What everyone “knows” about Reaganomics is that it failed. As the almost universally accepted story goes, the Reagan administration, influenced by supply-side theory, made a “Laffer-curve forecast” that its tax cuts would pay for themselves. Instead they produced surging budget deficits which saddled the U.S. with massive debt, financed by foreigners, to be repaid by future generations. The tax cuts also—so the story continues—fueled a consumption boom at the expense of savings and investment. Overconsumption at home led to an increase in imports, thereby adding a balance-of-trade deficit to the domestic budget deficit. These “twin deficits” were accompanied by a shift of the tax burden from upper- to lower- and middle-income classes, while unleashing a decade of greed on the one hand and, on the other, rising poverty and stagnation in median family income, all leading ultimately to a great crash.

We have all heard this litany of failure countless times from TV pundits and read it countless times in newspaper columns. Moreover, it has come at us not only from the Left but from across the full range of the political and ideological spectrum. Indeed, the most convincing purveyors of the litany have been members of Ronald Reagan’s own entourage, such as his first Budget Director, David Stockman, as well as moderate Republicans like Richard Nixon’s Secretary of Commerce, Peter G. Peterson, Senate Minority Leader Robert Dole, and House Minority Leader Bob Michel.

Turning to academia, we find that practically every economist anyone has ever heard of has jumped on Reaganomics with both feet. A typical example is Benjamin Friedman of Harvard in his book, Day of Reckoning: The Consequences of American Economic Policy Under Reagan and After (1988). Friedman’s “most favorable construction” is that Reagan and his administration genuinely believed that “the incentive effects of across-the-board cuts in personal tax rates would so stimulate individuals’ work efforts and business initiatives that lower tax rates would deliver higher tax revenues.” His “darker assessment” is that the Reagan administration was not that stupid, and that the deficit was deliberately created to “mortgage the nation’s future as a means of forcing Americans to give up government activities which they would otherwise have been able to afford.”

According to Professor Friedman, then, the only two possibilities are that Reagan was either a fool or a knave:

We shall probably never know which of these alternative accounts of the origins of the Reagan fiscal policy better describes what really happened. On one construction, it was an intellectual error of the first magnitude. On the other, it was deliberate moral irresponsibility on a truly astonishing scale.

Friedman, a liberal Democrat, was no doubt encouraged in this categorical judgment by the agreement of many Republicans within the profession, again including some who had worked for Reagan. Thus, at the annual meeting of the American Economic Association in 1985, Friedman’s Harvard colleague, Martin Feldstein, who had been chairman of Reagan’s Council of Economic Advisers, attacked supply-side economists for, among other things, forecasting that the reduction in tax rates would pay for itself in increased revenue. Herbert Stein, who had been a member of Nixon’s Council of Economic Advisers, also criticized Reaganomics for this same sin. Even Lawrence B. Lindsey, whose book, The Growth Experiment (1989), is a definitive account of the success of Reaganomics, states matter-of-factly that enthusiastic supply-siders claimed the tax cut would pay for itself.

Something is wrong when the American babble of competing voices can produce a uniformly inaccurate picture of the most discussed economic policy of this generation. For all these things that everyone “knows” with such certainty lack any basis in fact—and I stress that what is at issue here are precisely the basic facts of the case, not debatable interpretations of data. In particular, the Reagan administration did not predict that the tax cuts would be self-financing. It predicted the exact opposite—that every dollar of tax cut would lose a dollar of revenue. Moreover, as far as I can ascertain, no supply-side economist inside or outside the Reagan administration ever said that tax cuts would pay for themselves.

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President Reagan’s economic program was set forth in an inch-thick document, “A Program for Economic Recovery,” made available to the public and submitted to Congress on February 18, 1981. Tables in the document make it unmistakably clear that the administration expected the forthcoming tax cut to reduce revenues substantially below the amounts that would be collected in the absence of such a cut. Without the tax cut, revenues were projected as rising from $609 billion in 1981 to $1,159.8 billion in 1986. With the tax cut, they were projected to rise from $600.2 billion in 1981 to $942 billion in 1986. The total six-year revenue cost of the tax cut was thus estimated as $718.2 billion.

As the tax-rate reduction was expected to slow the growth of revenues, receipts as a percentage of GNP were expected to fall from 21.1 percent in 1981 to 19.6 percent in 1986. Accordingly, the document spelled out the necessity of slowing the growth of spending in order to avoid rising deficits. The administration planned to hold the annual growth of spending to 6 percent during 1981-84 and to 9 percent during 1984-86. On this basis, the Reagan budget projected a rise in spending (including the defense build-up) from $654.7 billion in 1981 to $912.1 billion in 1986.

A summary fact sheet showing the expected revenue losses and planned spending reductions was put out for wire transmission. Months of testimony and debate followed, during the course of which the massive revenue losses were in the forefront. After the Economic Recovery Tax Act of 1981 was passed, the Treasury Department issued to the media a comprehensive report on the legislation, including a three-page table detailing the revenue loss for each of its provisions. (Between introduction and final passage of the bill, the estimated total six-year revenue cost had grown slightly, from $718.2 to $726.6 billion.)

But if Reagan in office never predicted self-financing tax cuts, what about Reagan on the campaign trail? Surely he made that claim?

As a matter of fact, he did not. In Revolution (1988), Martin Anderson of the Hoover Institution reproduces the economic plan issued by Reagan and his economic advisers (of whom Anderson himself was one) during the 1980 presidential campaign. That plan estimated that 17 percent of the revenues lost by marginal tax-rate reduction would be recouped by increased economic growth. In other words, far from claiming that tax cuts would pay for themselves, Reagan on the campaign trail predicted that they would forfeit 83 percent of the revenues which would otherwise have accrued.

If, however, Reagan officials and economists never made the infamous claim, surely proponents of the supply-side theory like Jude Wanniski, George Gilder, and Jack Kemp did?

But again, as a matter of fact, they did not. In 1975, in an article in the Public Interest entitled “The Mundell-Laffer Hypothesis,” Wanniski claimed only that “sufficient tax revenues will be recovered to pay the interest on the government bonds used to finance the deficit” caused by cutting tax rates. In his book, An American Renaissance (1979), Jack Kemp used the Laffer curve only to explain why rising marginal tax rates are a disincentive and to argue against static revenue forecasts that ignore the effects of taxation on incentive. And in a letter to the Wall Street Journal in March 1980, Kemp said: “Under some circumstances, cutting tax rates will increase revenue; under others, reduce it.”

True, in Wealth and Poverty (1981), George Gilder wrote that “lower tax rates can so stimulate business and so shift income from shelters to taxable activity that lower rates bring in higher tax revenue.” But this was a nonspecific claim supported by studies of reductions in the top income bracket and in the capital-gains tax rates. Gilder also argued (as did Wanniski in his book The Way the World Works) that when the top tax rate is reduced, the earnings of the rich rise, “and they pay more taxes in absolute amounts”—a contention that has since been substantiated by Internal Revenue Service statistics demonstrating unequivocally that during the 1980’s, when the top tax rate was cut from 70 to 28 percent, the share of the income-tax revenues collected from the top 1 percent of taxpayers rose by 54 percent.

The kindest way to interpret the allegation that supply-siders predicted that the Reagan tax cut would pay for itself is that critics confused an exposition of the upper portion of the Laffer curve with a prediction of the revenue effects of specific legislation. To do so, however, they had to overlook what the supply-siders themselves were actually saying. In a piece of my own in the Wall Street Journal (April 24, 1980), I wrote: “The tax-cut movement in the Congress wasn’t based on getting all of the revenues back so the government could keep on spending. Much less were tax cuts advocated as a revenue-raising measure. The issue was whether you got any revenues back as a result of incentive effects operating on the supply side of the economy.” And in an earlier Wall Street Journal article (August 1, 1978), I argued that the combination of revenue feedbacks and increased saving would not result in inflationary deficits “if government spending in real terms could be held to current levels for about two years.”

It is possible that some members of Congress may have avoided the question of whose ox would be gored with lower spending growth by hiding behind the Laffer curve. However, it is shoddy work for academic economists and financial reporters to misrepresent any such political statement as a government forecast. Moreover, none of the supply-side legislative measures ever claimed that tax cuts would pay for themselves. The two most successful such measures, the Holt Amendment (1977-78) in the House and the Nunn Amendment (1978) in the Senate, explicitly linked marginal tax-rate reduction with spending limits. There is thus literally no basis for the caricature of supply-side economics as the belief that tax cuts pay for themselves.

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As for the Reagan budget deficits, close inspection shows them to be the product of an unsurprising failure and an unexpected success. The failure was on the spending side. During 1981-86 federal spending exceeded not only Reagan’s targets but also the current policy projections. Instead of spending cuts from the projected baseline, there were—thanks mainly to Congress—spending add-ons. On the revenue side, conversely, there was a shortfall relative to the budget projections. But this was due not to overestimating the incentive effects of tax reduction, but to overestimating the inflation rate.

The accuracy of revenue forecasts is dependent upon the accuracy of forecasts of nominal GNP, which in turn depend on the forecasts of inflation and real economic growth. In the beginning of 1981 the Reagan administration forecast 11.1 percent inflation for the year, as measured by the consumer price index (CPI), and foresaw inflation falling to 8.3 percent in 1982, 6.2 percent in 1983, 5.5 percent in 1984, 4.7 percent in 1985, and 4.2 percent in 1986. At the time, these forecasts were ridiculed as a “rosy scenario,” because they combined falling inflation with sustained real growth—an impossibility according to the “Phillips-curve” relationship which claimed to show that growth in employment and GNP had to be paid for with rising rates of inflation (just as lower inflation had to be paid for by rising rates of unemployment). Since most economists were under the sway of this theory, they refused to believe that the economy could expand for six years without sending inflation substantially higher. Indeed, in their view, to fuel spending through a tax cut when the CPI was already in double digits and when there was an inherited deficit of $70 billion, added up to a prescription for massive inflation.

As it turned out, the administration’s inflation forecast was not optimistic but pessimistic. For 1981 the CPI came in at 10.3 percent, almost a point below the forecast. In 1982 inflation measured 6.2 percent, more than 2 points (or 25 percent) below the forecast. In 1983 the inflation rate was 3.2, only half the amount forecast. In 1984 inflation measured 4.3 percent, 1.2 percentage points below forecast. In 1985 the inflation rate fell to 3.6 percent, almost a full point below forecast, and in 1986 it came in at 1.9 percent, less than half the rate forecast.

The cumulative effect of the unanticipated disinflation was a substantial reduction in the levels of nominal GNP, and hence in the tax base. By 1983 and 1984 nominal GNP was running $300 billion below forecast. In 1985 GNP was $500 billion below projections, and it was about $700 billion below in 1986. (In addition to all this, the 1982 recession, brought about by the Federal Reserve Board’s fear of inflation, contributed to the loss of revenues by shrinking real output by 2.5 percent in that year.)

In short, intentionally or unintentionally, critics of Reaganomics misinterpreted the revenue shortfalls caused by the unexpected collapse of inflation and attributed them entirely to the tax cuts.

The insistence by Reagan’s critics that the essence of supply-side economics consists of the belief that tax cuts pay for themselves is easy to understand. Without this strawman, there is no way to blame Reagan and supply-side economics for the budget deficits and alleged associated ills that have been used to paint a false picture of the 80’s as a decade of failure. For if—as is the fact—Reagan predicted that the tax cut would lose revenues, then it was the conventional Phillips-curve economists who produced the revenue shortfall by overpredicting inflation. It was Paul Volcker, then head of the Federal Reserve Board, who drove down revenues by collapsing the real economy in 1982 in a mistaken attempt to counteract “inflationary tax cuts.” It was Congress which inflated the deficit by busting every Reagan budget. And it was Reagan’s “pragmatic” advisers, romanticized in the media for refusing to let Reagan be Reagan and veto congressional spending, who allowed the debt to grow out of control.

No matter where one looks, then, the facts contradict what everyone “knows” about the “failure” of Reaganomics.

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Just as the case against supply-side economics collapses once there is no Latter-curve forecast to blame for the deficits, so the debt-fueled-consumption/foreign-dependence argument unravels under close examination. Indeed, it appears that the same economists and pundits who lack the ability to look up the Reagan forecasts in public documents also lack the ability to read balance-of-payments statistics.

Between 1982 and 1983, when the U.S. became a net importer of capital, distinguished academic economists put out the story of foreign money pouring into America to finance overconsumption caused by the Reagan tax-rate reduction. This story became firmly fixed in the world’s consciousness and was seen as further evidence that supply-side economics was just an extreme form of Keynesianism leading to excessive, unhealthy consumption. But this story also lacks any basis in fact.

Between 1982 and 1983 foreign-capital inflow into the U.S. actually fell by $9 billion. The change in the capital account of the balance of payments resulted from a $71-billion fall in U.S. capital outflows. During 1982-84 there was no significant change in the inflow of foreign capital into the U.S. However, U.S. capital outflows dropped, from $121 billion to $24 billion—a decline of 80 percent—throwing the U.S. capital account into a $100-billion surplus. It was this collapse in U.S. capital outflow that created the large trade deficit, which by definition is a mirror image of the capital surplus.

Why did American investors suddenly cease exporting their capital and instead retain it at home where it supposedly was subject to reckless policies of inflationary debt accumulation? After all, such a dangerous program as Reagan’s was said to be would normally result in capital flight. Why then the sudden preference of American capital for the U.S. as compared, for example, to West Germany, a country with an economic policy that everyone considered sound?

The answer is so obvious that the only mystery is how economists and financial writers could have missed it. The 1981 business-tax cut and the reductions in personal income-tax rates in 1982 and 1983 raised the after-tax earnings on real investment in the U.S. relative to the rest of the world. Instead of exporting capital, the U.S. retained it and financed its own deficit.

As in the case of the tax-revenue shortfall, we are confronted with the spectacle of almost every economist misinterpreting the source of the capital surplus. Economists looked at the net figure, ignored its composition, and, seeing what they wanted to see, erroneously concluded that the net inflow was foreign money financing American overconsumption.

After convincing themselves and many others on the basis of this fundamental error that the U.S. was dangerously dependent on foreign capital, economists began warning of the consequences. The inflow of foreign money to finance our consumption, they declared, was keeping the dollar high, thus wrecking the competitiveness of U.S. industry. Furthermore, our addiction to foreign capital meant that the U.S. would have to maintain high interest rates in order to continue to attract the money, thus undermining U.S. investment and de-industrializing America. If U.S. interest rates or the dollar were to fall, foreign capital would flee, depriving us of financing for the “twin deficits.”

This doomsday scenario was rapidly picked up by financial journalists and kept international financial markets unnerved. U.S. economic policy came under ever stronger criticism from our allies. America’s “twin deficits” became the scapegoat for every country’s problems.

Then, in the autumn of 1985, Secretary of the Treasury James A. Baker 3d engineered the political fall of the dollar, which plunged, along with U.S. interest rates, in 1986 and 1987. Remarkably, foreign capital inflows to the U.S. promptly doubled.

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There are other prominent stars in the constellation of misinformation: the U.S. is the world’s largest debtor nation; the U.S. has the world’s largest budget deficit; and debt-fueled consumption brought on a U.S. savings crisis. Each of these widely believed allegations is a product of the economists’ ability to mislead themselves and the public by failing to examine the data.

According to the conventional wisdom, the U.S. became a debtor nation in 1985. By 1988, we were $532 billion in debt to foreigners, as measured by the difference between their investments in the U.S. and our investments abroad. These allegations of massive indebtedness were used to demoralize Americans and to convince them that Reagan produced a temporary prosperity stolen from future living standards, as we would be forced to divert income to the service of foreign debts.

Yet even as economists and financial writers were painting this dismal picture of the U.S. as the world’s largest debtor, official statistics showed the U.S. receiving billions of dollars in net creditor income. As it is not possible for a net debtor to have a net creditor’s income, something was obviously wrong here. It was this: the data showing us to be a debtor nation were based on historical prices or book values that understated the market value of U.S. foreign investments by hundreds of billions of dollars.

It would have been correct for economists to point out the decline in the net-creditor position of the U.S. as foreigners found America during Reagan’s second term a more promising place to invest than their own countries. But this perspective would have pointed to our success rather than to our failure. And in any case, the solution to the problem, if that is what it was, was not for the U.S. to wreck its own investment climate with higher taxes, but for foreigners to cut their tax rates so as to make their economies more attractive to their own capital.

During the 1980’s economists made the U.S. budget deficit the scapegoat for the failure of European economies to create new jobs. Sucking away their capital to finance our deficit, it was said, saddled Europe with high unemployment rates. After listening to this story, our allies began demanding that the U.S. become a good world citizen and start cutting its budget deficit. Yet while in absolute dollar amounts, the U.S. in the 1980’s did have the world’s largest budget deficit, when measured as a percentage of GNP, which is the way economists usually measure deficits, the U.S. budget deficit throughout the 1980’s was below the Organization for European Cooperation and Development (OECD) average (as the internationally comparable general government budget balances published twice a year by the OECD made perfectly clear).¹ For example, Canada, Holland, and Spain consistently ran deficits twice as large as ours, while Italy’s was four times larger. British, French, and German deficits were not significantly lower, and the Japanese deficit had been lower only since 1984.

As a corollary to the budget deficit, there was the accumulated federal debt, which tripled under Reagan and became a “crisis” that would “doom our future.” Yet under Reagan the federal debt as a percentage of GNP rose only slightly higher than the percentage which obtained when John F. Kennedy was President, and it was only one-third of the accumulated debt at the end of World War II. As that much higher debt burden did not destroy our economy or prevent the postwar expansion, why should today’s much smaller burden do so? One answer, given by the economist Paul Samuelson and others, was that we owed this earlier debt to ourselves, whereas we owed the Reagan debt to foreigners. Yet official statistics reveal that the proportion of U.S. debt held by foreigners peaked in 1979, prior to Reagan.

Nor were these the only numbers ignored by the economists. In the mid-1980’s the Bank for International Settlements (BIS) published a table showing federal debt as a share of GNP for the U.S., Canada, Japan, and the European countries. Data were provided for 1973 and 1986 and the percentage increase was calculated. During 1973-86 in the U.S., the ratio of debt to GNP had grown 40.8 percent. However, in Germany and Japan, the supposedly successful countries against which our failure was measured, debt as a share of GNP had increased 121 percent and 194.2 percent respectively.

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Which brings us to yet another thing everyone “knows”: that the Reagan tax cut caused a savings crisis and a drop in investment, with concomitant declines in productivity and median family income accompanied by a rise in poverty. But here yet again the facts tell an entirely different story.

During the 1980’s, prices of capital goods in the U.S. rose only about half as fast as the overall U.S. inflation rate. Unless a real or inflation-adjusted measure of investment is used, the decline in the relative price of capital goods can be misinterpreted as a fall in investment’s share of GNP. For example, if the economy were adding new factories every year at a 10-percent higher cost, and if other prices were rising by 20 percent, the share of investment as a percentage of GNP would appear to be falling. Economists who have charged that the U.S. is undergoing “disinvestment” have confused themselves and the public by failing to use inflation-adjusted data.

On the surface, measuring investment net of depreciation, or replacement of the capital used in production, seems to be a more appropriate measure than gross investment. However, net investment understates the growth of our productive ability, because it fails to make any adjustment for the shift in the composition of investment from longer-lived assets, such as buildings, to shorter-lived assets, such as equipment, that generate more rapid depreciation. In other words, net investment can appear to be declining when what really is happening is a shift in the investment mix from plant to equipment. And so it has been in the past twenty-five years, during which equipment’s share of investment has increased 25 percent. As a consequence there has been a rise in the depreciation rate. Little wonder that the net measure of investment has been falling as a share of GNP for a quarter-century.

In contrast, gross investment is not affected by a change in its composition. In real terms, gross investment as a share of GNP reached a postwar high in the 1980’s. This investment performance greatly contributed to the recovery of U.S. productivity growth from its near standstill in the 1970’s. Since 1981 American manufacturing productivity has been especially impressive, growing at almost double the postwar average.

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During the past year or so, a few economists have finally begun to challenge the false image of American failures. In a recent issue of the Quarterly Review of the Federal Reserve Bank of Minneapolis, Fumio Hayashi of the University of Pennsylvania argues that “the apparent savings-rate gap between Japan and the U.S. is a statistical illusion attributable to differences in the way the two countries compile their national income accounts.” Japan values depreciation at historical cost rather than at the higher replacement-cost figure used by the U.S. As a result, Japanese accounting understates the value of assets used in production and makes Japanese investment look higher than it is. The other major source of the savings-gap illusion is the American practice of counting all government expenditures—including roads, bridges, schools, and warships—as consumption, whereas Japan counts such spending as investment. Once the accounting systems are put on an equal footing, Hayashi finds, the notoriously wide difference in the savings rate disappears.

In 1989 two other economists, Robert E. Lipsey of Queens College and Irving B. Kravis of the University of Pennsylvania, who studied savings and investment rates in industrialized countries, reported to the Western Economic Association that the reputation of the U.S. as a nation of spendthrifts depends on careless comparisons and narrow measures of investment. When U.S. savings and investment are broadened to include education, military capital, consumer durables, and research and development, the U.S. rate of capital formation, on a per-capita basis, is seen to be 25 percent higher than the average of industrialized countries. They report that Japan is “at the bottom of the list in the share of investment going into education.”

Other economists have exposed as seriously misleading the Census Bureau’s statistics trumpeting the growth of poverty. These statistics, it turns out, omit from poor people’s income $158 billion of in-kind assistance. As a recent Heritage Foundation report demonstrates, there are many other paradoxical elements in the Census Bureau’s definition of poverty as well. For example, according to official government figures, 38 percent of the persons identified as poor by the Census Bureau own their own homes, of which more than 100,000 are valued in excess of $200,000; 62 percent of poor households own a car, with 14 percent owning two or more; nearly half of all poor households have air-conditioning; 31 percent of poor households have microwave ovens; 22,000 poor households have heated swimming pools or hot tubs. In real terms, Heritage calculates, per-capita expenditures of the lowest income fifth of the U.S. population in 1988 exceeded the per-capita income of the median American household in 1955. And international comparisons reveal that poor Americans eat more meat and live in larger houses and apartments than the average West European.

It is thus not unlikely that a significant percentage of the alleged 31.5 million poor Americans are poor only in a relative sense. But whatever their true number, it is certain that the long Reagan economic expansion, which created 20 million jobs without any rise in the rate of inflation, did not increase poverty.

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The misinterpretation of Reaganomics by American economists and financial journalists is in some ways comparable to the misrepresentation by many intellectuals of Soviet experience, now fully exposed by Gorbachev’s glasnost—only it is worse, because the evidence showing the origins of the U.S. budget deficit and capital surplus was readily available. The economists and the journalists simply ignored it and launched a crusade to drive out the devil of Reaganomics, which (among its other sins) had been guilty of doing what they said could never be done—creating 20 million new jobs without causing an increase in inflation.

Thanks to the accumulated economic misinformation and disinformation from the 1980’s, the Bush administration—taking a step no administration has taken since the Great Depression—has supported tax increases as the economy was moving into recession. Pressed by conventional economists demanding tighter fiscal policy (that is, smaller budget deficits) and looser monetary policy (more money creation), President Bush agreed to raise taxes in exchange for lower interest rates. The combination of high taxes and easy money is the same policy mix that eventually produced the stagflation of the 1970’s, from which Reaganomics extricated us, and it is bound to do us harm again.

Conventional economists, ignoring the lessons of their own textbooks (including even Keynes), have pronounced this disastrous policy mix a great victory for the economy. In the course of 1991 they will forget their role, of course, and blame the recession on Reagan’s supply-side tax cut of a decade ago. And everyone will come to buy that story, too.

¹ The hysteria over the U.S. deficit was so pronounced that it eventually spread to the OECD, despite its own published tables.