The Great Deformation (18 page)

If the Reagan defense buildup was not much related to its stated objective of thwarting the Evil Empire, it did fatally undermine any modest prospect for shrinking the domestic welfare state that existed in January 1981. Within a year, in fact, the juxtaposition of domestic versus defense budgetary regimens became so stark and untenable as to thoroughly poison the political well.

The growing fat at the Pentagon generated acrid resentments throughout Washington's civilian branches, even as favored constituencies harvested a bonanza of defense contracts and local economic stimulus. In time, this blowback extinguished even the modest initial quantum of support on Capitol Hill for the White House's prescribed diet of domestic agency austerity.

So when all was said and done, it was not an impecunious public purse, but the rampant fiscal profligacy and flagrant pork barrel excesses issuing from the Defense Department's soaring top line that became the defining fiscal signature of the Reagan era. Indeed, in a supreme irony, Reagan's short-lived challenge to the welfare state in early 1981 was quickly supplanted by its opposite: a rapidly swelling warfare state that was both unnecessary at the time and destined to become an incubator of imperialist calamity in the decades ahead.

CHAPTER 6

 

T
HE REAGAN REVOLUTION'S TAX POLICY, TOO, WAS THE PRODUCT
of error and confusion. These misfires eventually morphed into a GOP anti-tax doctrine that was stunning in its denial of reality. It literally stood on its head the fiscal orthodoxy that Republicans had uniformly embraced prior to 1980.

Until then, conservatives had generally treated taxes as an element of balancing the expenditure and revenue accounts, not as an explicit tool of economic stimulus. All three postwar Republican presidents—Eisenhower, Nixon, and Ford—had even resorted to tax increases to eliminate red ink, albeit as a matter of last resort after spending-cut options had been exhausted.

These Republican administrations also espoused an economic philosophy of lower taxes to encourage capital formation and private enterprise. But at the end of the day, the tax code stood first and foremost as an instrument of revenue collection, not an all-purpose elixir to promote economic growth.

The story of how this tradition of sound fiscal policy was lost after 1980 is crucial to understanding the economic deformations plaguing the present era. This is especially so because the GOP's extended sojourn in the realm of fiscal know-nothingism has not been so much purposeful and explicit as it has been convoluted and accidental in its origin and institutionalization.

ORIGIN OF THE REAGAN TAX CUTS: KEYNESIAN INFLATION

Although the facts have been obscured by partisan revisionism from both sides, the Reagan tax cuts were initially grounded in this earlier conservative tradition. It was only much later that glib revisionist theories like “starve the beast” emerged. Similarly, the bastardized supply-side notion
that tax-rate reductions would not result in revenue loss owing to the Laffer curve had few adherents beyond Laffer himself.

In fact, while the Reagan White House and practical Republican politicians alike believed lower tax rates would stimulate economic growth and some revenue feedback, none believed these cuts would be 100 percent self-financing. The latter became incorporated into GOP catechism only much later—egged on by the rank sophistry of Laffer, Jude Wanniski, and one or two other charlatans who constituted the entirety of the supply-side coterie.

The fact is, when the Reagan administration took office it was confronted by an immense tax roadblock to economic expansion. The pernicious interaction of the 1970's double-digit inflation and the progressive rate structure of the individual income tax code were causing tax rates to rise rapidly due to bracket creep.

Based on the early 1981 outlook for continued high inflation, the existing tax law, owing to bracket creep, would have drastically and automatically raised the federal tax burden on the economy. From a level of about 19 percent of GDP in 1980 the revenue claim on national income would have risen to an unprecedented 24 percent by 1986.

A tax increase equal to 5 percentage points of GDP is no small matter, and would amount to $750 billion annually in today's economy. So what the Reagan administration had inherited was a huge prospective enlargement of the tax burden.

What it also inherited was the legacy of Keynesian fiscal policy activism and the resulting chronic deficits which became institutionalized in the late 1960s and had led to inflationary money printing by the Fed. Paul Volcker was aggressively attacking the latter, but it would take time to subdue.

In these circumstances, it did not require any belief in the finer points of supply-side doctrine to see the need for income tax reductions. If left on automatic pilot, the “bracket creep” then raging would quash the economy's capacity for recovery and growth.

Moreover, this looming, unlegislated escalation of the tax burden was something entirely new under the fiscal sun. To be sure, if the old right had long fulminated against the “abomination of 1913” which saw enactment of both the income tax and the Federal Reserve. But during peacetime, anyway, this potential witches' brew of inflationary money and confiscatory taxation had never really materialized.

During the Roaring Twenties era, for example, consumer prices had averaged a zero rate of change. Thus, there was no bracket creep during the income tax's first peacetime decade, just deep legislated cuts in the high wartime tax rates engineered by the incomparable Andrew Mellon.

Likewise, after plunging by 20 percent during the initial four years of the Great Depression, consumer prices had drifted up only tepidly until the onset of the Second World War. So there had been no bracket creep in the 1930s, just Franklin D. Roosevelt's deliberate legislative enactments aimed at soaking the rich.

When economic normalcy again returned after the Korean War, the consumer inflation rate settled into a peacetime crawl, rising by an average of 1.6 percent annually during 1953–1967. So again, significant bracket creep had still not emerged, while discretionary legislative action had functioned to modestly reduce income tax rates.

As it happened, President Lyndon Johnson's misbegotten “guns and butter” crusade eventually did uncork the evil genie of 1913. During the years subsequent to 1967, a pusillanimous Fed, shorn after 1971 of its last link to the fixed financial anchor of gold, unleashed a runaway inflation for the first time in peacetime history.

This unique outbreak of peacetime inflation is now forgotten, but its importance cannot by overemphasized. Consumer prices rose at an average rate of nearly 7.5 percent annually over the next decade and a half, including four years of double-digit gains. The resulting relentless push of inflation-swollen incomes into higher tax brackets clearly did stifle entrepreneurial energies and erode business investment incentives, thereby contributing to the abrupt slowdown of real GDP growth.

So it was the stagflationary breakdown of the national economy resulting from Nixon's abandonment of sound money in August 1971 which ultimately triggered the Reagan Revolution. Real growth faltered badly for the better part of a decade, averaging just 2.5 percent per annum in the eight inflation-racked years ending in 1981, compared to 3.8 percent during the two decades prior to 1969.

It was these threats to the middle-class living standard which set the stage for the 1980 campaign referendum on the “are you better off” question. Believing that it was worse off and fearing even further decline in the future, the public sent Ronald Reagan to the White House to fix the underlying problem Nixon had bequeathed.

THE REAGAN 10-10-10 TAX CUT WAS DE FACTO INDEXING—NOT LAFFER CURVE MAGIC

The long forgotten truth is that the original Reagan tax cuts essentially amounted to preventative indexing; that is, insulation of the tax code from further bracket creep before the anticipated inflation of incomes actually happened. At the time, Alan Greenspan explicitly argued for the Reagan cuts on this basis. It was also the practical justification embraced by old
guard congressional Republicans—few of whom put any stock in the Laffer Napkin and the free lunch theories of its author and purported economist, Arthur Laffer.

De facto tax indexing was in theory fully compatible with the older tradition of Republican fiscal orthodoxy. From the perspective of early 1981, at least, it did not appear to open up an insuperable fiscal gap: moderate tax cuts would simply forestall the bracket creep-driven rise of the tax burden.

In that context, the original Reagan tax plan—the Kemp-Roth rate cuts of 10 percent annually for three years and the business depreciation incentive known as 10-5-3—was not inordinately radical. In fact, while the revenue loss was large and measured out to 4.5 percent of GDP when fully implemented, it merely offset the projected bracket creep over the five-year fiscal horizon at issue.

Thus, the math of the Reagan tax plan brought the projected 1986 tax burden back down to 19.5 percent of GDP, exactly equal to the tax extraction from the American economy that had been embodied in Jimmy Carter's last budget (fiscal year 1981). Contrary to legend, then, the original Reagan tax package did not actually aim to reduce the inherited tax burden at all. Based on projections at the time, it penciled out as merely a reversion to the Carter status quo ante.

THE FISCAL MATH OF HOWARD BAKER'S LIBRARY—IT BARELY WORKED AND SOON CRASHED

The spending side of the final Carter budget had come in at about 22 percent of GDP. After the planned tax rollback there remained a 2.5 percent of GDP deficit, which was viewed in those days as dangerously large. Yet the Reagan Revolution was about shrinking the girth of the state—so a 2–3 percent retrenchment on the spending side seemed entirely appropriate and achievable.

Indeed, balancing the budget at 19.5 percent of GDP did not require especially radical spending cuts relative to recent norms: total federal outlays averaged 20 percent of GDP during the decade of the 1970s, and had been 20.2 percent as late as 1979. What made the Reagan fiscal plan seem radical was the mere fact that domestic spending was to be cut at all, especially after the massive increases of the Nixon-Ford era.

When the Republican leadership gathered in Majority Leader Howard Baker's library to plot fiscal strategy on the eve of the inauguration, the task of balancing Ronald Reagan's conflicting campaign promises was not yet insuperable. With taxes pinned at 19.5 percent of GDP—still high by all prior peacetime history—and the defense build-up still unquantified,
rolling back total Federal spending by a few percentage points of GDP was seen by the seasoned Republican leaders gathered there as a daunting but achievable goal.

But not long after the inauguration, the unraveling began. It never stopped. To this day its legacy hangs over the nation's battered financial accounts like a fiscal sword of Damocles.

The defense buildup got far bigger than had been implied by the back-of-the-envelope fiscal math of the Chicago speech. The tax cut also ballooned massively in size during the July 1981 bidding war. At the same time, the national economy and revenue base ended up much smaller than the original “Rosy Scenario” forecasts.

Finally, even the modest domestic spending cuts envisioned in Howard Baker's library proved unachievable. The result was a fiscal hemorrhage that was so abrupt, massive, and unrelenting that its causes were barely understood at the time, and have long since vanished into the fog of partisan disputation.

Still, the rudiments of the budgetary crack-up are reasonably clear and refute the revisionist legends fostered by both sides of the debate. The Democrats are wrong in saying the massive Reagan deficits were deliberate, because they were the opposite; that is, they were the consequence of budgetary innumeracy in the White House and a political gong show among the Republican factions which emerged from the fray.

The Republican legend that the Reagan deficits didn't matter is even faultier: the budget deficits triggered by the original 1981 plan were devastating in magnitude and mitigated only by a series of stiff tax increases during the next several years that amounted to $350 billion annually in today's economy.

Moreover, even after the Reagan tax increases there remained a 3–4 percent of GDP structural deficit. This gap was not cured by the robust economic rebound which did occur when the recession ended in 1982, nor could it have been eliminated by any conceivable amount of higher growth.

The Reagan-era fiscal legacy was, in fact, a permanent policy of massive deficit finance. The destructive consequences of it were not eliminated, but only deferred by the furious central bank buying of Treasury bonds over the next twenty-five years.

ROSY SCENARIO: THE $2 TRILLION ERROR THAT CRUSHED THE REAGAN BUDGET

The major culprit was the five-year economic forecast known from the start as Rosy Scenario. It embodied a mind-boggling $2 trillion error in the
form of an overestimate of nominal GDP for the fiscal year 1982–1986 period covered by the original Reagan plan.

In hindsight it might well be asked why anyone was trying to project the economy five years into the hazy future, especially when by early 1981 the economic future was unusually opaque. In the tumultuous environment of the final Carter years, things which had once been considered impossible—13 percent annual inflation, $40 per barrel oil, 20 percent prime rates, and $800 per ounce gold—had become recurring events.