Guest Contribution: “Which Reagan Tax Reform is This One Like?”

Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate.

The Republicans, it is said, absolutely must pass a massive tax bill by Christmas, in order to have some major accomplishment to show for 2017, the first year in which they control all branches of government. Having apparently failed in their seven-year campaign to deprive some 20 million Americans of health insurance, they dare not fail in their Scrooge-like campaign to transfer billions of dollars to the ultra-rich.

To try to sell this turkey of a “tax reform,” Donald Trump recently sought to invoke Ronald Reagan’s tax initiatives. Presumably some political advisor explained to him that hearkening back to Reagan’s fabled “sunny optimism” might help leaven Mr. Trump’s usual stormy diet of insult and anger.

To recall what transpired in the 1980s might indeed help shed some light on the current murkiness of proposed tax legislation.

Which Reagan Tax Reform?

There were, not one, but two huge tax bills during the Reagan years — the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986 – and they differed in almost every respect. The 1981 legislation was not true tax reform, but a rushed and poorly coordinated frenzy of fiscally irresponsible cuts in both corporate and personal income taxes. The 1986 law was the thought-out result of an extended, deliberate and bi-partisan process, designed to be revenue-neutral. In order to keep marginal income tax rates low, it made up the lost revenue by eliminating deductions, particularly on the corporate side. It even simplified the tax code, unlike the usual reform efforts that are launched in the name of much-needed simplification but end up making the tax code, if anything, more complicated.

If the 1986 tax bill was a model of how to do fiscal reform and the 1981 tax cut was a model of how not to do it, the 2017 process emulates the less worthy of the two precedents. First, the rushed process has been extreme: utterly lacking in both due deliberation and bi-partisanship. The usual hearings have not been held, nor has there been even a pretense of including Democrats in the negotiations. Almost every day brings news of some radical new turn in the legislation proposed in either the House or Senate. If a bill is in the end passed, everyone will have to read it after the fact to find out which special interests won and which lost when the music stopped.

What Happened to Those Worries About Budget Deficits?

The deliberate process is essential to good legislation, and not just to get some political buy-in from others or to avoid silly drafting errors and unintended consequences. Fiscally responsible reforms necessarily involve hard choices. They tend to work only if a general spirit of shared sacrifice is offered: “I will give up my cherished benefit if you give up yours.” So-called fiscal conservatives who agitate for tax cuts while pretending there will be no cost to pay will, if they prevail, blow up the budget deficit. They will do this regardless how frequently or fervently they have declared themselves opposed to budget deficits. This is what happened in the Reagan tax cuts of 1981. It happened again in the George W. Bush tax cuts of 2001 and 2003. It will happen a third time if the currently proposed tax cuts get enough votes to pass.

To be sure, the current proposals do not get everything wrong. Reducing the U.S. corporate income tax rate would be good policy, provided the lost revenue could be paid for by eliminating business loopholes that the economy would function better without anyway, such as the corporate interest deduction and the favored treatment of carried interest. But the legislation cuts the corporate tax rate too much and limits these deductions too little to come anywhere near meeting the criterion of revenue neutrality.

And where the Reagan White House in 1986 chose to meet the revenue constraint by prioritizing working families over corporate income tax cuts, including via an expanded Earned Income Tax Credit, the Republicans in 2017 are doing the reverse. In the current version of the proposal, the budget constraint (which this time is to limit the tax cuts to $1.5 trillion, cumulated over ten years) is met by allowing households’ tax cuts to expire before the ten years are up, while the corporations’ jackpot goes on forever. Taxes on families earning less than $75,000 actually go up on average, relative to today.

The next respect in which the current tax proposals follow in the footsteps of 1981, rather than 1986, is that their sponsors’ method for avoiding the hard trade-offs is to pretend that the tax cuts will pay for themselves. That golden oldie, the Laffer Hypothesis, makes yet another encore in its unnaturally prolonged life. The claim is that reduced tax rates will stimulate GDP so much that overall receipts will stay the same or even rise. When one hears these claims today, one might not guess that the argument, which was made by Presidents Reagan and Bush as well as by their political advisors, has always been rejected by virtually all mainstream economists, including the economic advisers to those two presidents. Or that when the tax cuts went ahead anyway, the theory failed miserably: Both times, budget deficits increased sharply.

By the way, there was another big tax bill under Reagan, In September of 1982, but it was a tax increase. The White House, surprised at the acceleration in the budget deficit that had resulted from the 1981 tax cuts, sharply reversed some of them, in the Tax Equity and Fiscal Responsibility Act of 1982. True, the budget deficit in the years 1983-86 was still twice the share of GDP that it had been before Reagan took office amid promises to reduce it. But at least the 1982 tax increase – well in excess of 1% of GDP and by that measure still the largest tax increase since 1968 – was probably enough to pay the interest on the increased debt that had been incurred in the meantime. [The debt/GDP ratio had risen by 16 percentage points by 1986 and the interest rate exceeded 7%.]

This Time It’s Even Worse

The tax cuts that the Republicans are trying to pass in 2017 would raise the budget deficit as the 1981 cuts did; but there is good reason to think that the long-term effects on the economy would be much worse this time. That has to do with two issues of timing: one cyclical and the other demographic. Cyclically, the 1981 tax cuts went into effect just as the 1981-82 recession was hitting, a time when some short-term fiscal stimulus came in handy. The opposite is true today: At a 4.1% unemployment rate, the economy does not need more stimulus. Indeed the Fed is expected to raise interest rates again in December to prevent the economy from overheating.

As for the demographic timing, the baby boom generation is now retiring at a rate of about 10,000 per day. As a result Medicare and social security outlays will increase rapidly from here on out. Despite the slowing in health care costs per person in recent years, the Medicare trust fund is projected to be depleted by 2029. The projected depletion date for the social security trust fund is 2034. Meanwhile, the national debt held by the public stands at 76% today. It was only 25% of GDP when Reagan took office. This is precisely the wrong time to increase the budget deficit and so borrow still more.

This post written by Jeffrey Frankel.

32 thoughts on “Guest Contribution: “Which Reagan Tax Reform is This One Like?”

  1. PeakTrader

    Reagan achieved a V-shaped recovery from a severe recession and Bush 43 achieved the mildest recession in history on top of the 1982-00 economic boom. Obama’s response to the severe recession was an expensive L-shaped recovery and depressed economy. So, I think, we should focus on re-restructuring the economy. We need to get more people into the workforce and working full-time. I suggest, lower middle class income taxes, less regulation, lower corporate taxes, a higher minimum wage, entitlement reform, and a much smaller tax code. Politicians need to stop micromanaging the economy, because they’re doing more harm than good. The GOP is fragmented and the “resistance” is more interested in scoring political points. So, it’s an uphill battle.

    1. pgl

      You would suggest lower taxes on the middle class and higher minimum wages? Stop right there – the current Republican proposals do neither.

    2. noneconomist

      In January, 1981,according to bls data, the unemployment rate was 7.1% with 8.3 million counted as unemployed.
      In January, 1986, again according to bls data, the unemployment rate was 6.8% with 8.98 million counted as unemployed.
      What was obviously needed and would have helped much more in 1981? More dynamic scoring.

      1. pgl

        “In January, 1981,according to bls data, the unemployment rate was 7.1% with 8.3 million counted as unemployed.”

        Yes the Volcker FED was hell bent in lowering inflation back then. BTW he was lowering interest rates until he saw the 1981 tax cut to which he jacked them up again. Remind us – what was the unemployment rate as of December 1982?

        1. noneconomisr

          11%. But 4 and 1/2 years after the cuts took efffect, the unemployment rate had tumbled 3/10 of 1 per cent.
          The current rate is 4.1. If these cuts are as successful as Reagan’s, we should see the rate down to 3.8 per cent by some time in 2022!

          1. pgl

            “If these cuts are as successful as Reagan’s”. Successful? Let’s see – a tripling of real interest rates that lowered private investment and a massive currency appreciation leading to yuuuuge trade deficits is now defined as success. St. Reagan’s devoted flock lives on.

    3. baffling

      st reagan achieved a v-shaped recovery because the fed raised rates dramatically to cause the recession, and then dropped rates dramatically to induce a sharp recovery. to argue st reagan performed a great job in comparison to the obama recovery, which occurred after a financial crisis which emerged under republican government, is basically an act of political hackery peak trader. but i expect nothing else from you and your ideological commentary on this blog.

      “I suggest, lower middle class income taxes, less regulation, lower corporate taxes, a higher minimum wage, entitlement reform, and a much smaller tax code.”
      you can do this without giving a YUUUGE tax cut to the wealthy.

      1. PeakTrader

        So, Reagan’s expansionary fiscal policy, which one economist called “Keynesian on steroids,” that resulted in very strong real GDP growth after 1982, and the Fed had to tighten the money supply, didn’t have anything to do with the strong recovery. And, it’s all the Republicans fault that caused the financial crisis. Moreover, taxing the “wealthy” even more will solve all the economic problems. It’s just more Baffling nonsense and political hacking.

        1. baffling

          st reagan tripled the debt to fund his expansion.
          “And, it’s all the Republicans fault that caused the financial crisis.”
          its not all their fault. but extreme ideologies from folks like you are major contributors to many of the problems of the financial crisis.
          “Moreover, taxing the “wealthy” even more will solve all the economic problems.”
          no. but giving those same folks, who already effectively pay a low tax rate, even more breaks does not solve all the economic problems either. look peak, my household fits in the brackets that will benefit the most from the proposed senate tax bill. that money saved will not be a major contributor to a consumption based economy, so the tax bill is not going to be an efficient stimulus to the economy. only to an increase in my bank account.

          1. PeakTrader

            Sure, you write letters to your lawyer politician saying: Please take more of my money, it’s just sitting in a bank account.

          2. baffling

            “Please take more of my money, it’s just sitting in a bank account.”
            peak, you are trying to change the argument. i am not asking to take more money. i am saying there is no need to give me more money tomorrow versus today. as of today, that money is already scheduled to be taken as tax. you have a very selfish way of looking at how a modern society is funded. we are talking about a tax cut here, not a tax hike. taking “more” money is an inappropriate way of looking at this situation. but you knew that already.

            further, the point of the new tax laws is to grow the economy. as i simply demonstrated, it is not going to be effective at accomplishing its goal. you have already defined what actions you want to take, i guess you need to be more honest in what goals it will actually accomplish. strong economic growth is not one of them.

  2. pgl

    A very well written critique. I’ll just take one aspect of this which needs a bit more discussion:

    “The next respect in which the current tax proposals follow in the footsteps of 1981, rather than 1986, is that their sponsors’ method for avoiding the hard trade-offs is to pretend that the tax cuts will pay for themselves. That golden oldie, the Laffer Hypothesis, makes yet another encore in its unnaturally prolonged life.”

    The Laffer Hypothesis has had an unnaturally prolonged life. But we should add that the macroeconomic mix of the early 1980’s lowered national savings which led to a lower long-term growth rate. Laffer claimed that the 1981 tax cut would lead to more growth but this tax cut led to less growth. Same would likely hold for the Trump tax cuts.

  3. dilbert dogbert

    This reminds me of the time the late wife won one of the Elijah Watts Sells awards. We attended the local cpa club where the award was presented. A tax attorney gave a talk about one of the two bills – can’t remember which. What do remember is that he called the bill The Tax Attorney, CPA and Accountants Full Employment Act.
    “The Elijah Watt Sells Award is bestowed annually upon candidates who: Have obtained a cumulative average score above 95.50 across all four sections of the Uniform CPA Examination. … The AICPA has bestowed the Elijah Watt Sells Award on candidates for outstanding performance on the …”

  4. noneconomist

    I’m feeling much now that Paul Ryan has gone from “deficit hawk” to “deficit hummingbird” or, at most, “deficit titmouse.”
    Can’t tell you how many fingernails I chewed to the nub while listening to Ryan’s warnings of how continually running deficits would lead to economic collapse. Or worse.
    Seems I’ve fretted too much. Borrowing to finance tax cuts will pay big dividends, so no one need worry because the other deficit hawks/hummingbirds/titmice say we can rely on more dynamic scoring than LeBron James could ever hope to deliver in his world.
    Just like the economy, my fingernails can now grow again.

  5. 2slugbaits

    The 1981 tax bill had a few other godawful features that Prof. Frankel didn’t mention. For example, it provided some perverse real estate incentives that resulted in lots of empty office buildings. Reagan promised that the 1981 tax deform would increase private saving. It didn’t. Personal saving plunged. It also created all kinds of new loopholes that created a lot of rent seeking behavior.

    PeakTrader Paul Volcker replaced Bill Miller in Oct 1979. Volcker immediately tightened the money supply, which pushed the economy into recession in early 1980. Volcker then pulled back on the reins and the economy started to recover by late 1980. After the election Volcker sharply increased interest rates in order to drive down inflation. At the same time Reagan started to run both cyclical and structural deficits. The structural deficits meant that Volcker had to keep interest rates higher and longer than the Fed probably would have without those structural deficits. After inflation was tamed, the Fed lowered interest rates. And that’s why the economy followed a “V” style recovery. Steep decline followed by a steep rise. No Reagan magic. Just textbook macro.

    The economy may or may not need restructuring; but even if it does, I surely wouldn’t trust a Clem Kadiddlehopper cretin like Trump to get the job done. Almost everything in the two GOP tax bills would make the economy less efficient, poorer and greater income inequality. After five years we’d end up with bigger deficits, slower income growth, higher taxes on the bottom four quintiles, higher interest rates and uncompetitive exchange rates. It’s almost as though the GOP tried to come up with the crappiest tax plan they could think of.

    1. PeakTrader

      2slugbaits, that’s quite a fairytale to dismiss Reagan’s timely tax cuts. The 1979-80 recession reduced inflation only slightly. So, a steeper tightening took place. Of course, the Fed eased the money supply in the severe recession However, Reagan’s expansionary fiscal policy largely ended the recession and created the V-shaped recovery, while the Fed tightened the money supply after 1982.

      1. 2slugbaits

        PeakTrader Your grasp on history is becoming increasingly tenuous. The early 1980 recession only reduced inflation slightly because Volcker realized that the Fed had tightened credit too much and the Fed quickly relaxed its tightening. Basically the Fed panicked when it saw how quickly the economy was falling. After the election the Fed took a second swing at inflation and increased the interest rates rather than directly tightening credit markets. That’s the recession that people remember. The consensus view is that the “V” shaped recovery was primarily due to the Fed. For example, the in Jul 1981 the effective Federal Funds Rate was 19.01%. Quite enough to choke off economic activity, drive up unemployment and cut inflation. After inflation fell the Fed allowed the effective Federal Funds Rate to 8.51% in Feb 1983. That’s a pretty big swing. And you need that kind of interest rate differential in order to get a strong “V” shaped recovery. That’s been one of the frequent criticisms of the Great Moderation; it didn’t give the Fed the kind of “elbow room” it needs to push the economy back to target once the economy jumps out of equilibrium. Your understanding of macro seems to be stuck in the early disco era. Here’s a holiday shopping suggestion: buy yourself a more current intermediate or advanced macro textbook.

        1. PeakTrader

          2slugbaits, I doubt the fundamentals of macro changed much and most disputes in grad econ likely haven’t been settled. Nonetheless, fiscal policy is an important component. In a recession, tax cuts and unemployment benefits provide money right away to boost consumer spending. And, optimism – showing people government is taking appropriate steps – boosts consumer and business confidence, to spur spending and investment.

          1. 2slugbaits

            PeakTrader I doubt the fundamentals of macro changed much

            Then you haven’t been paying attention. Granted, not all of the changes have been for the better, but the consensus is that absent a liquidity trap (which clearly did not apply in 1981-1982) monetary policy is the preferred approach. And if you insist on thinking in terms of macro during the disco era (e.g., Laidler or Dornbusch & Fischer), then you need to think about the relative slopes of Ye Olde IS-LM curves. Specifically, recall that within the IS-LM framework the relative slopes of the two curves tells you whether fiscal or monetary policy is likely to be the most volatile and overshoot the equilibrium.

            fiscal policy is an important component

            Fiscal policy is a second best choice, except when the economy is in a liquidity trap. Back in 1981-1982 the additional structural deficit (beyond the cyclical deficit) created by the Reagan tax cuts were counterproductive and only meant that the Fed had to raise interest rates even higher and longer than they would have without those large structural deficits. Reagan’s fiscal policies were fighting against the Fed’s monetary policies.

            In a recession, tax cuts and unemployment benefits provide money right away to boost consumer spending.

            Only if the Fed doesn’t raise interest rates. In any event, tax cuts are not a particularly effective way to stimulate aggregate demand. Increased government spending is much more effective, particularly if the marginal propensity to import is high. Unemployment benefits help stabilize demand, but making them too generous (as you propose) risks creating a higher efficiency wage, which tends to raise unemployment. So you need to get the balance right…and I’m pretty sure that Congress critters….especially GOP Congress critters don’t have the intellectual chops to get that balance right. They’re dumb as a bag of hammers.

          2. PeakTrader

            2slugbaits, I don’t see any new economics – just making things up don’t count (you may want to move up in time, and space, with the Mundell-Fleming model). It’s been said monetary policy is like pushing on a string.

          3. PeakTrader

            Even the proper terminology gives it away – we have “expansionary” fiscal policy and “accommodative” monetary policy.

          4. baffling

            2slugs, every office has the requisite old guy who was successful and knowledgeable 40 years ago. unfortunately, that person failed to learn anything new in the decades since graduation. you know the guy-constantly bothering the young guns to help him get his computer to work properly, wastes the IT folks time by requesting that his marvelous old DOS programs run on his windows workstation, takes a day to type a letter using two fingers. cannot be assigned any new, important projects, because he lacks modern knowledge to complete the tasks-so the younger folks get overworked while he covers the low hanging fruit assignments. everybody wishes such a person either quits or retires, because they are a net negative to the company. on this site, that would be peak trader. still living in the decade of st reagan.

  6. Bruce Hall

    If we could only raise everyone’s taxes by 100%, we wouldn’t have any fiscal or social problems. The government could spend much more on needed social and welfare programs and high income earners would finally be paying their fair share.

    But why stop with income taxes and excise taxes and gasoline taxes and utility taxes? Let’s have a national sales tax of 20%. But let’s call it a Value Added Tax which the producers and sellers pay. No one will notice the slight increase in the cost of their purchases. Then the government can really increase its social and welfare programs.

      1. Bruce Hall

        Menzie, from your comment I gather you think my comment borders on the absurd. But in reality, it is well within “reason”. A 100% increase in taxes plus a VAT is different from 100% of income… especially given the very low amount of taxes paid by 75% of the people in this country. And that would place the U.S. in a competitive position with countries that many of your blog’s readers hold up as shining examples of good government and social systems.

        But your idea may have merit. Let’s check with our friends in Saudi Arabia.

        1. 2slugbaits

          Bruce Hall The purpose of taxation is not to shake down taxpayers just for the hell of it. The reason we have taxes is to pay for goods and services that taxpayers demand from the government. We don’t need to increase taxes by 100%; however, we do need to increase total taxes to something in the neighborhood of 23% because that seems to be consistent with the level of goods and services people expect and demand from government. It should be perfectly obvious why people demand more goods and services from government as those same people become wealthier. Most public and quasi-public goods are normal goods; i.e., demand increases with income. Foul air and filthy water are acceptable when you’re desperately poor, but completely unacceptable when you’re wealthy. Education, crime prevention, a fair judicial system, cyber security, safe airplanes, strong defense, and a vigorous diplomatic presence. These are all things that we want more of as we become richer. We also want more quasi-public goods like education, cultural events and public health. And as we become wealthier we demand more of the one good that is highly inelastic; viz., time. The value of time increases faster than any other economic good. And that means we all demand more and better healthcare. So that means we need some kind of health insurance arrangement that diversifies risk. Private insurance can provide some of this risk diversification, but the business model requires that they effectively reduce diversification in order to maximize profits. Long story short, sooner or later advanced countries figure out that the most efficient way to provide healthcare is universal access coupled with a financial mandate to pay for it in a way that assumes a generational contract. And in most cases the best way to accomplish that goal is through some government program. That means government’s role in healthcare will certainly increase as we become wealthier. Sooner or later every advanced country comes to this realization. It just happens that voters in this country are exceptionally slow learners.

          The difference between today’s liberals and today’s conservatives is that today’s liberals believe in paying for government while conservatives believe in free lunches. One demographic has grown up to adulthood while the other remains in an arrested state of denial.

          1. PeakTrader

            2slugbaits, big government socialists should realize if they want more tax revenue and regulation, or government services, GDP needs to grow faster – 18% of $60,000 or 3% growth is more than 18% of $40,000 or 2% growth. And, it’s naive to trust politician-lawyers with more than a limited amount of money, e.g. 18% of GDP. You ignore the failures of socialism. It seems, you just want to punish successful people and show how generous you are with other people’s money. I guess, your idea of utopia is France.

          2. PeakTrader

            And, you need to understand the concept of trade-offs, e.g. do you want two miles of a repaved road completed in nine months or a new car.

          3. PeakTrader

            Anyway, if the federal government collected 5% more of GDP in taxes, it likely wouldn’t be long before it spends 7% or 8% more in GDP. And, the trade-off between private goods and public goods would be even worse. I suspect, if it’s kept within a budget, it would make wiser and more efficient choices. For example, on a limited budget, it may find filling in pot holes is sufficient compared to repaving a road.

            If a good is worth $500 per person to society, e.g. a high speed train, it may cost the government $1,000 per person. Of course, if someone only gives up $100 in private goods for a public good that’s worth $500, it’s a good deal. However, someone else may have to give up $5,000 for something worth $500 to society. Progressive taxes shouldn’t be an excuse for waste. Government needs to be held to a budget, to make better choices.

          4. Bruce Hall

            “The reason we have taxes is to pay for goods and services that taxpayers demand from the government.”

            Perhaps if the demands were coming primarily from those who actually paid taxes, the demands would be more judicious.

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