/ Supply-side

Economics "This plan is aimed at reducing the growth in government spending and taxing, reforming and eliminating which are unnecessary and counterproductive, and encouraging a consistent aimed at maintaining the of the ."

The Economic Problem

It was no accident that found the to be very high in the late 1970s because the US was experiencing a new problem - - the simultaneous appearance of high rates of and . The AS-AD diagram offers a visual representation of the problem. Twice in 1970s, the OPEC oil cartel raised substantially the 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 (lower GDP) that brings with it increased unemployment. People are out of work and watching rise rapidly.

Stagflation

The problem for policy makers was their Keynesian heritage, which meant they instinctively attempted to manage 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

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 . As Regan stated in his first 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 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 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 taxes, , 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 on tax machine credit credit 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 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 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. Kennedy's tax cut was a traditional demand-side tax cut that gave the to people who would spend it. This would increase aggregate demand - shift the AD curve out. Reagan, however, wanted to shift out the AS curve, so it could not be a Kennedy-like tax cut. The tax cut would go to those with high incomes because they would likely save it, which would give businesses more funds to use for investment. These businesses would then hire workers who would now have better

3 jobs and higher incomes. The tax cut to the wealthy would "trickle-down" through the system to eventually help those at the bottom, which is why Reaganomics has been referred to as "trickle-down economics."

But what about the prospect of workers striking and bargaining for higher if the unemployment rate drops - the Phillips Curve in action? What Reagan did was send a message to labor that they had no friend in the White House when his response to the air-traffic controllers' strike was to fire them. If air-traffic controllers could be replaced, so could others and an effective labor movement never materialized in this period. He also made union workers nervous about their jobs and weakened their ability to raise wages by encouraging the free movement that gutted many manufacturing industries and moved jobs abroad. At this point Reagan's plans seem to have logic, and now we will look at how he hoped to achieve some of the other objectives.

The Reagan Plan: Lower government spending, tax cuts, and balance the budget

All governments are constrained by the mathematics of governmental finance - the budget deficit (D) equals the difference between tax receipts (T) and outlays (G) - so any budget deficit (D >0) could be eliminated only by an increase in Taxes or a decrease in Government outlays. The task facing Republicans was to find a way to cut taxes AND increase defense spending without raising the budget deficit.

D = G - T

Traditionally Republicans had argued for lower taxes and lower government spending and a balanced budget, but Congressman Jack Kemp had warned Republicans of any attack on the programs since the voting public would not support a dismantling of the welfare state. This was not a problem for Reagan. Reagan would lower government spending without raising the specter of losses in favorite entitlement programs because of the extraordinary amount of waste in the government. All he would do is cut waste, a theme we still hear today.

As for simultaneously cutting taxes and reducing the deficit, the "solution" was found in a new "theory" suggesting that reductions in tax rates and a balanced budget were possible. had developed this idea, and on August 4, 1976 it surfaced in an editorial in the Wall Street Journal that maintained "it is far from clear that a tax cut will always cause a deficit. It depends on whether it succeeds in stimulating the economy enough that the lower tax rates yield a larger net revenue."

Part of the success in selling this idea can certainly be attributed to the simplicity with which it could be presented to the public using the . Normally, tax revenue would increase with tax rates, such as you would see at a rate at pt. A, but only to a certain point. Once tax rates reached a certain unspecified level, the equilibrium point in the diagram, then any additional tax rate increase would result in lower revenues. Republicans argued that high income tax rates in the U.S. put the economy into the range where a tax cut would actually raise revenue. If you had a tax rate at pt. B, then a reduction in the tax rate - movement left from point B - would increase tax revenue. This was the basis of the Republican National Committee's endorsement of the Kemp-Roth tax bill containing a cut in personal income tax rates of 10 percent per year for three years. The Laffer Curve

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How could this counter intuitive result be explained? The "mathematics" of the answer is straightforward. The level of tax income (T) is simply the product of the tax rate (t) and the level of income (Y). If the reduced tax rate ($t) could stimulate the economy and increase income (#Y), then the level of tax revenue could increase and the budget deficit would be reduced.

T = t*Y

The Reagan Plan: No cost lower inflation

The Phillips Curve had been an accepted piece of the Keynesian macro model in the 1960's and Carter's gradualism in the 1970's was grounded in the belief that the cost of lower inflation was higher unemployment. Carter accepted the trade-off as inescapable and hoped to use and price guidelines to reduce inflation without incurring the cost of higher inflation. This was not an option for the Republicans who had no interest in increased government intervention.

The key piece of the no-cost solution to lower inflation was a new spin on expectations, and to see this we return to the question: what will the weather be tomorrow? The simplest answer, and the one accepted in the 1970s', is the model. Expected inflation next period (i+1) would simply be equal to the current inflation rate (i), which is equivalent to a weather forecasting strategy of forecasting tomorrow to be the same as today. If the inflation rate last year were 5%, then you would expect it would be 5% this year.

Adaptive expectations I i+1 = i

The weaknesses of this model of expectations are it is backward looking and people are going to get fooled by any changes in inflation. The implication of this approach was that a painful, slow adjustment in inflationary expectations would limit the political value of discretionary policies designed to wring inflation out of the system. If inflation were to be reduced, it would come at a substantial cost because American workers had built inflation into their wage demands and bankers built it into their interest rates.

The transition from high to low inflation rates did not have to be painful, however, if you believed in the emerging theory of introduced by Robert Lucas, work that earned him the Nobel Prize in economics in 1995. According to Lucas, decision makers formed their expectations rationally by looking forward and people could learn, which would make it difficult to fool them continuously. Furthermore, if macroeconomic policies were credible, then decision makers' inflation expectations would adjust quickly and the economy would adjust quickly to the new equilibrium.

To see how this works, let's look back at what we learned about inflation earlier - that inflation is a monetary phenomenon. The Quantity Theory of Money that linked the and the , so if you knew the money supply was increasing, then you would adjust your estimate of inflation accordingly. For example, if people knew the inflation rate would equal the growth rate in the money supply (m), then they would immediately adjust their expectations for inflation downward if the Fed embarked on a tight money policy. Decision makers would then lower their demands for wage and price increases. Rational expectations offered policy makers a painless cure to inflation.iii

Rational expectations i+1 = m

In this situation there was no necessary connection between inflation and unemployment and we could therefore break inflation without any increase in unemployment - a no pain decline in inflation could be accomplished by the restrictive monetary polices being followed by the Fed as Reagan took office. The

5 research focus thus shifted to how macroeconomic policies could gain the credibility needed to influence the expectations.

The "results"

The rest, as they say, is history. Let's begin with the successes. The Fed's policies and the dramatic drop in the price of oil did break the rising spiral of inflation. By the first quarter of 1982 inflation was down to under 4%, and this was reflected in a boom in the stock . By the end of the 1980s the stock market had regained all of the losses incurred during the late 1960s and 1970s, although what you do not see is that terrifying day in 1987 known as Black Monday when the Dow Jones Industrial Average dropped nearly 23% in one day. You do not see it because by the end of the year the losses had been regained. The rapidly falling inflation rates were reflected in the rapid decline in interest rates, with the rate on 3-month US Treasuries down by more than 50%. Real interest rates, however, abruptly rose and this had an adverse effect on Latin American countries that had borrowed heavily in the 1970s. With the rise in real interest rates they faced a debt crisis that signaled the beginning of what has become known as the "Lost Decade."

The value of the dollar was also affected by the high interest rates, and as you know from the last unit, the high rates helped push the US $ higher - approximately an 80% increase in the trade-weighted exchange rate by 1985 before it fell back to 1980 levels.iv The rise in the value of the dollar severely "hammered" the traded- sectors of the US economy and the balance of trade, which had turned negative in the late 1970s, moved sharply negative in the 1980s, bottoming out at nearly $160 billion in 1986.

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Manufacturing firms began to lose out to foreign competitors as we began to hear much about the de- industrialization of the US economy. Employment in the steel industry, for example, declined from 400,000 in 1980 to 150,000 in 1986. These were tough times for the "Rust-Belt" with a net loss of 2 million manufacturing jobs - 10 percent - during the decade. Farmers were also hurt with agricultural exports down sharply and farmland prices following. The news was filled with stories of bankrupt farmers. On the coasts, however, it was a very different story. It was good times along the Atlantic and Pacific coasts, the beginning of the boom known in New England as the "Massachusetts Miracle."

The position of labor was weakened as those imports continued to flow into the country in record amounts and union workers found employers increasingly willing to shut down factories and move operations overseas where labor costs were substantially lower. In the Four-Tigers of Southeast Asia, countries where governments were committed to export-led growth, the cost advantage approached 90% in Korea and Taiwan and 85% in Singapore and Hong Kong. Even Japan, which by 1980 had become a rising world power, had costs nearly 50% lower than in the US. By mid decade Time magazine was running “Trade Wars” cover stories, and at that time the culprit was Japan. As for what they were doing with the $s flowing into the country, they were buying US assets, which became a hot topic by 1987 when Time ran a cover story, The Selling of America: Foreign Investors Buy, Buy, Buy.” And they were not low profile purchases, with Japanese investors landing two prime US assets – the Pebble Beach golf course and Rockefeller center in New York City. It was also the decade in which Americans began driving Hyundai autos imported from Korea and the Yugo from Yugoslavia, although the Yugo disappeared quickly due to serious safety and reliability issues. Honda and Toyota, meanwhile, in response to rising tensions over international trade and restrictive trade quotas opened up production facilities in the US. Honda opened its plant in Ohio in 1982 and Toyota followed in 1988 with a plant in Kentucky.

The combination of the government's anti protectionist policies and the "flattening" of the world, manufacturing employment in the US actually declined in the 1980s. In the 1970s manufacturing growth was still positive, although down almost 2/3rds from the growth in the 1960s, but weaknesses were showing up in the nondurable sector. Nondurable producers, especially textiles and apparel, are capable of moving their operations quickly in search of cheap labor and in the 1970s the US was already seeing employment declines. By the 1980s, though, employment losses in manufacturing had become widespread with over 1.5 million jobs lost - about 1 of every 12 manufacturing jobs - and the losses were concentrated in the heavier, more unionized, durable industries.

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Rising immigration - nearly 2/3rds higher than in the previous decade - also pushed wages of some less skilled American workers lower as they found themselves in with immigrants who were increasingly from Mexico. Immigration in the 1980s represented a full 1/3rd of the country's population growth - a number not seen since the 1910s when immigration was becoming a national issue. And if that were not enough, Reagan sent a very clear message to American workers that they had no friend in the White House when he ended the air traffic controllers strike by firing all of the PATCO union controllers. One impact of these developments was an increase in income inequality. Below is a graph of average incomes for the top 5t% percent of the income (95th percentile) and the lowest 20% of the distribution from the Institute. It is very clear that from the end of WW II through the end of the 1970s the incomes of these groups tracked each other pretty closely. In this time period was true that “a rising tide lifts all boats, but that ended in the 1970s as the gap between the wealthy and poor widened sharply.

In the output market GDP grew at faster rates than in the 1970s, but below the average for the 1960s. There was also no rebound in productivity growth, which was lower in the 1980s than in either the 1960s or 1970s. The significant employment gains in the 1980s, however, were not reflected in earnings that continued to fall during the decade. By 1989 real earnings for American workers were lower than they were in 1959. It was also a decade of rising inequality and insecurity that was especially hard on the less educated and less skilled workers who were staggered by the one-two punch of globalization and technological change.

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The biggest gap between the promises and the performance was in federal government finances. Reagan did get his tax cuts as Congress quickly passed the Economic Recovery and Tax Act of 1981 in the summer. The program included the three-step, across-the-board reduction in personal income tax rates. Reagan began to backtrack on his promises almost immediately, however, and the budget delivered in 1981 included a one-year delay in the eventual budget balance (1983 to 1984) and a six-month postponement in the starting date for the first-round of the tax cuts. It soon became obvious, however, that the Laffer curve was the weakest link in Reaganomics. The passage of the tax cut, coupled with the defense buildup, produced massive deficits by the middle of the decade. It soon became clear that there was a serious inconsistency in Reaganomics' goals, and that Reagan would give up the balanced budget to pursue the other goals. In fact, in a Washington Post article of June 6, 2004 reflecting on the Regan presidency, we hear about how , Reagan's budget director, used accounting gimmicks known as the "rosy scenario" and the "magic asterisk" to get the budget accepted, so it is not clear that Reagan's team ever really bought the idea. The rosy scenario predicted the economy would do much better than expected, providing revenue that would never materialize, while the magic asterisk designated spending cuts that would be identified later - but never were."v

There was also the promise that deregulation would unleash the powers of the market place, but it also unleashed some problems. In 1980 and 1982 the US passed two laws that allowed S&Ls to take bigger gambles on depositors’ funds, and by the end of the decade the country was hit by the S&L crisis - a precursor to the subprime crisis of 2008.

By the end of the 1980s there was no question monetary policy was powerful, but there were rising doubts about the ability to harness the power of as the US had entered a period of exceptionally high budget deficits, which is the focus of the Unit on the 1990s. First, however, we will look more closely at the concept of .

9 10 1980s Reagan i One of the results of this legislation designed to increase the demand for new machines and factories that was not anticipated was a surge in the purchases of rental property and vacation homes by successful, high-income professionals who used real estate to "hide" their income. The deal went something like the following. The professional who was earning $100,000 would buy a building for $200,000. Originally the government would allow the person to depreciate the building over 25 years, which meant the individual could subtract $10,000 from their income before taxes. Under the Reagan plan, meanwhile, the life was shortened to 10 years so the individual could write off $20,000. At a 35% income tax rate, the income taxes paid would be reduced by $3,500. You would be buying a home that was appreciating in value and it would allow you to lower your taxes. It was a deal many professional could not resist and it helped fuel the real estate boom in the mid to late 1980s. ii You can see the problem with a simple example summarized in the table below. Between 1978 and 1979 you got a 25% raise which puts you into a higher tax bracket - 50% rather than 40%. When you look at after-tax income - what you take home - your big raise has been almost eliminated. It's now only $1,000, but even this exaggerates the increase since one of the reasons you received the big raise was to compensate you for a 10% increase in prices (an increase in the price index of 100 to 110). Adjusting income for inflation using the formulas for real, in 1979 you feel like you are earning only $22,727 because prices had gone up faster (10%) than your after-tax income (4%). Tax Bracket Creep Actual tax rate Taxes paid Net income Prices Real income income 1978 40,000 40% 16,000 24,000 100 24,000 1979 50,000 50% 25,000 25,000 110 22,727 iii We can see how this works by returning to the Phillips Curve graph introduced in the 1970s unit. Assume the economy is at a with an unemployment rate of 5% and an inflation rate of 6%, a rate accepted as the prevailing inflation rate and the policy officials. If a policy maker wanted to lower the inflation rate to 4%, the Phillips curve provided a guide to the cost, which would be higher unemployment as the economy moved toward point b. This inflation rate was pushed below the expected rate (4% < 6%) and the unemployment rate rose as the economy contracted because decision makers were "fooled" by the lower inflation. Once they adjusted to it the economy would eventually move to point C, but only after a painful recession with high rates of unemployment.

But what if expectations were formed "rationally," if an announced reduction in the growth rate in the money supply would translate immediately into a lower expected rate of inflation. This would lower the Phillips curve and the economy would go straight from A to C. In this situation there was no necessary connection between inflation and unemployment and we could therefore break inflation without any increase in unemployment - a no pain decline in inflation could be accomplished by the restrictive monetary polices being followed by the Fed as Reagan took office. The research focus thus shifted to how macroeconomic policies could gain the credibility needed to influence the expectations. iv In the early 1980s the US government followed a policy of "benign neglect" and let the dollar, a symbol of American prosperity, rise sharply. High interest rates in the US attracted foreign capital and this increased demand for $s translated into a higher price for $s. By 1985 the finance ministers from France, UK, Germany, Japan and the US met at the New York Plaza Hotel and declared the dollar overvalued, but by February 22, 1987 the finance ministers were meeting again, this time at the Louvre where they agreed the dollar had fallen far enough. v In Reagan's second campaign, , acknowledging the magnitude of the federal deficit, made the classic blunder when he announced: "Let's tell the truth. Mr. Reagan will raise taxes, and so will I. He won't tell you. I just did." While this "honesty" may have contributed to the landslide Reagan victory, Mondale was in fact correct. Reagan's second term, as well as George Bush's presidency, were both affected by the budget deficits that became one of the defining issues of this period. In fact, in Reagan's first term there were two significant tax increases passed to reduce

11 the deficit - the Tax Equity and Fiscal Responsibility Act (TEFRA) in 1982 and the Deficit Reduction Act (DEFRA) of 1984 - and these were resisted by those who saw tax increases more as an opportunity to spend additional money on new programs and less as a means to reducing the deficit. The situation was described by as: "I do not claim an iron law of democratic politics that expenditures always increase by more than additional revenue, but powerful forces do push us in this direction." At the outset of Reagan's second term the Act of 1986 was passed which had two had two main components. The first was the simplification of the tax rate schedules. For federal taxes there would now be two basic rates , 15% and 28%, which would replace the graduated rate scheme that ranged from 15% to 28%. The second was the broadening of the tax base, which closed some existing loopholes. One of the loopholes was the set of tax incentives that were designed to increase the level of investment spending. Both the investment tax credit and accelerated depreciation features of the 1981 law were eliminated, as was the limitation on passive losses. Some researchers have identified the effect of these latter provisions as a major contributing factor to the real estate bust in the late 1980s and early 1990s.

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