What Was the Economic Recovery Tax Act of 1981?

The Economic Recovery Tax Act of 1981 (ERTA) was the largest tax cut in U.S. history. Signed by President Ronald Reagan about six months after he took office, ERTA slashed the top income tax rate and allowed for faster expensing of depreciable assets. It included incentives for small business and retirement savings, and established inflation indexing of tax brackets.

Key Takeaways

  • Signed by Ronald Reagan during his first year in office, the Economic Recovery Tax Act of 1981 was the largest tax cut in U.S. history.
  • The ERTA slashed the highest income tax bracket from 70% to 50%.
  • Combined with increased military spending, the ERTA contributed to soaring U.S. public debt, which tripled in Reagan's time in office.

Understanding the Economic Recovery Tax Act of 1981

ERTA was also known as the Kemp-Roth tax cut after its Republican sponsors, Representative Jack Kemp of New York and Senator William V. Roth of Delaware. 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 (ESOP); 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 economics 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, tax revenues would rise as the economy boomed.

But ERTA did not immediately 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 decline in tax revenue.

Congress Blunts ERTA a Year Later

By the time ERTA became law, the second half of the "double-dip" recession was beginning in the U.S., partly because Federal Reserve Chairman Paul Volcker was determined to quash inflation, with the benchmark interest rate as high as 20%. With the economy tanking and tax revenue sinking, the U.S. deficit began to soar. An alarmed Congress responded by reversing some of the provisions in the ERTA in September of 1982 with the Tax Equity and Fiscal Responsibility Act, led by Senate Finance Committee chairman Robert Dole. Recovery began almost immediately.

The ERTA remains controversial. Growth did rebound in the mid- and late 1980s, and proponents cited the tax cuts, claiming they eventually raised tax revenues by 6%. 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.