America's Fiscal Constitution (47 page)

In the 1970s Congress frequently passed new investment incentives. Those efforts resulted in a tax code so complex that Carter labeled it repeatedly as a “disgrace to the human race.”
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In prior eras a sweeping tax proposal from the leaders of the powerful House and Senate tax committees would have prompted a serious national debate. Long and Ullman’s sales tax initiative in 1979, however, died a quiet death. Its obituary included Ullman’s defeat for reelection in 1980.

As corporate income tax revenues declined as a share of national income, the federal government relied more heavily on personal income taxes. By 1980 those taxes had reached the limit that many Americans were willing to endure. Americans in the top bracket of 70 percent had always chafed at a tax rate that made tax-planning a part of every investment decision. Far more Americans felt squeezed when high World War II tax brackets began to apply to households with middle incomes in the late 1970s. At the end of World War II only fairly wealthy Americans earned $25,000 to $50,000 a year; 70 percent of taxable income in that range came from investments—proprietary business profits, dividends, interest, and capital gains.
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Even in the mid-1960s investments produced half the taxable income of taxpayers in the $25,000 to $50,000 bracket. The price and wage inflation of the late 1970s pushed wage-earning workers into that tax bracket. By 1980 salaries and wages accounted for more than 80 percent of income earned by taxpayers earning $25,000 to $50,000.
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Married couples filing a joint return with $25,000 in net taxable income, after deductions, were subject to a tax rate of 32 percent rate, a rate once reserved only for wealthy families.
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Inflation had also eroded the value of the standard deduction that once exempted all of the earnings of taxpayers with low wages.

Revenues from personal income taxes jumped from 7.21 percent of national income in 1976 to 8.75 percent of national income in 1980, the largest spike since World War II.
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The “effective” rate of personal income taxation—average personal tax revenue as a percentage of average revenue on the top line of tax returns—also jumped. In 1953, the end of the Korean War, the effective rate was 13 percent. It dipped a bit in the early 1960s before returning to 14 percent courtesy of the Vietnam War surtax. Federal personal income taxes remained between 13 and 14 percent of gross income until 1978, and then climbed to 15.6 percent in 1980 and a record 16 percent in 1981.
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Americans with middle incomes also felt pressed by payroll taxes supporting Social Security pensions and Medicare hospitalization insurance. Payroll tax rates climbed from 6 percent of covered payroll in 1961 to 10.7 percent of covered payroll in 1973 to 13.3 percent of covered payroll in 1981.
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A revolt against state taxes started in California in 1978 and soon spread to many other states. The share of national income consumed by state and local government spending and taxes had grown steadily for three decades. Most Americans valued the services provided by local governments, such as law enforcement, garbage collection, and schools for the massive Baby Boom. State constitutions and city charters, however, prohibited borrowing to pay for operating costs, so state and local governments had to either raise taxes or cut services their citizens valued.

By 1980 public opinion surveys showed that most Americans favored lower federal income tax rates, though not at the cost of greater federal borrowing. Since lower tax revenues without new debt required lower spending, where would the federal government cut? Rising interest expense on debts remaining from World War II, Vietnam, and the mid-1970s downturn made it quite difficult to answer that question.

In the 1970s many members of Congress had come to rely on strong presidential leadership—exemplified by the frequent use of vetoes by Nixon, Ford, and Carter—to enforce budget discipline. Presidential advisor and economic historian Herbert Stein noted of the era: “It was the president who took responsibility for . . . restraining deficits. . . . Presidents felt this responsibility and also felt that the public would hold them responsible. So it was presidents who resisted tax cuts, who pressed for tax increases . . . and who vetoed appropriations and impounded funds.”
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The nation would soon find out what happened when a president asked Congress to spend more and tax less.

T
HE
E
MERGENCE OF
R
ONALD
R
EAGAN

Just as New Deal programs and civil rights legislation came to symbolize Democratic ideals, so too did the Reagan administration’s tax cuts and high defense spending define the GOP’s identity by the late 1990s. This particular legacy would have surprised most observers of Reagan’s first year as governor of California. The retired actor campaigned for governor in 1966 as an outsider, a “citizen-politician.” Reagan won the race with the support of many blue-collar Democrats. Lou Cannon, an admiring biographer, could not find any gubernatorial campaign speech in which Reagan referred to himself as a “conservative.”

The newly elected governor immediately faced a projected gap between spending and taxes in a state with a constitution that required a balanced budget. Governor Reagan proposed closing the gap with higher taxes on sales, personal income, alcohol, tobacco, and businesses. Cannon observed that “Reagan’s proposal had the distinction of being the largest tax hike ever proposed by any governor in the history of the United States.”
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During Reagan’s eight years as California’s governor, the state’s personal income tax rates rose from 7 percent to 11 percent, corporate income tax rates rose from 5.5 percent to 9 percent, and the sales tax rate rose from 3 percent to 4.75 percent.
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Reagan never attempted to borrow to pay for routine state expenses.

Governor Reagan tried to restrain the growth in state spending, which nevertheless rose rapidly during his eight years in office. He was particularly successful in cutting the growth in mental health services, which contributed to a significant rise in the homeless population. The governor backed off from an attempt to purge the rolls of California’s Medicaid program—one of the most generous in the nation—after his first year in office.

Professional football player Jack Kemp worked as an intern in Reagan’s office in 1967 before returning to training camp. In 1970, when he retired from football after a knee injury, Kemp ran for Congress in Buffalo, New York—where he had earlier led the Bills to championships. Kemp instantly became a national GOP star after winning in a district with a blue-collar Democratic constituency. His passionate support for federal civil rights legislation and belief in a strong public social safety net distinguished him from many traditional conservatives.

The charismatic congressman attracted a circle of friends committed to altering the direction of the Republican Party. They included Congressman
David Stockman of Michigan and editorial writer Jude Wanniski. Wanniski developed his own theory of American budget politics after reading Herbert Stein’s account of mid-twentieth-century fiscal history,
The Fiscal Revolution in America
. Wanniski’s “two Santa Claus theory” tried to explain why Republicans had been a congressional minority for all but four years since the onset of the Great Depression. He noted that when Republicans last obtained an enduring congressional majority—in the 1920s—party leaders such as Andrew Mellon and Calvin Coolidge promised lower tax rates. Democrats became the majority when they offered more services during the New Deal. Wanniski believed this history framed a potential competition between two different political Santa Clauses—a Democratic one delivering more services and a Republican one delivering lower taxes. Wanniski faulted Republicans for not playing their role more adeptly. By giving a priority to balanced budgets rather than tax cuts, Republicans were perceived to be more like Scrooge than Santa. The editorial pages of the
Wall Street Journal
and Kemp’s speaking tours helped publicize Wanniski’s views.

Many other Republicans were troubled by their party’s lack of a clear budget policy. Nixon had embraced greater federal responsibilities and spending. Ford had gained ground in Republican primaries by attacking Reagan on his proposal to slash federal support for education, cancer research, Medicaid, and other popular programs. If balanced budgets precluded tax cuts, and many Republicans agreed to fund Cold War defense and other large federal financial commitments, then what was the distinctive vision of the modern GOP?

The energetic Kemp, who called cuts in social spending “barbaric,” offered a straightforward answer. Republicans should cut tax rates and not worry so much about the level of spending. Just when soaring inflation pushed vast numbers of middle-income Americans into higher brackets, Kemp sponsored a bill to cut all personal income tax rates by 30 percent. An unofficial “Kemp for President” bandwagon began to roll and stopped only when presidential candidate Reagan agreed to embrace Kemp’s tax plan in exchange for the congressman’s endorsement.

Reagan’s economic advisors were relieved by calculations showing that revenues lost as a result of the lower rates would be offset by revenue gains from inflation that pushed taxpayers into higher brackets. By assuming a high future rate of inflation, Reagan could promise tax cuts while avoiding the political problem of slashing federal spending. Another 1980
Republican presidential candidate, the onetime congressman and former CIA director George H. W. Bush of Texas, was not so sure. Before Bush became Reagan’s running mate, he derided Reagan’s plan to increase defense spending, cut taxes, and balance a budget already in deficit as “voodoo economics.”
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Carter trailed Reagan in the polls, especially after a failed attempt to rescue the hostages from Iran, the tightening of consumer credit, and the economic downturn in the spring of 1980. Reagan’s plan, drafted by a polling expert, appealed to Democratic voters by emphasizing social themes—such as the preservation of families and neighborhoods—rather than budget issues. The campaign plan stated that “people act on the basis of their perception of reality; there is, in fact, no political reality beyond what is perceived by the voters.”
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That was particularly true for a candidate who did not have to govern or cast votes in Congress while running for the presidency.

As the election neared, journalists and business leaders pressed the former California governor for a budget plan with concrete numbers. Editorial writers pressed Reagan to explain how he could balance the budget with Kemp’s tax cuts and Jackson’s ambitious boost in military spending. Despite the ongoing hostage crisis and a slowing economy, by early September 1980 Carter began gaining momentum. Reagan’s campaign chairman, William Casey, and campaign manager, James Baker, set out to allay doubts about whether the former Hollywood actor was prepared to be president. Casey arranged for Reagan to give a speech on budget policy buttressed by a “fact sheet” circulated to the press.

On September 8, 1980, after Reagan signed off on the text of the speech, Baker noticed that the fact sheet showed a rise in the projected deficit to $50 billion in the first fiscal year of his prospective presidency.
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Baker, a former conservative Democrat from Texas, pointedly asked how Reagan could hope to be elected as a conservative if his proposed budget incurred more debt than did Carter’s. The fact sheet’s author, economic advisor Martin Anderson, was asked to rework it in order to reduce the projected deficit.

Anderson prepared to confront the hard trade-off between Reagan’s commitments on tax cuts and military spending. He ultimately escaped the choice by relying on a Senate Budget Committee forecast showing that sustained high rates of inflation and economic growth would produce a phenomenal 80 percent rise in nominal national income within five years.
With those assumptions, federal tax revenues were projected to soar from $610 billion in fiscal 1981 to $1.1 trillion in 1985. The Senate Budget Committee’s forecast already included a planned Pentagon buildup on the scale advocated by Reagan. Anderson’s revised fact sheet outlined a budget for the fiscal year beginning October 1, 1981, with a modest deficit of $21 billion, a 10 percent cut in tax rates, and a freeze in all nondefense spending.
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Anderson later referred to the fact sheet as “the essence of the original Reaganomics program.”
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That fact sheet laid the groundwork for the momentous budget decisions a few months later. Unfortunately, the projections used by both the Senate Budget Committee and Reagan’s advisors rested on assumptions with flaws that should have become more obvious with each passing month. Estimates for the fiscal year beginning October 1, 1980, showed far higher federal revenues than would actually be collected; every successive month’s record of tax collections should have made that more apparent.

The premises underlying the fact sheet also contradicted the economic theories espoused by Reagan himself. The fact sheet rested on the assumption that rapid economic growth occurred even with high tax rates and that the Federal Reserve’s restriction of the money supply had little impact on either growth or inflation. Moreover, the fact sheet included a freeze on much spending in the unified budget—combining the federal funds budget with trust fund budgets—and therefore confused the relationship between various types of federal taxes and the spending paid for by each of those taxes. One could not freeze Social Security pension benefits and count on surplus payroll taxes to balance the federal funds budget; certainly no mainstream politician supported the diversion of payroll taxes for that purpose. If one removed trust funds interest and defense from a proposed spending freeze, balancing the federal funds budget would require cutting a third of domestic spending, not just a spending freeze.
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