In his book Econoclasts¹, historian Brian Domitrovic produces what he believes is the first historically rigorous account of the development of supply-side economics (that is, one that relies on primary sources).  He reviews contributions to supply-side theory by Nobel Prize winning economists Robert Mundell and Robert Lucas, as well as significant contributions from outstanding economists that have not yet won a Nobel, like Martin Feldstein, Art Laffer and John Rutledge.

As early as the 1950s, Mundell proposed an economic policy program of tight monetary policy to stabilize the value of the currency and low tax rates to stimulate economic activity.  During the late 1960s and early 1970s, economic policy in the U.S. moved in the opposite direction.  Easy money allowed rising inflation that combined with a highly progressive and non-indexed tax rate structure to produce high and rising tax rates on income, savings and capital formation. 

Martin Feldstein documented negative effects on capital formation of high and progressive tax rates, especially in a period of high inflation.  Art Laffer sketched on a napkin the famous curve that shows tax rates can be so high that increases in tax rates reduce revenues, because the tax base falls.  Conversely, lowering tax rates from very high levels can increase revenues, if the increase in the tax base more than offsets the lower tax rate.  Even if that is not the case, the key insight is that the tax base, economic activity, will be greater under lower marginal tax rates.

These and other arguments created a strong demand for lower marginal tax rates.  Although resisted by President Jimmy Carter, capital gains taxes were lowered in 1978.  But, it is often argued that these ideas fully arrived in Washington with the election of Ronald Reagan in 1980 and arrival of the supply-side team in January 1981.  But this team did not consist only of supply-siders; also included were monetarists, government spending hawks and regulatory experts.

The Players (partial list)

Office of Management and the Budget (OMB)

       Director:  David Stockman (Government spending hawk)

       Chief Economist:  Larry Kudlow (Monetarist and Supply-Sider)

Treasury

       Secretary:  Don Regan (Wall Street CEO)

       Under Secretary for Monetary Affairs:  Beryl Sprinkel (Monetarist)

       Assistant Secretary for Tax Policy:  Norman Ture (Supply-Sider)

       Assistant Secretary for Economic Policy:  Paul Craig Roberts (Supply-Sider)

Council of Economic Advisors (CEA)

       Chairman:  Murray Weidenbaum (De-regulation expert)

Consultants and Advisors

       Art Laffer (Supply-Sider)

       Allan Meltzer (Monetarist)

       John Rutledge (Portfolio shift theorist and Supply-Sider)

Reagan’s economic forecast was pulled together by Larry Kudlow at OMB.  He hired a California economic forecasting outfit, the Claremont Economics Institute (CEI) under Chairman John Rutledge, to prepare the forecast.  During the fall of 1980, CEI’s private forecast featured the Reagan Scenario as the most likely case.  The Reagan Scenario included a sharp drop in inflation, a recession in 1982 due to tight monetary policy, passage of the Kemp Roth tax cuts and an economic boom starting in 1983.  Consistent with falling inflation, nominal interest rates were projected to fall over the forecast horizon (1981-1985).

Rosy Scenario

The official economic forecast of the Reagan Administration (released with the President’s proposed budget for fiscal 1982) had some of the flavor of CEI’s Reagan Scenario, but there were substantial changes due to input from economists at the CEA and Treasury. That is, the final forecast was the product of a committee.  The biggest change was to eliminate the projected recession for 1982 on the grounds that the tax cut would immediately induce a spike in investment and savings that would offset the drag from tight money.  CEI’s forecast of negative growth in 1982 was replaced by plus 5 percent!  The second major change was that the drop in inflation forecasted by CEI was moderated.  CEA Chairman Murray Weidenbaum is quoted in Econoclasts “Nobody is going to predict two percent inflation on my watch.  We’d be the laughingstock of the world.”

Well, in the event, inflation did come down much as the private CEI forecast called for.  By 1985, CPI inflation had fallen to 3% from 12% in 1980.  As people look back on Reaganomics today, they often focus on the budget deficit, which did increase dramatically during the early 1980s.  This was a third area of dispute in the forecast committee.  The CEI forecast called for a large deficit in 1982 due to the projected recession and the effects of lower tax rates.  Over time, as the economy recovered and government spending growth was constrained, the federal deficit was projected to decline.  The official forecast, however, did not show a large budget deficit, mostly due to the first change mentioned above – elimination of the CEI projected recession.

Yet, the CEI Reagan Scenario is pretty much what happened.  The deficit spiked in 1982 due to the sharp recession that began in the fourth quarter of 1981.  The recession ended in late 1982 and a very strong economy recovery began.  Growth averaged over 4.5% for the last six years of the Reagan presidency.  Strong growth did lower the deficit as a share of GDP, but lack of success in lowering federal government expenditures prevented the projected surplus from coming to pass.  Interestingly, Domitrovic blames the failure to curtail non-defense spending in part on the government view that inflation would fall more slowly than it did.  Caps on increases in government spending were left at 6-8% when they should have been lowered to 3-4%. 

The official economic forecast released by the Administration was labeled “Rosy Scenario” because the combination of falling inflation and a boom in real growth was taken by many to be excessively optimistic.  It is hard to know how the private CEI Reagan Scenario forecast would have been taken, with its even sharper (and yet more accurate) projected decline in inflation. 

Personal Experience

My very minor role in this history is that I was the econometrician (keeper of the forecasting model) at CEI back then, much like Dan Hamilton is the senior econometrician at CERF today.  In contrast to what you might have heard, there really was an econometric model at CEI, and it resided on my APPLE 2e computer.  While it is a little embarrassing to have to go back thirty years to find a forecast that was any good, the CEI Reagan Scenario turned out to be pretty much spot on.

Today, after a 25 year career as an executive in the financial services industry, I am now once again associated with an economic forecasting outfit, the Center for Economic Research and Forecasting (CERF) at CLU.  Over the past few years, the CERF forecast has been consistently more negative on economic growth than the consensus, and has turned out to be more accurate than the consensus.  While my contribution to this accuracy has been zero, it is nice to be associated with a group with a great track record. 

Optimal Policy Mix

If you listen to supply-side economists today, they seem to be arguing that the optimal policy mix is the same today as they felt it was in 1980; namely, tight money to stabilize the value of the dollar and lower tax rates to stimulate the economy.  Yet, economic conditions are quite different today.  Inflation and interest rates are much lower and tax rates are lower as well. 

While a high tax rate structure (relative to the rest of world) likely is one of the impediments to growth today, it seems to me that bigger problems are falling home prices, high debt levels and rising regulatory burdens.

The major aim of supply side policy is to establish conditions to increase the long-term rate of economic growth.  Today, that means establishing a credible plan for corralling the growth of government expenditures, rationalizing regulations and simplifying the tax code.   Also, it wouldn’t be a bad idea to liberalize legal immigration. 

¹Brian Domitrovic, Econoclasts, ISI Books, 2009.