What Was the Economic Recovery Tax Act of 1981?

The Economic Recovery Tax Act of 1981 (ERTA) was the largest tax cut in American history. Signed by President Ronald Reagan about six months after taking office, ERTA slashed income tax rates and allowed for faster expensing of depreciable assets. The bill included several incentives for small business and retirement saving. It also provided for inflation indexing of tax brackets.

Understanding the Economic Recovery Tax Act of 1981 (ERTA)

ERTA was also known as the Kemp-Roth Tax Cut after its Republican sponsors, Representative Jack Kemp of N.Y. and Senator William V. Roth of Del. The biggest tax cuts were for wealthy Americans, with the top rate cut from 70% to 50% over three years. The bottom bracket was cut from 14% to 11%. Besides tax cuts and accelerated depreciation deductions, other features of the legislation included easier rules for establishing Employee Stock Ownership Plans (ESOPs); expanded eligibility for Individual Retirement Accounts (IRAs); a reduction in the capital gains tax from 28% to 20%; and a higher estate tax exemption. The indexing of tax brackets was a key provision given the era’s double-digit annual inflation, which was pushing even lower- and middle-class families into higher brackets.

ERTA Inspired By Supply-Side Economics

The bill was inspired by supply-side theories of monetary policy advanced by economist and Reagan adviser Arthur Laffer. The basic idea was that cutting taxes on the wealthy would spur more capital investment and innovation, with the benefits “trickling down” to average citizens through job growth and increased consumer spending. In return, taxes revenues would rise as the economy boomed.

But ERTA did not jumpstart the economy as proponents expected. Business capital investment remained anemic, unemployment stayed high, and consumer spending did not increase. Meanwhile, in the year after the bill’s passage, the federal deficit spiked due to the drastic cutback in tax revenue. This, in turn, caused interest rates to soar from an already high 12% to an alarming 20%. The Dow Jones Industrial Average (DJIA) lost nearly 30% of its value by September 1982.

Congress Reversed Itself a Year Later

All these factors combined to spin the country into a second recession, hard on the heels of the 1978-79 crunch; this was the so-called “double-dip recession.” With the economy in free fall, Congress reversed much of ERTA in September of 1982 with the Tax Equity and Fiscal Responsibility Act (TEFRA), led by Senate Finance Committee chairman Robert Dole. Recovery began almost immediately.

ERTA remains controversial. Proponents claim the tax cuts eventually raised tax revenues by 6%, but critics say that was due to 12% inflation at the time. Although it is unlikely to be the final word, in 2012 the non-partisan Congressional Research Service analyzed tax rates and their economic effects from 1940 to 2010 and concluded that lowering top tax rates has no effect on economic growth or productivity, but does contribute to greater wealth inequality. Under Reagan, the U.S. national debt tripled to $2.6 trillion.