The Great Deformation (19 page)

Yet the Reagan Revolution was not about incrementalist tinkering. The change of policy direction it sought would take years to roll out and therefore had to be built on an extended economic forecast, even if it was a stab in the dark.

But where this fateful stab went wrong is not in the area for which it has been so heavily criticized. Rosy Scenario did not necessarily overestimate the economy's potential for a sharp rebound after being liberated from the burden of soaring inflation, bracket creep, and sharply rising marginal tax rates.

In fact, real GDP expanded by 4.5 percent, 7.2 percent, and 4.1 percent, respectively, during the first three years of the Reagan recovery. The resulting 5.4 percent average gain for that period was almost dead-on the growth rates for the initial years assumed in Rosy Scenario. The problem was that it wasn't the same three years!

Like every administration before and since, the 1981 Reagan White House never even considered the possibility that its spanking new supply-side program for economic rejuvenation would initially result in a devastating recession. To the contrary, real economic growth was projected to come galloping out of the gate at a 4 percent annual rate in the 1981 final quarter, rising to a 5.2 percent growth rate in the first quarter of 1982 and for numerous quarters thereafter.

In hindsight this “no recession” assumption might be better described as a willful disregard for reality, given the administration's parallel embrace of a hard-core monetarist attack on inflation. Indeed, the Reagan White House was fully supportive of the harsh monetary contraction that Fed chairman Volcker was then administering, and should have therefore expected the resulting purge of inflationary fevers to be accompanied by a temporary collapse of production and employment.

In the event, that is exactly what happened. On the one hand, inflation plummeted from 9 percent in 1981 to 3.8 percent in 1982, an outcome far better than even Rosy Scenario had contemplated.

At the same time, during the first year of the Reagan tax cuts, real GDP did not surge into the 5.2 percent supply-side growth boom that had been
forecast. Instead, 1982 recorded a deep 1.5 percent contraction of output and soaring unemployment which reached nearly 11 percent by year-end.

So the Reagan program worked in sequence, not parallel. The contractionary effects of monetary disinflation came first; the output rebound and supply-side expansion came later. Indeed, by the calendar of Rosy Scenario the output surge came much later, nearly two years behind schedule. And that's where the fiscal numbers were thrown into a cocked hat.

The effects of this sequenced series of economic adjustment were cumulative, which means that the actual path of the US economy diverged more and more from the one that had been projected in Rosy Scenario. Due to lower than forecast inflation and negative real output in 1982, for example, nominal GDP came in nearly $140 billion, or 4 percent, short of the original forecast. This nominal GDP wedge between forecast and actual widened to $370 billion in 1983, representing a 10 percent shortfall to the Rosy Scenario path.

And the wedge kept getting wider in the out-years. By the fifth year of the plan, in 1986, these same forces of tamer inflation and delayed output recovery had widened the nominal GDP gap to $660 billion annually. This meant that the US economy was nearly 15 percent smaller than had been projected by Rosy Scenario when the Reagan Revolution was launched in February 1981.

This vast discrepancy between the forecast and actual path of the American economy during the first half of the 1980s is not simply the detritus of fiscal archeology. It is the key to understanding how subsequently an entire generation of conservative politicians went off the deep end on tax policy.

As a mechanical matter, high growth rates of nominal GDP, whether due to real output or inflation, produce a cornucopia of revenues in a progressive tax system. In the first instance, the tax-paying public is moved en masse into steadily higher tax brackets. At the same time, tax revenues are extracted from a rapidly rising base of nominal income. Taken together, these forces would amount to a confiscatory doomsday machine if allowed to run long enough.

Conversely, in an environment of slowly growing nominal incomes—again, whether due to low inflation or low real growth—the same tax régime will result in lower average tax rates due to less bracket creep. It will also generate measurably reduced aggregate tax revenues because these lower rates will be applied to substantially smaller nominal incomes.

Needless to say, here is precisely where the Reagan Revolution's fiscal math hit the shoals—and it did so before even one sentence of tax-cutting had been enacted into law. Specifically, Rosy Scenario had projected $4.8 trillion of nominal GDP by 1986 on the assumption that inflation would
only come down gradually, not abruptly; that there would be no recession; and that real GDP would continuously expand at an average 4.7 percent annual rate over the five-year period.

Under these assumptions, projected 1986 revenue from current tax law, that is, the Carter tax rates, was $1.16 trillion. This reflected a bracket-creep-induced gain in the federal tax take from 19.5 percent of GDP under the last Carter budget to 24 percent of GDP in 1986. And it was from this sky-high “baseline” that the Reagan tax cuts would be subtracted.

In the real world, however, 1986 nominal GDP only came in at $4.15 trillion—a whopping 15 percent lower than the Rosy Scenario projection. And, owing to far less bracket creep, the pre-Reagan tax law would have generated a tax take of only 22 percent of GDP, not 24 percent. This meant that federal revenue under Carter tax law would have amounted to only about $900 billion in 1986—a figure
one-quarter of a trillion dollars smaller than
the Rosy Scenario baseline projections had anticipated.

What this meant as a practical matter was that we were cutting phantom tax revenues in the out-years. Had we been more clairvoyant, or possibly honest, in formulating Rosy Scenario we would have given Volcker his recession first, the monetarists their victory over inflation earlier, and the supply-siders their real growth surge later.

In that event, the administration's February 1981 economic forecast might have tracked quite closely the actual course of the economy described above. But then the huge Reagan tax cuts would have never gotten out the White House door. The revenue baseline would have been so much lower that the Reagan fiscal plan announced on February 18 would have revealed $200–$300 billion annual deficits as far as the eye could see.

That would have stopped Reaganomics cold. Back then, Republican legislators were scared to death of big deficits. I was, too. So possibly was Ronald Reagan.

Admittedly, the lower actual path of inflation also reduced projected baseline spending for indexed entitlement programs like Social Security. By the same token, however, the unplanned deep recession, high unemployment, and huge initial deficits had the opposite effect: ballooning social safety net and debt service expenses far above the Rosy Scenario projections, and thereby washing out of the spending side much of the paper gain from lower inflation.

In short, the Reagan tax-cutting program had started with inherited Carter budget policy. The latter had penciled out to a substantial surplus by the mid-1980s. But this was a mirage. It represented an inflation-swollen economy that was unsustainable but which caused the Office of Management
and Budget (OMB) computers to spit out a windfall of phantom revenues from the pernicious process of bracket creep.

The truth of the matter was that Paul Volcker's crushing blow to runaway inflation was unavoidable. It meant that the US economy would be put through the wringer under any fiscal policy variation.

So for all practical purposes, the nation was already mired in deep budget deficits when Ronald Reagan took the oath of office; they were just hidden in a nonsustainable inflation-ridden economy. After the huge Reagan tax cuts were layered on top of this inherited red ink, the fiscal math was prohibitive. It became a generational albatross.

THE 1981 TAX BIDDING WAR:
COALITION OF THE BOUGHT

Within a few months the revenue situation skidded even further into the ditch, owing to the tax bidding war which erupted in conjunction with congressional action on the supply-side tax cuts. But strangely enough, this bidding war originated in legislative sentiment which went in the opposite direction—against any big tax cuts.

As of early 1981, there was not a corporal's guard among congressional Republicans in favor of the original undiluted 30 percent cut in income tax rates. Especially among the old-guard Republicans in the Senate, what had become known as the Kemp-Roth tax cut bill scared the daylights out of them. It was viewed as a huge “riverboat gamble,” as Majority Leader Howard Baker put it.

Accordingly, there had been immense pressure on the Republican side of the aisle for dilution and compromise from the very start. Unfortunately, however, in the heat of legislative battle the tax bill careened off in the opposite direction. The tax bill got bigger rather than smaller because the Reagan White House could not remotely obtain the votes based on conviction. So it horse-traded its way to a majority coalition on Capitol Hill.

In the end, the historic 1981 Reagan tax bill was passed not by a team of the convinced, but by a coalition of the bought. Whereas the original White House tax plan had cost 4.5 percent of GDP when fully phased in, the final legislation passed by Congress cost nearly 6.5 percent of GDP in the out-years.

The resulting plunge of the federal revenue base into the fiscal abyss reached stunning dimensions. At the time of the White House tax bill signing ceremony in July 1981, of course, the depth of the recession and the degree to which out-year GDP would fall short of the Rosy Scenario forecast were not yet fully apparent. However, with each new economic forecast
update during the balance of 1981 and early 1982, the unfolding fiscal train wreck became ever more evident.

As it finally turned out, the new tax law would have generated less than 16 percent of GDP in tax revenue under the actual disinflationary path of the economy which materialized over the 1980s. Having set out on a multiyear journey to roll back economically destructive bracket creep and end up by mid-decade with the federal tax burden at 19.5 percent of GDP, or within a whisker of Jimmy Carter's outgoing budget, the Reagan Administration's tax-cutting excursion actually landed on a different fiscal planet.

Amid the fog of faulty forecasts and undisciplined legislative battle, therefore, the nation's tax burden had been precipitously rolled back to the level under a much earlier Democratic president, namely, the 1948 budget of Harry Truman.

Alas, that fiscal era was long gone. Truman could pay Uncle Sam's bills on 16 percent of GDP because the Cold War defense buildup had not yet happened, most retirees were not yet eligible to collect Social Security, and LBJ's massive Great Society was not even imagined.

After the dust settled in the summer of 1981, what had been the Republican holy grail of a balanced budget had now been banished to the fiscal hereafter. In its place there was a structural deficit of 5–6 percent of GDP as far as the eye could see. Only in light of subsequent experience—thirty years later—was a permanent deficit of this magnitude not shocking.

Moreover, the internals of this fiscal hemorrhage betrayed an even more foreboding dimension. The tax bidding war of late July 1981 resulted in a compromise plan, Conable-Hance II, a tax Christmas tree of stupendous girth. It was a seminal event in the fiscal deformations of the present era because it revealed the frightening power of crony capitalism to raid the treasury, once released from traditional taboos against deficit finance.

As it had turned out, in order to get one dollar of pure supply-side tax rate cuts for individual taxpayers, the White House had been required to hand out a matching dollar of booty to the coalition of business lobbies and special interest groups it had assembled to secure passage of the bill. Some of this largesse was monumental, such as the virtual exemption of real estate from federal income taxes, owing to ten-year write-offs for commercial buildings designed to last a half century.

Other giveaways, such as tax credits for wood-burning stoves, were merely symbolic but still potent vote gatherers in places like New England. Still other subventions, such as the oil royalty owners' credit and the all-savers certificate, were the price of support demanded by the oil state delegations and the savings and loan industry, respectively.

And some of the revenue giveaways resembled nothing so much as the
camel's nose under the tent. The estate tax provisions, for example, had a first-year cost of only a few hundred million dollars but ended up in total repeal by the end of the decade at an annual cost fifty times greater.

In this manner the federal revenue base had been sacked by the marauding army of business lobbyists who had opportunistically enlisted in the supply-side crusade. Moreover, their larcenous raid on the treasury had been heavily “back loaded” into the more distant future in order to obscure the true cost.

Thus, when most of the provisions became fully effective by 1990, the revenue loss was a stunning 6.2 percent of GDP. In today's economy that would compute to an approximate $1 trillion annual loss of tax receipts.

That number can't be emphasized enough—it summarizes the sheer mayhem visited upon the nation's revenue basis in a few short weeks during July 1981. Crucially, more than half of that staggering total had gone toward new tax loopholes and tax subsidies for Washington-sanctioned economic endeavors, not liberating workers and entrepreneurs from the yoke of high marginal tax rates.