By Alan Reynolds
June 10, 2004, Cato Institute
The relentlessly partisan New York Times could not resist using Ronald Reagan’s death as a tawdry opportunity to denigrate his enduring, internationally emulated accomplishments in economic policy. The editors concluded Reagan merely “profited from good timing and good luck” by taking office just after the Fed raised interest rates from 9 to 19 percent. A New York Times reporter, Todd Purdum, added gratuitous insults about “Mr. Reagan’s … seeming indifference to civil rights, the environment and the plight of the poor.”
Even the obituary by Marilyn Berger recycled random nonsense, such as blaming the ephemeral stock crash of October 1987 on “the administration’s failure to deal with the budget.” October 1987 marked the end of a fiscal year in which the deficit fell 32 percent.
Like many others, Berger dug up former budget director Dave Stockman’s tiresome canard that the supply-side team in early 1981 spun a “Rosy Scenario” to make future budget deficits look small. I was the first recruit on Stockman’s transition team, so I know this was a self-serving scam.
The controversy among Stockman’s advisers in early 1981 was not about economic growth, but about an unduly gloomy forecast for inflation. We projected a one-year recession and five years of 3.9 percent real growth. Far from being wildly optimistic, this was the only official forecast that ever predicted a recession not yet begun. That recession turned out to be more persistent than anyone expected, starting in July 1981 and lasting through November 1982. But that was followed by seven years of 4.3 percent growth of real GDP, making our forecast look modest.
We never imagined the Fed would keep the funds rate above 14 percent through June 1982, even as inflation fell sharply. That Fed squeeze guaranteed big budget deficits by inflating the government’s interest bill and deflating the economy. Supply-side economists (Larry Kudlow, John Rutledge, Paul Craig Roberts and I) also did not anticipate that nearly all of the 25 percent reduction in tax rates would be foolishly postponed until 1983-84.
Once effective, the 1981 tax law greatly enhanced incentives for saving and investment, but tax rates of 42 percent to 50 percent on salaries still remained discouraging. The 1986 tax reform was far more conducive to lifetime work effort and education, but hostile to investment: The capital gains tax was raised to 28 percent, IRAs curtailed, and depreciation of business equipment extended. Mixing the best features of the 1981 and 1986 tax laws remains an elusive ideal.
In February 1981, supply-siders lost a key debate with Stockman’s more orthodox advisers. We initially predicted inflation would drop from 13.5 percent in 1980 to 4.2 percent in 1983 and to 2.6 percent by 1986. Inflation actually fell even faster — to 3.2 percent in 1983 and 1.9 percent in 1986. But Alan Greenspan and Murray Weidenbaum, reared in the Keynesian tradition, thought inflation could not come down quickly in a growing economy. With that as a cue, Stockman raised the inflation estimate to 7 percent for 1983 and 4.9 percent for 1986. Higher inflation made future deficits appear smaller, on paper, because inflation was assumed to push more people into higher tax brackets but (implausibly) to not inflate non-indexed spending.
Budget forecasting errors in the 1981 plan were entirely due to higher spending. Measured in constant dollars, federal revenues grew 26 percent from 1980 to 1989 — a larger gain than from 1970 to 1979. Federal spending, by contrast, was projected to drop to 19 percent of gross domestic product (GDP) by 1986, but actual spending turned out to be 22.5 percent of GDP. That was mainly due to investments in military capital, which Ross Perot dubbed “an investment in bankrupting the Soviet Union.” The resulting implosion of the Soviet Union allowed U.S. defense spending to be cut from 6 percent to 3 percent of GDP — enough to erase deficits that averaged 3 percent of GDP in 1987-89.
All the political fuss over raising individual tax rates in 1991 and 1993 was essentially irrelevant. Receipts from the individual income tax averaged 8.2 percent of GDP from 1988 to 1990, when the top tax rate was 28 percent, then fell to 7.8 percent from 1991 to 1994 after the highest tax rates were increased by Presidents Bush and Clinton. Revenues did surge in 1997-2000, but much of that revenue windfall was from capital gains taxed at the reduced rate of 20 percent.
Ironically, the fact that lower tax rates were not followed by lower tax revenue — just as supply-siders had predicted — was later used by Reagan’s critics to pretend tax rates had not fallen at all. New York Times columnist Paul Krugman claims “no peacetime president has raised taxes so much” as Reagan, merely because Social Security taxes are up to 6.4 percent of GDP this year from 6.2 percent in 1982.
In a March 2000 article, “Where Did Reagan’s Tax Cuts Go?” former Clinton economist Brad DeLong remarked that, “in fiscal 2000 the share of GDP collected by the federal government as taxes will amount to about 21 percent, up from an average of 18.7 percent 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?”
Between the Carter years and 2000, the top tax rate was cut from 70 percent to 39.6 percent on individual income, from 50 percent to 35 percent on corporate income, and from 35 percent to 20 percent on capital gains. DeLong was astonished to discover that both the economy and tax receipts grew faster with lower tax rates. But that was scarcely an embarrassment for supply-side economics.
Other desperate efforts to diminish the Reagan Revolution emphasize that President Clinton raised tax rates in 1993, yet the economy grew almost as briskly from 1993 to 1999 (3.7 percent a year) as it did from 1983 to 1989 (4.3 percent). The fatal flaw in this comparison is that key tax rates were much lower during the Clinton years than during most of the Reagan years. From 1983 to 1986, the highest income tax rate was 50 percent on individuals and corporations. From 1993 to 1996, the highest income tax was 39.6 percent for individuals and 35 percent for corporations. From 1987 to 1990, the capital gains tax was 28 percent. From 1997 to 2000, the capital gains tax was 20 percent.
President Reagan gave the United States this lasting legacy of lower tax rates to improve incentives for personal effort, investment and entrepreneurship. The results have been even better than contemplated in the so-called Rosy Scenario of 1981, and have been emulated by dozens of other countries, including China, India, Ireland and Russia. Bewildered critics responded by spinning metaphysical theories exaggerating the costs of budget deficits and benefits of surpluses. Yet none of their predictions came to pass.
On economic success alone — even aside from the critical impact of that success in discrediting communism — the facts permit only one credible verdict on President Ronald Reagan’s awesome accomplishments: Score another big win for the Gipper — and another big loss for the sore losers.