Editor’s note: Jeffrey Frankel is the James W. Harpel Professor of Capital Formation and Growth at the Harvard Kennedy School. This analysis is being published here in collaboration with EconoFact, a nonpartisan economic publication.
President Donald Trump has invoked the experience of the Reagan Administration’s tax reforms to promote the current Republican tax reform proposals. “Republicans and Democrats came together to cut taxes for hardworking families in 1981, and again in 1986 to simplify the tax code, so that everyone could get a fair shake. The rest, as they say, is history,” wrote Trump in a recent USA TODAY opinion editorial. To recall what transpired in the 1980s might indeed help shed some light on the potential impacts of proposed tax legislation. But the two huge tax bills during the Reagan years — the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986 – differed in almost every respect. These differences must be taken into account in order to draw lessons for today. Moreover economic conditions in the 1980s — particularly a high unemployment rate, a much lower inherited level of debt, and the relatively younger age of the American population — were markedly different from today’s U.S. economy.
- The Economic Recovery Tax Act of 1981, sponsored by Republicans Jack Kemp, Representative of New York, and William V. Roth Jr., Senator of Delaware, made deep cuts to both corporate and personal income taxes and was followed by a sharp increase in the government deficit. The act included an across-the-board decrease in the marginal income tax rates by 25 percentage points, with the top rate falling from 70 to 50 percent and the bottom rate dropping from 14 to 11 percent. The act also indexed income tax brackets and trimmed taxes paid by business corporations. (See here for a history). The tax cuts were swiftly followed by a ballooning government deficit, which grew from 2.8 percent of the gross national product in 1980 to a peak of 6.3 percent of GNP by 1983.
- The White House, surprised at the acceleration in the budget deficit that resulted from the 1981 tax cuts, sharply reversed some of them the next year, in the Tax Equity and Fiscal Responsibility Act of 1982. It raised taxes well in excess of 1 percent of GDP (and by that measure still stands as the largest tax increase since 1968). Nevertheless, 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 the 1982 tax increase 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 percent, so the interest that was incurred was a bit over 1.1 percent of GDP.)
- The 1986 law, by contrast, was the thought-out result of an extended and bi-partisan process, designed to be revenue-neutral. The bill had Democratic sponsorship from Richard Gephardt in the House of Representatives and Bill Bradley in the Senate. The top tax rate for individuals was lowered further to 38 percent by 1987. The reform simplified the tax code. It expanded the standard income deduction. In order to keep marginal income tax rates low, it made up the lost revenue by eliminating deductions, particularly on the corporate side.
- The Reagan Administration 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 (EITC). President Reagan’s reforms to the EITC included phasing in the credit more quickly as a worker’s income rises, expanding the maximum EITC, phasing the credit out more slowly so that more families would be eligible, and indexing these parameters for inflation to prevent erosion of the benefits over time. As the standard deduction, personal exemption, and earned income credit were all expanded, this resulted in a reduction of income tax liability across all income levels.
- The Republican tax reform proposals 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 additional debt, cumulated over ten years) is met by allowing households’ tax cuts to expire before the ten years are up, while the corporations’ tax cuts are made permanent. Taxes on families earning less than $75,000 actually go up on average by the year 2027, relative to today, according to a report by the Joint Committee on Taxation.
- It is essential to good legislation that the process be deliberate rather than rushed and unilateral, 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.” The current tax proposals follow in the footsteps of 1981, rather than 1986, in that their sponsors’ method for avoiding the hard trade-offs is to claim that tax cuts will pay for themselves.
- 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 been rejected by many mainstream economists, including the economic advisers to those two presidents. More importantly, when the tax cuts went ahead anyway, the theory failed miserably: Both times, budget deficits increased sharply.
- The tax cuts that the Republicans are proposing 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 (see chart). The opposite is true today: At a 4.1 percent unemployment rate, the economy does not need additional stimulus. Indeed the Federal Reserve is expected to raise interest rates again in December to prevent the economy from overheating. Expansion of the budget deficit is called for when the economy is weak and unemployment is high (1981 or 2009, as the graph shows), not when unemployment is low as it is today.
- 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 percent of GDP today. It was only 25 percent of GDP when Reagan took office. This is precisely the wrong time to increase the budget deficit and so borrow still more.
WHAT THIS MEANS
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. Instead of aiming for revenue neutrality, as the 1986 reform did, current proposals will expand the government’s budget deficit over the next decade, at a time when an aging population will place a growing fiscal burden. 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.