Did Reagan's "Supply Side" Tax Cuts Perform as Advertised?

Defenders of President Reagan's 1981 tax cut like to argue that his "supply side" approach resulted in an exceptional surge in economic growth.  In support of this claim defenders of the "supply side" approach point to growth rates that were higher than growth rates observed since the onset of the Great Recession.  Of course, no one disputes that GDP growth rates were higher during the Reagan years than growth rates since the Great Recession.  But does that mean Reagan style tax cuts in the immediate wake of the 2007/2008 financial collapse would have resulted in growth rates similar to those observed in the 1980s?

In attempting to answer this question we have to ask what distinguishes a "supply side" growth approach from a garden variety business cycle macro approach to managing aggregate demand (AD)?  Notice that you cannot answer this question simply by noting that Reagan's tax cuts are associated with an increase in the GDP growth rate.  Why?  Several reasons, but one among many is that tax cuts don't just operate on the supply side; they also stimulate AD, so this presents an identification problem.  What we observe with actual GDP is best thought of as the equilibrium point where AD and aggregate supply (AS) intersect.  In the econometric literature this is called "simultaneous equations bias."  This is a serious but not insurmountable problem.  It's also one that I'm not going to discuss further because I want to move things along.  For now just note that "simultaneous equations bias" is one of many problems a researcher is likely to come across if that researcher is only looking at observed GDP.

There are a lot of cartoon versions of what supply side economics is supposed to accomplish.  One of the more famous (or infamous) of these cartoon versions is the familiar one that non-technical readers would find on the op-ed pages of the Wall Street Journal.  But there was a more serious set of claims and predictions made by serious economists (i.e., economists not named Art Laffer).  There were three major claims, all of which are testable.  The first claim is that cutting the top marginal tax rate would encourage greater labor effort.  Leisure is a normal good, so people demand more leisure as incomes go up.  But with tax cuts the cost of leisure also goes up because workers are giving up a greater increment in after tax earnings with each additional hour of leisure.  This second effect is called the substitution effect.  Proponents of the Reagan supply side tax cuts argued that the substitution effect would dominate the income effect, and this would lead to an increase in labor effort.  This would predict an increase in average hours worked.  But when we look at the FRED data we find that average hours worked do not appear to have increased at all.  In fact, there has been a steady decline going back for decades.

The second claim is that Reagan's supply side structured tax cuts would encourage greater personal saving, which would then be available for private domestic investment.  Again, let's go to the FRED data showing saving as a percent of GDP:

Clearly the personal saving rate fell throughout the 1980s and 1990s.  A fall in personal saving would be associated with an increase in AD because it would signal an increase in consumption; but it would not suggest greater saving that could be applied to investment.  So it doesn't appear that this prediction panned out either.

The third prediction was that the tax cuts would pay for themselves.  If that were true, then we should have observed a shrinking of publicly held debt as a percent of GDP.  Clearly, that did not happen:

Finally, if the Reagan tax cuts actually affected the supply side of the macro economy in a way that was a unique historical event, then we should have observed an unparalleled increase in the growth rate of real potential GDP.  Looking at year-over-year seasonally adjusted annual rates (SAAR), there does not appear to be anything particularly special about the effect of Reagan's supply side tax cuts on the growth rate of real potential GDP.  Yes, real potential GDP did grow at a pretty good clip immediately after the Reagan recession, but it quickly faded and was nothing special by mid-decade.  In fact, even at its peak it was only barely above the growth rates during the Nixon, Ford and Carter years and well below the real potential GDP growth rates enjoyed during the LBJ and Clinton years.

So there doesn't appear to be anything especially unique or spectacular about economic growth during the Reagan years.  It was good, but not great.  And none of the three principal and testable claims made by supporters of the Reagan supply side approach seem to have panned out.

A far more interesting question is why the growth rate of real potential GDP started to fall after the 2001 recession and never really recovered to the historical growth rates going back at least 50 years.  Something has clearly happened to the growth rate of potential GDP.  And there is no evidence that Reagan style "supply side" tax cuts would have done anything to change the post-2001 trajectory.  The Reagan tax cuts did not accelerate the growth rate of real potential GDP during the 1980s, so why would we expect a different result in the 2010s?