(FORTUNE Magazine) – The economy is sputtering. A Republican President vows to cut taxes to get it moving again. Critics say the proposed cuts will leave the rich richer, federal deficits bigger, and the economy worse off.

You've heard it all before. Unless, that is, you weren't old enough to be paying attention in 1981, when Ronald Reagan unleashed supply-side economics on the nation, putting an end to decades of rising taxes and ushering in yawning budget deficits that would take 15 years to erase.

The tax cuts President Bush hopes to push through Congress in the coming months (and the ones he got through in 2001) don't measure up to Reagan's 1981 cuts in either scale or political import. But they are the biggest news on the tax-cutting front since then, and they're unleashing the same debates about deficits, growth, and supply-side economics that dominated political discourse 22 years ago.

That raises an important question, one that must be answered before anything meaningful can be said about whether Bush's tax proposals make sense. Who was right back in 1981?

If you define the goals of the 1981 tax cuts narrowly enough, it's easy to come up with an answer--President Reagan and his supply-side advisors were dead wrong. Back in 1981 the most zealous supply-siders argued that Reagan could cut tax rates and government revenues would go up. The basis for the argument was something called the Laffer curve--first drawn on a cocktail napkin at Washington's Two Continents restaurant on Dec. 4, 1974, legend has it, by University of Chicago economist Arthur Laffer for the edification of Wall Street Journal editorial writer Jude Wanniski and Ford administration staffer Dick Cheney (yes, that Dick Cheney). Actually, neither Laffer nor Cheney remembers it, but Wanniski went on to make the moment immortal nonetheless.

The gist of the Laffer curve is this: If tax rates are high enough, it's possible to cut rates and increase revenue. This was not a controversial, or new, proposition. But when Reagan backers argued that across-the-board cuts in income tax rates wouldn't bring big deficits--now that was controversial. "Voodoo economics" was what one of Reagan's Republican-primary opponents, George H.W. Bush, famously called it during the 1980 campaign. He was right.

"When Reagan cut taxes after he was elected, the result was less tax revenue, not more," wrote a prominent Harvard professor in 1998 in his bestselling economics textbook. "Revenue from personal income taxes (per person, adjusted for inflation) fell by 9% from 1980 to 1984, even though average income (per person, adjusted for inflation) grew by 4% over this period."

That failure of tax cuts to work budget magic has tainted the supply-side cause ever since. Opponents of the current President's tax plans have relished bringing up the old ghosts. "Deja-voodoo economics" is House Democratic whip Steny Hoyer's charming phrase for Bush's $726 billion tax cut.

Are the critics right? Are Bush's tax-cut plans--which consist chiefly of eliminating taxes on dividends and accelerating income tax cuts that were approved by Congress in 2001--the rankest charlatanism? Well, that Harvard professor quoted above is named N. Gregory Mankiw. He's the chairman-elect of President Bush's Council of Economic Advisors and has, of course, endorsed his new boss's tax plans. He also used to write a column for FORTUNE. That doesn't make those tax plans right--as you'll read, we aren't enthusiastic about anything but the proposal to cut dividend taxes. What it does indicate, though, is that the lessons of 1981 aren't as cut-and-dried as you might think.

Which brings us back to Reagan and his tax cuts. As we now know, it took five tax increases and a decade and a half of economic growth to deliver the balanced budget Reagan promised in 1980. But given how crushing taxes were at the time, the man had to do something.

In 1981 the federal tax burden hit 19.6% of GDP, a new peacetime record (and not far below the all-time peak of 20.9%, in 1944). What brought taxes to that level was something called bracket creep, in which inflation pushed ever more middle-income taxpayers into high tax brackets--the top rate back then was 70%--and ever more poor people onto the income tax rolls for the first time.

Inflation's impact was especially dire for investors. Taxes on capital gains and interest were not (and still aren't) adjusted for inflation--so in the high-inflation 1970s it was entirely possible to lose money in real terms on your stock or bond investments yet still owe serious taxes on them. Rising prices meant a similar tax penalty for corporate investments in new equipment and factories, which are deducted from income not all at once but over a period of years.

In other words, the interaction of inflation and the tax code had pushed the overall tax burden toward record levels and especially punished savings and investment. Possibly as a result, the U.S. economy just wasn't working the way it was supposed to. According to the demand-oriented Keynesian wisdom of the time, the national economy was like a big hydraulic system. Pump deficit spending in here, and higher GDP growth spurts out there. Pump in inflation, and out comes lower unemployment. But despite growing budget deficits in the 1970s, the economy kept sputtering. Despite rising inflation, unemployment kept going up.

That's where supply-side economics came in. The term was popularized by the Journal's Wanniski, who borrowed it from economist Herb Stein, and the "supply" he was talking about was the supply of labor and capital. What could government do to make people work harder? What could it do to induce people to save more and businesses to invest more? His answer: Cut taxes! There was nothing new about this thinking--it was simply a revival of the "classical" economic theories swept away by the Great Depression and the persuasive powers of John Maynard Keynes. But in the environment of the 1970s, it seemed revolutionary.

The 1981 tax cut was the revolution made real. It included big tax breaks for corporate capital investment. So big, in fact, that it became possible to make money, after taxes, on money-losing investments--which is why most of those breaks were repealed in 1986. But the really giant cuts were on the personal income tax side, and they've survived. The top marginal rate went immediately from 70% to 50%, and in lower brackets rates were reduced 10% a year for three years. Those brackets also were tied to the consumer price index to prevent inflationary bracket creep.

What did people do with all that extra money? By the reckoning of economist Larry Lindsey--who was, until a few months ago, chief economic advisor to President Bush--taxpayers in the lower income brackets spent it, delivering an old-fashioned Keynesian boost to the economy but failing to deliver on supply-side promises that revenue would rise. In the highest brackets, though, something remarkable happened. People actually paid more taxes at a 50% marginal rate than at a 70% rate. Arthur Laffer was right. "The core supply-side tenet--that tax rates powerfully affect the willingness of taxpayers to work, save, and invest, and thereby also affect the health of the economy--won as stunning a vindication as has been seen in at least a half-century of economics," Lindsey wrote in his 1990 book, The Growth Experiment.

Well, maybe. Other economists who've studied the 1981 cuts, and the subsequent 1986 tax reform that brought the top marginal rate all the way down to 28%, agree with Lindsey that lowering rates on the rich brought in more money. But many attribute it more to a decline in tax avoidance than to an increased "willingness... to work, save, and invest." And the effect of tweaking marginal rates diminishes as they drop below 50%. Some supply-siders predicted economic disaster in 1993 when Congress raised the top rate back up to almost 40%. They were clearly wrong.

So the economic lesson of 1981 may be this: Something had to be done. It could have been done better. To a certain extent it was done better in the tax reform of 1986. That effort, inspired by Democratic Senator Bill Bradley and adopted by the Reagan White House, was an attempt to get tax rates as low as possible without reducing revenue, by eliminating deductions, exemptions, and special preferences. (Supply-siders had mixed feelings about it, since it meant getting rid of some of their special preferences, like a lower tax rate for capital gains.) But true economic voodoo in 1981 would have been continuing with the tax-and-inflation status quo.

Fast-forward to 2003. The economy is troubled, but--unlike in 1981--it would be quite a stretch to blame the tax system for those troubles. Voters certainly aren't blaming it: According to Gallup, dissatisfaction with the federal income tax is at its lowest level in 41 years. So if the tax code isn't to blame for the economy's problems and the electorate isn't clamoring for change, why do we need a tax cut? The President says we need it to stimulate growth. That's a good reason. But it's not clear his tax cuts fit the bill.

The one element of the current tax proposal most likely to spur growth is, sadly, the one most likely to collapse in Congress. That's the elimination of the double taxation of corporate income. If a company pays income tax on its profits, then shareholders wouldn't have to pay taxes when they got those profits in the form of dividends or capital gains. The thinking behind the cut is supply-side, sort of. The idea is not so much to increase the supply of capital as to make it flow more efficiently. Corporations would no longer face a tax-induced bias to fund themselves with debt (interest payments are tax-deductible) instead of equity, or to buy back shares instead of paying dividends. Owning shares in corporations would be a better deal, at least for those doing their investing outside tax-protected accounts like 401(k)s and IRAs, and that would give the battered stock market a boost.

It's an intriguing plan that might just have a significant economic impact. How significant is anyone's guess. The estimates coming out of Washington of more than a million new jobs a year are almost certainly delusional, but given the relatively low cost of the dividend proposal (about $36 billion a year after five years, or 0.3% of projected GDP), it's a reasonable gamble.

The rest of the $726 billion in tax cuts (over ten years) that Bush wants, and most of the $500 billion or so that, at most, he's likely to get, consists of speeding up and making permanent the tax cuts approved by Congress early in Bush's term. And therein lies the problem.

The 2001 bill consisted of cuts in personal income tax rates, expanded child credits, an easing of the marriage penalty, elimination of the estate tax, and accelerated depreciation of corporate capital spending. When it became law, we were fresh off a $236 billion surplus, and the federal tax burden as a share of GDP hit 20.8%--breaking the 1981 peacetime record. In other words, a tax cut was certainly a reasonable alternative to running huge budget surpluses that, in any case, were likely to tempt Congress out of the frugality it had adopted in response to the big deficits of the 1980s.

Two years later we're back in Kansas. The fantastic gains in tax revenue of the late 1990s turned out to be ephemeral, the product of a stock market that had become detached from economic reality. When the stock market boom evaporated, so did they. As a result, the tax burden is already down to a far more reasonable 17% of GDP, and those 2001 cuts will no longer be gnawing away at a giant surplus but will--if they're made permanent--bring chronic budget deficits. The deficits projected by the Congressional Budget Office aren't on the scale (as a percentage of GDP) of the whoppers of the mid-1980s. But they do mean the cuts must be judged by different standards from those of two years ago.

One standard is Keynesian. Economists--and politicians--haven't entirely abandoned demand-side thinking because over the short run pumping up demand works. The 2001 tax plan included a well-timed bit of pumping--$36 billion in tax rebates sent out during the summer months, in what turned out to be the depths of the 2001 recession. The new proposal would give a similar boost later this year, but there are cheaper ways to provide Keynesian stimulus--government spending or temporary tax relief--than permanent tax cuts.

Then there's the standard of fairness. As the chart shows, the effective federal tax rates (including Social Security and other taxes) paid by most Americans have barely budged over the past two decades. The wealthiest taxpayers, however, have seen their burden drop a bit, and since President Bush has taken over, it has dropped further. In ivory-tower economics terms that isn't all bad--there's often a tradeoff between economic efficiency and income equality. But one of these days Americans might decide it's worthwhile to give up a little economic growth for the sake of reducing inequality.

The main standard by which the Bush tax proposal deserves to be judged, though, is the standard that created it: supply-side economics. And that is where it runs into the most trouble. The challenge for supply-side policymaking in a time when the tax code isn't positively stifling economic activity, as it was in the late 1970s, is that there are no easy targets. Income tax rates are already low enough that cutting them slightly--the top rate is set to drop from 39.6% to 35%--won't bring the kind of behavioral change wrought by the rate cuts of the 1980s. Sure, there'll be a positive economic impact from people working harder and sheltering less income. It just might not be big enough to measure.

Another supply-side prescription for economic growth is to reduce the size of government, the idea being that the private economy is better at allocating resources than Congress. Economists disagree about that, especially since the government's share of the U.S. economy (31%, including state and local governments) is already at the low end among the world's rich countries. In any case the discussion is irrelevant: Federal spending has been rising sharply since Bush came into office. There is the argument that by cutting taxes and running huge deficits, as Reagan did in the 1980s, you force future governments to rein in spending. But if that's the true motivation behind the President's tax proposals, we'd sure like to hear him say it.

Finally, we come to the core of the modern supply-side case, the one area where the supply-siders have truly won the hearts and minds of the economics profession. Today the accepted formula for long-run economic growth mixes capital, labor, and a bit of inspiration. Increasing the labor supply brings growth but not necessarily higher living standards. Increasing the rate of inspiration--a.k.a. technological progress--is a tall order, at least for the tax code. That leaves capital, which is anything that can be used to produce something else: factories, software, tractors, office buildings and, as economists have become increasingly aware in recent decades, human capital like education and skills. There is now widespread consensus that a tax code that favors capital accumulation and investment over consumption could increase economic growth by a few tenths of a percentage point a year--which would, over the course of a few decades, seriously add up.

That is certainly the view of Bush advisors like Greg Mankiw and his predecessor at the Council of Economic Advisors, Glenn Hubbard, and Harvard's Martin Feldstein, a mentor to both who was chairman of Reagan's CEA from 1982 to 1984. But here's the weird part: It's also the view of many of the 450 economists, including ten Nobel Prize winners, who signed a statement in February condemning Bush's tax cuts. What's up with that? "I don't know of anybody who says this is a bad idea because of tax policy," says Feldstein. "What they say is, this is a bad idea because of the budget."

The core idea of the 2001 tax cuts was to get people to save and invest money--after they had spent some of it buying a car, to give the economy a bit of a Keynesian kick. (Hey, we never said this stuff was simple.) The elimination of the estate tax was most obviously conceived along those lines. So far, so good. But if the whole idea is to increase saving, having the federal government borrow money to pay for the tax cut entirely defeats that purpose. So much that some economists otherwise sympathetic to the supply-side argument on saving, like Alan Auerbach of the University of California at Berkeley, are pretty sure the 2001 cuts will reduce long-run economic growth.

For the cuts to have their desired growth impact, Congress would eventually have to either cut spending sharply or approve a few savings-friendly tax increases. What would a savings-friendly tax increase look like? Well, the current tax code massively subsidizes the consumption of housing, which plays no role in that long-run growth equation. The mortgage-interest deduction is probably sacrosanct, so some economists suggest a tax on new housing construction as a (slightly) less politically charged substitute. Another possibility would be to increase federal taxes on gasoline, something Mankiw suggested in his FORTUNE column a couple of years back.

In other words, there's nothing there that would win George Bush any votes in November 2004. But once it's clear that the recession is over, the President is going to have to start addressing the budgetary consequences of his actions. If he fails to, his tax cuts may eventually be seen as only so much deja-voodoo, all over again.

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RESEARCH ASSOCIATE Joan Levinstein