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Created: 2000-03-21
Last Modified: 2000-03-28
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Where Did Reagan's Tax Cut Go?

 

J. Bradford DeLong
delong@econ.berkeley.edu

http://www.j-bradford-delong.net/

834 words

Two decades ago Ronald Reagan campaigned for president, promising to shrink the size of the federal government. And in America's political mythology Ronald Reagan's victory started the rollback of the social insurance state. Reagan pushed his immense supply-side tax cut through Congress and so starved and shrank the beast Leviathan that is the government.

This is the mythology. But it is not the economic history. In the current budget year--in fiscal 2000--the share of GDP collected by the federal government as taxes will amount to about 21%, up from an average of 18.7% in the last five pre-Reagan years 1976-1980. How did this come to pass? What happened to the supply-side line in the sand drawn by Reagan?

The story of how the 1981 tax-cut shift in America's political economy was eroded away to nothing has three parts: the 1980s deficits, the early 1990s forecasts, and the late 1990s boom.

Reagan's 1981 tax cut came without significant spending cuts. 1981 was the year of tax cuts. 1982 and the years following were the years of deficits. Even before the ink of Reagan's signature was dry, his senior policymakers began to loudly and angrily blame each other for the deficit.

Budget Director David Stockman, and his aides blamed the deficits on the rest of the administration's unwillingness to think about serious budget cuts. Domestic Policy Advisor Martin Anderson disagreed, blaming the deficit on Congress that "time and time again... rebuffed" presidential plans to cut spending. But (Democratic) House leaders and (Republican) Senate leaders pointed out--accurately--that 9/10 of the deficit would have remained had Congress accepted every single one of Reagan's spending proposals. Perhaps the most interesting attribution of blame came late, in the mid-1990s, from right-wing intellectual Irving Kristol--whose magazine _The Public Interest_ had launched the supply side boom. Kristol claimed the mistake was in implementing the campaign promises of 1980, for supply-side doctrine was a political platform, not a public policy, and had a "rather cavalier attitude toward the budget deficit and other monetary or fiscal problems" because the point "was to create a... Republican majority--so political effectiveness was the priority, not the accounting deficiencies of government." No matter whose finger-pointing you agree with--David Stockman's, Martin Anderson's, Robert Dole's, or Irving Kristol's--the fact of the deficits of the 1980s created slow but inexorable pressure to raise taxes to close the deficit.

The pressure to raise taxes was amplified by another consequence of the deficit: slower economic growth. The deficit meant reduced money for investment, which meant lower income growth, which meant lower revenue growth, which meant that the long-term forecasts of the Executive Branch Office of Management and Budget [OMB] and the Congressional Budget Office [CBO] kept turning out to have been in retrospect too optimistic. So by the early 1990s both OMB and CBO--anxious not to overestimate federal revenues yet again--began (perhaps unconsciously) to lowball their forecasts. Thus the early 1990s saw increasingly pessimistic and horrifying deficit forecasts. They further increased the pressure for tax increases. And by 1994-95 federal revenues as a share of GDP were as high as they had been during Jimmy Carter's presidential term.

Then came the late 1990s boom. Lowered interest rates driven in part by the end of the deficit coupled with the flourishing of the information technology sector--a flourishing partly made possible by the extra funds no longer going to cover the government deficit that fueled the high-investment expansion--made for a boom in asset prices. And as the marked-to-market wealth of rich Americans grew beyond their previous dreams, the well-off began to cash in their gains. Such increases in the stock of wealth from higher asset prices are not part of GDP--GDP is the flow of goods and services newly produced, and has no place for changes in value of assets that already exist. But the IRS collects taxes when the well off sell assets and realize capital gains. The magnitude of the late 1990s boom in production and the value of wealth is the last of the three factors that have pushed federal revenues relative to GDP to their current high level.

And so in retrospect the people who worked hard in the late 1970s to elect a president to cut federal spending and roll back the social insurance state saw their work go for nought. They had succeeded, or thought they did, with the election of Ronald Reagan--they were elated, and their social democratic adversaries (like me) disheartened. But today the level of federal taxes shows no sign of their work.

Perhaps there is a moral here. Perhaps if you are in politics to change actual policy--rather than to get jobs for your friends--it is important to make sure that those you vote and work for do not take political effectiveness and media splash as their sole compass...


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Both of the quotes-- deficits crowd out private investment and deficits cause high interest rates (more specifically there that lowering deficits cause lower interest rates) are pure Summers, but you are right that "pre-Keynesian" is the correct general label. Bob Eisner and Bill Vickrey spent their lifetimes trying to debunk these kind of standard mantras, that would be ridiculous if not for the fact that they influence policy. They are called "pre-Keynesian" because these generally depend on assuming full employment. My students in Principles understand this. It is amazing that the same news summary will quote Clinton on paying down the national debt will allow lower interest rates and then report on the Fed will decide whether to raise or lower interest rates, without blinking. But why would Brad contribute to perpetuating such theoretically, empirically, historically, unsupportable views, when he surely knows better?

Contributed by Mathew Forstater forstate@levy.org on April 6, 2000


Because the Federal Reserve does not set interest rates in a vacuum.

These days Federal Reserve sets interest rates to try to make unemployment equal to its estimate of the natural rate. In the context of the 1980s and 1990s, the Federal Reserve has its target for real GDP and unemployment that it will try to hit. A bigger deficit means higher interest rates because the Federal Reserve will offset the expansionary effects of the deficit..

My view is not the pre-Keynesian childish babbling of a Say, but is based on a particular--and correct--interpretation of how the Federal Reserve behaves. Any analysis that does not look into how and why the Fed sets interest rates is going to go far awry...

Contributed by Brad DeLong (delong@econ.berkeley.edu) on April 6, 2000.


Professor of Economics J. Bradford DeLong, 601 Evans Hall, #3880
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