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The Truth About Supply-Side Tax Cuts in the 1980s
by
Dr. Judd W. Patton

     Reaganomics, the term dubbed by the media for President Reagan’s economic program, called for reduced federal spending, balanced budgets, deregulation, return to sound money, and lower taxes.  It was this latter component - cutting taxes and tax rates - that is particularly identified with Supply-Side economics.  Supply-Siders won the day.  Major legislation cutting income taxes and tax rates passed in 1981 and 1986.

     History shows, however, that the 1980s had unparalleled federal budget deficits.  Critics of Reaganomics therefore ridicule Supply-Side economics (calling it Voodoo economics) claiming the tax cuts were responsible for the huge deficits and were, as well, a bonanza to the rich at the expense of other Americans.  These critics have an erroneous view of history.

     The plain truth is that while tax rates declined, tax revenue actually rose in the 1980s.  Tax cuts did not cause expanding deficits, excessive federal spending did.  In terms of the tax incidence, the rich got richer but paid a larger percentage of the income tax revenue.  Americans in the bottom 50% of the income distribution got richer too, but paid a lower percentage of the federal income revenue as a group and as individuals.

Supply-Side Theory Background

     Supply-Siders emerged in the mid 1970s in response to the Demand-Siders, also known as the Keynesians.  Decades of Keynesian efforts to manage and fine-tune the economy had culminated in a wholly new phenomenon in the 1970s: “stagflation” - an inflationary recession.  Supply-Siders (as the Austrian economists before them) wisely challenged the Keynesians pointing out that macroeconomic policies that ignored individual and entrepreneurial incentives were bound to fail.  Ever higher taxes and tax rates are major disincentives for Americans to work, save, invest and engage in risk-taking ventures.  Furthermore, rising government spending with ever more transfer payments and entitlements act as incentives for additional people to “line up at the public trough,” and leave the ranks of the producers and productive in society.  Keynesian macrotheorists seem oblivious to these economic truths.  Their easy money policies combined with higher taxes and government programs produced “stagflation,” something that admittedly baffled them!

     Enter Art Laffer – who some consider the father of the Supply-Side economics - with his now famous “Laffer Curve.”  A simple parabola, the Laffer Curve dramatically demonstrates that as tax rates rise eventually a point will be reached where tax revenues decline.  In short, a high tax economy induces less work, saving, investing and entrepreneurial risk-taking.  Capital formation and incomes decline.  The economic “pie” shrinks causing lower tax revenues. In other words, there is an inverse relationship between tax rates and tax revenue above a certain height of the tax rates.

     Interestingly, Adam Smith, the founder of Classical economics, expressed this Supply-Side tax proposition 200 years before Laffer! He said, “High taxes, sometimes by diminishing the consumption of taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to government than what might be drawn from more moderate taxes…there can be but one remedy, and that is the lowering of the tax”1

     The eminent Austrian economist Ludwig von Mises expressed the principle this way: “The true crux of the taxation issue is to be seen in the paradox that the more taxes increase, the more they undermine the market economy and concomitantly the system of taxation itself…  Every specific tax, as well as a nation’s whole tax system, becomes self-defeating above a certain height of the rates.”2

The 1980s Tax Statistics3

     The Kemp-Roth tax cut of 1981 and the Tax Reform Act of 1986 together lowered our Federal income tax rates from fourteen brackets, starting with a 14% rate up to a top marginal rate of 70%, to three brackets: 15%, 28% and 33%.  Though far from a flat tax, the progressivity declined sharply.  Were he alive, Karl Marx would have been livid. 

     But notice what happened.  The real (inflation-adjusted) tax revenue collected from the top 1 percent of earners rose a whopping 51% between 1980 and 1990.  The percentages were 35.9% and 28.8% for the top 5% and top 10% of earners, respectively.  Likewise, the share of the total tax paid for each of these groups went up sharply, as it did on a per return basis.  It was quite different, however, for the rest of the American taxpayers.  The real tax revenue collected from the bottom 50% of earners fell 8.5% as a group, and 25% per individual return.  Overall Federal tax revenue went up 14% in real terms.  Unfortunately, Federal budget outlays increased 112% from 1980 to 1990.  Enough said as to why deficits skyrocketed in the 1980!  For those wanting a comprehensive economic picture of the 1980s, read, “What Went Right in the 1980s by Richard B. McKenzie.

     A word of caution to Supply-Siders and other public policy analysts is in order, however.  Never forget the fundamental economic truth that the actual burden of government on the private economy is measured by the total level of government spending, not the level of taxation.  Serfs during the middle ages were required to work no more than a third of their time for their masters.  The average American now works about 40% for the government!  In that light, tax cuts obviously seem warranted.  But even more compelling is the moral and economic case to eliminate big government, and restore the limited, constitutional government our Founding Fathers bequeathed to us.

1 Adam Smith, The Wealth of Nations.  (New York: Random House, 1937),  p.835.

2 Ludwig von Mises, Human Action.  (Chicago: Henry Regnery Company, 1966). p. 741.

3 James Gwartney and Richard Stroup, Introduction to Economics. (New York: The Dryden Press, 1994),  p. 361.

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