2




Reagan’s 1981 tax cut

s is well known, large-scale tax reduction was a central element of the Reagan campaign, both for reasons of promoting long-term economic growth and for providing tax relief from inflation-induced bracket creep. The Economic Recovery Tax Act of 1981 (ERTA), built largely on the Reagan administration’s proposals for across-the-board cuts in marginal rates and indexing of the tax brackets against inflation along with an increase in depreciation allowances for business, was passed in both the Senate and the House by overwhelming majorities.

It is widely believed that erta was a major contributor to the large deficits of the 1980s. Was this true? The answer is that erta surely contributed to the deficit; but the more difficult and important question is whether the long run effects were on balance more harmful or beneficial given the alternatives.

The Joint Committee on Taxation (JCT), which is responsible for estimating the revenue effects of all legislation being considered by Congress, predicted that by 1984 erta would result in a revenue loss of $148 billion compared to the revenues expected under pre-erta law. That is a substantial loss, amounting to almost 4 percent of GDP. As it turned out, tax revenues as a percentage of GDP averaged around the same level as they were during the Carter years — the annual average for 1981-88 was 18.1 percent (that is with some help from subsequent tax-raising legislation). But in the absence of erta, taxes would have been a much higher proportion of national output — about 21 percent of GDP in 1984 and still higher later on. That would have been enough to eliminate 80 percent of the 1984 deficit. But the price for that deficit reduction would have been sharply higher marginal tax rates that likely would have impeded economic growth in the long run. Moreover, by accommodating higher levels of spending with tax increases, pressure to restrain spending growth (and therefore help control future deficits) would have been diminished.

Figure 3
Spending and Outlay Components as a Percentage of GDP (4 year average)



1
2
3
4



Years
Defense
Discretionary
Non-defense
Entitlements
Net Interest
Payments
Total
Outlays

Nixon/Ford
73-76
5.6
4.4
9.9
1.5
20.0

Carter
77-80
4.8
5.1
10.3
1.7
20.8

Reagan I
81-84
5.8
4.4
11.3
2.6
22.7

Reagan II
85-88
6.1
3.7
10.4
3.1
22.1



Figure 3

The spending side also contributed to the 1980s deficits (see Figure 3). Outlays over the period 1981-88 averaged 22.4 percent of GDP a year, and that was 1.6 percentage points above the average for the Carter years. The popular view is that the Reagan defense buildup (reversing a decline from 1973 to 1979) was the main factor in this growth in outlays. However, the growth in interest payments on the outstanding debt (fed by the enormous rise in interest rates at the end of the ’70s and early ’80s), and a surge in entitlement spending in the early 1980s, were also major contibutors. Even after inflation had been sharply reduced, inflationary expectations kept interest rates high into the mid-’80s. The composite interest rate on new and old debt paid by Treasury increased by about 2.4 percentage points between 1979 and 1985.

Over the period 1982-1986 the deficit averaged about 5 percent of GDP. But during the last half of the 1980s the deficit picture improved as real GDP growth increased to a healthy average of 3.7 percent a year, while tax revenues grew by slightly more. At the same time, the growth in both discretionary and entitlement spending declined as a percentage of GDP. By 1989 the deficit was reduced to 2.8 percent of GDP, which is slightly above what it was in 1980.

The good times, however, did not last. In 1990 the economy again slipped into recession, which was further exacerbated by the Gulf War. Tax revenues actually declined in real terms from 1989 to 1992, outlays increased, and the deficit widened again to almost 5 percent of GDP in 1992. Contributing to the gloomy picture was a large dose of bad luck. The savings and loan crisis led to an eruption of spending to make good on deposit insurance. Many states figured out a loophole in Medicaid reimbursements that enabled them to enrich state coffers for non-Medicaid purposes. These "disproportionate share" payments caused Medicaid to grow by close to 30 percent a year for a couple of years. cbo projections of the budget outlook grew more pessimistic at the start of 1992. The budget office announced that it expected a deficit of $350 billion for that year, which would have been 6 percent of GDP. The actual 1992 deficit was 5 percent of GDP; still not a reassuring number.

What brought the surplus?

hen I came to CBO in March 1995, the budget office was projecting deficits of 3 percent of GDP "as far as the eye could see." This projection was based on what appeared to be reasonable assumptions at the time. Although the economy had recovered from the 1990-91 recession, it did not experience the usual spurt in growth that is typical of the early years of an expansion. Real GDP grew by about 3 percent a year during the 1992-94 period compared with the 5 percent growth rates in the comparable years following the 1982 and 1974-75 recessions. The Clinton tax hike enacted in 1993 increased revenues, but they had not risen above 18.1 percent of GDP.

Although we did not know it then, these pessimistic forecasts were probably one of the proximate causes of today’s unanticipated surplus. The large actual deficits, and projections of more of the same, put tremendous pressure on legislators to find ways to reduce federal spending. Deficit reduction appeared on the national stage when it became a central issue of the 1992 presidential campaign. But even before that, the high deficits of the 1980s had spurred legislative efforts to reduce the deficit. The Gramm-Rudman-Hollings (GRH) legislation of 1985 specified deficit targets and spending cuts to be made automatically if the targets were not met. The targets proved impossible to meet in years when underlying conditions worsened unexpectedly. In 1990, a new budget act replaced GRH with far more effective rules: ceilings or "caps" on discretionary outlays and the so-called "paygo" provision requiring any new legislation that would increase entitlement spending or reduce taxes to be paid for with a cut in other entitlement spending or a tax increase. (The 1990 legislation also contained the famous tax increase that caused President Bush to break his "no new taxes" pledge.) The caps and spending restrictions of the 1990 act were subsequently renewed in 1993 and again in 1997. When the newly elected Republican majority came to Congress in January 1995, the goal shifted from deficit reduction to the more ambitious one of balancing the budget by 2002.

Did these budget rules work? Clearly growth in outlays slowed dramatically through the 1990s. From a level of 21.2 percent of GDP in 1989 — the low point of the 1980s — outlays fell to 18.7 percent of GDP in 1999, a level not seen since 1974. Some of that reduction is attributable to very low inflation, which reduced cost-of-living adjustments, and to lower interest rates, which reduced payments on the federal debt. The growth in spending on Medicare and Medicaid was lowered in part as a result of legislation and in part for reasons not wholly understood. However, most of the reduction in outlays came from a huge decline in discretionary spending, which fell to 6.3 percent of GDP in 1999 from 9 percent in 1989 (see Figure 4). Discretionary spending, in fact, did not even increase as much as inflation, declining in real terms by almost 9 percent over the decade.


Figure 4

It is tempting to credit the budget caps with the reduction in discretionary spending. However, all of that reduction came from cutbacks in defense, which in nominal dollars declined by 9 percent from 1989 to 1999 and in real terms by 29 percent. Should the credit for defense cutbacks be given to the peace dividend from ending the Cold War, or was it the budget caps? There is no counterfactual that would enable us to answer that question scientifically. In my view, having observed Congress struggling with a constant stream of requests and temptations to spend more, the caps provided an important reason to say no. Violating the caps in the face of large deficits was not something to be done lightly. Congress generally abided by the caps, exceeding them only slightly, and then in allowed areas where Congress could claim an emergency or a disaster. Two divergences from the general pattern are worth noting. One occurred in 1996, when actual discretionary spending was $13 billion below the legislative ceiling. That was the year of the battle of the budget between Congress and the president; the year of government shutdowns and snowstorms that kept the government closed and the year of many months without an enacted budget in place. The Republicans may have paid a political price, but the deficit was narrowed by a year of low spending. Moreover, the president was brought aboard the balanced budget movement. The president’s initial budget that year contained no deficit reduction proposals. But just a few months later, the administration countered the congressional plan calling for balance by the year 2002 with its own proposal for balancing the budget by 2005; and as the summer turned to winter, it came to accept the 2002 target date and put forth its own ideas for how to get there.

In contrast, the other divergence involves the opposite behavior in the face of current rosy budget forecasts. In 1999 and 2000, for the first time in many years, surpluses were anticipated well in advance of the annual round of legislative activity on the budget. And in both 1999 and, as it now appears, 2000, discretionary spending has grown faster than inflation, as the caps have been stretched by classifying more and more spending as "emergency" and by resorting to a variety of gimmicks that have shocked even the most cynical budgeteers.

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