August 13 marks an important anniversary in American economic history. Twenty-five years ago that day, Ronald Reagan signed into law the Economic Recovery Tax Act of 1981, which cut income tax rates by about 30 percent across the board. It marked an end to stagflation and the beginning of an economic renaissance that we all benefit from to this day.
After the economic boom of the 1960s, the 1970s were a period of economic distress, marked by simultaneous inflation and stagnation -- dubbed stagflation. Most economists had no clue about how to deal with this problem because the dominant economic theory of the day said that high inflation and high unemployment could not exist simultaneously.
This theory also said that inflation was largely a fiscal problem resulting from the federal budget deficit, and that there was an inverse relationship between inflation and unemployment: The higher one was, the lower the other would be. Believing this, there was virtually nothing policymakers could do. They couldn't increase spending or cut taxes to reduce unemployment because that would be inflationary. But if they fought inflation by cutting spending and raising taxes, that would raise unemployment.
Clearly, a new theory was needed to get the country out of this dilemma. It came from two economists at the University of Chicago. The first was Milton Friedman, who argued that the Federal Reserve's monetary policy, which had been largely ignored by economic theorists, was the principal cause of inflation; the budget deficit had no effect. The cure for inflation, he said, was to severely restrict growth of the money supply.
The second economist was Robert Mundell. He agreed with Friedman that tight money was needed to stop inflation. But Mundell argued that measures were also needed to stimulate production at the same time. After all, if inflation resulted from too much money chasing too few goods, then increasing the supply of goods and services would be anti-inflationary.
Mundell thought the tax system was the major impediment to economic growth at that time. He reasoned that inflation had severely distorted it by pushing workers up into higher tax brackets when they received cost-of-living pay raises; by forcing investors to pay taxes on capital gains that represented nothing but inflation; and by taxing businesses on illusory inventory profits while eroding the value of depreciation allowances.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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