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.