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JUNE 21, 2004

Reagan's Economic Legacy
His policies helped spur the 1980s boom and were integral to the high-tech revolution. But the poor paid a price

On Aug. 13, 1981, President Ronald Reagan signed the legislation that defined his vision for the U.S. economy. The Economic Recovery Tax Act, also known as the Kemp-Roth bill, slashed taxes for many individuals and corporations and ushered in a new era. From that date on, government would play a far smaller role in the economy, and markets would reign supreme.

Just the previous day, with far less attention and fanfare, IBM (IBM ) announced the introduction of its first personal computer, the IBM PC. Powered by a microprocessor from Intel Corp. (INTC ), which then had revenues of less than $1 billion, and sporting an operating system by a virtually unknown company called Microsoft Corp. (MSFT ), the IBM PC, and the machines that followed, took the country by storm.

In a way that few have realized, Reagan's economic legacy is inextricably interwoven with the Information Revolution that the IBM PC helped kick off. His message of competitive markets, entrepreneurial vigor, and minimal regulation found a willing audience in an era of rapid technological change, where innovation was opening new opportunities seemingly every day. Reagan's first term saw the creation of such future giants as Sun Microsystems (SUNW ), Compaq Computer (HPQ ), Dell (DELL ), and Cisco Systems (CSCO ) -- the greatest entrepreneurial burst of new companies since the early 20th century.

It's likely that those companies would still have been founded, and would have prospered, even if Reagan hadn't been elected. Moreover, some of his policies, such as reduced support for nondefense research and development, were negatives for a tech-driven economy.

But the Californian's program of slashing taxes was perfectly suited to -- and helped foster -- the new environment, with its emphasis on investment in human capital and ideas rather than heavy equipment. His tax bills -- including the 1981 legislation and the major 1986 tax reform act -- whacked the marginal tax rates on top earners from 70% to about 30% and made it far more attractive for people to raise their incomes by getting more education or taking the risks of starting a company.

In addition, Reagan's 1986 tax-reform bill had another major impact. The new law helped support "idea-based" industries such as software and financial services. It lowered corporate tax rates for those companies while cutting or eliminating provisions in the tax code, such as the investment tax credit, that had primarily benefited old-line industries like utilities and railroads. The effect on corporate tax bills was immediate: Oracle Corp.'s (ORCL ) average tax rate fell from 44% in 1986 to 32% once the law took effect. Microsoft's taxes saw a similar decline.

Taken together, the changes Reagan championed in the tax system fostered innovation and entrepreneurialism even as they encouraged the development of venture capital and investment in human capital. And Reagan's willingness to push for more flexible labor markets and less regulation helped companies react faster to economic changes, including new technologies.

As a result, the impact of the policies Reagan set out in the 1980s, which slowly worked their way through the economy, helped lay the groundwork for the Information Revolution of the 1990s. That's nothing to sneeze at, especially since technology has been the major factor driving the U.S.'s rapid productivity growth since 1996.

Still, there's heated dispute about just how important Reaganomics was to the tech boom. To Milton Friedman, the Nobel prize-winning economist, Reagan's tax cuts -- especially the 1986 bill -- were "one of the most important factors in the boom of the 1990s." Adds Robert A. Mundell, another Nobel laureate: "[They] made the U.S. economy the motor for the world economy in the 1990s, on which the great revolution in information technology was able to feed."

Other economists, however, are far less willing to give Reagan credit for the boom. They argue that the big deficits generated by the drop in tax revenues were detrimental to business investment; had the red ink continued, it would have been much harder for companies to fund their spending on info tech in the 1990s. Instead, these economists believe far greater kudos go to President Bill Clinton for raising taxes and bringing down the budget deficit. "As for Reagan being responsible [for the 1990s boom], that's far-fetched," says another Nobel prize winner, Robert Solow of Massachusetts Institute of Technology. "What we got in the Reagan years was a deep recession and then half a dozen years of fine growth as we climbed out of the recession, but nothing beyond that."

Whichever side you take, the right way to assess Reaganomics, like any revolution, is not by looking at the immediate effect. Instead, it's the long-term impact -- on productivity, on the growth of gross domestic product, on technology -- that matters. After all, making changes to the tax system and regulatory policies of a mammoth economy like the U.S. is like turning the rudder slightly on a supertanker: The initial effects are small, but it leads to a big shift in course over time.

Indeed, the positive incentives created by lower tax rates -- as well as the negative effects of high budget deficits on investment -- show up over a period of decades, not months or even years. Certainly some sober-minded economists were aware of that when Reagan's changes to the tax system were being discussed. In 1985, Edgar R. Fiedler, then chief economist at the New York-based Conference Board, noted that "it will take some time -- maybe 10 years or so -- before the full impact of Reagan's proposals becomes evident." At the same time, Alan Greenspan, then running his own consulting firm, told BusinessWeek that "more efficient allocation of capital investment, which may occur in the years ahead, is irrelevant in the short run."

This lag helps explain why Reagan's tax changes in the 1980s may have helped stimulate growth in the 1990s. For example, a lower tax rate for high-income taxpayers substantially increases the return from going to college or graduate school. This would eventually boost the education level of the workforce, but the process would take years before enough people moved through the education system to make a real difference.

Similarly, some economic studies suggest that lower tax rates can encourage business startups. "There is a positive effect of lower taxes on work effort and on entrepreneurship," says James M. Poterba, an MIT economist. "The Reagan tax cuts surely contributed some of the economic growth that we have seen in the last two decades."

Even fast-growing new companies take time to reach an economically significant size. Cisco Systems Inc., founded in 1984, didn't reach $1 billion in sales until 1994. Thus the Reagan tax changes, even as they eased the way for the formation of new companies, may not have had their full economic impact until the 1990s. Just as clearly, inculcating the willingness to take risks is not a process that happens overnight. According to some economists, "it may take a generation to change behavior," says Joel A. Slemrod, a tax economist at the University of Michigan at Ann Arbor.

But if Reaganomics set the stage for some long-term gains, there were plenty of places where it fell down as well. For one, nondefense research and development spending by the federal government -- a critical component for long-term growth -- averaged roughly 0.4% of GDP under Reagan, a sharp drop from the roughly 0.6% spent by President Jimmy Carter. Instead, spending on defense R&D rose sharply. Much of those billions went into funding the Strategic Defense Initiative -- the anti-missile shield that still isn't functional and produced little in the way of private-sector spin-offs. "The moral of the Reagan era is that it is possible to throw big bucks and throw them badly," says Kenneth Flamm, a technology expert in Clinton's Defense Dept. and now a professor at the University of Texas at Austin. "Very little stuck."

Moreover, despite Reagan's rhetoric in favor of competitive markets, deregulation and trade were the low-priority items on Reagan's economic agenda. Indeed, Carter and Clinton were arguably more active deregulators than Reagan: Airlines and trucking were deregulated under Carter, while electricity and telecom deregulation came under Clinton. And the Reagan Administration was quick to support trade limits on autos, steel, and semiconductors.

Yet another long-term legacy of the Reagan years was the damage done to the living standards of less educated workers. Hit hard by the double whammy of globalization and technology, many saw their real wages sink as the income gap between rich and poor widened sharply. Today, real earnings for production and nonsupervisory workers are barely above where they were in 1981 despite the gains of the '90s boom.

True, the percentage of families below the poverty line fell under Reagan, going from 11.2% in 1981 to 10.3% when he left office in early 1989. But under Clinton, that poverty rate dropped a full three percentage points.

While Reagan can't be blamed for globalization or other big economic shifts, he did little to ease the transition for workers. He refused to raise the minimum wage and was hostile toward unions -- as shown by his 1981 firing of striking air-traffic controllers. And the real value of the minimum wage sank 27% during his Administration. "He helped global forces along" rather than cushioning them, says MIT economist Frank S. Levy.

In the end, there may be no way to tell just how much Reaganomics helped create and foster the environment that has led to today's tech-driven, high-productivity economy. But ultimately, his economic policies -- and more important, his message of optimism about the future -- were the right way to go in an increasingly global and tech-driven world.

By Michael J. Mandel in New York

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