Reagan’s Tax Cut Just Turned 40 — And It’s Still The Most Important Tax Reform Since World War II

Ronald Reagan made tax cuts the centerpiece of his 1980 campaign for the presidency. And after winning the election, he made good on his promise. 

The Economic Recovery Tax Act (ERTA), enacted on August 13, 1981, was the biggest tax cut in American history. It was also remarkably durable, reshaping the federal tax system — and American politics — for decades to come. 

First some numbers: Reagan’s tax cut slashed revenues by 2.9% of GDP, according to the Committee for a Responsible Federal Budget. That makes it the biggest tax cut since the introduction of the modern income tax in 1913, surpassing even the mammoth cuts passed after World War II (2.7% of GDP in 1945 and 1.9% in 1948).

Needless to say, ERTA also eclipses the 2017 tax cut; despite former President Trump’s repeated claim that his cut was the biggest, the Tax Cuts and Jobs Act clocked in at just 0.6% of GDP. 

Now it has to be said that the 1981 tax cut didn’t remain quite so big; almost immediately after Reagan signed the bill into law, his economic advisers started looking for ways to unravel it. Worried by grim deficit forecasts, they unveiled a collection of “revenue enhancements” designed to slow the river of red ink flowing from the treasury. 

Reagan would eventually agree to a series of tax hikes; taken together, they reduced the size of the 1981 cut by almost half, according to Bruce Bartlett, who had a hand in drafting ERTA while working for the Reagan administration.

So the 1981 tax cut started big . . . and then got smaller. But all that initial bigness mattered, establishing Reagan’s bona fides as a tax reformer — and as someone who would deliver on his promises. In the short term, that mattered for U.S. electoral politics.

But other aspects of the 1981 tax law were even more important — and had even more profound consequences. When Reagan arrived at the White House, the top marginal income tax rate for individuals was 70%. ERTA slashed it to 50% while also lowering rates in lower brackets.

Five years later, the Tax Reform Act of 1986 would lower (and consolidate) rates even more. 

These rate reductions were economically important, especially when coupled with the elimination of tax preferences in the 1986 tax reform. But not all of them proved durable; Congress began to fiddle with the rates (and the tax base) almost immediately. Many of the reforms were undone within a few years.

But one aspect of the rate cuts proved very durable: Lawmakers never seriously reconsidered Reagan’s drastic cuts at the top end of the income scale.

ERTA knocked 20 percentage points off the top bracket rate, and the politics of post-ERTA taxation made no room for restoring that rate to its pre-Reagan heights — or anything even close. After 1981, 50% was the new 70%. And after a few more years, 28% was the new 70%. 

Lopping 20 points off the top rate was just one of the two transformative achievements embedded in ERTA. The other was tax system indexing.

Before 1981, inflation would regularly push taxpayers into higher brackets, boosting revenue through a process known as “bracket creep.” It was a convenient way to raise more revenue — painful for hapless taxpayers but painless for the gutless lawmakers. 

ERTA put an end to the bracket creep by requiring that key elements of the tax system be indexed for inflation. That ended easy finance, forcing lawmakers to confront unpleasant realities and make hard choices. It permanently transformed fiscal politics. 

Finally, ERTA changed American politics well beyond the fiscal realm. As sociologist Monica Prasad argued in her outstanding 2018 book, Starving the Beast: Ronald Reagan and the Tax Cut Revolution, the 1981 tax cut taught Republicans that tax cuts could be the ticket to victory. 

“This first tax cut taught Republicans that tax cuts could be popular — something that was not clear at the time, because for decades before then opinion polls had shown strong and consistent opposition to deficits,” Prasad writes.

“ERTA transformed the Republican Party from a party of fiscal rectitude into a party whose main domestic policy goal is to cut taxes.” That transformation, moreover, proved extremely durable — far more durable than ERTA itself. 

Nowadays, it’s fashionable to talk about the 1986 tax reform as a watershed moment in the history of American taxation. And in some respects it was: It was certainly the apotheosis of good intentions in fiscal policymaking.

Ultimately, however, it’s ERTA that deserves the crown for Most Important Tax Law in Living Memory. Because ERTA did more than change the tax system: It changed America.

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