What it means
The policies grew out of the troubled economy of the 1970s, when high inflation and weak growth occurred together. Supporters argued that heavy taxes and regulation were discouraging effort and investment.
They proposed cutting marginal tax rates, the rate paid on each extra dollar of income, so that people keep more of what they earn. The programme had four main parts: lower taxes on income and business, less regulation, slower growth in federal spending outside defence, and tighter monetary policy to curb inflation.
The tax cuts of 1981 and the tax reform of 1986 reduced the top income tax rates substantially. Meanwhile, defence spending grew.
A central idea was the Laffer curve, which says that at very high tax rates, cutting the rate can actually raise revenue because the economic activity it encourages expands the tax base. Whether this happened in practice is still debated.
Most economists accept that the effect holds only at very high rates, and that tax cuts usually reduce revenue at moderate rates unless they produce strong growth. The results are argued over.
Supporters point to falling inflation and a long period of economic expansion in the 1980s. Critics point to large budget deficits, growing public debt and widening income inequality.
The nuance is that it is hard to separate the effects of the policies from other factors, such as the central bank's tight monetary policy, falling oil prices and the business cycle. For finance readers, the term is best used as a label for a policy approach, with the evidence assessed carefully.
Anyone using it in a business setting should be clear on which claim they are making. The legacy of the period is visible in today's debates about tax and spending.
Arguments about whether to cut rates to boost growth or to protect revenue to limit debt often echo the same ideas. For that reason, the term is useful shorthand even when the details of the 1980s are not the topic.
In practice
Real-world examples.
Example
A business owner in the early 1980s sees the top tax rate on income fall and the rules on depreciation become more generous. She decides to invest in new equipment for her factory. The lower tax cost makes the project look more profitable.
Example
A finance student compares two tax proposals. One cuts rates and assumes that growth will make up the lost revenue, and the other cuts spending. Using the Laffer curve, she tests how large the growth would have to be.
Example
A bond analyst studies the effect of the large budget deficits of the period on interest rates. She notes that heavy government borrowing can push up the cost of capital for companies. The historical episode is a case study in the link between tax policy and debt.
Formula
Calculation
Tax revenue = tax rate x tax base
Suppose a country has a taxable income base of $600,000,000 and taxes it at 40%, collecting 0.40 x 600,000,000 = $240,000,000. The rate is cut to 30%, and the base grows to $700,000,000 because of extra activity, giving revenue of 0.30 x 700,000,000 = $210,000,000. To collect the same $240,000,000 at a 30% rate, the base would need to reach 240,000,000 / 0.30 = $800,000,000, so the tax cut would need to raise the base by a third to pay for itself.Case study
Seen in the real world.
Eastlake Republic is an illustrative, fictional country whose government cut its top income tax rate from 70% to 50% and promised that growth would offset the loss of revenue. The taxable income base was $400,000,000,000 before the cut.
Before the cut, revenue from the top bracket was 0.70 x 400,000,000,000 = $280,000,000,000. After the cut, the base grew by 10% to $440,000,000,000, so revenue was 0.50 x 440,000,000,000 = $220,000,000,000.
Revenue fell by $60,000,000,000, so the cut did not pay for itself at this level, though growth did soften the loss. The illustrative lesson is that whether tax cuts raise revenue depends on how high the starting rate is and how strongly the economy responds.
Watch out
Common mistakes.
- Assuming tax cuts always pay for themselves, when this is true only in limited circumstances at very high rates.
- Crediting or blaming the policies for every economic result of the period, when other factors played a part.
- Using the term as a general label for any tax cut, when it refers to a specific set of policies in a specific period.
Questions
People also ask.
What is supply-side economics?
It is the view that economic growth is best encouraged by lowering taxes and reducing regulation to raise production, rather than by boosting demand.
What is the Laffer curve?
It is a diagram showing the relationship between tax rates and tax revenue, with revenue rising up to a point and then falling as rates become very high.
What were the main criticisms?
Critics said that the policies increased deficits and public debt and widened the gap between rich and poor.
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