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The Silence of the Reaganites
Subject Federal Budget
Topic Taxes, Spending, and Deficits
Key Words Budget Deficit, Budget Surplus, GDP
News Story

One of the most prominent proposals of George W. Bush's campaign for President was his push for a substantial tax cut. Although Ronald Reagan also made a tax cut an important part of his Administration's initiatives, the similarity ends there - the Bush tax cut is being justified on Keynesian grounds, whereas Reagan preached supply-side economics to support his cuts.

When Reagan came to office, tax rates where much more punitive, the highest tax bracket having a 70 percent marginal tax rate. Reagan supporters argued that big cuts in marginal tax rates would sharpen incentives for workers to work harder and the increased labor would boost output. Marginal tax rates have decreased considerably since the Reagan era. The top marginal tax rate is less than 40 percent. Consequently, additional tax cuts of the magnitude that Bush has proposed, would likely have modest labor supply effects at best. Furthermore, tax cuts would likely reduce savings, as a tax cut distributed to individuals would result in greater spending than if the government kept the surplus and used it to buy down the Federal debt. The reduction in saving would inhibit investment, and the decrease in the capital per worker could offset any modest increase in labor supply. This does not mean that decreasing marginal tax rates is a bad idea; rather, that the arguments for doing so should not include a promised increase in economic growth.

The Bush Administration is justifying its proposed tax cut on Keynesian grounds. A decrease in taxes will increase consumer spending, and by stimulating spending, prevent a recession. Treasury Secretary Paul O'Neill and White House economic advisor Lawrence Lindsey both have supply-side leanings. Both have expressed doubt in earlier writings about the efficacy of using tax cuts to fight recession. Yet, because supply-side arguments are difficult to make and a compelling argument for tax cuts is wanted, both advisors have resurrected Keynes for support.

(Updated March 1, 2001)

Questions
1. Show, using an aggregate supply/aggregate demand diagram, the impact on the economy of a tax cut. Assume that aggregate demand is the only sector affected. What happens to equilibrium output? Equilibrium prices?
2. Now suppose that the supply curve is also affected by the tax cut. What happens to aggregate supply? Output? Prices?
3. Because the government is more likely to save than individuals receiving a tax cut, it is argued that a tax cut will hurt savings and consequently, investment. Show on your diagram the consequences of this claim.
Source Sebastian Mallaby, "Goodbye to Reaganomics," The Washington Post, February 19, 2001.

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