Reagan Handled Deficit Politics with Uncommon Leadership

Brian Domitrovic
Forbes
Reagan Handled Deficit Politics with Uncommon Leadership

President Obama wants a deal on the budget. What that deal is supposed to be isn’t clear. Apparently it’s this: in exchange for big cuts in entitlements in the future, current tax law, which will soon take personal rates up considerably, will remain in place.

Sounds simple, if unpalatable to Republicans: sure tax increases in exchange for uncertain spending cuts. Except there is – or at least there was last week – a sweetener. Since the personal income-tax rates are currently not scheduled to go up for another sixteen months, the president has indicated he would be open to rapidly compiled legislation on “tax reform,” where in exchange for loophole-closing, the marginal income-tax rate would be taken down for good from the current level by some 20%.

Enough to make your head spin. It would have been nice if the president had articulated these points comprehensively sometime, say during the campaign, if not in the profuse reports of his Office of Management and Budget and Council of Economic Advisors. After all, we’ve had a succession of self-styled rock stars leading these shops.

Time to ask the timeless question: What Would Reagan Do? This will take us back to the moment early in his presidency when Reagan confronted enormous pressure to accept a budget deal that would affront his principles – and, in all likelihood, prove an obstacle to economic growth, opportunity, and prosperity.

In January 1982, Reagan’s signature tax cut had been signed into law five months before. By statute, at that point, it provided about a 10% reduction in income-tax rates. But since inflation had run at 10% in 1981, and the code was unindexed for inflation, real tax rates had actually been flat in spite of the statutory cut.

This is a useful fact to keep in mind. For as real tax rates stayed steady, the deficit began to explode. The deficit of the fiscal year beginning in October 1981 was gathering enough steam to come in at $128 billion, 62% above the previous year’s level, which itself had been high at 2.6% of GDP.

So in January 1982, Reagan started to hear it. Raise taxes, raise taxes, raise taxes!

It wasn’t just the dutiful party in opposition, the Democrats, who at that point were the majority in the tax-origination body, the House of Representatives. The Senate, though controlled by Republicans, included powerful members of the president’s own party, such as Bob Dole, who were so smarting from Reagan’s political successes that they were seeking to muddy the Reagan legacy. And even Reagan’s own in-house economic policy board had members, such as Alan Greenspan and Herb Stein, who argued that the grimness of the deficit number required tax-increase medicine.

Reagan listened and in a few months accepted a deal of $3 in spending cuts for every $1 in tax increases. Needless to say, the spending cuts never came. As for the tax increases, they mainly fell on business. Some of them were horrid (such as the repeal of accelerated depreciation); but some fell on industries – the phone monopoly and the airlines – that were currently in the process of being freed from extensive government regulation.

It remains pathetic that the “TEFRA” compromise of summer 1982 produced nothing in terms of expenditure cuts, a fact that Reagan rued for years and remains a lesson for us today. But its ingeniousness on the tax side remains unappreciated. 

The iconic Reagan tax cut of August 1981 provided for five years’ worth of personal rate-cut installments. There would be a 5% cut in 1981, two 10% cuts phased in from 1982 to 1984, and finally in 1985 the code would be indexed for inflation. All this was on the block in early 1982 as Reagan faced the pressure to raise taxes.

What ensued – because of Reagan’s determination and that of a few others in his administration, mainly at the Treasury department – was that the entire schedule of future tax cuts remained intact despite TEFRA. Moreover, some of the tax hikes that did come would serve to grease the skids of remarkably salutary deregulation. AT&T was broken up in 1984, touching off one of the phenomenal developments in the history of the industrial revolution, the communications boom of the last quarter century. And airline deregulation would bring plane travel to the masses.

When the economy witnessed this kind of leadership – in the face of acute pressure, Reagan kept the audacious coming tax cuts on track and focused on tax increases that would serve as a quid pro quo for exceedingly enlightened deregulation – it fell over itself as it raced into a boom. The Dow Jones industrial average bottomed just as TEFRA came to the president’s desk and went up 30% for the rest of the year, and 15-fold over the next eighteen years. Inflation, which had settled in the double digits in the early 1980s, sunk to 3% in 1983 and 2% in 1986. Unemployment fell from 11% to 5%. Growth surged at 4.3% for seven years.

And this is not the end of the story. Given the boom that came, Reagan asked for more. Why not do a tax reform that would close loopholes in exchange for a really big drop in the marginal rate of the income tax? This deal was done in 1986, with the top rate cut to 28%. The first year of the 28% rate’s applicability, 1987, federal receipts exceeded 18.2% of GDP (and GDP was high), which is to say the level of federal spending thirteen years later, in 2000.

All this showed that low taxes were perfectly compatible with balanced budgets. Low tax rates will produce booms and thus good revenue; with a modicum of spending restraint, the only option is for the budget to tip into surplus.

Reagan’s is quite a record – serious, savvy, and meaningful. President Obama should attend to it as he acts panicky about the debt ceiling and throws around flip proposals for tax increases, spending cuts, and reform.