What Is Reaganomics?:
Reaganomics describes President Ronald Reagan's conservative approach for dealing with the 1980 recession. Voters were being pummeled by stagflation -- an economic contraction combined with double-digit inflation.
Reaganomics would fix stagflation by reducing government -- a policy that was dramatically different from the status quo. Reagan promised to reduce:
- The growth of government spending.
- Tax rates on both income and capital gains.
- Inflation by controlling the growth of the money supply.
Reaganomics was based on the theory of supply-side economics, which states that tax cuts give workers more money to spend, creating demand. Tax cuts give companies more cash to hire new workers and expand their businesses. Eventually, economic growth expands the tax base enough to replace the government revenue initially lost from the tax cuts.
Did Reaganomics Work?:
William A. Niskanen, a member of President Reagan's Council of Economic Advisers from 1981 to 1985, and a founder of Reaganomics, said that President Reagan delivered on each of his four major policy objectives, although not to the extent that he and his supporters had hoped. Inflation was tamed -- thanks to monetary, not fiscal policy. Reagan's tax cuts did end the recession. However, government spending wasn't lowered, just shifted from domestic programs to defense. The result? The Federal debt almost tripled, from $997 billion in 1981 to $2.857 trillion in 1989. (Source: Library of Economics and Liberty, Reaganomics, William A. Niskanen)
Taxes Were Cut:
Tax rates were cut significantly, stimulating consumer demand. By Reagan's last year in office, the top income tax rate was down to 28% for every one making $18,550 or more. Anyone making less paid no taxes at all. This was a significant drop from the 1980 top tax rate of 70% for individuals earning $108,000 or more. In addition, Reagan made sure tax brackets were indexed for inflation. These tax cuts were somewhat offset by several tax increases in the Social Security payroll tax and some excise taxes, and some deductions that were eliminated.
The corporate tax rate was also cut, from 48% to 34%. However, the effect from this break was muddied. Reagan changed the tax treatment for many new investments. The complexity meant that the results of his corporate tax changes couldn't really be measured.
Growth in Spending Was Reduced:
Government spending still grew, just not as fast as under President Carter. Reagan increased spending by 2.5% a year, mostly for defense. Cuts to other discretionary programs only occurred in his first year. Reagan did not cut Social Security or Medicare payments at all. In fact, Reagan's budget was 22% of GDP (total economic output). Nevertheless, the growth in spending was less than President Carter's 4% annual increase (figures adjusted for inflation).
Regulations Were Reduced -- Somewhat:
Reagan was applauded for continuing to eliminate the Nixon-era price controls. These were blamed for constraining the free-market equilibrium that would have prevented inflation. Reagan further removed controls on oil and natural gas, cable TV, long-distance telephone service, interstate bus service, and ocean shipping. Bank regulation was eased, helping to create the Savings and Loan crisis of 1989.
Import barriers were actually increased, as Reagan doubled the number of items that were subject to trade restraint from 12% in 1980 to 23% in 1988. Little was done in other regulations affecting health, safety, and the environment. In fact, although Reagan reduced regulations, it was at a slower pace than under Carter.
Inflation Was Tamed -- at a Cost:
Reagan was fortunate that he had Federal Reserve Chairman Paul Volcker already in place. Volcker was vigorously attacking the double-digit inflation of the 1970s, using contractionary monetary policy, despite the potential for a double-dip recession. In 1979, Volcker began steadily raising the Fed funds rate. By December 1980, it was at a historic 20%.
Although inflation was tamed, these rates also choked off economic growth. Volcker's policy triggered the recession of 1981-1982. Unemployment rose to 10.8%, and stayed above 10% for ten months.
Why Is Reaganomics Relevant Today?:
Reaganomics is the economic policy advocated by conservatives, especially followers of the Tea Party in 2011 and the Republican Presidential candidates in 2012. However, the theoretical basis of Reaganomics reveal why it worked so well in the 1980s, but could actually harm growth based on economic conditions in 2012.
Reaganomics and supply-side economics are based on the theoretical underpinning provided by the Laffer Curve. Developed in 1979 by economist Arthur Laffer, the curve showed how tax cuts could stimulate the economy to the point where the tax base actually expanded. That's because tax cuts reduced the federal budget immediately, and dollar-for-dollar. These same cuts, however, have a multiplier effect on economic growth. Tax cuts mean more money in consumers' pockets, which they spend. This stimulates business growth and additional hiring. The result? A larger tax base. However, the effect tax cuts have depends on whether the economy is growing, how high taxes were to begin with, and which taxes are cut.
For example, President Bush cut taxes in 2001 (JGTRRA) and 2003 (EGTRRA). The economy grew, and revenues increased. Supply-siders, including the President, said that was because of the tax cuts. Other economists point to lower interest rates as the real stimulator of the economy. The FOMC lowered the Fed Funds rate from 6% in the beginning of 2001 to a low of 1% by June 2003. (Source: New York Federal Reserve, Historical Fed Funds Rate)