As so many have observed, if we don't understand the past, we cannot understand the present. To understand the past, let's begin with Reaganomics.
So what Was Reaganomics?
"Reaganomics" was the media's name for supply-side economics, which was a correction to Keynesian demand management. Worsening "Phillips curve" tradeoffs between employment and inflation became a policy issue during the Carter administration. The Keynesians had no solution except an incomes policy that had no appeal to Congress. This opened the door to a supply-side solution.
Demand management treats the aggregate supply schedule as fixed. Fiscal and monetary policies were assumed to have no impact on aggregate supply, a function of technology and resources. Changes in marginal tax rates, for example, would, if expansionary (lower rates), move aggregate demand along the aggregate supply schedule to higher employment; if contractionary (higher rates), the policy would reduce inflation by reducing aggregate demand and employment.
Supply-side economists said that some fiscal policies directly shift the aggregate supply schedule and that neglect of this by Keynesians was the explanation for the worsening Phillips curve trade-offs. The Keynesian policy stimulated demand but high tax rates held back the responsiveness of supply, so prices rose relative to output and employment. This was the explanation of the worsening Phillips curve trade-offs.
Supply-side economists pointed out that marginal tax rates affect two important relative prices. One is the price of leisure in terms of forgone current income. The other is the price of current consumption in terms of forgone future income. Thus, marginal tax rates affect both the supply of labor and the supply of savings. The higher the tax rate on labor income, the cheaper is leisure. The higher the tax rate on investment income, the cheaper is current consumption or what is the same thing, the higher is the opportunity cost of saving and investing.
Supply-side economists said that the solution to the worsening Phillips curve trade-offs was to change the policy mix: tighten monetary policy and "loosen" fiscal policy by lowering marginal tax rates.
Despite the clarity of my explanations in The Supply-Side Revolution (Harvard University Press, 1984) The New Palgrave Dictionary of Money and Finance (1992), The McGraw-Hill Encyclopedia of Economics (1994), Zeitschrift fur Wirtschaftspolitik (38 Jahrgang 1989), Rivista di Politica Economica (Maggio 1989), The Public Interest (Fall 1988) and here, the myth has been established that supply-side economics is about tax cuts paying for themselves.
As the Wikipedia entry, for example, puts it, "The Laffer curve is one of the main theoretical constructs of supply-side economics." This is nonsense. The issue that the policy addressed was the worsening Phillips curve trade-offs, not raising revenues for the government. As all official documents show, the Treasury's revenue forecast of the Reagan tax rate reduction is the Treasury's static revenue forecast that every dollar of tax reduction will lose a dollar of revenue.
Where then did the "Reagan deficits" come from? The answer is that they came from the Phillips Curve. The Council of Economic Advisers took the position that a forecast that departed significantly from the Phillips curve belief that the economy could not grow while inflation declined would lack credibility. A forecast of rapidly falling inflation would especially discredit a budget that encompassed a tax rate reduction that would be, despite our explanation, interpreted as a demand stimulus policy. The budget director, David Stockman, and the White House chief of staff took the position that the Republican Senate would not vote for a tax rate reduction that enlarged the budget deficit. Therefore, against my advice (I was Assistant Secretary of the Treasury for Economic Policy) the inflation numbers in the six-year (1981-86) budget forecast were raised to accommodate the Phillips curve and the Republican fear of budget deficits.
Having been present at Fed chairman Paul Volcker's meetings with the Fed's outside consultants, I heard them tell Volcker that the administration's policy was a massive fiscal stimulus and that, in Alan Greenspan's words, "monetary policy is a weak sister; at best it can conduct a weak rear-guard action." I saw that Volcker was not going to follow the Treasury's request to gradually reduce the growth rate of money, but in order to protect himself would throw on the brakes before any part of the phased-in tax rate reduction had gone into effect.
And that is what Volcker did. Inflation collapsed relative to forecast. The collapse in inflation collapsed GDP and the tax base and is the origin of the budget deficits. The Reagan inflation forecast was below the Carter administration and CBO forecasts, but high relative to actual inflation. For example, Reagan's budget forecast inflation rates (1981-86) of 11.1%, 8.3%, 6.2%, 5.5%, 4.7%, and 4.2%. Actual inflation was 8.9%, 3.8%, 3.8%, 3.9%, 3.8%, and 1.1%.
The budget deficits, which had been hidden by a curtsy to the Phillips curve and Republican deficit phobia, became a weapon in the Democrats' hands. As a member of the Senate staff during 1977-78, I succeeded in securing the support of leading Democrats, such as Russell Long, chairman of the Senate Finance Committee, Lloyd Bentsen, chairman of the Joint Economic Committee, and Sam Nunn on the Armed Services Committee, for a supply-side policy. Indeed, the first Senate reports endorsing a supply-side policy were issued by the Joint Economic Committee under Bentsen's chairmanship in 1979 and 1980. Support for a supply-side policy had also spread into the House Democrats. House Speaker Tip O'Neill introduced a Democratic supply-side alternative to Reagan's. The only way Reagan could differentiate his tax cut from the Democratic alternative was by indexing the tax rates for inflation (beginning in the mid-1980s).
Despite the willingness of Democrats to support a supply-side policy, the White House staff wanted to give Reagan a "political victory" by picking a fight and cutting the Democrats out of the tax bill. This "victory" turned to ashes when the Phillips curve proved to be bogus. Democrats, media, and academics turned on the administration, accusing it of a Laffer curve forecast, and Wall Street economists kept interest rates high with their absurd prediction that budget deficits resulting from the collapse of inflation would cause inflation to explode.
In the United States the Phillips curve has disappeared. Not even a decade of quantitative easing and an enormous expansion in the Fed's balance sheet have been able to bring it back. The Fed is still trying and remains unsure whether it can raise the short term interest rate by 25 basis points. And this despite enormous budget deficits. The miniscule rate increases about which the Fed worries are not even real increases as they do not offset the low reported inflation.
Those who recognize the Phillip Curve's demise attribute it to globalization, that is, to the offshoring of high-productivity, high value-added manufacturing jobs that have destroyed manufacturing unions. However, the Phillips Curve disappeared long before globalization took off. The US 70% tax rate on investment income and the 50% tax rate on personal income from the Phillips Curve era have been absent for 35 years. To resurrect the Phillips Curve, the responsiveness of output to demand would have to again be impaired.
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