“Reaganomics” and its Critics

“Reaganomics” and its Critics

Income tax in the United States historically followed the doctrine of progressive taxation, creating tax brackets that increase as an individual earns more money throughout the year. For example, a physician making $200,000 might have the majority of her income taxed at 40 percent, while a firefighter who made $35,000 would be taxed at 20 percent, and a college student working part time who earned only $5,000 might pay no federal income tax at all. For Reagan, the progressive tax structure was responsible for the persistence of America’s economic problems. As a Hollywood actor in an era where taxes on those with large salaries was very high, Reagan saw more and more of his income go to taxes as his annual earnings increased. After producing a couple of films each year, any additional money Reagan might make could be taxed at rates approaching 90 percent when adding California’s state tax to the federal rate. In response, Reagan chose to make only a handful of films each year.

Reagan drew heavily from his experience as an actor in many aspects of his presidency. In the case of tax policies, the president believed that high tax rates discouraged other talented and successful individuals in their chosen fields from making a maximum effort each year. In his field, it might mean fewer movies. However, if entrepreneurs and financiers followed a similar strategy, then high taxes would constrain economic growth. Believing in a sort of economic Darwinism, Reagan argued that the best way to encourage job creation was to reduce the taxes for high-income Americans because these elites had demonstrated a talent for creating wealth. The wealthy, Reagan argued, could be expected to use their money to produce more wealth through investment and innovation that would spur job growth for everyone else. To this end, Reagan’s Economic Recovery Tax Act of 1981 reduced the top tax bracket from 70 to 50 percent while slashing taxes paid by corporations.

The super wealthy were not the only beneficiaries of Reagan’s tax cuts, which led to an overall reduction of tax rates by 30 percent throughout his first term. More controversial was the reduction in inheritance taxes. These taxes were not based on earned income, but rather taxed the transfer of wealth from one generation to another. These taxes had inspired many of the richest Americans to donate their fortunes in previous decades. As a result, removing the inheritance tax was much harder to justify in terms of economic stimulus.

Figure 13.5

President Reagan discusses a chart that portrays his tax plan as offering substantial savings for the average family. In reality, Reagan’s tax policies favored the wealthy and corporations, something the president’s supporters believed would result in greater overall economic development.

In his second term, Reagan passed the most sweeping changes to the tax code since the Sixteenth Amendment established the modern system of federal income tax. The Tax Reform Act of 1986A sweeping tax reform law that simplified the tax code and eliminated some tax shelters and other methods that had been used in the past to hide income or illegally reduce one’s tax burden. The law reduced the top tax rates wealthy individuals paid from 50 percent to 28 percent, while raising the minimum tax rate to 15 percent lowered the highest tax bracket from 50 percent to 28 percent while increasing the minimum rate from 11 percent to 15 percent. The reform also eliminated many of the various tax brackets between these rates, meaning that most Americans either paid 15 percent or 28 percent. A few provisions helped the poor, such as a cost-of-living adjustment to the amount of money that was exempt from taxation so that those living below the federal poverty level no longer received a tax bill. Other reforms eliminated various tax shelters for individuals, although many of these ways of hiding income remained for corporations. The law also required parents to list the social security numbers for each dependent child they claimed for tax purposes, eliminating the ability of individuals to increase their tax deductions through fraudulently listing imaginary dependents. As a popular economist has shown, the reform led to the disappearance of 7 million “children” on April 15, 1987.

Reagan’s tax cuts reduced federal revenue by hundreds of billions of dollars each year. This reduction of income could only be offset by equal reductions to the federal budget, borrowing money, or a massive economic boom that created so much taxable wealth that the government still took in more money each year. Reagan promised the latter would occur—the result of an unfettered economy free from aggressive taxation and government regulation. Reagan also proposed significant budget cuts to Social Security and Medicare, just to make sure that the federal budget could be balanced while the nation awaited the economic bonanza he believed his tax cuts would produce. However, cuts to Social Security and Medicare provoked outrage, and Reagan quickly reversed course. In the end, the president approved a budget that was similar to previous years except with massive increases for the military.

Reagan’s defense budgets continued to grow each year, doubling the annual budget to an incredible $330 billion by 1985. As a result, many challenged the president to identify exactly how he would fulfill his promise to reduce the nation’s indebtedness. Even Reagan’s budget director admitted that his administration’s economic projections were based on an optimistic faith that reducing taxes for the wealthy would “trickle down” to the middle and lower classes through job creation. This confidence in supply-side economicsAn economic theory that suggests government policies should be geared toward keeping revenue and economic decisions in the hands of businesses and consumers. While Keynesian economics suggests using the federal government to stimulate growth through a variety of measures, supply-side economics suggest lowering taxes and regulations on business and trade as ways of stimulating the economy. that emphasized government intervention to spur growth and investment through tax reduction was certainly not a new idea. However, because the Reagan administration pursued the principles of supply-side economics with such vigor, the basic theory that increasing the wealth of the wealthy would eventually trickle down to the rest of the nation became known as “Reaganomics.” Critics of the president used other monikers such as “voodoo economics” to describe Reagan’s theories.

Supporters of Reagan’s belief in supply-side economics point out that the Dow Jones Industrial Average—a measurement of the value of the 30 largest companies in the United States—tripled during the 1980s. Inflation fell from over 10 percent when Reagan took office to less than 4 percent, while unemployment fell from 7 percent to just over 5 percent. Critics of Reagan point to the increasing disparity between the rich and the poor that also accelerated during the 1980s as being the real consequence of Reagan’s regressive tax policies. They also disagree that tax cuts for the wealthy created jobs, pointing out that the percentage of jobs that paid wages above the poverty level had declined. Critics agree that tax cuts for corporations provided additional revenue for investment, but argue that much of this investment had been used to create manufacturing facilities in other nations.

Although the president’s critics usually concede that Reagan’s tax cuts and military spending did spur the economy and create some jobs in the short run, they argue that they did so only by borrowing massive sums of money. The size of the national debtThe total amount of money that a nation presently owes its creditors.—the cumulative total of all the money the federal government owes—tripled from $900 billion to nearly $3 trillion in only eight years. Between the start and conclusion of the Reagan administration, the United States had gone from being the leading creditor in the world to the most indebted nation in the world.

Previous administrations tolerated deficit spendingThis occurs when a government borrows money to finance its operations.—the practice of borrowing money to make up for the amount the government overspent in one particular year. However, the amounts the government borrowed were usually quite small unless the nation was at war. After the 1930s, some government borrowing was also accepted in times of financial crisis as a way to spur the economy. Neither scenario applied to the eight peaceful years of Reagan’s presidency, yet the government accumulated a debt that was three times greater than the combined annual deficits of the past two centuries. And contrary to the tradition of repaying the debt, deficits and debt continued to grow at the same pace when former vice president George H. W. Bush took office. The interest on the debt alone quickly became the largest non-defense-related federal expenditure. As a result, any effort to reduce the national debt could only be achieved after balancing the budget and paying hundreds of billions of dollars in interest.

Political candidates are known for making sweeping promises, yet the question of whether Reagan kept his pledge to restore the strength of the US economy remains an item of fierce debate. Democrats are quick to point out that Carter’s decision to halt inflationary measures as well as the normal business cycle were part of the reason the economy recovered during the 1980s. Reagan’s critics also contrast his promise of fiscal responsibility and smaller government with the tripling of the national debt and the expansion of the federal government, which grew in terms of both budget and the number of federal workers. Furthermore, President Reagan never submitted a balanced budget, and even the debt projections that came from his budget office were too optimistic.

Reagan himself usually deflected the criticisms of his economic policy in a good-humored manner that undermined some of his critics. “You know economists,” he would respond, they “see something that works in practice and wonder if it works in theory.” Reagan even seemed impervious to an assassin’s bullet that ricocheted and lodged near his heart in March 1981. The unfazed president thanked nearby secret servicemen for their service and even joked with surgeons by asking if they were Democrats before they removed the bullet. Most Americans lacked a sophisticated understanding of supply-side economics, but they knew the economy had floundered under Carter and was recovering under Reagan. Questions regarding the long-term wisdom of Reagan’s policies continue to engage historians and pundits alike, with responses usually reflecting both economic theory and one’s political orientation.