinary that anyone would be so careless as to write a Wikipedia economics entry without consulting The New Palgrave. I also wrote the entry for the McGraw-Hill Encyclopedia of Economics.

The Laffer curve is not a theory. It is not Supply-Side economics. It is an expository device that illustrates that both high and low tax rates can produce the same tax revenues. There is nothing wrong with this demonstration.

The economic policy of the Reagan administration was most certainly not based on tax rate reductions paying for themselves in increased revenues. The Treasury’s revenue forecast of the Reagan tax rate reduction was the Treasury’s traditional static revenue forecast that every dollar of tax cut would lose a dollar of tax revenue. In other words, it was a worse forecast of revenue loss than the Keynesian economists predicted. Keynesians predicted that some of the revenues would be regained from increased employment and output. Walter Heller, chairman of the Council of Economic Advisors under President John F. Kennedy said that the Kennedy reduction in marginal tax rates, on which Reagan’s reduction was modeled, paid for itself in increased revenues.

Possibly. But the Reagan Treasury—in which I was entrenched with two deputies of my choosing, US Rep. Jack Kemp’s support, President Ronald Reagan’s support, Treasury Secretary Don Regan’s support, former Treasury Secretary William E. Simon’ support, the House Republicans’ support, support from influential Democrats and Republicans in the Senate, and support from the Wall Street Journal where I was associate editor prior to my Treasury appointment—based its revenue forecast on the traditional Treasury static revenue estimate that every dollar of tax cut would lose a dollar of revenue. This is a fact not subject to dispute. It is in the public record.

So how did the fabricated fake news story originate that Supply-Side economics was a theory that cutting taxes would increase tax revenues. It originated from three sources.

One was that in those days Republican economics consisted of fear of deficits. Cutting taxes would at least initially worsen the deficit and, from Wall Street’s point of view, would lead to higher interest rates that would sink their stock and bond portofilios. The result was that Wall Street economists campaigned against Supply-Side economics, and misrepresentation was part of their attack.

A second was that Supply-Side economics challenged Keynesian demand management policy by its emphasis on supply. In other words, Supply-Side economics took the leadership over economic policy away from the long-entrenched Keynesians. Academic economists aggressively defended their turf and misrepresentation—“trickle-down economics,” “voodoo economics”— was part of their attack.

The third was that in order to reassure Senate Republians who were prone to hysteria over federal budget deficits, Budget Director David Stockman, against my advice, raised the inflation forecast in the five-year budget projection in order to forecast higher GDP and, thereby, higher tax revenues. The higher the inflation forecast, the higher the nominal GDP and the tax base that it provided.

I argued, correctly as it turned out, that inflation would come in lower than Stockman’s figures and that our opponents would place the blame for the budget deficits on the tax rate reductions instead of blaming the faulty inflation forecasts. However, the argument that the Republican Senate could not be trusted to vote for a budget that projected deficits carried the day and brought the consequences that I predicted.

What produced the unequitable distribution of income in the 21st century was not the Reagan marginal tax rate reductions, but the offshoring of high-productivity, high value-added, high wage jobs by global US corporations. When a country moves its middle class manufacturing and professional skill jobs abroad, it decapitates itself by reducing both personal income and personal income tax revenues.

What is Supply-Side economics? Supply-Side economics is a correction to Keynesian demand-side economics. In Keynesian theory, the supply function is fixed and changes only very slowly with technology and discovery of new resources. Supply is passive and aggregate demand, the summation of consumer demand, investment demand, and government demand determine employment and economic growth.

If consumer and investor demand are insufficient to maintain full employment, the Keynesians say that the government can add to demand by running a deficit in its budget. The government can create a deficit by holding spending constant and cutting taxes, or it can hold taxes constant and overspend the revenues. The Keynesian policymakers preferred the latter fiscal policy, because it let them expand the size and responsibilities of government. In other words, Keynesians could use their employment policy also for social engineering. Content in this role, they didn’t think about the supply-side of the economy.

It was the neglect of the supply-side of the economy that had produced stagflation, which required a rising rate of inflation in order to maintain full employment. Supply-Side economics showed that the Keynesian picture was incomplete and corrected it. Keynesians emphasized that fiscal policy impacted aggregate demand. Supply-Side economists showed that fiscal policy directly impacts aggregate supply.

The Keynesian policy of pumping up consumer demand with easy monetary policy while suppressing the response of output with high marginal tax rates resulted in prices rising more than output. This is the explanation of stagflation. As Assistant Secretary of the US Treasury in charge of US domestic economic policy, this was my challege.

Supply-side economics says that the aggregate supply schedule is not dependent merely on technology and discovey of new resources. The ability to produce is also determined by the incentive effects of tax rates.
The supply of labor is dependent on choices on the margin between work and leisure, and the supply of savings is dependent on choices between current consumption and future income.

Supply-side economics introduced into macroeconomic policy the valid point that the cost of leisure is the foregone income from not working and that the cost of current consumption or immediate enjoyment is foregone future income from not saving and investing.

In other words, taxation is a cost of production. A high marginal tax rate on labor makes leisure inexpensive in terms of after-tax foregone income from not working A high tax rate on saving makes current consumption cheap in terms of foregone future income.

In other words, Supply-Side economics introduced microeconomics into macroeconomics and should have won a Nobel prize.

Keynesian demand management relied on easy monetary policy to stimulate consumer demand and relied on high tax rates to reduce purchasing power and restrain inflation. The result was that the high tax rates curtailed output while the easy monetary policy pushed up consumer demand. The result was that prices rose.

The Supply-Side policy was a tremendous success. The US economy has not experienced worsening “Phillips curve” trade offs between inflation and employment since the Reagan economic program went into effect. Stagflation is a problem of the past until new policy errors revive it.

Yet, this entire story is totally missing in the Wikipedia account of Supply-Side economics.

In 1989 I wrote an assessment published by the Institute for Political Economy of the results of Reagan’s supply-side policy. It was republished in The Public Interest, by a think tank in England, and in peer-reviewed premier economic publications in Germany and Italy, such as Zeitschrift fur Wirtschaftspolitik and Rivista Di Politica Economica.

Despite the abandance of factual information, propaganda has prevailed.

Here is my assessment of the Reagan Administration’s Supply-Side policy as I wrote it in 1989:

Supply-Side Economics, Theory and Results: An Assessment of the Amercian Experience in the 1980s

Paul Craig Roberts

Republished from January 1989


Printed in the United States

Permission to quote from or to reproduce materials in this publication is granted when
due acknowledgement is made

Table of Contents

Chapter I – Introduction 1
Chapter II -Theory of Supply-Side Economics 4
Chapter III – Some Empirical Studies of the Relative
Price Effects of Fiscal Policy 9
Chapter IV – Implementation and Results of Supply-Side
Economics in the United States 15
Chapter V – Conclusion 33
References 37
About the Author 40

I. Introduction
When John F. Kennedy was elected President of the United States in 1960, Keynesian demand management entered its American heyday. Keynesianism had been entrenched in the universities for a decade or more, and a generation of journalists and civil servants had been in­culcated in its principles. There were few critics, and no one paid them any attention. Demand management had free reign and rode off into stagflation and political destruction during the administration of Presi­dent Jimmy Carter.

Two decades later when Ronald Reagan was elected President, another fiscal revolution occurred, but this time few people and prac­tically no academics were familiar with the supply-side principles at its core. It was a policy born in the congressional budget process and frustrations with stagflation and worsening trade-offs between inflation and unemployment. In the autumn of 1978 the Democratic Congress passed what was later known as Reaganomics – tax rate reductions combined with reductions in the growth of federal spending – but the measure was killed by President Carter’s announcement that he would veto the measure. Nevertheless, the Congress rejected the Carter­ Administration’s tax reform legislation, designed to close “loopholes” without lowering tax rates, and cut the capital gains tax rate. The supply­-side revolution had begun.

In its 1979 Annual Report and again in 1980, the Joint Economic Committee of Congress called for the implementation of a supply-side fiscal policy. During the 1980 presidential campaign the Senate Finance Committee endorsed a supply-side tax cut. The Democrats in the Senate wanted to be identified with the new policy. However, they refrained from passing the tax cut before the presidential election, because it would appear to be an endorsement of Republican Ronald Reagan over their own candidate. The Senate leadership decided to wait until after the November election to pass the tax cut. Unexpectedly, Reagan’s victory also cost the Democrats control of the Senate, and the tax cut issue was delivered firmly into Republican hands.

The Reagan White House, with the exception of Martin Anderson, was staffed with people who were unfamiliar with the change in economic thinking that Congress had undergone in the previous four years. Gratuitously uninformed and confident from control of the Senate, the White House staff maneuvered to deny congressional Democrats any credit for the 1981 tax rate reduction. When Democrats in the House of Representatives saw that they were being denied a part in the historic legislation in order to give President Reagan a political “victory,” they devised their own tax cut. It was just as supply-side in content as the administration’s. Indeed, there was no way to differentiate the two bills politically until Reagan decided to add the indexation of the personal income tax (beginning in 1985) to his measure.

While White House political neophytes were threatening the new policy by denying the Democrats any credit, conservatives, who wanted a rapid victory over inflation at any cost, permitted a disastrous monetary policy during 1981-82. Encouraged by political conservatives, the New York bond houses, and its own fears over inflation, the Federal Reserve inflicted the severest recession in the postwar era. These two er­rors combined to create a political problem for Reagan. He had picked a fight with Democrats over an issue they were willing to support and claimed a victory over them just as the economy entered deep recession. The Democrats and their allies in the media were quick to take revenge, and budget deficits resulting from the recession were blamed on Reagan’s tax cut before the rate reductions were even phased in. By January 1982 large deficits were being attributed to Reagan’s supply­ side policy even though the first significant cut in taxes was not effective until July 1982 and the second cut was not scheduled until July 1983.

The lack of understanding outside the Congress of the nature of the new policy allowed both opponents and proponents of supply-side economics to caricature it, often ruthlessly, as the belief that across-the­ board tax rate reductions are self-financing. Today the policy is widely misunderstood as the belief that tax cuts pay for themselves in increased revenues. This misunderstanding has made it easy for the budget deficits to be blamed on the 1981 tax rate reduction.

The “Laffer curve” was confined to political rhetoric and jour­nalistic caricatures. It played no analytical role in the development of a supply-side economic policy in the U.S. Congress during 1975-80 or in the development or implementation of the Reagan Administration’s economic policy. No one ever proposed to cut only the top tax rates, and the supply-side policy was not designed to secure more revenues for the government or to balance the budget.
The supply-side policy was directed toward overcoming the economy’s inability to grow without rising inflation and toward revers­ing the decline in the competitive position of the U.S. During the 1970s productivity growth declined sharply. Policymakers were confronted with worsening “Phillips curve” trade-offs between inflation and unemployment, ending in both rising inflation and unemployment. In 1971 the U.S. merchandise trade deficit turned negative and grew dramatically during the latter part of the decade despite the continuous fall in the dollar exchange rate.

Keynesian economists could not explain these developments or of­fer elected policymakers an escape from the problems. This failure created an opportunity for supply-side economics, which argued that the policy of pumping up demand while neglecting incentives to produce had resulted in stagflation. As incentives eroded, each additional incre­ment of demand called forth less real output and more inflation. Supply­-siders argued that improved incentives and less costs imposed by govern­ment would result in a greater supply and more efficient use of produc­tive inputs. The supply-side policy is an anti-inflationary one, because its goal is to increase real output relative to demand.
The social welfare implications are clear and were understood by all in the debate over U.S. economic policy that set the stage for “Reaganomics.”

The purpose of this paper is to explain concisely and accurately the analytical and empirical basis of the new fiscal policy and to use freely available official statistics to correct widespread misconceptions of the impact that the supply-side policy has had on the US economy. Reaganomics was more than tax reductions and fiscal policy. It also comprised a monetarist policy and a policy of limited economic deregulation. This study does not deal with the regulatory aspects of Reaganomics, and the discussion of monetary policy is limited to its relationship to the “twin deficits.”

Some of the striking results of Reaganomics were not anticipated. For example, the extraordinary increase in wealth that resulted from the sharp rise in stock and bond prices was not generally expected, because most financial market gurus predicted that inflationary fears would keep the financial markets in the doldrums. The rise in the dollar and the currency’s prolonged strength was not anticipated by forecasters for basically the same reason. In 1981 the economics profession from left to right interpreted supply-side economics as an inflationary policy. The Federal Reserve was advised by its consultants that monetary policy was the junior partner, a “weak sister” that would be overwhelmed by ex­pansionist fiscal policy — predictions which reflected economists’ lack of knowledge of the basis and origin of the new fiscal policy as well as a firm belief in the “Phillips curve.”

II. Theory of Supply-Side Economics

In the U.S. in the 1980s, a second post-war fiscal revolution occurred. Keynesian demand management of the economy was replaced by supply-side economics — a policy that focuses on individual incen­tives. This change represents a fundamental shift in thinking about fiscal policy. In the Keynesian approach, a fiscal change operates to alter demand in the economy. A tax rate reduction, for example, raises the disposable income of consumers, who then spend more. With govern­ment spending held constant, increased consumer spending stimulates supply and moves the economy to higher levels of employment and GNP. In this view, the size of the deficit determines the amount of stimulus.
In contrast, supply-side economics emphasizes that fiscal policy works by changing relative prices or incentives. High income tax rates and regulations are seen as disincentives to work and production regardless of the level of demand. To understand the difference in em­phasis between Keynesianism and supply-side economics, consider the removal of a tariff that is high enough to prevent trade in a commodity. When the tariff is repealed, no revenues are lost, no budget deficits result and no money is put into anyone’s hands. Yet clearly economic activity will expand, because the disincentive is removed. Nothing in demand management captures this effect.

Supply-side economics brought a new perspective to fiscal policy by focusing on the relative price effects. Lower tax rates encourage saving, investing, working, and risk-taking. As people switch into these ac­tivities out of leisure, consumption, tax shelters and working for nontax­able income, the incentive effects cause an increase in the market supply of goods and services – thus the name “supply-side economics.” As people respond to the higher after-tax income and wealth, or greater profitability, incomes rise and the tax base grows, thus feeding back some of the lost revenues to the Treasury. The savings rate also rises, providing more funds for government and private borrowing.

Relative Price Effects of Fiscal Policy

The relative-price argument is straightforward. There are two im­portant relative prices. One governs people’s decisions about how they allocate their income between consumption and saving. The cost to the individual of allocating a dollar of income to current consumption is the future income stream given up by not saving and investing that dollar. The present value of that income stream is influenced by marginal tax rates. The higher the marginal rate, the lower is the value of the income stream. High tax rates make consumption cheap in terms of forgone in­come, and the saving rate declines, resulting in less investment.

The other important relative price governs people’s decisions about how they allocate their time between work and leisure or between leisure and improving their education and skills. The cost to a person of allocating additional time to leisure is the current earnings given up by not working (for example, overtime on Saturday) or the future income given up by not taking courses to improve skills. The value of the forgone income is determined by the rate at which additional income is taxed. The higher the marginal tax rates, the cheaper the price of leisure. Absenteeism goes up, willingness to accept overtime declines, and peo­ple spend less time improving their work skills.

Physicians who encountered a 50 percent tax rate after six months of work were faced with working another six months for only 50 percent of their actual earnings. Such a low reward for effort encouraged doc­tors to share practices in order to reduce their working hours and enjoy longer vacations. The high tax rates shrunk the tax base by discouraging them from earning additional amounts of taxable income. The high tax rates also drove up the cost of medical care by reducing the supply of medical services.

The effect of tax rates on the decision to earn additional taxable in­ come is not limited to physicians in the top bracket. Studies by Martin Feldstein at the National Bureau of Economic Research found that in many cases the tax rates on the average worker left almost no gap be­tween take-home pay and unemployment compensation. Feldstein found that a 30 percent marginal tax rate made unemployment suffi­ciently competitive with work to raise the unemployment rate by 1.25 percentage points and to shrink the tax base by the lost production of one million workers. Blue collar professionals also encounter disincen­tive effects even at “moderate” tax rates. Take the case of a carpenter facing a 25 percent marginal tax rate. For every additional $100 he earns, he is allowed to keep $75. Suppose his house needs painting and he can hire a painter for $80 a day. Since the carpenter’s take-home pay is only $75, he would save $5 by painting his own house. In this case the tax base shrinks by $180- $100 that the carpenter chooses not to earn and $80 that he does not pay the painter.

Studies by Professor Gary Becker of the University of Chicago have shown that capital and labor are employed by households to pro­duce goods and services through nonmarket activities — for example, the carpenter paints his own house. Goods and services produced in this way are not subject to taxation. Therefore the amount of capital and labor that households supply in the market is influenced by marginal tax rates. The higher the tax rates, the more likely it is that people can in­crease their income by using their resources in non-market activities or in the ‘black’ economy. A clear implication of household economics is that marginal tax rates influence the amount of labor and capital that is used to produce taxable income.

The progressive income tax was devised to “soak the rich.” In prac­tice it works as a barrier to upward mobility and discourages people from making their best effort. As a result, the tax system can make it more difficult for the average taxpayer to achieve financial in­dependence. It is this barrier to success that supply-side economists at­ tacked. The greater the extent of private success, the smaller the need for public assistance and the lower the burden of government. Supply-side economics is not anti-government. It simply accepts the fact that government is costly by nature and maintains that the greater the incen­tives and opportunities to earn income, the smaller will be the size and burden of government.

Supply-side economics has also brought a new perspective to the impact of interest rates and taxation on the cost of capital. Traditional­ly, interest rates have been stressed as the important factor in the cost of capital. According to this perspective, higher government revenue from increased taxation can spur capital investment by lowering deficits and interest rates or by building budget surpluses and retiring debt. Recent studies, however, have found taxation to be a major factor in the cost of capital (Roberts, et. al., 1985, 1986a, 1986b, and 1986c). As taxation also reduces investment, the only certain way to reduce “crowding out” is to cut government expenditure.

Some economists argued that the real tax burden is measured by the total amount of resources that the government removes from the private sector by taxing and borrowing. They therefore argued that a tax cut that is not matched dollar for dollar with a spending cut just means the government takes by borrowing what it formerly took by taxing.

The total resources claimed by government is a better measure of the tax burden than tax revenues alone. But this adding up of concrete resources can make us blind to another measure of the real tax burden — the production that is lost to disincentives. It is difficult to see the pro­duction that does not take place because the government has made it un­profitable, but it is nevertheless a part of the tax burden.

From the viewpoint of this more complete measure of the tax burden, a tax cut can be real even if it is not matched dollar for dollar with a spending cut. That is because a reduction in marginal tax rates changes relative prices and causes people to shift into work out of leisure and into investment out of current consumption. These shifts will occur even if people expect that in the future taxes might be raised to pay off any government debt incurred by cutting tax rates. In the meantime, however, the additional work and investment expands the tax base; to make good on the deficit, future tax rates would not have to be raised as much as they were cut. Moreover, if the government did need more tax revenues in the future to pay off debts, it could raise them by some other type of tax, such as a consumption tax, which does not have the disincen­tive effects of high marginal income tax rates.
The importance of supply-side economics lies in its claim that fiscal policy works through relative price changes or incentives. This claim is not an assertion of the “Laffer curve.”

Keynesian Criticism

Keynesians objected to the fiscal emphasis on relative price effects (Roberts, 1984). They argued that the elasticities of response of work and saving to tax rates were zero or negative, and they questioned whether incentive effects would deal effectively with an immediate economic stabilization problem. Neither objection withstood analysis. The long-run consists of a series of short-runs. If policies that are effective over a longer period are neglected because they do not have an immediate impact, and if policies that are damaging over the longer period are adopted because they initially have beneficial results, then policy-makers will inevitably find that they have no solution for the crisis they have provoked. In the U.S. this happened during the period of stagflation in the mid- 1970s.

Some Keynesians argued that the incentive effect of lower tax rates would be perverse. It would let people reach their targeted levels of in­come sooner and, therefore, they would work less. This could be true for individuals but not in the aggregate. If everyone responded to a tax cut by working less, total production would fall and people would not be able to maintain their living standard while working less. The argument that people would take their tax cut in the form of increased leisure undercut the Keynesian interpretation of expansionary fiscal policy just as thoroughly as it undercut the supply-side interpretation that was its target. When Keynesians realized this, they abandoned this argument. The argument that incentive effects are perverse in the aggregate failed, because it was an attempt to aggregate a series of partial equilibrium analyses (individual responses to a change in relative prices) while ignoring the general equilibrium effects.

Today many economists claim that their analysis always incor­porated supply-side effects and that they were only opposed to an alleged claim that the 1981 tax rate reduction would pay for itself. In fact, a decade ago practically every economist was arguing that people respond to incentives in perverse ways. They argued that people have a targeted level of income regardless of the cost of acquiring it, so that a tax cut would allow them to reach their target net income by working less. Lester Thurow, now a dean at Massachusetts Institute of Technology, actually employed this reasoning to argue for a wealth tax. According to Thurow, a wealth tax is a costless way to raise revenue, because the “income effect” runs counter to, and dominates, the “substitution effect.” Therefore, it will cause people to work harder in order to maintain their desired post-tax wealth. Such confused thinking was responsible for the neglect of the relative price effects of fiscal policy in post-war economic management.

Economists were slow to see the flaw in the argument against incen­tives. Take something simple, like an assertion that a fixed work-week precludes adjustment of the labor supply to tax-rate changes. This sounded reasonable enough to many who did not realize that the “ad­justments” were reflected in the quality and intensity of work. Thus higher absenteeism and turnover, longer average duration of unemploy­ment, and labor demands for shorter work-weeks and more paid vaca­tion were all responses to high marginal tax rates on wages and salaries. The Keynesian concept of the economy as an unstable private sec­tor that had to be stabilized by fiscal and monetary policies served as a pretext for the expansion of government. It also served the interests of economists by transforming them from ivory-tower denizens to public­ spirited social activists, a transformation which increased their power and enlivened their life styles. Unemployment can always be said to be too high. And the rate of economic growth can always be judged below “potential.” Before the supply-side challenge to the Keynesian policymakers, there was always a “scientific” economic reason for expanding government spending programs that enlarge the constituen­cies of the Congress and the Federal bureaucracy at the expense of private property rights and economic freedom.

III. Some Empirical studies of the Relative Price effects of Fiscal Policy

A number of economists have assessed the responsiveness of sav­ing, labor force, and tax revenues to changes in tax rates. The following is a brief summary of empirical studies that have found the responses to be significant.


The 1964 Kennedy income tax reductions were intended to increase aggregate demand by stimulating consumption leading to additional em­ployment and output. Marginal tax rates were cut approximately 20 per­cent for each bracket, and corporate tax rates were cut 10 percent. Pop­ular economics textbooks have reinforced the view that the tax cuts in­creased demand and propelled a recovery. However, studies by Paul Evans (1981) and the U.S. Treasury (Roberts, 1984) have found that the recovery occurred despite a fall in the propensity to consume. The evidence shows that after the marginal tax rate reduction went into ef­fect, people spent a smaller percentage of their income. In 1964, actual consumer expenditures dipped below the trend rate. By 1967, consump­tion was at least $17.5 billion below the previous trend — a sum larger than the size of the personal tax cut (measured in constant dollars).

People were actually consuming a smaller percentage of their in­come and saving a larger percentage after the tax rate reduction than before. Following the tax reduction there was a significant increase in the real volume of personal saving, and the personal saving rate rose sharply, reversing the decline begun in the 1960s. The personal saving rate remained high for nearly a decade until demographic changes and rising marginal tax rates pushed it down.

In 1964 real personal saving rose $6.6 billion above the trend pro­jected prior to the reduction in marginal tax rates. The gain in saving was 74 percent of the tax cut. In the next two years saving increased $10.2 billion and $10.8 billion above the previous trend, a gain equal to 72 percent of the tax cut. In 1967 saving was $19 billion above the previous trend — a gain equal to 121 percent of the size of the tax cut.

This increase in saving released resources from consumption, thus allowing a rapid growth in business investment. In real terms, capital spending (for both the expansion of the capital stock and the replace­ment of worn-out stock) had grown at an annual rate of 3. l percent dur­ing the 1950s and early 1960s through 1962. The remainder of the 1960s saw real capital spending rise over twice as fast, increasing 6.8 percent annually. The rate of growth from 1963 to 1966 was especially marked. While growth was high in the corporate sector, small business invest­ment showed the greatest improvements.

The acceleration of investment greatly enhanced the economy’s ability to produce. The net stock of capital had grown 3.5 percent an­nually between 1949 and 1963, but with the tax cuts it rose to a 5.0 per­ cent growth rate for the remainder of the decade. Keynesian economists claim that the investment boom resulted from the investment tax credit passed in 1962, which allowed businesses a direct deduction from their taxes for certain investments. However, the sharp rise in investment could not have taken place if consumers had not released resources from consumption by saving a larger share of their incomes.

Professor Michael Boskin of Stanford University (1978) found that the total elasticity of saving (income and substitution effects combined) was positive at around 0.3 to 0.4. While the size of this response has since been disputed by other studies, Boskin’s elasticities are commonly used in econometric studies. Boskin predicted that raising the after-tax rate of return to saving would “increase income substantially” and “remove an enormous dead-weight loss to society resulting from the distortion of the consumption-saving choice.”

Another interesting conclusion of Boskin’s study is that people will not only respond positively to changes in the relative price of saving or lower tax rates, but also that a larger share of total income will be transferred from capital to labor. Boskin confirms earlier studies in­ dicating that the elasticity of substitution between capital and labor is less than one, so that an increase in the capital-labor ratio (following an increase in saving) leads to a corresponding increase in labor’s share of total income. Boskin wrote that:
“the current tax treatment of income from capital induces an astounding loss in welfare due to the distortion of the consumption/saving choice . . . . Reducing taxes on interest income would in the long run raise the level of income and transfer a substantial portion of capital’s share of gross income to labor.”

Allen Sinai, Andrew Lin and Russell Robins (1983) examined the 1981 tax rate reduction. They found that private saving was influenced by the greater rate of return allowed by lower tax rates and that the economy would have performed much more poorly in 1981-82 had it not been for the 1981 tax rate reduction. They also found that the cash flow effects of the tax cuts reduced the burden of loan repayment and interest charges on debt, thereby strengthening personal and business balance sheets.

Using an augmented Data Resources model of the U.S. economy incorporating previously neglected effects of after-tax interest rates on saving, investment, and consumption, Sinai et. al. estimated that the net tax reductions introduced by the Reagan administration increased business saving by $27 billion during 1981-82 and that personal saving rose $48 billion above the baseline trend in 1982. Sinai et. al. concluded that in the absence of the tax cut, “the U.S. economy would have per­formed considerably worse in 1981 and 1982 than actually was the case,” with an additional loss in real GNP of about 1.6 percentage points. “The evidence indicates that ERTA (the Economic Recovery Tax Act of1981) has had major impact on U.S. economic growth.”

Effects on Revenues

Dr. Lawrence Lindsey (1986) of Harvard University has examined the revenue effects of capital gains taxation. Because capital gains are only taxed when an asset is sold, inclusion of gains in taxable income is largely discretionary from the point of view of the taxpayer. Conse­quently, tax rate sensitivity is greater for capital gains income than for other income types. Lindsey studied the evidence in tax returns from 1965-82. He concludes that capital gains tax revenues are maximized at 20 percent or lower, “with a central estimate of 16 percent.” In response to the Tax Reform Act of 1986 in which capital gains are treated as or­dinary income (except in 1987, when the tax rate on capital gains is limited to 28 percent), Lindsey estimates that taxpayers will respond to the higher tax rates by postponing — in some cases indefinitely — their sales of assets.

Lindsey (1988) has also researched the revenue effects of lowering the top tax rate from 70% to 50%. He found that taxpayers earning over $200,000 per year paid $18.3 billion more in taxes under the new tax code with a top tax rate of 50 percent than they would have been expected to pay under the old rates of up to 70 percent. He continues:
“The evidence also in dicates that upper-middle-income groups may have increased their labor supply dramatically as a result of the tax rate reductions, particularly the labor supply of the secondary earner in the family.”

Lindsey estimates that, “by 1985, the 1981 tax cuts had boosted real economic activity (GNP) by about 2 percent above what it would have been otherwise,” and states, “the equivalent of 2.5 million more people are working today as a result of the supply-side effects of the tax cuts.” He concludes, “the evidence from a wide range of studies shows that taxpayers are highly sensitive to tax rates in many of their economic ac­tivities.”

A U.S. Treasury Department study conducted by Michael Darby (1988) found that the 1978 and 1981 cuts in the capital gains tax rate raised revenue $15 billion by the end of 1985. The study also concluded that the evidence suggested that a capital gains rate reduction “from current high levels” would raise federal tax revenues. Moreover, in 1987 after the capital gains tax rate went up, many states including Massachusetts, New York, and California experienced an unexpected drop in revenues. Massachusetts projected a $430 million budget deficit for 1988 of which, according to Robert Tannenwald of the Federal Reserve Bank of Boston, one-fifth to one-third is due to the loss of revenues caused by the higher capital gains tax rate.

Professors James Gwartney and Richard Stroup (1982) have ex­amined the changes in the distribution of the tax burden following the Mellon tax cut of the 1920s and the Kennedy tax cuts of the 1960s. In the case of the Mellon tax cuts, named after Treasury Secretary Andrew Mellon, marginal tax rates that reached 73 percent in 1921 were reduced to a top rate of 25 percent by 1926. The effect on the economy was positive: “The economy’s performance during the 1921-26 period was quite impressive. Price stability accompanied a rapid growth in real out­put.”

Gwartney and Stroup found the shift in the tax burden equally im­pressive. By 1926 personal income tax revenues from returns reporting $10,000 or less dropped to 4.6 percent of total collections, compared to 22.5 percent in 1921. In contrast total income tax revenues from returns by people with incomes of $100,000 or more rose to 50.9 percent in 1926 from 28.1 percent to 1921. They conclude that “as a result of the strong response of high-income taxpayers, the tax cuts of the 1920s actually shifted the tax burden to the higher income brackets even though the rate reductions were greatest in this area.”

Their analysis of the Kennedy tax rate reductions (which cut the top rate from 91 to 70 percent) yields similar results. In 1965, after the tax rate reductions, collections from the highest 5 percent of income earners rose to 38.5 percent of the total from 35.6 percent in 1963. In contrast, the proportion of income tax revenues from the bottom 50 percent of tax returns fell from 10.9 percent in 1963 to 9.5 percent in 1965.

In testimony before the Joint Economic Committee of Congress in 1984, Gwartney noted that the Economic Recovery Tax Act of 1981 (ER­TA) yielded similar results. The reduction of the top marginal tax rate from 70 to 50 percent cut the tax rates paid by high-income earners by as much as 28.6 percent, but tax revenues collected from the rich increased. Revenues from the top 1.36 percent of taxpayers, the group that most benefited from the rate reductions, rose from $58.0 billion in 1981 to $60.5 billion in 1982. The proportion of the total income tax collected from the top 1.36 percent of taxpayers rose to 21.8 percent in 1982 from20.4 percent in 1981.

The tax liability of low-income taxpayers fell both in absolute terms and as a percentage of the total. Taxes paid by the bottom 50 percent of income earners fell from $21.7 billion in 1981 to $19.5 billion 1982, and the share shrank from 7.6 percent in 1981 to 7.0 percent in 1982. Gwart­ ney concludes that:
“far from creating a windfall gain for the rich, as some have charged, ERTA actually shifted the burden of the income tax toward taxpayers in upper brackets, including those who received the largest rate reductions as the result of the 50 percent rate ceiling.”

This seems to be a general conclusion supported by the empirical evidence from marginal income tax rate reductions in the United States. A Joint Economic Committee staff study, “The Mellon and Kennedy Tax Cuts: A Review and Analysis” (1982), found that tax cuts in the 1920s and 1960s led to a rise in tax revenue, particularly from the rich. During the decade of the 1920s despite, or because of, the tax cuts, Treasury Secretary Mellon was able to pay off 36% of the national debt.

Effects on Employment and Effort

Massachusetts Institute of Technology economist Jerry Hausman has devoted much time and energy to studying the effect of taxes on work decisions. In a Brookings Institution study, Hausman (1981) reports the following:
“Although income and payroll taxes account for 75 percent of federal revenues, most economists have concluded that they cause little reduction in the supply of labor and do little harm to economic efficiency. The results of this study contradict that comforting view. Direct taxes on income and earnings significantly reduce labor supply and economic effi­ciency. Moreover, the replacement of the present tax structure by a rate structure that ­ proportionally taxes income above an exempt amount would eliminate nearly all of the distor­tion of labor supply and more than half of the economic waste caused by tax-induced distor­tions.”

In another study Hausman (1983) finds that, using 1975 data, labor supply was 8.2 percent lower than it would have been without federal in­come taxes, FICA taxes, and state income taxes. He notes in particular that:
“the effect of the progressiveness of the tax system is to cause high wage individuals to reduce their labor supply more from the no tax situation than do low tax individuals….Of course, this pattern of labor supply has an adverse effect on tax revenues because of the higher tax rates that high income individuals pay tax at.”

Measuring the effects on labor supply of the tax system and of a 10 and 30 percent reduction in marginal income tax rates, Hausman reports that a person earning a nominal wage of $3.15 an hour worked 4.5 per­ cent less than he would have in the absence of taxes. He would choose to work 0.4 and 1.3 percent more after 10 and 30 percent tax rate reduc­ tions. As income increases, the responses get larger. Taxes cause a per­son earning $10 an hour to reduce the number of hours worked by 12.8 percent. A 10 and 30 percent reduction would induce him to increase his work time by 1.47 and 4.6 percent, respectively.

Another interesting result of Hausman’s work is his calculation of the “dead-weight loss” incurred by the imposition of the progressive in­come tax system. He defines dead-weight loss as the amount an in­dividual would need to be given to be as well off after the tax, less the amount of tax revenues raised. Hausman found that there was an average dead-weight loss equivalent to 22.1 percent of tax revenue col­lected, which is income that is “lost” because of taxes. As income in­creases, so does dead-weight loss. A person earning $10 an hour, accord­ing to Hausman, has a dead-weight loss of 39.5 percent of tax revenue.

The impact of income maintenance programs on the work effect of low-income earners also clearly demonstrates the relative price effects of taxation explained by supply-side economists. The Seattle/Denver In­come Maintenance Experiments (SIME/DIME) were the fourth and most comprehensive of the experiments undertaken by the government in the 1960s and 1970s to examine the effects of a cash transfer program or negative income tax on low-income earners. People were given cash transfers of varying amounts, which guaranteed them incomes whether they worked or not. Their incomes were taxed so that when they began earning income above a certain level, the subsidy was gradually reduced to zero. The purpose of the study was to determine whether a cash transfer would be a more efficient way to transfer income to the poor than the variety of welfare programs already in existence.

The negative income tax lowers the relative price of leisure and, not surprisingly, the SIME/ DIME results, published in May 1983, show “a significant negative effect on hours worked per year.” Married males participating in the three-year cash transfer programs worked an average of 7.3 percent less than they would have in the absence of the negative income tax. Those who participated in the five-year program reduced their labor supply 13.6 percent, demonstrating that work disincentives rise with the permanence of income support programs. Wives and female heads of households showed a larger response to the cash transfer program.

When the cash transfer experiment ended, the report noted that labor supply increased:
“By the end of the first post-treatment year, labor supply for NIT-eligible husbands had again returned essentially to the same level as that for controls, indicating strongly both that the observed response was indeed a result of the treatment and that husbands can adjust their labor supply fairly rapidly to changed incentives.

Today in the U.S. no serious economist any longer denies the relative price effects of taxation. The arguments no longer dispute their existence but their precise magnitude. The supply­ side won, and the Keynesian emphasis that focused exclusively on the in­come effects of taxation has been superceded by a broader appreciation of fiscal policy.

IV. Implementation and Results of Supply-Side Economics in the United States

In August 1980 during the U.S. presidential campaign, the view of reputable economic forecasters was that tax revenues in succeeding years would be growing much faster than government expenditures, resulting in rapidly growing budget surpluses within three years. The Congressional Budget Office forecast a surplus of $37 billion in 1983, rising to $96 billion in 1984 and $175 billion in 1985. Reagan’s campaign ad­visers decided to take advantage of these surpluses and hook his presidential candidacy on the emerging supply-side movement in the Congress. These surpluses were calculated allowing for normal growth in government spending and a 40 percent increase in the defense budget during 1981-85 (Anderson, 1988).

The Republicans promised that instead of creating new government spending programs, they would return the money to the taxpayers by cutting tax rates. Despite the tax reductions, both revenues and expenditures would continue to grow absolutely, but the growth of both would be slowed and would decline as a share of GNP, reaching a goal of
19.3 percent of GNP in 1984 and a balanced budget.

In August 1981, President Ronald Reagan signed into law an across the board 25 percent cut in personal income tax rates to be phased in over three years with a provision to index the personal income tax in 1985 to prevent inflation from pushing taxpayers into higher tax brackets. In 1986, the President signed a tax reform bill further reducing personal in­come tax rates with a top statutory rate of 28 percent (33% for some up­per income ranges), down from 50 percent in the 1981 bill.

The 1981 bill also substantially reduced the taxation of business in­come. Tax rates were cut, and accelerated depreciation expanded business saving. In 1982 the Administration, panicked by the unexpected recession and large budget deficit, agreed to a tax increase that limited the benefits of accelerated depreciation and the investment tax credit. Despite the 1982 tax increase, depreciation was more rapid and business income was less heavily taxed than it was before the 1981 tax cut. In 1986 tax rates on business income were further reduced. However, the invest­ment tax credit was repealed, and depreciation periods were lengthened. The overall impact of the 1986 bill is yet to be calculated. The 1986 bill was motivated in part by an effort to reduce the tax distortions that influence the choice of investments. It ignored the more fundamental problem of the tax bias against saving that reduces the overall level of investment due to the multiple taxation of income from saving (Roberts, 1986a). Nevertheless, in the 1980s business saving is up sharply as a share of GNP.

Despite predictions of rampant inflation, the Reagan economy was more successful than anyone thought possible. The Reagan expansion has not experienced the worsening “Phillips curve” tradeoff between employment growth and inflation that led to President Carter’s in­famous declaration of “malaise”. Despite the longest peacetime expansion
on record and 17 million new jobs, there has been no rise in the in­flation rate.

It is instructive to compare the Reagan recovery to the previous recovery. In the 58-month period from March 1975 through January 1980 (the beginning and end of the expansion from the 1974 recession), the unemployment rate fell 27 percent, the consumer price index (CPI) rose 48 percent, and gross private domestic investment rose 50 percent (1982 dollars). In contrast, during the first 58-month period of the Reagan expansion, (from November 1982 through September 1987), the unemployment rate fell 45 percent (about twice as much), the CPI rose 17 percent (only one-third as much), and gross private domestic invest­ ment grew 77 percent (about 50% more).

The Reagan economy is remarkable in many other ways. It has pro­duced the highest manufacturing productivity growth in the postwar period, averaging 4.6% annually since the recovery began in 1982, com­pared with 2.3% in the 1970s, 2.7% in the 1960s, and 2% in the 1950s. Since the Reagan recovery began, per capita real disposable personal in­come has grown 2.6% annually, compared with 1.8% in the 1970s, 3% in the 1960s, and 1.5% in the 1950s.

Moreover, the evidence shows that the tax burden has shifted up­ward in the Reagan years. The latest Treasury Department data show that between 1981 and 1986 the share of federal income taxes paid by the richest 1 percent rose from 18.1 to 26.1 percent — a 44 percent increase — while the share of taxes paid by the bottom 50 percent fell from 7.5 to 6.4 percent.

The Twin Deficits

Despite these successes, supply-side economics has been given a bad name as a result of the budget and trade deficits. Supply-side’s critics have blamed the deficits and the crisis of the day (the strong dollar, the weak dollar, the October 1987 stock market crash, the trade deficit, deb­tor nation status) on the 1981 tax rate reduction. Inevitably, they ad­vocate an increase in taxes as a panacea.

The administration’s embarrassment over the deficit was com­pounded by its delay in explaining the deficit. This failure resulted from an act of political opportunism and allowed the President’s critics to control the explanation of his policy for almost three quarters of a decade.

An objective account of the “twin deficits” must include the role of monetary policy. In early 1981, the Reagan administration asked the Federal Reserve to gradually reduce the growth rate of the money supply by 50 percent over a period of four to six years. Instead, while warning of future inflation from the tax cuts, the Fed collapsed the growth of the money supply and delivered 75 percent of this reduction in 1981. By 1982 inflation was at the low rate the Administration had predicted for 1986.

The result was the most severe recession in the postwar era and a totally unexpected collapse in the growth of nominal GNP . During 1981-86, nominal GNP was $2.5 trillion less than forecast (Roberts, 1987). The loss of revenues from this collapse of the tax base had not been an­ticipated, and the result was large budget deficits. Only in February 1988, did the Budget of the U.S. Government for Fiscal Year 1989 finally acknowledge that the large budget deficits that have plagued Reagan had originated in the “1981-82 economic downturn and the concomi­tant decline in the inflation rate.”

In early 1982, however, the Administration decided to take credit for the rapid fall in the inflation rate despite the fact that its economic and budget plans had predicted no such result. This attempt to claim credit prevented the Administration from holding the Federal Reserve responsible for wrecking the budget and left the White House with “triple-digit” deficits hanging around Mr. Reagan’s neck. The Ad­ministration never recovered from this public relations fiasco.

In October 1987 the Treasury Department study, “Accounting for the Deficit,” belatedly documented that “the business cycle and com­pounding high interest rates – not changes in tax structure or program­matic spending – are the major causes of the major 1982-83 jump in the federal deficit.”

The Treasury study breaks the deficit down into its three com­ponents: structural, cyclical and net interest, which is net of the taxes the government collects on the interest it pays. The structural deficit, the gap between expenditures and receipts at full employment, is the smallest component. Only during 1984-86 did the federal structural deficit ap­proach the levels it frequently reached during the 1966-76 period. On a general government basis, which includes state and local budgets, the budget has been in structural surplus almost continually since 1977. This empirically refutes the propaganda that the tax cuts caused a structural deficit.

In contrast, the cyclical and net-interest components of the deficit are large. Beginning in 1980 the Federal Reserve’s high-interest-rate policy and the large cyclical deficits from the recession greatly increased the net interest component. By 1987 net interest accounted for two­ thirds of the federal deficit.

Critics have charged that these high interest rates were caused by the budget deficits. The truth is that high interest rates preceded the large deficits. An inverted-yield curve, with short-term rates above long-term rates, characterized the economy in 1979, 1980, and 1981. The inverted­ yield curve is an unmistakable sign that high interest rates were caused by stringent monetary policy. The federal-funds rate, an overnight rate set by the Fed, was higher than the interest rate on long-term triple-A cor­porate bonds from October 1978 to May 1980, from October 1980 to Oc­tober 1981, and from March 1982 to June 1982. In April 1980 the federal­ funds rate exceeded the corporate bond rate by 5.57 percentage points and in December 1980 by 5.69 percentage points. In January 1981, when Mr. Reagan was inaugurated as President, the gap peaked at 6.27 percentage points. Overall, interest rates peaked in 1981 with the budget deficit unchanged from its previous year’s level. The budget deficit peaked in 1986 at three times the size of the 1981 deficit, with the federal funds rate only one-third as high as it was in 1981.

The President and some of his supporters have attributed the budget deficit and debt buildup to Congress’ refusal to abide by its own budget rules. Few have been convinced. Although Congress has set aside the Budget Control Act of 1974 and discarded the budgets submitted by the Reagan Administration, congressional overspending does not add up to the amount of the cumulative deficit.

Early in 1982, the White House decided to put the tax cuts at risk in order to protect the Federal Reserve’s unexpectedly tough anti-inflation policy. Despite its supply-side tone, the administration could not bring itself to discard the Phillips curve inverse relationship between unemployment and inflation. It was an election year, and there was a fear that Congress would force the Fed to reflate, thus adding to infla­tionary pressures and confirming opponents’ charges of “in flationary tax cuts.” As an internal Office of Management and Budget document put it, “the recession must not be blamed on the Fed” (Roberts, 1984). By adopting this tactic, the White House ensured that its fiscal policy would be blamed for the deficit.

This tactic did not serve public policy well. It turned the deficit into a political “football” and pre-empted rebasing the budget to take into account the lower than expected growth path of nominal GNP. In ef­fect, the budget deficit became a political weapon of value to many participants in the political process. Congressional Democrats, who had been denied credit for the tax cut by Reagan’s White House staff, used the deficit as a weapon against Reagan’s supply-side policy. So did Keynesian economists, who were bitter about the eclipse of their in­ fluence on public policy by up-start supply-siders. So did the Republican Establishment, who resented the takeover of “their” party by populists Ronald Reagan and Jack Kemp. So did some monetarists, who wanted to consolidate “their” victory over inflation by shifting the public’s perception of its budgetary cost to the supply-side tax cut. In turn, Presi­dent Reagan and some of his staff used the deficit as a weapon against the spending proclivities of the Congress, which systematically buys votes with taxpayer dollars.

Various politicians, elected and appointed, used the deficit to great­ly enhance their public visibility. Regardless of which side of the argu­ment a person was on, deficit-mania became a ticket to fame. The deficit was far too valuable politically for either side to have much interest in eliminating it. Moreover, once rival wielders of the deficit weapon realized that the predicted dire consequences of the deficit never materialized, there was no incentive for any party to accept responsibili­ty for the deficit and to give up its political value and the gains it pro­tected.

Unlike some countries, the budget process in the U.S. is not con­trolled by the executive branch of government. The U.S. Treasury Secretary has no power over the government’s budget. Within the ex­ecutive branch of government, authority over the budget resides in the White House’s Office of Management and Budget (0MB). This office, supposedly, has authority over the various federal agencies and depart­ments and coordinates the separate budget submissions into a budget for the U.S. Government, which is submitted to Congress.

Congress can do what it likes with this budget, and usually does. When Congress’ priorities prove unacceptable to the executive branch, the President’s only real power is that of the veto, which can be over­ ridden by a two-thirds vote. During most of Reagan’s presidency, Con­gress prevented him from using his veto by combining formerly separate appropriations into a single massive bill that was delivered to the White House only hours before the U.S. government was scheduled to shut down from lack of funding and/or the Treasury was faced with default on its bonds (Roberts, 1988). The only prospect Reagan had of im­mediately reducing the deficit was to give up his one real achievement – the marginal tax rate reductions. Neither Reagan nor his Treasury Department believed that the net budgetary gain from higher taxes would offset the adverse effects on the economy. Neither did the U.S. Congress, which made no effort whatsoever to roll back the Reagan tax cut. Had they wanted to, the Democrats could have easily repealed the 1981 tax legislation over the President’s veto.

Whatever the merits of shielding the Fed from responsibility for the deficit, it gave rise to blaming the deficit on the tax cut, an erroneous argument with three formulations:

1) Claim: The administration made a “Laffer curve” forecast that the tax cuts would pay for themselves.

Fact: On February 18, 1981, the administration presented its policy proposals in an official publication titled “America’s New Beginning: A Program for Economic Recovery.” It included a table showing the Treasury’s forecast that its tax cut proposals would lose $718.2 billion in tax revenues over the 1981-86 period. The budget was based on a tradi­tional static revenue estimate that the tax cuts would lose revenues dollar for dollar. The loss of revenue from the tax cuts was fully anticipated in the budget.

It requires neither academic research nor investigative journalism to discover this fact in official government documents. Yet, Martin Anderson (1988) documents that respected academic economists such as Martin S. Feldstein, Walter S. Salant, Alan S. Blinder, William H. Branson, Robert M. Solow, and Herbert Stein were among the many who spread the erroneous accusation that the Reagan Administration made a “Laffer curve” forecast.

2) Claim: The administration made a “rosy” forecast that assumed tax cuts would provide unrealistic economic growth.

Fact: The administration forecast lower rates of economic growth than the economy had attained during the 1976-80 period of “stagfla­tion.” Moreover, the Reagan Administration’s forecasts of economic growth was substantially lower than those of both previous Presidential administrations and not sufficiently better than President Carter’s final forecast in January 1981 to show much stimulative impact from the tax cut. The Reagan forecast originally was labeled “rosy” because it com­bined economic growth with falling inflation – an impossible combina­tion according to the Phillips-curve theorizing of the time. It is precisely this “rosy” aspect of the forecast that proved true. The forecast failed to predict the deficit not because it was optimistic, but because it was pessimistic about inflation.

The administration was influenced by the concept of “core inflation.” This maintained that inflation was deeply ingrained and could only gradually recede. Consequently, when the Federal Reserve reduced inflation below the administration’s forecast, the budget plan collapsed. The spending cuts that were achieved in 1981 were turned into in­creases in real outlays, and revenues projected on a “core inflation” basis failed to materialize. (The Treasury objected to the core inflation forecast but could not overcome the coalition of Phillips curve analysts in the Office of Management and Budget and Council of Economic Ad­visors.)

3) Claim: The administration cut taxes deliberately to create large deficits, which it hid from view with a rigged forecast, in order to create political pressure against government spending. Senator Daniel Patrick Moynihan (Democrat, New York), former budget director David Stockman, Nobel Laureate F.A. Hayek, and a number of academics and journalists have helped to spread this view of a duplicitous Reagan team. (See, for example, Tom Wicker, “A Deliberate Deficit,” The New York Times, July 19, 1985, p.A27.) M.I.T. professor Olivier Blanchard’s claim (1987) that President Reagan lost his political bet that “cuts in taxes would create, via deficits, the political pressure to reduce government spending” is an example of the uninformed, careless speculation that characterizes academic analysis of Reaganomics. Moreover, it is one-sided speculation. One could just as well say that Congress lost its bet that deficits would lead to higher taxes and a political defeat for Ronald Reagan.

Fact: The notion that the professional staffs of the Treasury, the Council of Economic Advisers, and the Office of Management and Budget, along with the political appointees, could be organized in a con­spiracy to rig a phony forecast in the most leak-prone administration in history is so farfetched that it is inexplicable that U.S. Senators, Nobel laureates, and M.I.T. professors can profess to believe it. Moreover, it is demonstrably false. The original deficit forecast failed because it overestimated inflation and the nominal growth path of GNP. If the “core inflation” theory had proved to be true, or if the Federal Reserve had brought inflation down more slowly in keeping with the forecast, the large deficits would not have materialized.

To see why this is so without having to work through the arithmetic of the budget, assume that the administration made a Laffer-curve forecast and greatly overestimated the revenue reflows from the tax cut. In this event, one would expect revenue collections as a percentage of GNP to fall dramatically below projections. This did not happen. The Reagan deficits are associated with a sharp increase in government spending as a percentage of GNP. Tax cuts can cause revenues to fall, but they cannot cause federal spending to rise as a share of GNP. Only programmatic spending increases and cyclical factors can cause the government’s budget to grow faster than the economy. In the case of Reagan’s deficits, or more accurately Volcker’s deficits, the collapse of inflation relate to forecast lowered GDP relative to the spending levels in the budget that were based on a higher nominal GDP forecast. In other words, the collapse of inflation resulted in real government spending being higher than intended.

Disinflation and the Deficit

The Reagan administration’s reluctance to criticize the Federal Reserve resulted from a genuine sense of relief that inflation collapsed. Yet, this collapse had enormous economic, political, budgetary and social costs that are still being felt. The farm crisis is one example of the enormous costs of unanticipated disinflation. Lower crop prices, higher mortgage rates, and lower inflation led to a 46% decline of farm land values since 1979. (In 1979 the average value of farm land and buildings per acre was $1053 (1988 dollars) compared to $564 in 1988.)

The unexpected pace of disinflation helped to enlarge the deficit in more ways than one. Direct government payments to farmers soared from $1.3 billion in 1980 to $17 billion in 1987. During Reagan’s first term farm income and price supports were the most rapidly growing compo­nent of the federal budget. The social costs of the farm crisis were also devastating. In Nebraska, for example, the percentage of farmers suf­fering psychological disorders increased from 10 percent in 1981 to 22 percent in 1986, causing some who lost their land to murder their inno­cent bankers. (See, for example, “The Iowa, Mental Anguish Still Racks Families, Taxes Social Workers, Even as Farm Crisis Abates,” The Wall Street Journal, May 18, 1988, p.70, and Roberts 1986b.) The ripple effects of unexpected disinflation in the farm, real estate, and energy sectors are still threatening the stability of the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation. Current estimates are that a federal budget expenditure of $100 billion is required to make good the federal guarantees of the Federal Savings and Loan Insurance Corporation alone. In the face of these almost daily revelations of the budgetary con­sequences of unanticipated disinflation, it is extraordinary that people still ask why Reagan did not offset the deficit. The very question reflects an insouciance to facts and process that is unimaginable to an informed person.

On the international scene, the 1981 tax reduction, even after subse­quent tax increases, improved the climate for investing in the United States. Additional credit was needed to facilitate new investment. The Federal Reserve refused to accommodate the increased demand for dollars and allowed the dollar to appreciate sharply. That action, in turn, produced the trade deficit. Moreover, the stringent monetary policy curtailed U.S. bank lending abroad by making it clear that the forecasts of rising commodity prices, such as oil and copper, which had been the basis for the loans, would not materialize. Without an infusion of new funds, debtor countries have been unable to service their debts, adding more strains to the world financial system.

The Capital Account

Critics of the Reagan economic program point to the twin deficits and to a decline in the personal saving rate as evidence that the tax rate reductions, far from being a supply-side policy, launched a Keynesian consumption boom that has left America awash in debt at the expense of future living standards.

One strand of the argument is that America is dependent on foreign capital to finance the budget deficit. Table 1 permits a different explana­tion: instead of exporting our capital, we are financing our own deficit, while foreign capital inflows finance the investments that foreigners want in the U.S.

Between 1982 and 1983, when the net identified capital inflow shifted from negative to positive, foreign capital inflows into the U.S. actually fell by $9 billion. The change in the capital account resulted from a $71 billion fall in U.S. capital outflows. And over the 1982-84 period – the time when the story of massive foreign money pouring into the U.S. from abroad was firmly fixed in the world’s consciousness – there was no significant change in inflows of foreign capital into the U.S., but capital outflows collapsed from $121 billion to $22 billion, a decline of 82 percent. This collapse in U.S. capital outflows is clearly the origin of the large trade deficit, which by definition is a mirror image of the capital surplus. Only in 1986 — the year of the falling dollar and low U.S. interest rates — was there a dramatic jump in foreign capital in­flows. The falling dollar and interest rates may have worried foreign in­ vestors in U.S. financial assets, but real investment in the U.S. was very attractive to foreigners.

What caused the collapse in U.S. capital outflows? The business tax cut in 1981 and the reductions in personal income tax rates in mid-1982 and mid-1983, together with less attractive investment opportunities in foreign countries, especially in the Third World, raised the after-tax rate of return on real investment in the U.S. relative to the rest of the world. Therefore, instead of going abroad, the money stayed home.

U.S. Deficit in Perspective

The memoirs of former Treasury Secretary and White House chief of staff Donald T. Regan (1988) reveal that most of President Reagan’s political appointees believed that “his agenda was unfashionable.” They feared that their support for Reagan’s agenda would give them a bad press and damage their future careers. Consequently, they added their voices to those of the President’s opponents decrying his economic policy. On January 14, 1983, the anti-Reagan newspaper, the Washington Post, asked what the President thinks “when he reads the latest bulletin (co-authored by his advisers without attribution) an­nouncing that nobody in the country agrees with the President’s economic policies.”

In a famous article published in the December 1981 issue of The Atlantic Monthly, William Greider, a well-known left-wing journalist who was assistant managing editor of the Washington Post, revealed that he had established a “leak” relationship with David Stockman, Reagan’s director of the Office of Management and Budget during his first term. Greider’s article, “The Education of David Stockman,” ap­peared at the moment of the Reagan Administration’s greatest political crisis. An unexpected recession had dramatically altered the deficit outlook, and Stockman was driving Reagan toward calling for a large tax increase in the January 1982 budget. On the heels of the tax-cut vic­tory of the previous August, such a major change in policy would have destroyed Reagan’s credibility and made him a one-term President. Nevertheless, Stockman pulled out all stops and used Wall Street, establishment Republicans and the media in his effort to raise taxes. Greider’s article added to the momentum by damaging the credibility of Reagan’s supply-side policy with the public. He drew on his recorded, regular, secret meetings with Stockman and revealed that early in 1981 the President’s own budget director had accused the supply-side policy of being a “Trojan horse,” a trick to cut taxes for the rich. Despite these extraordinarily damaging false accusations, Stockman was not removed from office and used his pulpit for more than three more years to create public myths about the origin and consequence of the “Reagan deficit.” The fact that a new policy could survive such extreme disloyalty is a testament to the lack of an alternative.

One of the most influential myths is that the U.S. budget deficit is consuming the investment resources of the globe. European leaders, quick to appreciate any scapegoat offered by Americans, seized on this fantasy as the reason why investment and employment in their own economies was low. This guaranteed that the U.S. “deficit imbalance” would be a concern of successive economic summits, endowing the im­balance” with a long media life. Whereas in fact the OECD’s data showed that the U.S. deficit was less than the average for the OECD as a percent of GNP.

The OECD publishes data on “internationally comparable general government budget balances.” This definition encompasses central, regional and local government balances, as well as social security finan­cial balances, and is claimed by OECD to represent the “most widely accepted basis of measurement … for international comparisons.” Recent data, along with long-term averages and the latest OECD forecasts from the May 1988 “Economic Outlook” are included in Table 2. If there has been a uniquely Reagan deficit crisis, it is not reflected in this data.

Bank for International Settlements data in Table 3 reveal other in­teresting comparisons. The U.S. has one of the lowest ratios of federal debt to GNP in the developed world. Moreover, during 1973-86, a period of the largest deficits in U.S. history, only the U.K. and Switzerland ex­perienced a lower growth in the ratio of debt to GNP. In the U.S. the ratio rose 40.8 percent, but in Germany and Japan, countries that are often represented as hallmarks of fiscal responsibility, the ratio rose 121 percent and 194 percent.

The unjustified hysteria over the U.S. budget deficit served many purposes, chief of which were to discredit the supply-side policy of restoring people’s property rights in their own income and to make a scapegoat of the U.S. for the failure of European policies to create new jobs. The hysteria produced an unbroken string of erroneous financial forecasts from 1981 onwards. It was alleged that the U.S. budget deficit would cause higher inflation. When inflation collapsed, it was alleged that the deficit would prevent interest rates from falling. When interest rates collapsed, Martin Feldstein, Chairman of Reagan’s Council of Economic Advisors, predicted that the deficit would crowd out private investment and prevent an economic recovery. When the recovery began, it was alleged that the deficits would prevent the dollar from fall­ing and deindustrialize America. When the dollar fell, the “crisis” was blamed on a budget deficit that, only a few months before, was sup­posed to prevent “dollar adjustment.” All the while as important finan­cial publications and renowned economists compiled a record for themselves of being 100 percent wrong year after year, they maintained that Reaganomics was “voodoo economics” for predicting that the 1981 tax cuts would pay for themselves — a prediction never made. This ex­traordinary record of disinformation is devastating for the expectations that academics have for public policy.

When inconvenienced by facts, critics still attempt to blame Reagan’s policy for causing a “global imbalance” by making the U.S. a debtor nation. This view reflects a lack of understanding of supply-side economics and global capital markets; it is an expression of anti­-economic thinking that the function of “rich” nations is to finance “poor” nations. By becoming a debtor, the U.S. has ceased to lead the international transfer of resources from rich to poor.

The caricature of the U.S. as “the world’s largest debtor” is based on faulty accounting that compares older book values of U.S. in­ vestments abroad with the more recent values of foreign owned U.S. assets. When U.S. overseas assets are valued at current prices, the pic­ture changes dramatically. Moreover, during the period of “concern” over American indebtedness, U.S. income from its foreign assets con­tinued to exceed the income paid to foreigners. For example, in 1987 the U.S. was allegedly a net debtor in the amount of $368 billion but earned
$21 billion more on its foreign investments than it paid to its foreign creditors. It is simply not possible to be a net debtor and to enjoy a net creditor’s income. But this is not the main point.

The notion that “mature” industrial countries are natural ex­porters of capital reflects the old Keynesian stagnation view that they run out of profitable investment opportunities at home. Stagnationists came in for many criticisms, which need not be repeated here, but it is appropriate to add one from a supply-side perspective. The rate of return on investment is an after-tax phenomenon. When tax rates are lowered, the number of profitable investments rises. The “imbalance” caused by the Reagan Administration was to raise the after-tax rate of return in the U.S. relative to the rest of the world. Instead of moving quickly to catch up, other countries responded with austerity policies that increased and maintained the U.S. advantage. Now that Britain and other countries are reducing their own tax rates, this U.S. advantage will disappear.

The Saving Rate

Critics have also painted a distorted picture of U.S. saving and in­vestment during the 1980s. Analysts have focused on statistical series that provide the least favorable view, such as growth in the net stock of business fixed capital, net private saving and the personal saving rate, and they have not explained why these statistics are fundamentally misleading. Some analysts have even made international investment comparisons that do not adjust for the fact that the U.S. national in­come accounts are unique in classifying public investment as consump­tion!

Changes in U.S. tax law in the 1980s caused a shift in the composi­tion of investment toward assets with shorter lives that increase business cash flow by generating more depreciation. A comparison on a net basis of U.S. saving and investment behavior in the 1980s with prior periods or other countries misreads a change in the assortment of assets (caused by tax law changes) as a decline in investment behavior. Comparison on a gross basis tells a different story. Despite the recession, during 1980-84 gross business fixed investment averaged 11.4 percent of GNP, ex­ceeding the 1947-81 average of 10.15 percent and every 5-year average beginning in 1950, including 1960-64, 1965-69, and 1975- 79 (See Table 4). Moreover, this investment record was achieved despite the volatility in monetary policy and exchange rates and despite the constant hysteria in the financial media.

The growth of real business fixed investment was exceptionally strong during the first two years of the Reagan expansion — a 12.3 per­ cent annual rate of growth. Investment then slowed during the middle of the expansion until 1987 when there was a renewal of rapid investment. The latest figures suggest that the U.S. economy is entering an unusual second stage of a capital spending boom.

There are three reasons for the slowdown in investment from the fourth quarter of 1984 to the fourth quarter of 1986: Investment in non­-residential structures fell at an 8 percent annual rate as lower tax rates discouraged former tax shelters, such as office buildings, and other tax law changes shifted investment to shorter-lived assets. The sharp drop in inflation and energy prices caused investment in oil and natural gas to decline. The long legislative debate over tax reform discouraged invest­ment in general while investors waited to see the final outcome.

Critics point to the decline in one component of the saving rate — the personal saving rate — as proof that the tax rate reductions did not increase saving. Statistics do show that gross personal saving has fallen as a percentage of GNP. During 1947-81 it averaged 4.8 percent; during 1982-87 it averaged 3.7 percent. However, this decline is not the smoking gun for which critics have been searching. Rather, it is a reflection of demographics and the way saving is measured.

The coming of age of the postwar baby boomers has overwhelmed the personal saving rate with a wave of young adults. Young adults have notoriously low saving rates while they acquire homes and furnish them. Furthermore, in computing GNP, rental values are imputed to housing and counted as consumption whether the housing is owned or rented by the occupant. Any time there is a demographic bulge of young adults forming households, the “consumption” of housing will rise relative to disposable income as rents are bid up and debt is used to purchase hous­ing and its contents.

Since saving is measured as what’s left after consumption, it tends to fall whenever population trends produce a larger proportion of young adults. Economist Edward Yardeni (1988) with Prudential-Bache Securities estimates that demographics account for 68 percent of the decline in the saving rate during the 1980s. As the demographic trend reverses in the 1990s, the personal saving rate should rise.

Other factors have worked to lower the saving rate in the 1980s. The severe 1981-82 recession brought down both the personal and public sav­ing rates. A tenet of Keynesian economics is that recessions are periods of dissaving. The unemployed cannot save, and savings are drawn down to maintain living standards. The government budget automatically ac­cumulates red ink as tax receipts fall and unemployment payments swell. When a recession’s deficits are financed at historically high interest rates, more red ink is produced. Since recessions cause pent-up demand and force consumers to defer purchases, the initial stages of recoveries are also characterized by low savings.

Many economists believe that the extraordinary rise in the values of financial assets such as stocks and bonds also lowered the personal sav­ing rate during the Reagan recovery. They argue that this large increase in wealth caused people to increase consumption, thus lowering the sav­ing rate.

Paradoxically, supply-siders underestimated the rise in wealth that their policy would cause. But no one ever claimed that a tax rate reduc­tion could fully offset demographic changes or the impact on saving rates of recession and sharp rises in wealth.

The remarkable fact is that the rise in business saving during the 1980s (resulting largely from faster depreciation) has offset the fall in the personal saving rate. Despite the factors working to lower personal ­ savings, the gross private savings rate (which includes personal and business saving) has averaged 16.7 percent during the Reagan recovery, com­pared to 16.6 percent during the 1947-81 period. The supply-side policy has succeeded in maintaining the private saving rate at its post-war average despite the demographic and other pressures operating to push it down.

Some economists have attempted to adjust for some of the factors depressing the private saving rate in order to get a more accurate measure of the impact of the 1981 tax rate reduction. In a 1986 study, Paul D. Evans and Douglas H. Joines concluded that the incentive ef­fects raised private saving relative to the trend by nearly the same percen­tage amount “as that following the Kennedy tax cut.”

The most depressing factor on the U.S. saving rate in the 1980s has been the 1981-82 recession, which pushed the public saving rate deep in the red by swelling the budget deficit. The large cyclical deficit, together with the Federal Reserve’s high- interest-rate policy, greatly increased the net interest component of the budget.
The focus on the personal saving rate as a measure of supply-side success allows critics to ignore the adverse impact on saving of demographics, recession, and a rise in wealth. It demonstrates the grind­ing of axes, not the failure of a policy.

The statistical facts are inconsistent with the picture of the U.S. economy as a consumption-driven machine fuelled by large deficits threatening the world with inflation. Polemicists, who claim that the Reagan expansion is nothing but a deficit-fuelled Keynesian consump­tion binge, have to explain what happened to the economic establishment’s “Phillips curve” belief that increased employment requires higher inflation? Why did the Keynesian policy not work for President Carter, instead producing stagflation? Why did smaller deficits lead to worsening inflation for Carter, while larger deficits were accompanied by declining inflation under Reagan? There was a bad recession in 1974-75, but it was not followed by a six-year ex­pansion with low inflation.

If the Reagan tax rate reductions have brought the American economy to its knees as so many critics have claimed, why are so many other countries cutting their tax rates? Moreover, even Jesse Jackson, the most left-wing candidate ever to run for the presidential nomination of the Democratic Party, said that he does not favor a top tax rate higher than 38 percent, which is far below the 70 percent rate with which the Reagan era began. Neil Kinnock, leader of the British Labour Party has said that he no longer favors a rate above 50 percent, which is far below the punitive rates that the Labour Party used to demand.

As the old saying goes, “the proof is in the pudding.” If Reaganomics had brought the U.S. economy to its knees, the U.S. would be experiencing massive capital flight. Instead, since 1982 Americans have curtailed their export of capital, and foreigners have sunk hundreds of billions of dollars into real investments in the U.S. Why should we believe the academic and journalistic critics and not the private investors?

The U.S. was a debtor country for its first 300 years. Japan ex­perienced trade deficits for 20 years following World War II. Neither country suffered any damage to its long-run viability.

V. Conclusion

In 1956 Swedish socialist Gunnar Myrdal was able to brag of the success of his ideology:
“Grand scale national planning is the goal in underdeveloped countries all over the globe and this policy line is unanimously endorsed by governments and experts in the advanced countries.”

No one is making such claims today. In the 1980s, socialist countries everywhere are in retreat from the consequences of their own policies. Privatization and tax rate reduction in Britain and France, the collapse
of Third World “development planning,” the stagnation of the Soviet economy, and the transformation under way in China have destroyed socialism. The supply-side approach to economic policy is spreading throughout the world, and the revolutionary re-emergence of private property out of communism is a historical watershed. “It is good to be rich,” declare China’s leaders, and these six words are a resounding af­ firmation for individual incentive.

The effects of disincentives have clearly thwarted the intended results of central planning, government investment programs, and de­mand management. On the other hand, there is today an abundance of evidence of the power of incentives. Only free people are productive and forward-looking, but they cease to be free when their property rights are sacrificed to interest-group politics and ideologies of government plan­ning. To see how far we have come, think back a decade to President Carter, battered by worsening Phillips curve trade-offs between inflation and unemployment and without hopeful policy options. Remember the infamous “malaise” speech signaling the death of hope. Remember the policymakers’ emphasis on income policy and industrial policy, which would lead to further erosion of economic liberty. That is where we were, and that is from where Reagan’s supply-side policy brought us.

Reagan brought confidence back – confidence that could even survive year after year of doom and gloom about budget and trade deficits and interest and exchange rate volatility. Confidence returned because of the steps taken to restore private property rights. Tax rates were cut. Regulation was slowed. Inflation fell. Abroad socialized coun­tries began privatizing. The tide finally turned in a 50-year-old war that advocates of economic liberty had been losing. It is extraordinary that even freedom’s allies are little inclined to cheer and greatly inclined to blame the expansion of private property rights for the “twin towers of debt.”

The reconstruction of economic liberty is not complete. The deficit needs to be cut, but in the right way. It is self-defeating to try to reduce the deficit by withdrawing pro-growth incentives. The most successful way of reducing deficits is to have the economy grow relative to the government’s budget by controlling public spending and maintaining incentives for economic growth. A high interest rate policy “to support the dollar” is at odds with deficit reduction. Instead, private saving needs to be expanded by reducing and eliminating the existing tax bias against saving that results in the multiple taxation of investment income. A consumption-based income tax that excludes saving from the tax base would obviously increase personal saving. (See Blueprints for Basic Tax Reform, US Department of the Treasury, January 17, 1977.)

Close attention must be paid to monetary policy. It is just as impor­tant to avoid unnecessary restraint on economic growth as it is to avoid inflation. We cannot afford a monetary policy that elects to take only recessionary risks, and we cannot permit the pretense that fiscal policy determines interest rates.

An important function of representatives in diplomatic, economic, and multilateral lending institutions must be to spread understanding of the supply-side policy. Reliance on incentives, markets, and private in­vestments is an easy sell in light of the unhappy experience of the Third World with development planning, of Europe with socialization, and of the Soviet Union and China with central planning and economic coercion.

To be deterred from this easy task, and to be thrown on the defen­sive by a budget deficit, indicates a lack of belief that is inconsistent with leadership. This is especially the case with a deficit that reflects nothing but the failure to rebase the budget to take into account a quicker than expected victory over inflation. A spending freeze for one or two years is all it would take to wipe out the deficit. If, following many years of large increases in federal spending, this small step is considered too drastic, the budget deficit cannot possibly be the dire problem it is claimed, and we should be content to eliminate the deficit more gradually by expand­ing the economy.

If the spokesmen for economic freedom do not lose their nerve, the extraordinary failure of socialism and central economic planning in the 20th century promises that the 21st century will be one of private proper­ty and expanded economic liberty.

This transformation is underway in the U.S. After an eight-year struggle with Ronald Reagan, the Democrats have taken steps to reclaim supply-side policy as their own. Michael Dukakis, the Democratic can­didate for President in the November 1988 election, rejected the left­ wing of his party and chose Senator Lloyd Bentsen of Texas, one of the original supply-side politicians. In 1979 and 1980 the annual reports of the Joint Economic Committee of Congress, under the leadership of Senator Bentsen, rejected a continuation of Keynesian demand manage­ment and called for the implementation of a supply-side economic policy. Dukakis himself did not run against Reaganomics or call for a repeal of the supply-side tax rate reductions.

The campaign against the supply-side policy failed because it was based on false charges, namely that Reagan based his budget on a “Laf­fer curve” forecast that the tax cuts would pay for themselves. But no such forecast was made. Moreover, the alleged interest and exchange rate effects of alleged “supply-side” deficits failed to materialize. Fur­thermore, the U.S. Treasury’s important study, The Effect of Deficits on Prices of Financial Assets: Theory and Evidence, surveyed the economic literature and found that neither theory nor empirical evidence supports the argument that interest and exchange rates are ex­plained by budget deficits. This conclusion has been reinforced by events since the study’s publication in March 1984.

Faced with a record-breaking successful economy that they can no longer denigrate, some diehard critics have changed their tune. They now attribute Reagan’s success to Keynesian deficit-spending and call it their own. It is amusing to watch people simultaneously claim that Reagan’s successful economy is based on Keynesian deficits but that supply-side deficits are an enormous threat to the economy. For examples of this contradictory argument, see Paul Craig Roberts, “Hoover Democrats,” Wall Street Journal, August 11, 1988, and “yesterday’s Economic Doomsayers are Today’s Pollyannas,” Business Week, August 15, 1988. With its critics reduced to such blatant inconsistency and special pleading, the supply-side has clearly triumphed.

POSTSCRIPT, July 17, 2017:

The empirical data in this 1989 report is the official data extant at the time the report was written. The data is the data that existed at the time that biased economists were making their absurd claims that the suppy-side economic policy had failed. Clearly, the empirical evidence contradicted the false claims of the critics.

Today, 28 years later, the data in the tables might have been re-based, adjusted for this and that and the other, or “corrected.” John Auten, director of the US Treasury’s Office of Financial analysis, one of the Treasury divisions that reported to me as Assistant Secretary, told me that the practice of the Federal Reserve was to eliminate the record of the abrupt changes in monetary policy that caused recessions and recoveries by “smoothing the data” over time. For example, Auten told me that the chart on page 223 of my book, The Supply-Side Revolution (Harvard University Press, 1984), which shows how far below the Fed’s target range Volcker collapsed the money supply, thus inaugurating President Reagan with a major recession, would disappear as empirical evidence as the Federal Reserve “smoothed” the monetary data.

In other words, empirical evidence also disappears into Big Brother’s “memory hole” and is replaced with whatever orchestration serves the purpose. Nevertheless, the sources I cite still exist in libraries that have the documents of the time.

What about the optimism in my 28-year old report? What has become of that? Unfortunately, optimism was destroyed by capitalist greed. Instead of productively restructuring the world economic system, capitalists looted it. With the Soviet collapse, the Russians’ belief during the Yeltsin era that now we were all on the same side facilitated the looting of Russia by the West. The collapse of socialism in Russia, China, and India, gave us “globalism,” that is the international arbitrage of wage rates. US corporations, pushed by Wall Street with takeover threats, closed their manufacturing facilities in the US and moved their production for US markets to lower labor costs in Asia. Capital gains for shareholders and “performance bonuses” for executives soared, but the US consumer market shrunk from the loss of wage income. Jobs offshoring also ruined the tax base of former manufacturing US states and has propelled them toward state pension bankruptcy and downgrading of their bonds.

President Bill Clinton colluded with Republican US Senator Phil Gramm, a former “free market” economics professor, to repeal the Glass-Steagall Act that separated commercial from investment banking. This unleashed a devastating increase in financial fraud and advanced the financialization of the economy so accurately described by Michael Hudson. Today the financial system serves not to finance real productive investment, but to absorb all discretionary consumer purchasing power in interest and fees.

American financial hegemony has linked itself to American military and political hegemony. They advance together.

Initially, the destruction of barriers to US unilateralism was easy in Iraq and Libya, but has run into trouble in Syria. The prospects of prevailing over Iran, Russia, and China are even more remote.

The privatizations in England and France have some positive results, but on the whole went too far and were vehicles for politicians to reward supporters by handing over the public domain at bargain prices.

The success of the supply-side policy together with the failure of socialism has resulted in unleashing greed as an economic policy. Tax rate reduction has become a panacea instead of a considered correction to demand-management economic policy.

What I and other supply-side economists were committed to was to correct the economic disability arising from one-sided demand management that produced the situation in which the economy and employment could not grow unless inflation rose. We succeeded in fixing this problem. Unfortunately, the critics of the policy were so discredited by its real world success that greed was able to claim the victory and foreclose the prospect of productive social democracy.


Martin Anderson, Revolution (New York: Harcourt Brace Jovanovich, 1988).

Olivier Jean Blanchard, “Reaganomics,” Economic Policy, October 1987.

Michael J. Boskin, ”Taxation, Saving, and the Rate of Interest,” Jour­ nal of Political Economy 86 (April 1978, part 2).

Paul Evans, ”Kemp-Roth and Saving,” Weekly Letter, Federal Reserve Bank of San Francisco, May 8, 1981.

Paul Evans and Douglas H. Joines, “The Resolution of the Tax Debate,” in Victor A. Canto, Charles Kadlec, and Arthur B. Laffer eds., The Financial Analysts Guide to Fiscal Policy (New York: Praeger, 1986).

James Gwartney, “Tax Rates, Taxable Income and the Distributional Effects of the Economic Recovery Tax Act of 1981,” testimony before the Joint Economic Committee, June 12, 1984.

James Gwartney and Richard Stroup, “Tax Cuts: Who Shoulders the Burden?” Economic Review, Federal Reserve Bank of Atlanta, March 1982.

Jerry Hausman, “Labor Supply,” in Henry J. Aaron and Joseph A. Pechman, eds., How Taxes Affect Economic Behavior (Washington, D.C.: The Brookings Institution, 1981).

Jerry Hausman, “Taxes and Labor Supply,” Working Paper No.1102, National Bureau of Economic Research, March 1983.

Lawrence B. Lindsey, “Capital Gains: Rates, Realizations and Revenues,” Working Paper No.1893, National Bureau of Economic Research, April 1986.

Lawrence B. Lindsey, “Tax Reform and Taxpayer Behavior,” NBER Reporter, National Bureau of Economic Research, Spring 1988

Gunnar Myrdal, Development and Underdevelopment, National Bank of Egypt Fiftieth Anniversary Commemoration Lectures, Cairo, 1956.

Donald T. Regan, For the Record: From Wall Street to Washington
(New York: Harcourt Brace Jovanovich, 1988).

Paul Craig Roberts, The Supply-Side Revolution (Cambridge: Harvard University Press, 1984).

Paul Craig Roberts, “The Revolution in U.S. Tax Policy,” National Westminister Bank Quarterly Review, November 1986a. Paul Craig Roberts, “The Mortals Below: Tragedy on the Farm,” The Wall Street Journal, June 6, 1986b.

Paul Craig Roberts, testimony before the Senate Banking Committee, February, 18, 1987.

Paul Craig Roberts, “The Presidency Must Reclaim Its Powers from Congress,” Business Week, February 29, 1988.

Paul Craig Roberts, Aldana Robbins, Gary Robbins, and David Brazell, The Cost of Corporate Capital in the United States and Japan (Washington, D.C.: Institute for Political Economy, 1985).

Paul Craig Roberts, Aldana Robbins, Gary Robbins, and David Brazell, The House Tax Bill: Does the U.S. Win or Lose? (Washington, D.C.: Institute for Political Economy, 1986a).

Paul Craig Roberts, Aldana E. Robbins, and Gary A. Robbins,” Supply Side Economics and the Cost of Capital” in Studies in Banking and Finance (Amsterdam: North-Holland Publishing Company, 1986b).

Paul Craig Roberts, Aldana E. Robbins, and Gary A. Robbins, “The Relative Impact of Taxation and Interest Rates on the Cost of Capital,” in Ralph Landau and Dale Jorgenson, eds., Technology and Economic Policy (Cambridge, Massachusetts: Ballinger, 1986c).

Allen Sinai, Andrew Lin, and Russel Robins, “Taxes, Saving, and In­ vestment: Some Empirical Evidence,” National Tax Journal36 (No. 3, September 1983).

U.S . Congress, Joint Economic Committee, ”The Mellon and Kennedy Tax Cuts: A Review and Analysis,” a staff study for the Subcommittee on Monetary and Fiscal Policy, June 18, 1982.

U.S. Government, Council of Economic Advisers, Economic Report of the President: February 1983, February 1983.

U.S. Government, Department of the Treasury, “Accounting for the Deficit: An Analysis of Sources of Change in the Federal and Total Government Deficits,” by Michael Darby, Research Paper 38704, Oc­tober 2, 1987.

U.S. Government, Department of the Treasury, “The Direct Revenue Effects of Capital Gains Taxation: A Reconsideration of the Time­ Series Evidence,” by Michael R. Darby, Robert Gillingham, and John
S. Greenlees, Research Paper 18801, May 24, 1988, published in
Treasury Bulletin, (Spring 1988).

U.S. Government, Department of Health and Human Services, Final Report of the Seattle-Denver Income Maintenance Experiment, SRI In­ ternational, May 1983.

U.S. Government, Office of Management and Budget, Budget of the United States Government for Fiscal Year 1989, February 18, 1988.

Edward Yardeni, “How the Baby Boomers are Changing the Economy,” Prudential Bache Securities, Topical Study No.12, April 6, 1988.

About the Author

Paul Craig Roberts is Chairman of the Institute for Political Economy and has the William E. Simon Chair in Political Economy at the Center for Strategic and International Studies in Washington, D.C., and he is Senior Research Fellow at the Hoover Institution, Stanford University. A former editor and col­umnist for the Wall Street Journal, he is currently a columnist for Business Week, Financial Post, Liberation, and Washington Times and a frequent con­ tributor to the Wall Street Journal, the Los Angeles Times and II Sole 24 ORE. He is nationally syndicated by the Scripps Howard News Service.

During 1981-82 he served as Assistant Secretary of the Treasury for Economic Policy. President Reagan and Treasury Secretary Regan credited him with a major role in the Economic Recovery Tax Act of 1981, and he was awarded the Treasury Department’s Meritorious Service Award for “his outstanding contributions to the formulation of United States economic policy.” During 1975-78 Dr. Roberts served on the Congressional staff where he drafted the Kemp-Roth bill and played a leading role in developing bipar­tisan support for a supply-side economic policy.
In 1987 the French government recognized him as “the artisan of a renewal in economic science and policy after half a century of state interventionism” and inducted him into the Legion of Honor.

Dr. Roberts’ latest book, The Supply-Side Revolution, was published by Harvard University Press in 1984. Widely reviewed and favorably received, the book was praised by Forbes as ”a timely masterpiece that will have real impact on economic thinking in the years ahead.” He is the author of Alienation and The Soviet Economy (1971) and Marx’s Theory of Exchange, Alienation, and Crisis (1973).

He has published a large number of articles in journals of scholarship, in­ cluding the Journal of Political Economy, Oxford Economic Papers, Journal of Law and Economics, Studies in Banking and Finance, Journal of Monetary Economics, Public Finance Quarterly, Public Choice, Classica Et Mediaevalia, Ethics, Slavic Review, and Soviet Studies. He has contributed to The Public In­terest, Harper’s, New York Times, Washington Post, Fortune, London Times, and Financial Times. He has testified before committees of Congress on twenty-five occasions.

Dr. Roberts is a member of the board of directors of the Value Line Invest­ment Funds, a member of the international advisory board of Wright Investors’ Service, a member of the board of Marvin & Palmer, and an advisor to Morgan Guaranty Trust Company, Lazard Freres Asset Management, and other money managers.
Dr. Roberts was educated at the Georgia Institute of Technology, the University of Virginia, the University of California at Berkeley, and Oxford University where he was a member of Merton College.