Phil Gramm and Mike Solon bust myths about Reagan’s tax cuts. Two slices:
No major economic policy in modern American history is as misunderstood or inaccurately portrayed as President Reagan’s 1981 tax cuts. According to the Encyclopaedia Britannica, “the tax cuts, in fact, produced the largest budget deficit in the country’s history,” all to finance “tax cuts for the wealthy.” That summarizes the consensus contained in virtually every historical account of the era.
The characterization of the tax cuts as “for the wealthy” is easily refuted by comparing relative income tax burdens before and after. Since the top 40% of income earners in America pay some 90% of income taxes, reductions in tax rates would be expected to give a larger dollar-value tax cut to people who pay the most taxes. But data from both the Internal Revenue Service and the Joint Committee on Taxation show that when Reagan took office in 1981, the top fifth of income earners paid 64% of all federal income tax, the next-highest fifth paid 21%, and the bottom three-fifths paid 15%.
By 1985, the 1981 tax cuts, including inflation indexing of the tax brackets, had been fully implemented. The share of the individual income-tax burden had increased to 67% for the top fifth and dropped to 19% for the next fifth and 14% for the bottom 60%. By 1988, Reagan’s last year in office (and after the 1986 tax reforms), the figures were 71%, 17% and 12%.
Incredibly, by 2022, the top fifth paid 88% of income taxes, the next fifth 13% and the middle fifth 4%. That adds up to 105%, but the arithmetic works because the bottom 40% received checks from the Treasury thanks to refundable credits like the earned-income tax credit, on net paying them a total of 5% of all income-tax collections.
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The day Reagan left office, the American economy was one-third bigger than when he arrived. Tax rates had been cut and tax brackets indexed to eliminate bracket creep. Nondefense spending was 2.5% of GDP less than it had been the day Reagan took office, and defense spending was 0.9% bigger.
The deficit was 3% of GDP—up from 2.6% in 1980. But revenue from bracket creep narrowed the 1980 deficit by half a percentage point. That means the entire increase in the deficit during the Reagan presidency resulted from the abolition of bracket creep—which by definition doesn’t help anyone rich enough to be already paying the top rate.
The untold story of the Reagan era is that the cost of financing the welfare spending explosion of the 1970s was always there but much of it did not show up in the federal budget deficit. Inflation-created bracket creep took the money from taxpayers to cover much of the cost without Congress ever voting to raise taxes. The full cost of making America a welfare state wasn’t fully recorded in the federal budget deficits of the 1970s because inflation and bracket creep tax increases transferred much of the cost to the family budget.
Murray Sabrin’s recent letter in the Wall Street Journal is excellent:
Arthur Laffer and Stephen Moore argue in “The Big Bob Packwood Tax Reform” (op-ed, June 11) that lower tax rates—the hallmark of the 1986 tax reform bill spearheaded by the late Sen. Bob Packwood—generate higher tax revenues. But the deeper issue isn’t tax rates; it’s federal spending.
Every dollar Washington spends is a dollar removed from the private sector, the true engine of prosperity, innovation and job creation. If tax revenues increase because of economic growth, lawmakers shouldn’t view it as an invitation for the government to spend even more. A growing economy should require less government intervention as private-sector employment and opportunity expand. Why should Washington continue absorbing an ever-larger share of the nation’s resources?
As we approach the 250th anniversary of the Declaration of Independence, Americans can reflect upon the Founders’ vision of a nation built on self-reliance and limited government. Today, tens of millions of Americans, businesses and institutions depend on federal dollars for income and benefits. This dependency is far removed from the spirit of independence that animated the American Revolution.
America needs a constitutional budget that phases out unauthorized federal programs. The goal should be to restore economic independence by reducing Washington’s reach and allowing citizens to keep more of what they earn while relying less on the government for their livelihoods.
If you ever come across an economic argument that seems to make sense but goes completely against conventional economic wisdom, it’s probably “reasoning from an accounting identity.” Run in the other direction. Accounting does not explain anything. That’s why we have price theory.
Take the following example. We all know that “Growth in real GDP depends on only four factors: consumption, government spending, business investment and net exports (the difference between exports and imports).” That comes from the definition of GDP as GDP = C + I + G + NX, so any growth in GDP comes from growth in one of those factors.
From there, one may mistakenly believe that, as Peter Navarro suggested, “Reducing a trade deficit through tough, smart negotiations is a way to increase net exports — and boost the rate of economic growth.” After all, there’s an equal sign there! Y EQUALS C + I + G + NX. It’s just math losers. QED.
No. Wrong.
Just as we never reason from a price change, we need to never reason from an accounting identity. My income equals my savings plus my consumption: I = S + C. But we would never say that if I spend more money, that will cause my income to rise.
It all depends on what caused the change. In my income example, more spending could cause me to work more to cover those expenses. Or I could save less. It depends. In the GDP example, we need to know what caused the change in net exports (or any other part of the equation). We need to be explicit about what actually caused the change in net exports. Exports don’t simply fall from the sky, and move up and down based on our wishes. We need to know the causes. There is an added complication in this example since the reason we subtract imports from GDP is that they are already part of consumption (C) and shouldn’t have been since imports are not domestic production.
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Every semester I make sure to include “Never Reason from an Accounting Identity” in my courses. The reason I’m mentioning trade policy today is that there was a recent “handbook for conservative policymakers” released by American Compass. One of their policy proposals was to eliminate the trade deficit. To accomplish this, we should:
Establish a uniform Global Tariff on all imports, set initially at 10% and adjusted automatically each year based on the trade deficit. After any year when the trade deficit has persisted, the tariff would increase by five percentage points for the following year. After any year when trade is in balance or surplus, the tariff would decline by five points the following year.
The essays defending this general position (although not necessarily the exact policy proposal) are just a series of reasoning from accounting. There is no economic content. As one essay put it,
For decades, the implicit and explicit subsidies to manufacturers that have driven surpluses in countries like China and Germany have caused global manufacturing to migrate from deficit countries to surplus countries, and from none more so than the largest deficit country by far, the United States.
The argument above supposes that there exist countries out there in the ether called surplus countries, and manufacturing moves to them. In reality, when you’re not just playing with definitions but looking at causation, Chinese subsidies increase manufacturing which increases the trade surplus (in some cases). The causal arrows point from subsidy to manufacturing and trade surplus, not from surplus to manufacturing.
The essay goes on to say that “American trade deficits force Americans to choose between higher unemployment, more household debt, or greater fiscal deficits.” Ignore the unemployment red-herring. The trade deficit doesn’t force (or cause) household debt or fiscal deficits. Something else causes both trade deficits and fiscal deficits to go up together.
Noah Rothman reports on “the fantastical abstract world of Democratic Socialists.” Three slices:
If you were looking for an excruciating experience, the New York Editorial Board — a Substack — has you covered.
The outlet recently posted a lengthy interview with Darializa Avila Chevalier, the Zohran Mamdani-endorsed candidate mounting a primary challenge against the Democratic Party’s Hispanic Caucus chair, Representative Adriano Espaillat. In it, Chevalier’s interlocutors tried valiantly to drag the self-described socialist candidate down from the clouds, albeit to no avail.
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Their aggravation now palpable, another interviewer asked if it was possible for Chevalier to be “a little less abstract.” But, of course, it was not. Her contention that it is her goal to “create systems where that’s not even the possibility” — by which she meant the act of murder, an evil so intrinsic to the human experience it is literally Biblical.
Chevalier could not “be a little less abstract” because she deals with the world as though it were an abstraction — really, one big metaphor that an intrepid constructivist could reshape with the right combination of words and concepts.
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To ask Chevalier to abandon abstractions and descend to ground level with us mere mortals is to abandon her entire worldview. Politics is, to her, an abstraction — an extension of a poetic struggle against the American civic and social compacts. And it must forever be an abstraction. Because when you ask her to make concrete sense of it all for anyone who doesn’t subscribe to her outlook, she can’t do it.
[DBx: Ms. Chevalier is typical of the intellectuals who Hayek described as being guilty of “constructivist rationalism.” This mouthful of a term applies to those persons who are convinced that if they can think of a concept (details are unnecessary) – if they can describe a concept in words or graphs or equations – then that concept is therefore not only possible to achieve in reality, but achievable in a way that has no unforeseen negative consequences.]
GMU Econ alum Bryan Cutsinger reflects on Kevin Warsh’s start as Fed Chairman. A slice:
Warsh inherited both the inflation overshoot and a committee still divided over how to respond. The test is whether the resolve he voiced shows up in the rate decisions to come.
Even so, Warsh has given more reason for optimism than the Fed has offered in years. A chairman who calls inflation a monetary phenomenon, rejects the idea that the Fed must accept higher prices to secure more jobs, and wants to reexamine the inflation framework from first principles is saying what the institution has long needed to hear.
Harsh but accurate: Alan Dlugash describes Bernie Sanders as a “climate doomsday clown.”
The feeling that government should “do something” has seldom been based on a comparison of what actually happens when government does and when it does not “do something.” Doing something almost always seems like such a good idea, to those who do not look beyond stage one, that they see no need to look back at history or to apply economics. The alternative to a “do something” approach is not to have the government always do absolutely nothing but, rather, to recognize that governments can only do something specific – and that these specifics must be assessed in terms of their specific effects, both immediate and long-term, as well as the general effects of extended experimentation.
Indeed, [Alexander] Hamilton was skeptical of high protective tariffs because they sheltered both inefficient and efficient producers, led to higher prices for consumers, and gave rise to smuggling, which cut into government revenue.
Protectionism … gradually dulls our awareness of our comparative advantages as well as opportunities to pursue them. Tariffs and import quotas seek to offset foreign competition’s impact on a given domestic industry. For a time, they may even succeed. But such measures also discourage that industry from adapting and becoming more efficient. The more you protect an industry, the more inflexible and inefficient it will become. If protectionist measures are thus systematically applied to more industries across a state’s economy, the same inefficiencies and inflexibility will emerge everywhere, thereby weakening that economy and therefore a state’s ability to resource its national security needs.
With nearly every member of both Houses professing belief in the principle of protection, the question as to what sort of protection is proper and what is not proper was frequently raised. The tests that were advanced to separate the just from the unjust were many, and often conflicting. Despite a pretense in the debates that there was some objective test of national welfare, the record of voting on individual items furnishes much evidence in support of the cynical proposition that sound protection was that which raised the prices of things produced by one’s constituents, and unsound protection that which raised the prices of things made by someone’s else constituents.
