The Reagan Tax Cuts Did Not Cause The Reagan Deficits

Or

If You Want to Soak the Rich, Cut Their Taxes

Richard Halverson

Recent news coverage of Ronald Reagan’s funeral thrust his tax policies back in to the news.  Generally, what I heard indicated that much to the surprise of many experts the tax cuts did not result in lower but increased tax revenues.  Every report I heard also added the conjunctive “but”.  The “but” was always followed by the comment that the tax cuts led to a huge deficit.

The first part of the statement is true.  Tax revenues did increase more than even the architects of the tax cuts had predicted.  The second part is not true.  The tax cuts did not result in the deficit.  Think how illogical the statement that was made over and over again is.  “Surprisingly the Reagan tax cuts resulted in higher tax revenues ‘but’ they also resulted in record deficits.”  Ask yourself how can surprisingly high revenues result in higher deficits?

Not meant to be political

I want to say here this piece is not intended to be political.  Tax cuts and deficits are once again a hotly debated political issue.  It is not my intention to enter the debate but to offer some insight that might be of interest.  (Actually, I probably would enter the debate if anyone on the national scene were interested in my opinion – but they are not.  So, I hope what I write will increase the understanding of interested Meridian readers a little.)

Tax Cuts Can Increase Revenues

Can cuts in income taxes actually lead to increased tax revenues?  The answer is “Yes”.  It seems counter intuitive – reducing taxes to increase them.  There are many things in economics that are counter intuitive.  There are many situations where it seems you must walk south to go north.  It all has to do with influencing the behavior of the individual.  The economy is not the government!  The economy is made up of hundreds of millions of individual decision makers like you and me and the companies that employ us.  Whether the economy is growing or shrinking depends on how those decision makers are acting.

Tax Cuts Stimulate the Economy

The first way a tax cut increases revenues is by stimulating the economy.  This principle is relatively well understood and is widely taught in schools.  A tax cut puts more money in the pockets of those individual decision makers.  They will spend the money.  That will increase economic activity.  This will lead to more employment, more income and more profits.  Taxes are paid on these incomes and profits.  There is a multiplier effect associated with this activity meaning that a dollar of tax cut can actually produce enough income related economic activity to more than offset the original cut in taxes.

Economic models suggest this multiplier effect is most pronounced when the country is in a recession.  In this regard it has everything to do with the mood of those hundreds of millions of individual decision makers.  Pessimism and optimism are powerful economic emotions.  During a recession some people lose their jobs.  In the recent recession unemployment increased by only 2.5%.  The vast majority of Americans did not lose their jobs.  Of course, the economy is hurt when some lose their jobs but it is hurt far more when the 94% who are still employed get frightened.  Pessimistic decision makers are unwilling to spend or invest their money and the economy sags.  The reverse is true when the economy is stimulated with a tax cut.  Employment improves. Of far greater importance, however, is the general increase in confidence of consumers and businesses.  Optimistic consumers are willing to spend and invest their money.

Reagan inherited the most difficult economic period since the Great Depression.  Stagflation, 21% interest rates and the unemployment rate had been above today’s much discussed level for six years.  The mood was definitely one of concern, pessimism and despair.  Much has been made of Reagan’s optimistic persona.  Like Franklin D. Roosevelt during the Great Depression the nation needed a leader that projected infectious optimism.  The tax cuts and their stimulative  effect was well timed.

Taxes are a Disincentive to Work, Tax Cuts are an Incentive to Work

There is a second powerful but far less obvious reason why reducing tax cuts increases revenues.  Not only is this less obvious it can be difficult to understand.  This influence rests on the concept that taxes are a disincentive to work.  As they rise, the disincentive to work rises.  Eventually, it rises to the point of being destructive to the economy.

Stick with me on the following example.  Assume a country has zero taxes.  Sounds good!  Not really.  There are a great many goods and services we enjoy as citizens that we can have if we come together in the form of government but can not enjoy if we act individually.  It takes pooling our money in the form of taxes to pay for those goods and services.  But assume for a minute a country with zero taxes.  The country would also have zero revenue.  The following graph captures the situation - $0.00 and 0% tax rate.

Assume the government sees a need for roads and the citizens agree.  This will take money.  Assume the government proposes a tax.  Assume to make it more palatable the government proposes this tax will only be imposed on the wealthy – say those earning over $200,000 a year.  (This government already understands what politicians have learned worldwide.  It is a lot easier to get people to vote for taxes that are paid by someone else.  Beware of such politicians.  They are engaging in a form of class division and warfare that can ultimately be injurious to society.)  Assume the modest tax is imposed.  The graph below represents the fact that revenues are raised.  It should be noted the actual amount of tax revenue will likely be less than projected.  This is the case nearly 100% of the time.  The reasons are the subject of this article.

Assume the government next sees a need for police and fire protection.  More money will be needed.  An increase in the tax rate on income over $200,000 is proposed.  Once again it passes.  The graph might look like this.

O.K. let’s jump to the illogical conclusion.  Let us assume the government sees so many needs they propose a 100% tax rate on all income over $200,000.  How much tax revenue do you think the government will receive?  Your right (I hope) ZERO!  At a 100% tax rate the disincentive to earn over $200,000 will be at 100% so no one will.  People will either quit working or get compensated in some other way.  No one will be interested in putting in the effort to earn $300,000 when they know everything over $200,000 will be taken.  The graph will look something like this.

This curve is popularly called the Laffer curve after Dr. Art Laffer.  Dr. Laffer is an articulate and entertaining economist who’s work had substantial influence in the Reagan administration.  I mention this mostly because it is so rare to find an articulate and entertaining economist.  (I am a closet economist so I can get away with these slurs.)

Despite the obvious logic behind the Laffer curve and an increasing body of real statistics that it works there is still much we do not know about it.  We do not know the true shape of the curve.  We do not know whether it changes shapes as optimism and pessimism among tax payers changes.  We do not know if it is the same for everyone.

We do know some people do not get the idea at all.  It is almost humorous to watch some people struggle with the idea that at some point taxes become so oppressive that people will quit working.  There are those who believe work is its own reward and that beyond that there are those who will keep working and paying taxes out of a sense of civic pride.  Both of these concepts are true to some extent.

For example, I have no doubt that most professional athletes love playing the game so much that they would do it for far less than the mega-millions they are being paid.  I am confident there are many CEO’s who love the power of running a corporation so much that they would do it for far less than today’s compensation levels.  Further, I have no doubt that during periods of grave crises for the country people will work hard despite heavy taxes.  World War II is certainly an example of that.

Real People Decide Working More is Not Worth It Because of Taxes

In more ordinary times, however, what we will find is that the Laffer curve is alive and having a considerable effect.  If there were a 100% tax on all income over $200,000 what we would find is the athletes and CEO’s would find some non-taxed way to get paid.  But far more important than athletes and CEO’s are the ordinary taxpayers.  Ask yourself if you have ever heard comments like this.

“I could work overtime but it puts me in a higher bracket and by the time they take the taxes out it isn’t worth it.”

“My spouse would like to go back to work but by the time we pay for the higher taxes, transportation and day care there is nothing left.”

These are every day real life examples of the Laffer curve at work.  People who feel the extra income is not worth the effort after they pay taxes.  It can happen at all levels of the income scale.  Not only have I heard the comments above from middle income Americans I have heard this comment from people who have no income.

“If I go to work I will lose my welfare benefits and I will actually have less money to spend.”

The Laffer curve effecting the behavior of even the poorest in society.

Want to Soak the Rich?  Cut their Taxes!

In my hypothetical society the government taxed only the rich. In our real non-hypothetical society the federal and most state governments impose income taxes on nearly all workers.  However, the tax rates are graduated so there are higher tax rates on the higher income earners.  If the Laffer curve theory is correct cutting the tax rate – especially for the wealthy – will not only increase tax revenues generally it will shift a greater portion of the total taxes paid to the upper income earners. Look at the following chart prepared by the Congressional Joint Economic Committee.  (The complete article, which is excellent, can be found at [http://www.house.gov/jec/fiscal/tx-grwth/reagtxct/reagtxct.htm])

This graph clearly shows the predicted Laffer effect worked after the Reagan tax cuts. i.e. the wealthy did pay more of the total taxes. So the apparent message seems to be if you want to soak the rich cut their taxes. (Once again walking south to go north.)

This Principle is Found Everywhere

Incidentally, you find this same principle in many areas.  If you don’t water your plant it will die.  If you water your plant too much it will die.  If you don’t pay any attention to your relationship it will wither.  If you pay too much attention to your relationship it will wither.

Despite the apparent message in the Laffer curve there will still be heated debates about tax policy.  We are no closer to knowing the true shape of the Laffer curve.  Will it work in the future as it apparently has in the past?  Did it really work in the past or did some other economic phenomenon produce the observed result?  What side of the Laffer curve are we on today, after all the marginal tax rate for upper income earners is about half what it was when Reagan took office?  And, of course, there will always be those that always want higher taxes for those who are rich just because they are rich!

You Get Less and Less of What You Tax and More and More of What You Subsidize

While this debate rages I would like to insert this observation.  One of the very few things I know that will work every time in economics and tax policy is this.  You get less and less of what you tax and more and more of what you subsidize.  It is true.  One might argue that our current tax structure tends to tax the most productive people in society and subsidize the least.  While this might be compassionate and it might even be Christian it will result in less productivity and more people on the dole.  Politicians and citizens need to be aware of this phenomenon.  Tax policy can have powerful effects on social policy.

There are Two Sides to a Budget – Revenue and Spending

If there is and always will be heated debate about past and future tax policy there should be no debate about where the deficit came from during the Reagan presidency.  The statement that is repeated over and over is that the Reagan tax cuts resulted in increased revenues “but” they led to a large deficit.  That is not possible.  I know I have said in this article that often in economics the outcome of an action is counter intuitive.  This is not one of those situations.  In fact, this is not economics at all.  This is accounting.  Higher than expected revenues can not be the cause of a deficit.  Only high spending can account for that.  You can have a deficit if your spending is in line and your revenues are less than forecast but not the other way around.  When many people hear the words “tax cut” their immediate assumption revenues were down.  However, during the Reagan years revenues were up and up more than forecast.  The culprit in this equation therefore can only be spending.

During the 1980’s we had a classic guns or butter debate.  President Reagan not only wanted to cut taxes he wanted to increase military spending.  He was able to persuade congress to go along.  However, he was not able to persuade congress to cut spending in other areas.  In fact, spending on a range of social programs increased.  This article does not intend to moralize in anyway on whether the spending was justified or not.  I simply want to make the point that what we got was not “guns or butter” but “guns and butter”. It was the spending side of the equation not the tax revenue side of the equation that produced the deficits of the 1980’s

The Same Situation Today

We are faced with a very similar situation today.  There is every indication that the Bush tax cuts will result in higher tax revenues.  Certainly, they have helped stimulate the economy and the economy today is one of the strongest in history!  In fact, (It is baffling that the news can still seem to report this as anything less than a blow out expansion.  It just doesn’t get much better than this. Low inflation, low interest rates, high productivity, strong gross national product, strong employment, everything expanding. But that is another article.)  Beyond stimulating the economy there probably will be some Laffer Curve revenue increases.  If you pay close attention I am confident you will hear the government continuously reporting higher than forecast tax revenues for many months.  But the deficit is rising.  Once again it is “guns and butter” instead of “guns or butter”. We are fighting a war and trying to keep every politicians’ – including the President’s – promises regarding social spending.  Someday you may well hear a statement that goes something like this:

“The Bush tax cuts surprisingly resulted in higher than forecast revenues ‘but’ they also caused the largest deficits in history.”