Why Reagan's Tax Cuts Didn't Work (Right Away) And Why Trump's Probably Will

Posted: Mar 06, 2018 10:38 AM
Why Reagan's Tax Cuts Didn't Work (Right Away) And Why Trump's Probably Will

Ronald Reagan presided over one of the great economic expansions of modern times. What many of his admirers (and I consider myself one of them) don't realize is that Reagan's tax cuts took a couple of years to show up in economic growth, and that for reasons which it is imperative to understand, actually hurt growth for a short time.

The main thing you need to understand is that tax cuts, while generally good for growth, only tend to stimulate growth when the taxes actually go down. You usually don't get growth when congress votes for them. That's because business managers look down the road and see that tax cuts are coming - and then try their best to wait until those cuts arrive before expanding their businesses. Think of business tax cuts and of income tax cuts for owners of business as putting profits 'on sale'. If the top business tax rate is 35%, but going down to 23% next year, that means that profits are 'on sale' starting next year. You will get to keep 12% more of your earnings once the taxes are actually cut. Reagan was forced to negotiate with Tip O'Neil and other congressional Democrats in such a way as to defer his tax cuts for a few years.

This graph tells some of the story:

But there's another important point to be made here. Unlike the period after the JFK and George W. Bush tax cuts, the economy continued to languish to some degree after the cuts were implemented. That's because Paul Volcker, Chairman of the FOMC, was pursuing a policy of aggressively shrinking credit to banks. He did this to break the back of inflation. It worked, and inflation stayed broken, really even up until now.

This graph shows the story:

When both ingredients were in the mix -- stable money and lower taxes -- we initiated one of the great booms in US history.

What does all of this mean for now? Money policy is unlikely to be as tight as Volcker's. First of all, there is not yet much inflation to stamp out. Second of all, it is hard to imagine the kind of policy courage we saw in DC in the early '80s taking hold in DC now. It takes a lot of inflation and a lot of guts for political leaders to risk a deep recession in order to stop inflation.

This short video was created for people who want to understand the powerful ways in which tax cuts work with or against monetary policy and how real world business actors respond to real world incentives: