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Did Reagan’s tax cuts cause those big 1980s budget deficits? Or was it Paul Volcker’s inflation fighting?

Image Credit: The Official CTBTO Photostream (Flickr) (CC BY 2.0)

Image Credit: The Official CTBTO Photostream (Flickr) (CC BY 2.0)

“It is undeniable that the sharp reduction in taxes in the early 1980s was a strong impetus to economic growth.” - President Bill Clinton’s Council of Economic Advisers, 1994

Growth. Sure. Whatever.

But what about the deficits? All that tax cutting created huge budget gaps, right? That’s the liberal rap against President Ronald Reagan’s tax cuts. And, indeed, annual budget deficits averaged $167 billion a year, or 4.2% of GDP, during Reagan’s two terms vs. $57 billion a year, or 2.4% of GDP, during Jimmy Carter’s single term.

Supporters of Reaganomics point to the drop in revenue caused by the 1981-82 recession as one cause of the shortfalls. Another was the 30% increase in U.S. defense spending — which seems to have been a pretty good investment given the subsequent demise of the Soviet Union and accompanying budgetary “peace dividend.”

But you can also “blame” Federal Reserve Chairman Paul Volcker and his successful crusade against inflation, argues Bruce Bartlett in The New American Economy. The New York Times economics writer and former Reagan administration official writes that the plunge in inflation from 13% in 1980 to 4% in 1982 collapsed the tax base since taxes are assessed on nominal incomes each year, not inflation-adjusted incomes

Inflation fell faster than anyone expected, so nominal incomes and revenue came in way lower than anyone expected. (The Reagan administration expected a GNP deflator of 36% between 1981 and 1986. Instead, it was 21%.) The Carter administration’s last budget predicted 12.6% inflation in 1981 and 9.6% inflation in 1982. It also predicted each percentage point decline in inflation below its forecasts would reduce tax revenue by $11 billion. Inflation actually came in at 8.9% in 1981 and 3.8% in 1982, suggesting the inflation drop increased the deficits those years by 50%.

Of course, the larger deficits were a tolerable side effect of the successful war on inflation. And Bartlett says the Reagan tax cuts helped provide growth to offset the Volcker monetary tightening. Economists had thought it would take another Great Depression to sharply lower inflation.

17 thoughts on “Did Reagan’s tax cuts cause those big 1980s budget deficits? Or was it Paul Volcker’s inflation fighting?

  1. The relevant point is not speculation about possible causes but the fact that Reagan saw what was happening and took action to prevent the deficit from running amok

    UNLIKE the modern-day Reagan-wannabies who bragged that deficits did not matter and indeed .. things went to hell in a handbasket – something Reagan would have never been so irresponsible about.

  2. Um … the deficit is the difference between spending and revenue. To the extent that revenue was lower due to lower-than-expected inflation rather than the tax cuts, wouldn’t spending also similarly come in under projections, thus having little effect on the deficit?

    • ” To the extent that revenue was lower due to lower-than-expected inflation rather than the tax cuts, wouldn’t spending also similarly come in under projections, thus having little effect on the deficit?”

      oh oh.. he may have to re-write, eh?

    • To the extent that revenue was lower due to lower-than-expected inflation rather than the tax cuts, wouldn’t spending also similarly come in under projections, thus having little effect on the deficit?

      Not necessarily. If the budget was passed with a certain dollar amount earmarked for various departments and spending, that spending would have occurred anyway. There is a strong incentive in government to spend everything you get regardless of what you actually need. If you do not spend it, you will get less next year.

      So, if we have the equation: D=R-S,

      Where
      D = Deficit
      R = Revenue (taxes, in this case)
      S = Spending

      I think it’s reasonable to assume S is constant (S*), given the budgetary process.

      So, our equation is thus D=R-S*, and the change in R (in this case, falling tax revenue) would be the driving factor in a deficit.

      • re: ” falling tax revenue) would be the driving factor in a deficit.”

        and what would be the proper policy response?

        Did Reagan take action to deal with the deficit?

        • Hey, I’m just playing with the math here.

          Besides, Regan’s a politician. And all politician’s behave the same way: Credit travels up, blame travels down.

          Frankly, I think Ron gets way too much credit. Now, I like Ronnie, I really do, but there was no need to build up our military the way he did (and I think it’s absurd to claim there is a “peace dividend” because of it). The Soviets were dead, they just didn’t realize it. To give Ronnie the credit is to ignore the fact that the Soviet economy had truly stagnated for 30+ years (the standard of living in Russia in 1989 was no different from 1950. That claim cannot be made in the US, now or then). It also ignores the fact that the Soviet Empire was amazingly corrupt. Ronald Reagan was the lucky son of a gun who was in office when the Soviet Union fell. If Dukakus or Carter had one, they’d be the ones credited.

          But that was a large digression. To answer your question (sorry about that), Ron did take some steps to cut back spending in response to the decline in tax revenue. Unfortunately, it was not nearly enough.

          Republicans are about as serious as Democrats when it comes to cutting the deficit and curbing spending.

          • Jon M,

            The Soviet Union could have limped along for many more decades. Reagan took a gamble and certainly the outcome was favourable, which usually inspires people to think the decision to outspend the Soviets was a good one. But to say that Reagan lucked into a time when the Soviet Union failed is also incorrect. The Soviets freaked out when Reagan started the arms race and made a lot of decisions they wouldn’t have otherwise made. The arms race pushed them over the cliff. Was it worth the price? I don’t know, but I think probably not.

            In fairness, Reagan did more than any president in recent history to cut government.

      • @Jon Murphy – That might be partially true in the first year, as departments find that they can get extra goods and services for the same money. But once inflation falls, someone should be paying attention and adjusting the budget to take into account the lower inflation. Social Security and federal salary COLAs will automatically be reduced as inflation falls, deflating projected spending on those items just as projected revenues are deflated.

  3. Reagan generated 5.7% GDP growth during his recovery and 1984 saw GDP growth at a bodacious 7%. Millions of jobs were created. He launched from a very hostile economic terrain that included 21% interest (prime) rates and an imploded S&L industry. In addition to cutting marginal rates, he rolled back costly regulations.

    In sharp contrast, and during the comparable recovery period, Obama launched from an environment of very friendly (a 0% ff rate) interest rates while imposing massive new costly regulations that generated just 2% growth and very few jobs. He pissed-away $5.5 trillion in the process and he still has nothing to show for it almost 4 years later.

    You can argue which recession was more severe…but you can’t argue that the respective responses and solution s were comparable.

    • Actually, you can’t argue that the recessions are comparable. The Dubya recession began when the housing bust erased $7 trillion in household wealth, Inflation expectations can disappear overnight. A hole that size lingers and lingers.

      To repeat, you are laughably off base about the S&L debacle. Reagan’s man to take over the regulatory FHLBB– actually Don Regan’s man– was Richard Pratt. He decimated the ranks of examiners, relaxed accounting standards and brokered dozens of deals that kept failed thrifts afloat, often by turning them over to developers. When the stuff hit the fan in Bush 1′s term, the hole was three times larger than it would have been, but miniscule by today’s standards at estimates of $90 to $124 billion.

      Love that deregulatioln eh?

      • I should add that the healthy thrifts that accommodated Pratt by taking over sick ones got screwed royally when the FDIC in the Bush era crackdown reneged on promises of forbearance. The poster child was the 176 yo Philadelphia Savings Fund Society. PSFS won a $276 million judgment against the FDIC in 2011, after 19 YEARS OF LITIGATION. The mom-and-pop savers who paid $8 a share in 1983 got back $4.50. PSFS was a Philly institution — at one point conducting regular rounds of schools to collect pennies from tiny savers.
        LOVE that deregulation, eh?

  4. “Reagan generated 5.7% GDP growth during his recovery and 1984 saw GDP growth at a bodacious 7%. Millions of jobs were created. He launched from a very hostile economic terrain that included 21% interest (prime) rates and an imploded S&L industry. In addition to cutting marginal rates, he rolled back costly regulations.”

    Yeah, he rolled back those costly regulations, all right. Those regulations were so ineffective, that their removal by the Reagan administration touched off the S&L crisis, which you wrongly say Reagan inherited. Reagan CREATED IT. The S&L bailouts cost the US taxpayer over $500 billion, and it took the Resolution Trust Company years to put things right.

    Later, it seems we learned NOTHING from this, even as Jamie Dimon fights Dodd-Frank now after living in the backwash of the deregulation of the late 90s and 2000s.

    The marginal rare cuts were bullsh*t. If I were President and had overnight interest rates cut by 1300 basis points after the life was strangled out of the economy, they would name airports after me too.

    What a joke. These pathetic idiots, promoting an almost Mao-like cult of personality around Ronald Reagan, when they weren’t even around during his term.

    “Oh, him? He cut taxes and the economy boomed for a while. We idolize him.”

    Great.

    “Tax Reform Act of 1986

    By enacting 26 U.S.C. § 469 (relating to limitations on deductions for passive activity losses and limitations on passive activity credits) to remove many tax shelters, especially for real estate investments, the Tax Reform Act of 1986 significantly decreased the value of many such investments which had been held more for their tax-advantaged status than for their inherent profitability. This contributed to the end of the real estate boom of the early-to-mid-1980s and facilitated the Savings and Loan crisis.[6] Prior to 1986, much real estate investment was done by passive investors. It was common for syndicates of investors to pool their resources in order to invest in property, commercial or residential. They would then hire management companies to run the operation. TRA 86 reduced the value of these investments by limiting the extent to which losses associated with them could be deducted from the investor’s gross income. This, in turn, encouraged the holders of loss-generating properties to try to unload them, which contributed further to the problem of sinking real estate values.[citation needed]

    [edit] Moral Hazard

    The deregulation of S&Ls in 1980 gave them many of the capabilities of banks, without the same regulations as banks. Savings and loan associations could choose to be under either a state or a federal charter. Immediately after deregulation of the federally chartered thrifts, state-chartered thrifts rushed to become federally chartered, because of the advantages associated with a federal charter. In response, states such as California and Texas changed their regulations to be similar to federal regulations.[7]

    More important, however, was the moral hazard of insuring already troubled institutions with public dollars. In the view of a savings and loan president or manager, the trend line was fatal over the long haul; thus, to get liquid, the institution had to take on riskier assets, particularly land. When the real estate market crashed, the S&Ls went with it. By insuring the risk, the government guaranteed that desperate S&L owners and managers would engage in ever more risky investments, knowing that if they were successful, the institution would be saved, and if unsuccessful, their depositors would still be bailed out.[citation needed]“

  5. The glorification of Reagan- who was the biggest deficit whore of the post war era- while slandering Obama, is merely a reflection of the moral character of those who promote these myths about the Reagan economy.

  6. It was Reagan, not Buffet, who first said that it is immoral to have a tax code that allows billionaires to pay less in taxes than bus drivers. It was Reagan who raised taxes on passive income to make passive (billionaires’) and active (working middle class) income taxed at exactly the same max tax rates – 28%. Today’s GOP fights for a tax code which allows billionaires like Romney, Soros, Buffet, Adelson, to pay 10-13% in taxes, while the working middle class pays that much just in payroll tax + up to 35% in federal taxes. No wonder the working middle class voted for Reagan and vote against today’s GOP.

    • You have a good point there, Reagan even won California. In 1984 Reagan won Orange County California at 74 percent and Rommey only at 53 percent. In fact Rommey won rural countries the most in the US and did poor in urban or Suburban Counties. He took Modoc in California at 68 percent. The Tea Party elements now in the Republican Party supported giving the big boys the break on taxes but are against illegal immigration because it drives down wages. The Tea Party is not consistent, you can’t be a cross between the Koch brothers and Jeff Sessions. This is why people don’t take the Tea party seriously, since they help the millionaires and billionaires get tax breaks and these are the same billionaires and millionaires that support immigration reform to flood the labor market with guest worker programs.

  7. Please explain why the Nation has to pay the Fed for issuing Fed Reserve Notes for the privilege of holding U.S. Treasury Bonds? Why can’t the Congress issue United States Currency in the form of Dollars and by-pass the payment of debt to the Non-Federal Federal Reserve? Does it matter really if the form of “money” is FedNotes vice $’s when it comes to the inflation effect? Does the mechanics of this unnecessary transformation of liability from the US Congress to the Treasury change anything except introduce an unnecessary cost of doing business? After all, the Fed does not “give” us actual “money”. It simply gives us alternate debt instruments which we the people accept (currently) as actual money. I just don’t get it!
    Help me understand this please.

  8. Yeah, but the Republicans don’t have the high aerospace spending that produce a lot of better paying factory jobs today. A lot of Dems and some paleo-cons complain about the lower paying textile jobs going overseas but disliked the better paying aerospace which got ax for peace spending recently. In fact if people were employed in aerospace like they were in Ronnie’s day Obamacare might not have passed since most the aerospace jobs had health insurance. In fact Ronnie even won Los Angeles County since it had about a 140,000 aerospace jobs and is now down to 50,000. Granted, robots and automation would make it unlikely to return to those levels. The next best thing is to go back to space. The Chinese are heading to the moon, so why not to the moon. Also, the USA should support more of the Space X and Virgin Airlines and other private space commercial. Space X proves you can do it.

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