August 13 marks an important anniversary in American economic history. Twenty-five years ago that day, Ronald Reagan signed into law the Economic Recovery Tax Act of 1981, which cut income tax rates by about 30 percent across the board. It marked an end to stagflation and the beginning of an economic renaissance that we all benefit from to this day.
After the economic boom of the 1960s, the 1970s were a period of economic distress, marked by simultaneous inflation and stagnation — dubbed stagflation. Most economists had no clue about how to deal with this problem because the dominant economic theory of the day said that high inflation and high unemployment could not exist simultaneously.
This theory also said that inflation was largely a fiscal problem resulting from the federal budget deficit, and that there was an inverse relationship between inflation and unemployment: The higher one was, the lower the other would be. Believing this, there was virtually nothing policymakers could do. They couldn’t increase spending or cut taxes to reduce unemployment because that would be inflationary. But if they fought inflation by cutting spending and raising taxes, that would raise unemployment.
Clearly, a new theory was needed to get the country out of this dilemma. It came from two economists at the University of Chicago. The first was Milton Friedman, who argued that the Federal Reserve’s monetary policy, which had been largely ignored by economic theorists, was the principal cause of inflation; the budget deficit had no effect. The cure for inflation, he said, was to severely restrict growth of the money supply.
The second economist was Robert Mundell. He agreed with Friedman that tight money was needed to stop inflation. But Mundell argued that measures were also needed to stimulate production at the same time. After all, if inflation resulted from too much money chasing too few goods, then increasing the supply of goods and services would be anti-inflationary.
Mundell thought the tax system was the major impediment to economic growth at that time. He reasoned that inflation had severely distorted it by pushing workers up into higher tax brackets when they received cost-of-living pay raises; by forcing investors to pay taxes on capital gains that represented nothing but inflation; and by taxing businesses on illusory inventory profits while eroding the value of depreciation allowances.
Another University of Chicago economist named Arthur Laffer brought the idea of tight money plus tax cuts as the cure for stagflation to Washington, where he served as chief economist for the Office of Management and Budget during the Nixon administration. A key convert to this idea was the late Jude Wanniski, an editorial writer for The Wall Street Journal, who began writing about it. Wanniski, in turn, convinced a young Republican congressman from Buffalo, N.Y., named Jack Kemp to make tax cuts a political issue that would help revive the Republican Party, which was in danger of extinction after big losses in the 1974 and 1976 elections.
Wanniski explained that tax cuts were key to two of the most prosperous eras in American history: the 1920s and 1960s. He urged Kemp to emulate President John F. Kennedy, who proposed an across the board tax-rate reduction in 1963 that was enacted by Lyndon Johnson in 1964. Together with the late Sen. William Roth, Kemp introduced a bill in 1977 to replicate the Kennedy tax cut by reducing the top income-tax rate from 70 percent to 50 percent and the bottom rate from 14 percent to 10 percent. (Kennedy and Johnson had dropped the top rate from 91 percent to 70 percent and the bottom rate from 20 percent to 14 percent.)
Reagan adopted the Kemp-Roth-Mundell-Laffer-Wanniski idea, which came to be called supply-side economics, and made a big tax-rate reduction the centerpiece of his economic program. Although mainstream economists all said it would be massively inflationary, voters no longer had much faith in their pronouncements because the economy had reached a crisis situation by 1980. There was a sharp recession that year, but inflation and interest rates continued to rise to unprecedented levels.
Immediately after taking office, Reagan began pushing his tax plan through Congress. It finally came to fruition in early August 1981, and he signed it into law on the 13th. Contrary to the predictions of establishment economists, it was not inflationary. On the contrary, inflation virtually collapsed, just as the supply-side economists expected. It fell from 13.5 percent in 1980 to 1.9 percent by 1985. Beforehand, virtually every economist in the United States would have said this was impossible.
Mundell and Friedman were both awarded the Nobel Prize in economics and Reagan was re-elected handily in 1984 as rewards for their insight and leadership. Their achievement should not be forgotten.