Reaganomics / Supply-side Economics "This plan is aimed at reducing the growth in government spending and taxing, reforming and eliminating regulations which are unnecessary and counterproductive, and encouraging a consistent monetary policy aimed at maintaining the value of the currency." The Economic Problem It was no accident that Ronald Reagan found the Misery Index to be very high in the late 1970s because the US was experiencing a new problem - stagflation - the simultaneous appearance of high rates of inflation and unemployment. The AS-AD diagram offers a visual representation of the problem. Twice in 1970s, the OPEC oil cartel raised substantially the price of oil, a major resource used by the nation's businesses, and this shows up as an inward shift in the AS curve. The result was the worst of both worlds. The equilibrium moves up to the left so the economy is “hit” by more inflation (higher P) and recession (lower GDP) that brings with it increased unemployment. People are out of work and watching prices rise rapidly. Stagflation The problem for policy makers was their Keynesian heritage, which meant they instinctively attempted to manage aggregate demand to solve any macroeconomic problem. Too much unemployment, just increase in aggregate demand and shift the AD curve out (left-side diagram below). Too much inflation, just decrease aggregate demand and shift the AD curve in (right-side diagram below). The problem is that each "solution" also creates a macro problem. If you used AD policies to reduce unemployment and increase AD, you made inflation worse since the new equilibrium is higher, while if you worried about inflation and decreased AD, you made unemployment worse since the new equilibrium is to the left. There was an opening for a "new set of eyes." Alternative Demand Management Policies with Supply Shock 1 The spokesperson for that new perspective was Ronald Regan who offered the American people a free lunch - a solution to the stagflation that had little, if any, negative side effects. At an abstract level, the solution is obvious. The appropriate policy response to an adverse AS shock would be a compensating AS policy shock. It was time to break with the Keynesian demand-management tradition and return to a focus on aggregate supply - hence the term "supply-side" economics. Ronald Reagan promised the American people that his policies would reduce inflation, AND put people back to work, AND balance the budget AND cut taxes, AND stabilize the US $, AND raise defense spending to win the Cold War. As Regan stated in his first State of the Union address, "This plan is aimed at reducing the growth in government spending and taxing, reforming and eliminating regulations which are unnecessary and counterproductive, and encouraging a consistent monetary policy aimed at maintaining the value of the currency" and in the remainder of this unit we will examine the theories upon which he based his policies. The centerpiece of his program was the Economic Recovery Tax Act of 1981. The Reagan Plan: Expand output To understand Reagan's plan we start with a simple production function. The supply of national output (AS) depends upon the size of the capital stock (K), the size of the labor force (L), and the level of technology (t), so any increase in AS would require an increase in the resources the nation employed and the technology its worker's used. AS = f(K,L,t) The solution to mobilizing resources was all in the incentives, which is what you would expect from conservatives. If you wanted a larger capital stock - new and better factories, offices, and machines - businesses had to think it was in their best interest to build these offices and factories and purchase these new machines. People, meanwhile, needed an incentive to get out of bed and supply the labor needed to work in those new offices and factories and use the new machines. In microeconomics you learned the secret to altering behavior was to alter prices, which is precisely what Reagan's policies were designed to do. Increase the capital stock To increase the capital stock the level of investment spending would need to increase since investment spending is by definition the addition to the nation's capital stock, and Reagan's program relied on five policies - investment tax credit, accelerated depreciation, corporate profit taxes, deregulation, and individual retirement accounts. The investment tax credit, similar to what Kennedy had used twenty years earlier, allowed businesses to reduce their tax bill by investing in plant and equipment. For example, if the investment tax credit were 10% and your business spent $100,000 on a new machine, then you would be able to deduct $10,000 from your federal tax bill (10%*100,000). The "bottom line" is the machine costs $100,000 but because the company saves $10,000 in taxes, the net cost of the machine is $90,000. This effectively reduces the cost of the investment by 10%, so you would expect to see an increase in demand for the equipment. Investment Tax Credit ($1,000s) Profit Cost of 10% Investment tax Profit tax + tax Tax Net Cost of Profit Net savings on tax machine credit credit saving Machine machine $1,000 $500 $100 - $500 0 $100 $1,000 $500 $100 $10 $490 $10 $90 $10 Accelerated depreciation is a little more complex. Let's assume you construct a factory for $1,000,000 and the government allows you to depreciate this over 25 years. You can charge your business $40,000 as a 2 depreciation expense each year, which in theory represents the value of the building "used up" during the year ($1,000,000/25), so that at the end of the 25 years the building would have no value. Each year taxable income is lowered by the $40,000 depreciation expense, so with a business tax rate of 50%, you would save $20,000 a year in taxes ($4,980,000 vs. $5,000,000). What Reagan did was shorten the depreciation schedule to 10 years. Now the business could subtract $100,000 from its business income ($1,000,000/10) instead of the $40,000, which generated a tax savings of $30,000. This effectively reduces the cost of the investment by 3% ($30/$1,000), so you would expect to see an increase in demand for the equipment.i Accelerated Depreciation for business ($1,000s) Value of Depreciation @ Depreciation @ 10 Net Income Net savings Gross Income Taxes@ 50% building 25 year life year life before taxes on machine $1,000 $40 $10,000 $9,960 $4,980 $1,000 $100 $10,000 $9,900 $4,950 $30 Reducing the corporate profit (income) tax was expected to raise after-tax profits and corporations were expected to use some of the additional profit to make the capital investments. Finally, Reagan increased the pool of funds saved by households that could be used by businesses to make the desired investments. This was accomplished by introducing the individual retirement accounts (IRAs) that lowered the tax on some savings and thus made savings more attractive. Increase the labor supply To get people to work you need to make work more attractive and non work less attractive. To make work more attractive, Reagan proposed a tax cut to allow people to keep more of what they earned. During the inflation of the 1970s people had been pushed into higher tax brackets, and because we had a progressive tax system, their buying power fell - a phenomenon called tax bracket creep.ii Reagan planned to correct this with his 30% across the board tax cut where all tax rates would be reduced by 30%, an idea that was contained in the Kemp-Roth bill proposed in 1978. Although the proposal was never passed, it was a piece of Congressman Kemp's platform in his bid for the presidency in 1980 and eventually Reagan adopted it. One of the major appeals of the Reagan tax package was that it sounded "fair," it sounded like everyone would share equally in the tax cut. This is not exactly how it worked, however, because of the progressive nature of the income tax system. (History of tax rates). In the United States in 1980, the tax rate on the lowest income bracket (up to $2,100) was 14%, while the rate for the highest income bracket (>$212,000) was 70%. The "math" of the tax cut can be seen in the simple table below. If you earned $300,000 and your tax rate was 70%, then your tax rate would be cut to 49%, while a person earning $40,000 would see their tax rate cut from 20% to 14%. The biggest beneficiaries of the cut are clearly those with the higher incomes and higher rates. In this example the 30% across-the-board tax cut would save the person earning $40,000 a total of $2,400 in taxes, while the person earning $300,000 would save $63,000 in taxes. If you looked at the gain relative to their initial net income, the gain for the person with a $40,000 income would be 8%, while the gain for the person with a $300,000 income would be 70%. An Across-the-Board Tax Cut Actual Gain in after- tax rate Taxes paid Net income New rate Taxes paid Net income % Gain income tax income 40,000 20% 8,000 32,000 14% 5,600 34,400 2,400 8% 200,000 70% 210,000 90,000 49% 147,000 153,000 63,000 70% This is not what Kennedy did with his personal income tax cut in the early 1960s, but Kennedy’s tax cut was never designed to achieve the same goal.