Laffer: How Reagan and Thatcher Tax Cuts Drove 4% Growth

The strongest testimonial to Reaganomics is imitation: successors from rival parties — Bill Clinton and Tony Blair — continued the policies of Ronald Reagan and Margaret Thatcher.

The benefits did not just “trickle down” — they poured, writes Arthur Laffer

When Reagan became president in 1981 the top income-tax rate in the United States was 70%. When he left in 1989 that rate was 28%. When Thatcher became prime minister in 1979 the top income-tax rate in Britain was 83%. When she left in 1990 it was 40%. These declines were nothing short of incredible.

In the 1980s the chains holding prosperity at bay were removed.

High taxes, sluggish growth and 1970s stagflation

Reagan and Thatcher’s reforms transformed their respective economies. Before the 1980s big companies that could manage tax deductions and offer compensation packages that included tax-free benefits and expense accounts were the norm. Entrepreneurialism was a rare bird. Downturns — some massive — were common, along with persistent sluggishness.

Top tax rates in the 60-70% range prevailed as these two countries sank into the Great Depression in the 1930s. Top tax rates above 90% accompanied the slow private-sector growth of the 1950s. And top tax rates at 70% and higher ushered in stagflation in the 1970s.

Is the body politic so short-sighted that it has forgotten the inflation and despair when the major nations led the world off the Bretton Woods gold standard in the early 1970s? During the decade to 1982, inclusive of the 1978-79 Winter of Discontent that threw the Labour government from power in favour of Thatcher’s Conservatives, British retail prices rose by a truly unconscionable 14% a year on average, while real economic growth crept along at mere 1.6% a year.

“Labour isn’t working”, declared the iconic Saatchi & Saatchi slogan for Thatcher’s campaign, amid 5.3% unemployment. A similar situation — economic stagflation with high joblessness — also gripped America.

How lower taxes, sounder money and privatisation remade business

In the 1980s, as Reagan and Thatcher broke with historical precedent and slashed top tax rates, the old corporate business models that had made sense under high-tax regimes became obsolete. Entrepreneurialism thrived.

Top-performing employees demanded a preponderance of cash over in-kind compensation, amassed startup capital and left legacy firms to launch their own enterprises. Legacy firms in turn restructured their organisations to fit the new lower-tax, lower-regulation and sounder-money structure.

Wall Street and the City of London attracted immense new business as companies that had survived the 1970s reorganised to fit the new circumstances, while startups inhaled capital and multiplied like rabbits.

From sub-2% stagnation to 4% growth

Suddenly gone were the struggles with sub-2% economic growth and stratospheric inflation. When Reagan and Thatcher cut tax rates — and Thatcher vigorously pursued the privatisation of state industries — growth exploded and inflation dematerialised.

Between 1982 and 1988 Britain clocked GDP growth of 4% on average each year, and inflation halved to 4%. America did just as well. The contention that tax-rate cuts at the top would merely provide a “trickle-down” effect was unfounded: 4% growth, unheard of today, and over the long haul no less, is a roaring wave.

Jobs, incomes and wider share ownership

Ordinary Americans reaped the benefits: between 1980 and 2000 around 40m new jobs were created — an increase of more than 40%. Mass participation in the stock market led to incredible gains in household wealth. The Dow Jones Industrial Average went up about 15-fold between 1982 and 2000.

Median household income shot up by 12% and 15% over the Reagan and Clinton booms respectively, only faltering in the early 1990s, when President George H.W. Bush raised top tax rates. Meanwhile, in Britain the median household’s weekly earnings increased by 26% during Thatcher’s premiership, while the number of adults owning shares rose from 3m to 11m.

Early mistakes before the mid-1980s boom

Reagan and Thatcher did make their fair share of mistakes, especially in the early days. Both were initially hesitant to reform their tax systems; Thatcher was uncomfortable with immediate tax-rate cuts. She dubbed them “Lafferism” — the theory behind the “Laffer Curve” that I drew on a cocktail napkin in 1974, which holds that tax cuts can pay for themselves by stimulating enough de-sheltering and growth to increase government revenue.

In her first term Thatcher cut the tax rates very few paid — the top tax rate went to 60% — while raising taxes that everyone did, value-added tax — and the result was a net tax increase. Growth was non-existent over her first two and a half years in power.

Meanwhile, Reagan opted to phase in his first tax cut between 1981 and 1983 in three stages. While he dithered the economy suffered: the recession of 1981-82 was justly regarded as the worst since the Depression. It was only in the mid-1980s, when both leaders overcame all reluctance to slash taxes, that their economies boomed and left the stagflation of the previous period in the dust.

Why Clinton and Blair kept the revolution

Despite an initial two years of economic-policy missteps on the part of both leaders, the Reagan and Thatcher revolutions transformed both countries’ economies until the end of the millennium. Their long-serving successors from opposition parties, Mr Clinton and Sir Tony, did not permit a return to the old world of very high top tax rates; the highest rate during the 1990s was 40%.

Both countries’ strong growth runs continued in the 1990s, 3.9% on average per year in America between 1993 and 2000 and 3.3% in Britain over the same period. These figures are a world away from the paltry numbers with which large economies have to content themselves today.

Arthur Laffer is a former chief economist at the Office of Management and Budget. He served on Ronald Reagan’s economic policy advisory board from 1981 to 1989.

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