The Temptation of Bob Dole

Dole is sorely tempted to forget everything he knows about the 1980s tax cuts. Here’s a reminder.

Dole is sorely tempted to forget everything he knows about the 1980s tax cuts. Here’s a reminder.

(1648 words, plus links)

By Jodie T. Allen

All his career, Bob Dole has stood for fiscal conservatism and balanced budgets. Most famously, he was almost alone among Republican leaders in his caustic skepticism about the supply-side economics of the 1980s. Now, political and economic advisers are urging the Republican presidential candidate to take off his green eyeshade, push aside that unappetizing bowl of budget cuts, and scarf down a tasty dose of tax-cut rejuvenator. Just the tonic for anemic poll numbers. And Dole is tempted. He reportedly will endorse some kind of broad-based tax cut in July.

Like Dole, the voters know better. But like Dole, they are tempted, too. A persistent majority of Americans piously tells pollsters that budget-deficit reduction is more important than tax cuts. “Yet,” says Brookings Institution economist Barry Bosworth, “the politicians clearly believe that people are lying–and the election results tend to support the fact that they are lying. When they vote, they want a tax cut.”

Of course, nobody is out there urging tax cuts instead of deficit reduction. And certainly no enthusiast is presenting tax cuts as a deficit booster. On the other hand, few (outside the Wall Street Journal editorial page) are still brash enough to claim that tax cuts could actually raise tax revenues. Many “old school” supply-side economists, such as Ronald Reagan’s first Council of Economic Advisers chairman, Martin Feldstein, never did endorse the so-called Laffer Curve, that cocktail-napkin art purporting to show that big tax cuts would soon pay for themselves. The “loose talk of the supply-side extremists gave fundamentally good policies a bad name,” Feldstein complained in 1986.

Now, though, Feldstein is reported to be among a group of well-known economists urging Dole to adopt a so-called “pro-growth” tax strategy, meaning substantial tax cuts. How they are to be paid for is unclear. The promise of painless redemption is there–if not quite explicit. But, unlike the last time we had this argument, in 1981, there is the record of the 1980s to show what happens when the supply-siders get their way.

Sen. Spencer Abraham, R-Mich., is an ardent advocate of a 15-percent across-the-board cut in tax rates. “Can we reconcile the seemingly contradictory notions of cutting tax rates and balancing the budget?” he asked in (where else?) a Wall Street Journal article last month. “The answer is yes,” the senator revealed, if only we ignore the claims of “conventional thinkers” and focus instead on the fact that “from 1982 to 1989, federal revenues, adjusted for inflation, expanded by an average of 3.8 percent per year despite a sharp reduction in tax rates.”

Abraham picked his years with care. Shortly after passage of the supposedly rejuvenating Reagan tax cut of 1981, the U.S. economy plunged into the deepest economic downturn since the Great Depression. The years 1982 through 1989 cover the recovery period from the pit of that recession to the beginning of the next one. If you believe that Reagan’s 1981 tax cut was responsible for all those growth years–that otherwise we would have wallowed in stagnation for seven years–Abraham’s choice may be fair enough. If you doubt it, you might prefer the traditional economists’ method of measuring long-term trends from equivalent places in the business cycle.

Even so, Abraham’s trough-to-peak comparison does not support his point. Official budget numbers do show total federal revenue growing at an inflation-adjusted rate of 3.1 percent over the period, reasonably close to Abraham’s 3.8. But the components of that growth tell the real story. Individual income taxes–which, by supply-side theory, should have spurted since rates were cut–grew at only a 2.1-percent rate. What boosted federal revenues most was the 4.3-percent average growth in payroll taxes. This was mainly the result of rate hikes–not cuts–legislated in the Social Security Reform act of 1983.

Corporate taxes also were cut substantially in 1981. Corporate-tax revenues took a nose dive in 1982 and 1983, regained some ground with the economic recovery, but then surged following passage of the 1986 tax reform–which deliberately raised taxes on corporations to pay for tax breaks for individuals.

A “conventional thinker” might be forgiven for concluding from this record that what raises revenues is raising taxes, not cutting them.

The campaign to convert Bob Dole, and to prepare the public for his imminent conversion, is resurrecting many golden-oldie rhetorical points from circa 1981. For example, Abraham asserts that marginal tax rates are what determine “whether a worker works overtime or goes home for the day … whether Americans save and invest their income or spend it.” No question, taxes can affect behavior. Reducing very high tax rates can, at the very least, encourage less tax evasion and avoidance. And restructuring taxes should, at least in theory, encourage desirable types of economic behavior such as hard work, saving, and investment.

But cultural attitudes, not taxes or other government policies, tend to swamp all other explanatory variables in international comparisons of savings and investment. This is especially so in the United States, where tax rates are low by international standards. So how much do tax rates matter? Not a whole lot, if the Reagan-era experience is any guide.

Even by the supply-siders’ own calculations, any offsetting behavioral response to the Reagan tax cuts was swamped by the direct revenue loss to the Treasury. For example, at a 1988 Manhattan Institute meeting, Lawrence B. Lindsey, a leading supply-side flag-waver in the Reagan Treasury Department (now a governor of the Federal Reserve) whipped out a graph (see above/below) to show that tax revenues in 1985 were some $13 billion higher than would have been predicted by “static” revenue models used by the Congressional Budget Office during the 1981 tax-cut debate. (“Static” is the supply-siders’ pejorative term for thinking that doesn’t acknowledge sufficiently the explosive power of tax cuts.) What didn’t seem to attract Lindsey’s attention in his own graph was that actual revenues were almost $100 billion lower in 1985 than they would have been if the 1981 tax cut had not been passed. [NOTE: JODIE HAS SUPPLIED this graph]

As for people working harder because of lower tax rates, the record of the 1980s is more complex than supply-side rhetoric predicted. Studying the effects of 1980s tax policy, Bosworth and his Brookings colleague Gary Burtless found that only one group–high-income women–substantially increased their hours of work in response to lower taxes. The group whose work effort increased most sharply was not the well-paid, whose tax rates declined most sharply. It was the poorly paid, whose marginal tax rates, thanks to Social Security tax hikes, actually went up. For these workers, higher taxes prompted harder work to make up for the lost income.

Even more damaging to the supply-siders’ case was the disappointing performance of the nation’s savings behavior. The Reagan program provided numerous inducements: not just marginal rate cuts on income but capital-gains tax reductions, a variety of new tax-exempt investment vehicles, vast new opportunities for tax sheltering–plus the Federal Reserve’s tight money policies which, along with financial deregulation, sent the interest rates available to savers soaring. The more sober-minded supply-siders figured that even if the tax cuts didn’t pay for themselves, the increased savings they generated would make the resulting deficits easy to finance. (Even today, Feldstein says he still believes that while it’s a “tall order,” the right tax cuts can, “in some cases,” raise saving by more than they raise the budget deficit.)

But in the 1980s, savings did not cooperate. The national savings rate, which ran at close to 12 percent in the 1960s, and more than 9 percent in the 1970s, sank to only 5.8 percent in the 1980s. The swelling government deficit, which amounts to national dissaving, did much to drag down the 1980s figure. But even private savings in the 1980s ran well below their 1970s level.

Still more perverse was the behavior of business investment. During the eight years of the business-friendly Reagan administration, business-equipment investment rose at an inflation-adjusted annual rate of only 4.4 percent while corporate before-tax profits grew at 4.7 percent. By contrast, during the presumably hostile Clinton years, business investment has grown at an annual real rate of 10.6 percent while corporate pre-tax profits have climbed at a 13.2-percent rate.

The overall national economic growth rate has been about 0.8 percentage points lower under Clinton than under Reagan. But, amusingly, that difference is totally accounted for by the shrinking government. While government spending grew by an average 3.6 percent annually under Reagan, it has shrunk at a 4.1-percent rate under Clinton. The way national economic growth is calculated, the expansion of government under Reagan adds to his growth total, while the contraction of government under Clinton reduces his growth total.

In addition to supply-side arguments, there are the traditional demand-side arguments that a tax cut stimulates the economy by pouring more money into it. But this would be a very odd time for a demand-side tax cut. As former Congressional Budget Office Director Robert Reischauer notes: With unemployment well below the 1980s average and considerably lower labor-force growth, the economy seems to be operating near capacity–“or, at least the Federal Reserve thinks it is, which is what counts.” Any deficit-increasing tax cut would surely prompt the Fed to tighten the money supply, curbing economic growth or even prompting a recession.

Dole could, as Abraham counsels, offset part of the costs of a tax-rate cut by dumping other tax-reform plans–such as the child tax credit, once a key feature of the GOP’s “pro-family” agenda. What would the Christian Coalition think about that? Or, he could propose to cut spending even more than his party has already promised–but that sounds like spinach, and the GOP seems to have lost its appetite for even the healthy serving it has promised to serve up over the next seven years.

Or, of course, Bob Dole could resist temptation. After all, he really does know better.