by Eva Macián Avendaño
Tax changes influence the economy mainly through changes in consumer expenditure. Over long periods of time, consumer expenditures are proportional to real net private income. A reduction in the tax rate will raise private income, thus increasing consumer expenditures. Aside from such demand-side effects associated with a change in tax rates, there is potential to influence aggregate supply as well. This argument was popularized by the so-called supply-side economics, adopted by the Reagan Administration during the early 1980s.
This doctrine argues that income taxes reduce the after-tax reward to work and saving. Lower taxes will lead to a greater work effort, encourage people to work more and consume less leisure, thus increasing efficiency in the economy. Furthermore, the increase in work and saving can be so significant that after the tax cut it is possible for the government to collect higher revenues than before the tax cut. Opponents of these arguments claimed that such large tax cuts would create enormous government budget deficits (now we know that the critics were right).
The argument underlying the supply-side proposition was illustrated by the Laffer curve, named after economist Arthur Laffer of Pepperdine University. He presented his curve in order to convince Ronald Reagan that lower tax rates could result in higher tax revenues for the government, submitting evidence based on the 1964 tax cut episode.
A typical Laffer curve is reproduced in the figure. If the tax rate is zero, then the government will raise no tax revenue. As tax rates increase, tax revenues will first raise, reach a maximum (point B), and then fall. At a rate of 100%, no one will work, and thus tax revenues will equal zero again. If the government introduces a tax cut, and the economy starts from point A, it will move to the left along the Laffer curve, and government revenues will fall. But a tax cut starting from point C will cause a leftward movement along the curve, resulting in an increase in tax revenues. The question then becomes the following. Was the economy at point A or point C in 1981? President Reagan's economic advisors based their recommendations on a belief that the U.S. economy was in the downward sloping region of the Laffer curve.
The mistake of the Reagan administration was to ignore the difference between the expansionary monetary policy that accompanied the 1964 tax cut and the restrictive policy that accompanied the 1981 and 1982 stages of the Reagan tax cuts. A stimulative fiscal policy is usually combined with a stimulative monetary policy, which will finance part of the higher government spending or lower taxation. In 1964-65 both the IS and LM curves moved to the right. But in 1981 and 1982 the IS curve moved to the right while the LM curve moved to the left by a greater distance, thus creating a recession.