Arnold Kling  

Reagan's Economics in Context

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Ronald Reagan's Economics... Lucas on Growth...

I decided to put my thoughts into a longer essay.


When Ronald Reagan defeated Carter's re-election bid, "incomes policies" were a proven failure. Notwithstanding Milton Friedman's comments quoted above, by 1980 it took a lot less courage to stand by a monetary approach to disinflation than it did a decade earlier. I believe that Carter would also have stuck with Volcker through the recession, and if that is the case, then the behavior of the economy in the 1980s would have been about the same regardless of who had been President.

...I believe that President Reagan made a positive difference for the economy. However, unlike most analysts, I do not focus on his tax cuts. Instead, I think that Reagan's main contributions were on energy policy, tax reform, and resisting government expansion.

I try to make several points in the essay. One is that looking at the performance of macroeconomic variables during a President's term of office is a poor way to judge economic policy. Related to that is my view that supply-siders engage in contortionism by choosing to "throw out" the 1981-1982 recession from Reagan's record, even though the disinflation that came from the monetary policy of that period had great lasting benefit.

Another point that I make is that the experience of the 1970's discredited one of the most important left-wing ideas for government intervention--the idea that "incomes policies" rather than monetary policy could be used to fight inflation. Finally, I believe that supply-siders overstate the virtues of Reagan's tax cuts, as opposed to other policies that I think were more clearly constructive.

For Discussion. How did the experience of the 1970's shift the consensus within the economics profession concerning macroeconomic theory and policy?


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COMMENTS (17 to date)
Boonton writes:

I suspect supply siders have lost the intellectual argument because they choose the easy way out, focusing on tax rates. Looking at just definitions, a 'supply-sider' should be focused on the supply side of the economy. This means the ability of the economy to put labor and capital together to create goods and services.

Tax rates are a very small part of that picture. From my experience in business and from tutoring many business subjects like accounting, I think most people look at taxes as an afterthought. In most accounting texts, most of the focus is on figuring out a business's income statement and then taxes are simply lumped in as a flat 30% or 40%. Yes, behavior is sometimes changed by taxes (especially with real estate where depreciation and mortgage interest deductions become really important). The reality, though, is that much of the activity of businessmen if focused on seeking profit thru additional sales and improved efficiency.

A real supply-side school would focus in on the economy's actual supply side. This would mean supply-siders should be more concerned with regulation, hidden price controls, the distortions caused by businesses who lobby for regulations that protect them from competition. There should even be a 'liberal' side to a real supply-side school of thought focusing on how gov't sponsorship of general research can improve the economy's supply side. The 'liberal' side can also focus on whether overly aggressive intellectual property law is really benefiting the supply side or inhibiting it.

But these are difficult issues that require a lot of time and patient research. In the 80's the supply-siders had the White House so they didn't have time to focus on the intellectual rigour of their ideology. So they (and their think tanks) took the easy way out, focusing on what is easy to measure instead of what makes the difference. It's easy to look up tax rates. It isn't easy to measure regulation. One rule of thumb was the # of pages in the Federal Registrar but that's very imperfect. A 1000 pages of regulation may be so trivial and minor that it's impact on the economy is irrelevant but a single page can contain a regulation that could lop off 1% of GDP growth!

Perhaps the real story of the 80's was of an intellectual movement that was chocked off and killed by scoring a victory!

Lawrance George Lux writes:

The most interesting aspect of the 1970s experience comes in the disrespect generated for social welfare programs, coincident with maintenance and expansion of these self-same programs. Supply-side conservatives abandoned all effort to control such programs, solely venting their contempt for social welfare. They did this to gain a business welfare program, which no one except myself will admit is as dangerous to fair market normalization as social welfare programs.

It is highly indicative of the current trend of supply-side economic thought that they tout Reagan's tax rate reduction, but gloss over his elimination of special tax exclusions. This is because there are three times as many of such tax evasions today, as there were in 1986. The 1970s taught the Business community to lobby for heavy tax exclusionary policies, and Reagan could not permanently forestall such tax removals. It is not tax rate reduction which is responsible for the extreme deficits endured, but the special tax reductions combined with stupid fiscal irreponsibility of Politicians. The 1970s-1980s period reminds of the last days of the old Roman republic, before the advent of the Imperium; lobbys of property interests replacing the effective power of the Roman Senate to legislate. lgl

Jim Glass writes:

"I suspect supply siders have lost the intellectual argument ..."

You can take up that intellectual argument with Lucas if you want...

"Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand
management...." [emphasis in original]

"The potential gains from improved stabilization policies are on the order of hundredths of a percent of consumption, perhaps two orders of magnitude smaller than the potential benefits of available 'supply-side' fiscal reforms.

2003 AEA Presidential Address [pdf file]

Lucas elsewhere:

"When I left graduate school, in 1963, I believed that the single most desirable change in the U.S. tax structure would be the taxation of capital gains as ordinary income. I now believe that neither capital gains nor any of the income from capital should be taxed at all.

"Supply side economics [is] a term associated in the United States with extravagant claims about the effects of changes in the tax structure on capital accumulation.

"The analysis I have reviewed supports these claims: Under what I view as conservative assumptions, I estimated that eliminating capital income taxation would increase the capital stock by about 35 percent.

"The supply side economists have delivered the largest genuinely free lunch that I have seen in 25 years in this business, and I believe that we would have a better society if we followed their advice."

In Supply Side Economics: An Analytical Review, Oxford Economic Papers, 42:293.

Patrick R. Sullivan writes:

More generally, Reagan was the politician who re-established respect for markets as the important coordinator of economic activity. I've always thought that the economics degree he earned before the Keynesian revolution served him well in that regard.

Also, we should count as one of his accomplishments Murray Weidenbaum's work on cost-benefit analysis of proposed government regulation.

Boonton writes:
You can take up that intellectual argument with Lucas if you want...

Which proves my point. Extravagant claims are great for a pundit or politically centered think tank. Where's the real theory here? One would think 'supply-side economics' would be the place to look for a comprehensive model of how the supply side of the economy works. Instead we get promises of free lunches, just like any other politician on a soap box.

Mcwop writes:

Boonton, in some ways I agree with your post, but taxes do come into play for business planning. At the core taxes are simply a cost of doing business and added to the prices charged for products and services. Businesses consider taxes when locating their business, allocating foreign revenues, corporate formation, and in many other ways.

With that said the rate was not as important as the means by which you determine what is taxable in th efirst place. Reagan's policies made many changes in this area - more specifically introducing a dramatic departure in the treatment of business outlays for plant and equipment. Reagan instituted the Accelerated Cost Recovery System which greatly reduced the disincentive facing business investment and ultimately prepared the way for the subsequent boom in capital formation. In addition to accelerated cost recovery, the 1981 Act also instituted a 10 percent Investment Tax Credit to spur additional capital formation.

Boonton writes:

I'm simply noting that supply-siders seemed to have fixated on an easy to measure variable; tax rates (or even taxes in general). Imagine what would have become of Keynesian economics if they simply asserted prosperity was created by gov't spending on construction and only measured that each year.

Taxes are important but I wonder how much of the reform you just mentioned was good for the economy or just good for business? If the free market really works, then there is no need for a tax credit to spur investment. In fact, such a thing in a free market would actually be harmful by subsizing unnecessary investment (wasn't there a story in the news a while ago about SUV and Hummer dealers marketing to doctors and lawyers telling them that they could get a 'business investment' tax credit if they purchased a $50K+ vehicle?).

Mcwop writes:

Boonton, agreed that the fixation was wronly on rates. I do think the reforms were good (though not without some problems) for business, because the previous way the taxes were handled prevented businesses from making decisions, and moving forward with product developments. A doctor buying a Hummer is a good thing as someone has to build the car, make the parts, forge the steel, mine the steel etc... Money flowed through the economy.

Jim Glass writes:
"'You can take up that intellectual argument with Lucas if you want...'"

"Which proves my point. Extravagant claims are great for a pundit or politically centered think tank."

Lucas again:

"Supply side economics [is] a term associated in the United States with extravagant claims about the effects of changes in the tax structure on capital accumulation. The analysis I have reviewed supports these claims:... [my emphasis this time]

This proves your point?

"Under what I view as conservative assumptions, I estimated that eliminating capital income taxation would increase the capital stock by about 35 percent."

"Where's the real theory here?"

I was under the impression that the AEA Presidential address that I provided the link to was rather full of that.

Boonton writes:

Mcwop, you've just fallen into a classic economic fallacy. The problem is not the doctor buying a Hummer, the problem is the tax code giving the doctor a special treat for buying the Hummer as a 'business investment'.

Your previous post implied favorable tax treatment for business investment was good because increased investment expands the economy. But the doctor's purchase is basically consumption, not investment. Next year that doctor's medical practice will not be more efficient because he burns a gallon every 14 miles. National Income accounts will show a $50K increase in 'business investment' that year but no increase in GDP in future years.

To drive the point home, suppose if the 'investment credit' didn't exist the doctor would have spent the money on advertising because his office had a lot of downtime? The return on the pre-existing investment (the office) would increase & GDP would expand as services produced (medical care) increased. In reality that $50K may have been spent a thousand different ways & it's impossible to predict who would have benefited from it directly but what is clear is that $50K would have been spent according to the signals given by the market.

Instead the gov't overrode those signals to divert the $50K to the Hummer dealorship. Of course the auto dealer will be happy to spin you a story depicting this as the foundation of a free economy. But like protectionism & other silliness it is really just self-interest seeking gov't distortion of the economy for private gain.

Boonton writes:

Jim,

I noticed the word's 'capital stock' cropping up a lot in your quotes. Just take my example of the doctor buying a Hummer due to a 'business investment credit'. In such a transaction, the $50K would be considered an investment or increase in the stock of capital. If the doctor's practice had $142K of capital already invested in it (computers, furniture, exam room equipment etc.) then the $50K would indeed represent a 35% increase.

But this increase is entirely meaningless. It would be an example of consumption being mislabeled as investment. Accounting wise, the distinction between a capital investment and business expense can be quite blurry. Economically an investment is supposed to generate a return. For example, a contractor who buys a truck (the intended target for the credit), would expect to be able to service bigger contracts or more of them with better wheels.

But sometimes a business expense can really be an investment. Suppose the doctor's practice is poorly run and could do much better if he had a good office manager/nurse instead of a teenager. If the doctor 'invested' that $50k in finding and hiring such a manager, he may find that had a real return (which would help him but also help the economy as a whole). But tax wise salaries or payments to consultants are almost always labeled expenses so they would never qualify for an 'investment' credit.

If this tax loophole caused the doctor to buy the hummer instead of hiring a office manager, then on paper supply-side economics will appear to have worked. 'Capital stock' will have increased but there will be no increase in economic growth later on.

Arnold Kling writes:

"I was under the impression that the AEA Presidential address that I provided the link to was rather full of that."

Full of something, anyway. I thought that all Lucas did was assume away the problem of macroeconomics. See http://econlog.econlib.org/GQE/gqe378.html

Mcwop writes:

Investment does not mean much if products produced by the investments are not consumed. Maybe the doctor lives in a snow ridden area and needs that Hummer to get to the hospital when on call - is that consumption or an investment? If you need a vehicle for your business it is an investment. Regardless, overall the tax changes Reagan made were good for investment, though not without some loopholes. In 1986 Reagan's tax proposal eliminated many loopholes - score one for the gipper again.

Jim Glass writes:

"I noticed the word's 'capital stock' cropping up a lot in your quotes. Just take my example of the doctor buying a Hummer due to a 'business investment credit'. In such a transaction, the $50K would be considered an investment or increase in the stock of capital ... But this increase is entirely meaningless. It would be an example of consumption being mislabeled as investment..."
~~~~~~~~~~

So you are arguing that Lucas doesn't know the difference between consumption and investment?

Just for the record I'll note that he doesn't propose creating tax subsidies for particular kinds of purchases and investments but rather removing taxes from investment generally.

Boonton writes:
Investment does not mean much if products produced by the investments are not consumed. Maybe the doctor lives in a snow ridden area and needs that Hummer to get to the hospital when on call - is that consumption or an investment? If you need a vehicle for your business it is an investment. Regardless, overall the tax changes Reagan made were good for investment,

What you are missing is the distortion caused by the gov't granting certain behavior favored status. Why is the economy unable to properly function if the gov't DOESN'T grant a special credit for buying expensive vehicles? If a doctor can make a good living driving his Hummer over glaciers to treat remote patients, then certainly the economy can provide the needed incentive.

I direct this argument at favored treatment of 'investment' as well. First of all, if the economy suffers from a lack of savings/investment then why would the rewards for investing not increase sufficiently to motivate individuals to do more of it? Second, why the implicit assumption that investment is immune to the law of diminishing returns? Like everything else, too much of a good thing soon becomes bad. Invest too much and the economy ends up with thousands of miles of unused fiber optic cable and hundreds of $2,000 executive chairs keeping the buns of 20yr old dot-com 'executives' warm.

So you are arguing that Lucas doesn't know the difference between consumption and investment?

Just for the record I'll note that he doesn't propose creating tax subsidies for particular kinds of purchases and investments but rather removing taxes from investment generally.

I'm sure Lucas does know the difference however we are limited to the reported statistics. When business buys $5B of 'capital goods' the clerks assembling the statistics cannot break that into good investment, bad investment and consumption cross-dressing as investment... For some doctors the Hummer may very well be a sensible investment...for other doctors the office computer may be little more than a video game & porn surfing machine written off as a 'business investment'.

When you make statements like 'Policy X will increase the capital stock', you should be careful about what that means. The capital stock may very well increase but that may generate no new benefit for the economy.

Here's another illustration. Suppose the gov't announced anyone named 'John' will have their tax rates cut in half. No doubt such a policy will result in millions of name changes and if you look at tax receipts from 'Johns' you'll notice that they probably will go up. A supply-sider, named John or paid by people so named, will no doubt announce that this is the key to economic growth.

Now replace 'John' with 'investment income'. Even being very precise, it is very easy for people to make consumption look like investment (or investment look like consumption) if they are given a reason to do it. I'm only asking you to consider that your wonderful increase in the 'capital stock' may be a lot more of an accounting fiction than an economic fact!

Festa writes:

Arnold,

I think you are not giving Ronald Reagan enough support for supporting Volker in the fight to curb inflation. As Peter Robinson points out in his book "How Ronald Reagan changed my life," Volker reversed his tight monetary stance early in 1980 right around the time the election was gearing up. Coincidence? I do not think so.

Given Carter's previous speeches, I am not sure he would have had the political will to stand up to Volkers critics. Furthermore, I am not sure the country could have made it through without someone as articulate as Reagan.

As to deregulation, I must say Carter deserves some credit, but so what? Ronald Reagan made significant advances in deregulating the economy as well and was infinetly better at articulating the reasons for doing it. Reagan gave moral support to free enteprise.

At the end of Reagan's at years the following had occured
1) A much fairer and flatter tax system that was good for long term growth
2) the ending of inflation for ever and the appointment of the best fed chairmen in the history of the federal reserve
3) a shift in the court that brought (some) sanity back to the judiciary system
4) Solid advancements in deregulation
5) Amazing advancements in the cold war
6) A restoration of the confidence of the American people
7) A change in debate from "what can we do to help" to "what should we be doing to help."

Not half bad!

DSpears writes:

Reagan's single biggest contribution was his dratic decrease in regulations. The numebr o pages of the national register dropped dramatically during his term. This is what liberals howled the most about, not his tax reductions which many saw as a classical Keynsian move (coupled with dramatic spending increases).

To say that a lowering of tax rates didn't matter to businesses is quite puzzling to me. Do businessmen really not care about being allowed to keep more of their hard earned money? That wouldn't apply to any of the businessmen I've ever known or anybody I've ever known period.

In the end, the tax structure was dramatically altered. The missing part of the equation is that lowering the top rate from 70% down to 28% meant that people who had previously put their money into un-productive tax shelters and tax avoidance schemes could now put that money at risk because they could expect to get a good return in exchange for that risk, of which they couldn't get when 70% of the gain went to the govenment.

The difference between 70% and 28% is more than 2x. How many investment decisions would change if the potential return was doubled? My answer is "quite a few".

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