Monday, August 07, 2006

REAGANOMICS, THE ECONOMICS OF SUCCESS

The economic policy pursued by Ronald Reagan is often called “Reaganomics” or “supply-side” economics. Fortunately, this policy meant a radical cut of Keynesianism where consumption was stimulated with massive government spending. Keynes put the emphasis of economic policy on the demand-side (consumption). Reagan, by contrast, put the emphasis on the supply-side (production). Keynes believed that demand would create supply, but Reaganomics started from the opposite idea, namely that supply would create demand. In this way of thinking, the supply side of the economy (economic activity, production etc…) had to be stimulated in order to create wealth. The best way to do this was to cut the marginal tax rates on personal income. Such a tax cut would create a strong incentive to increase economic activity and would have spectacular effects on growth, investment, risk-taking and saving.





President Ronald Reagan’s stature will grow as his achievements come to be more widely recognized. It was Reagan’s confidence in capitalism, not his defense buildup that caused Soviet leaders to lose their confidence in further pursuit of destructively devastating state-controlled economy. Ronald Reagan took away the Soviets’ comfort factor when he said that the “Phillips curve” and falling US productivity were the results of the wrong policy mix, not inherent features of a market economy. The U.S. economy, in other words, could be easily fixed, but the Soviet economy could not. Later I will speak about Reagan’s slashing of tax rates from 70 to 28 percent. After imposing genius liberal economic reforms, Margaret Thatcher achieved similar results in reforming Keynesian legacy of British economy. Surprisingly, even French followed and pursued fueled privatization of their socialized economy. Reagan revitalized the U.S. economy. He abandoned the Keynesian policy mix of monetary expansion to stimulate demand and high tax rates to restrain inflation--which was obviously not being restrained by Keynesian demand management. Reagan got the supply-side message that high tax rates were restraining real output while money growth pumped up demand, thus causing inflation.


Reagan’s policy was a success. But at the time it was misunderstood. Accustomed to thinking of tax cuts as a demand-side measure to stimulate consumer spending, the entire economics profession, along with the Federal Reserve, the Republican Senate, and most of Reagan’s own government, predicted accelerating inflation. Reaganomics is probably the only economic doctrine that made its way into a pop song. In 1985, the British group Simply Red criticized the 'antisocial' policy of Reagan in their song “Money’s Too Tight To Mention” (actually, a cover version of an original American song by the Valentine Brothers from 1982).

The popular perception of Reaganomics is clear: an antisocial policy with a curtailment of social expenses. But criticizing Reaganomics is not the monopoly of the left. Even classical (i.e. pro free market) liberals and libertarians are convinced that although Reagan stimulated the economy, it came at the cost of an enormous budget deficit. Even George Herbert Walker Bush was initially very sceptical of the economic ideas of Reagan. In 1980 he spoke about “voodoo economics”. He changed course when Reagan chose him as running mate for the presidency.

In the sixties and seventies, Keynes' economic theory was applied on a large scale. Keynes developed his ideas in the deep economic recession of the thirties, with its high unemployment. Keynes argued that governments should stimulate aggregate demand by massive spending and infrastructure works in order to invigorate the economy. Through the “multiplier” effect every dollar spent by the government would create a multiple in income. Unemployment would vanish, the tax base would broaden, and the budget deficit would disappear, Keynes argued. But during the oil crisis of the seventies, it became clear that Keynesianism did not work. Higher public spending did not resolve unemployment. On the contrary, unemployment increased in line with the increase of government spending. Moreover, unemployment and inflation appeared simultaneously, a fact which could not be explained by the dogmas of Keynesian thinking. The only thing they were able to do, was to give it a name: “stagflation”, which meant that we had a combination of creeping inflation, recession and unemployment. During the Carter years, inflation was at a staggering 13%. Huge interest rates were necessary to fight it. The interest rate on credit facilities reached the unbelievable level of 21%. The drama was complete when taxes were increased to fight both inflation and government deficits. During the Carter years, the top marginal tax rate on personal income rose to the insane record level of 70%. Experts in Economic & Tax Policy did not know how to agree on any economic policy. They simply had no solution!

Many of the recent studies have indicated that high public spending as Keynes had advocated does not stimulate the economy. The main reason is that money that could otherwise be spent by private sectors, shags off with public jobs which offer very little or even zero return. Money to pay the deficit must come from somewhere else to paid-off and usually it is the taxpayer who must pay it. The fundamental basis of Keynesian logic is that it hardly makes sense to tax money away from productive people, thereby reducing their rewards, so as to spend it on unproductive goals. The United Kingdom which is the home of Keynesianism experienced it long years after the war. Keynesian economic policy was sticking and sticking and everybody seemed that there’s no way to stop it. Finally, Margaret Thatcher stopped putting continued Keynesian economic policy into practice. Another, more recently observed example is Japan. This country has provided one of history’s best demonstrations that the Keynesian demand stimulus is a deeply flawed economic philosophy. Despite huge government outlays, the Japanese economy is still wallowing in the slump that has afflicted it for more than ten years. According to the analysis of the relationship between and the size of governments in 16 European countries, the two main causes leading to poor growth performance are excessive government spending and a demotivating tax structure, which put a heavy burden on work, income and profit. This study has recently been confirmed and underpinned by multiple regression analysis, using econometrics tools to show the results.



There were four young economists who convinced Reagan to completely reserve the economic policy of that time. Those four economists were: Paul Craig Roberts, Robert Mundell, Norman Ture and Steve Entin. And there was another Journalist Jude Wanninski who contributed a great portion to the turnover of economic policy when Ronald Reagan started running his first mandate. The very basic point of view was that tax rates very extreme, too high and worked like a barrier, embodying a strong disincentive to work, risk and save. In a very popular point of view, “Economics of Discouragement” had to be translated into “Economics of Encouragement”. People are producing because it pays to do so. Consumption will not result in increased production when there are no incentives to do so. The logic is simple. When tax rates are becoming higher, people are loosing their interest in taxed working activities such as risk-taking, work and entrepreneurship. When tax rates fall down, people are starting to increase their participation in those activities since they see more incentives to participate in productive behavior and raise their incomes on a permanent basis. Only few people knew that Reagan had a major in Economics from Eureka College (Illinois) in 1932 The economic theory he was taught was untouched by Keynesian thinking and, as a consequence, very appropriate to the problems of the eighties. Reagan immediately took action. He lowered marginal tax rates from 70% in two phases: to 50% (Economic Recovery Tax Act of 1981) and in a later phase to 28% (The Tax Act of 1986).

These tax cuts created 18 million new jobs in 8 years, lowered inflation to 4.3% and cut unemployment from 9.7% to 5.4%. One of the longest and strongest economic expansions since World War II had begun, with an average annual growth rate of 3.5%. But the first two years (1981 and 1982) were lost for Reagan. Fed chairman Paul Volcker fought inflation with a tight monetary policy and high interest rates. The Reagan administration urged Volcker to decrease monetary growth by a maximum of 50%, in order not to kill the tax cut program. But as the Federal Reserve is totally independent, Volcker cut money growth by 75% in 1981. The recession became even worse, and unemployment rose further. But after inflation had been defeated, money growth resumed and the Reagan expansion took shape.

Many leftist critics claim that Reagan gave money away to the rich at the expense of poor. Under Reagan’s leadership the so called rich people paid-out comparatively more through income and corporate taxes than ever before. The economic position for the poor was suitable and enabled them to move-up because tax revenues paid by the poor went down. But the reason for that is very simple. Lowering tax rates enabled instant participation in productive behavior. If the rich worked more, they saved more and logically they paid more. Reagan’s tax policy was followed by a principle in which increasing tax rates will not result in an increase of tax revenue. If you want to increase tax revenue you must expand the tax base and consequently lower marginal rates in order to let the economy grow.

It is often claimed that the budget deficit had risen to enormous proportions during the Reagan years. But between 1981 and 1989 the budget deficit increased only slightly, from 2.6% to 2.9% of GDP. The deficit peaked in 1983 to 6.1% of GDP (the Volcker recession with tight money). During the same years the Belgian budget deficit varied between 7% and 13% of GDP. The average budget deficit for the G-7 countries was only slightly lower than that of the US. The public debt of the US as a percentage of GDP, remained below that of the G-7 countries, i.e. below 32% of GDP. But Belgian public debt, the result of years of Keynesian policy, was higher than 100% of GDP and remains around 100% at this moment.

Increasing social outlays doesn’t make sense when you have previously created poverty and unemployment with wrong and possibly destructive economic policy. Redistribution of wealth through high marginal tax rates has no clue. It distributes poverty.

Keynesian thinking explained the economic achievement in terms of the level of spending. Deficit spending will keep employment high and will stimulate the economy. Cutting the deficit (for the Keynesians) would reduce spending and throw people out of work, raising the unemployment rate, reduce national income and hence produce less tax revenues. Reagan on the contrary brought a totally new perspective to economic policy. Instead of putting the emphasis on spending, supply-side economists showed that tax rates directly affect the supply of goods and services. Lowering tax rates mean better incentives to produce, to save, to invest and to take risks. In other words lower tax rates stimulate supply and not demand. The broader tax base will compensate at least partially for the lost revenue caused by the tax cut. Higher savings will result in increased investment and unemployment will disappear. Instead of pumping up demand to stimulate the economy, reliance would be placed on improving incentives on the supply side.

Entire population couldn’t believe that former movie actor could enable the most explosive expansion of the growth of income with revolutionary economic policy that stepped with new supply-side approach.
But Ronald Reagan was not the only one leading a strong, productive and impressive economic policy considering supply-side mechanism. Ludwig Erhard put in practice supply-side economics in Western Germany in 1948. At that time he was in charge of economic policy. He introduced an economic shock therapy completely in line with Reaganomics. He abolished rationing and price-controls, although he restricted his own power with this measure. Erhard believed in the self regulation of the market.

Not only the Social Democrats were vehement opponents of the abolishment of price-control, but also Lucius D. Clay, the US. military governor, was furious. Erhard had pushed through the economic deregulation without ever asking the general. Clay called Erhard to account, thundering that the professor had infringed upon the Allies’ privileges by changing the rationing regulations. Erhard coolly responded : “you are mistaken, sir, I have not changed them, I have abolished them.” Later on Erhard, as secretary for the economy, cut the high marginal tax rate in two steps: first from 95% to 63% and afterwards to 53%. The first 8000 DM earned became tax free. The decisions taken by Ludwig Erhard allowed West-Germany to rebuild itself at a pace never seen. No surprise that he was called the “father of the wirtschaftswunder”. The German economic miracle cannot be explained by the Marshall Plan. Britain and France received Marshall money too, but they wasted their chances. Britain voted Labour, which brought rationing and price controls. France opted for economic protectionism, which prevented Marshal help to be used in an efficient way. After Reagan, the theory of supply-side economics was applied in numerous countries. In Iceland, David Oddson became prime minister in 1991. He inherited a poorly performing economy burdened by heavy income taxes. He lowered the corporate tax rate from 50% to 30%. During the next five years the economy grew by 5% per year. Government income did not fall and social outlays could be maintained. Ireland is another example. In 1987 this country was the “sick man” of Europe, with a public debt of 135 % of GDP. After the elections of 1987 a new economic policy was introduced. Corporate tax rate was reduced from 32% to 12.5% and capital gains tax was lowered from 40% to 20%. Ireland is now the fastest growing country of the EU. Japan, to the contrary, is a classic example of the failure of a Keynesian demand-side policy. The economy has been in shambles for many years and public debt has risen to a gigantic 170% of GDP. The following graph compares government spending and GDP per capita in Ireland and Belgium between 1960 and 2003. The Irish 'turning point' came with the adoption of supply-side economics.

A Reaganomics Plan for Slovenia

1. A considerable tax cut down to 20% on personal income.

2. The complete abolition of corporate tax rates repealing all public subsidies transferred to public enterprises where government owns major or partial stake

3. The abolition of taxes on dividends. Investment and risk taking has to be encouraged, not punished. A reduction (or abolition) of tax rates can make investment opportunities profitable that formerly were not

4. The abolition of all agricultural subsidies. At this moment 45% of the total EU budget goes to agricultural subsidies, respresenting the huge amount of 45 billion euro per year. This is not only dramatic for the tax payers, but it is also very harmful for the developing world, mainly for the poor countries in Africa. As a consequence of the subsidies, European agricultural products are dumped (at prices far below the cost) on the markets of these countries, preventing them from competing on the world markets with their own products.

5. A radical cut in the size of Government. After Sweden, Slovenia has the second largest part of public expenditures according to Fraser Institute. The government has received more than 2% of total revenues from public enterprises and other forms of government ownership.

Supply-Side and the Laffer curve

Supply-Side economics is widely misinterpreted as the Laffer curve. Arthur Laffer, an economics Professor at University of Southern California claimed that an important feature of supply-side economics is that tax cuts will pay for themselves. Laffer became famous after he illustrated this idea on a napkin in a restaurant in Washington in 1974. But the question is not whether tax cuts pay for themselves, but whether they are more effective in creating economic growth and welfare, compared to a Keynesian policy of increasing government spending. The difference between Keynesianism and the supply side school centers on fiscal policy. Does a successful fiscal policy work by incentives (tax cuts) or by increasing demand (spending)? The important question is not whether such a fiscal policy will pay for itself. The Keynesians stress demand, supply-siders stress incentives. Changing fiscal policy by creating incentives will change the behaviour of people. If tax rates rise, people will reduce their participation in taxed economic activities, such as working, risk-taking, investment and saving. When tax rates go down, people are motivated to increase their economic activity. The economic expansion that will follow a tax cut is far more important than the fact that tax cuts should pay for themselves. Most politicians in Western Europe have not yet understood this very important distinction. Even worse: the media in Europe have killed Reaganomics because they do not understand this difference.


Flat Tax: A Gate to the Future

Flat tax is even better solution to the problem than 5 points program above. If flat tax was introduced it would apply to both personal and corporate income. All relieves, deductions, allowances and subsidies will be eliminated. Loopholes would be impossible. The system would be so simple that it will perhaps take no more than five minutes to file a tax return. In 2004, 85% of Estonians filled their tax returns electronically. In the last ten years flat tax rates have been introduced in several economies. The first among them was Estonia in 1994 after having ignored painful advice from IMF aiming to introduce progressively applied tax rates and increase administrative costs what would push the economy even deeper of the cliff. Luckily, Mart Laar has been smart enough to follow Milton Friedman’s sophisticated solutions from “Free to Choose” in order to let Estonia become the pioneer of classical liberal free market policies shifting its economy ever upward.

A low level of a flat tax is important. The well-known Richard K. Armey, previous Majority Leader of the House of Representatives advocates a tariff for the US of maximum 17%. But this rate could even be lower. An analysis by the French economist Philippe Manière indicates that a flat tax rate of 10% in France would maintain the government revenues at the present level.

For Slovenia, an introduction of maximum 20% flat tax rate applied on both personal and corporate income would have enormous advantages:

1. Economic Growth would explode, leading Slovenia to become one of the fastest growing economies in Europe. Simple, fair and non-discriminatory Flat tax would create beneficial incentives to encourage people to expand their productive behavior with more risk, work, entrepreneurship, investment and saving habits. To find loopholes would be impossible and thus people would find very little reason to hide or offshore their money away from the government

2. Unemployment would be likely to almost disappear.

3. Since it makes almost impossible to avoid paying taxes, people would not evade them since they are willing to pay minimal tax burden when tax rates are less off. Flat tax won’t punish people for their contribution for “working too much” or perhaps “saving too much” since there’s a principle of territorial taxation put into context so you don’t have to pay taxes on your properties if you own one abroad. Tax return can be done in less than 15 minutes on a postcard-sized filling form.

4. At last, an important part of bureaucrats would be ripped off and perhaps they could transform their activity towards more productive tasks.

5. Remember what “Der Vater den Deutschen Wirtschaftswunder” Ludwig Erhard once wisely told: “A compromise is the art of dividing a cake in such a way that everyone believes he has the biggest piece.”

Will Reaganomics or supply-side economics ever be applied in Slovenia? In the UK, Ireland, Iceland and Eastern Europe current economic policy has strong supply-side influences. Currently Germany is in a worse socio-economic situation than Slovenia. Who knows, perhaps some day Slovenia might return to the successful formula of Ludwig Erhard and create a new Wirtschaftswunder, by applying supply-side economics. Such an example could show the way for Germany and other countries too.

Reference:

Paul Craig Roberts: Reagan Changed the World, Townhall, 7 June 2004

William A. Niskanen: Reaganomics, The Concise Encyclopedia of Economics

Larry Kudlow and Stephen Moore: Reaganomics. Then, Now and Forever, The Growth Club, 12th of June 2004

Murray Rothbard: The Myths of Reaganomics, Mises

William A. Niskanen, Stephen Moore: Supply Tax Cuts and the Truth Aboutthe Reagan Economic Record, CATO

Robert Bartley, Seven Fat Years and How to do it Again, Free Press, 1995

Luc van Braekel, Reaganomics, A Success Story, Brussels Journal
Daniel J. Mitchell: Taxes, Deficits and Economic Growth, Heritage Lecture

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