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On August 13, 1981, at his California home Rancho del Cielo, Ronald Reagan signs the Economic Recovery Tax Act (ERTA), a historic package of tax and budget reductions that set the tone for his administration’s overall economic policy.
During his campaign for the White House in 1980, Reagan argued on behalf of “supply-side economics,” the theory of using tax cuts as incentives for individuals and businesses to work and produce goods (supply) rather than as an incentive for consumers to buy goods (demand). In Congress, Representative Jack Kemp, Republican of New York, and Senator Bill Roth, Republican of Delaware, had long supported the supply-side principles behind the ERTA, which would also be known as the Kemp-Roth act. The bill, which received broad bipartisan support in Congress, represented a significant change in the course of federal income tax policy, which until then was believed by most people to work best when used to affect demand during times of recession.
The ERTA included a 25 percent reduction in marginal tax rates for individuals, phased in over three years, and indexed for inflation from that point on. The marginal tax rate, or the tax rate on the last dollar earned, was considered more important to economic activity than the average tax rate (total tax paid as a percentage of income earned), as it affected income earned through “extra” activities such as education, entrepreneurship or investment. Reducing marginal tax rates, the theory went, would help the economy grow faster through such extra efforts by individuals and businesses. The 1981 act, combined with another major tax reform act in 1986, cut marginal tax rates on high-income taxpayers from 70 percent to around 30 percent, and would be the defining economic legacy of Reagan’s presidency.
Reagan’s tax cuts were designed to put maximum emphasis on encouraging innovation and entrepreneurship and creating incentives for the development of venture capital and greater investment in human capital through training and education. The cuts particularly benefited “idea” industries such as software or financial services; fittingly, Reagan’s first term saw the advent of the information revolution, including IBM’s introduction of its first personal computer (PC) and the rise or launch of such tech companies as Intel, Microsoft, Dell, Sun Microsystems, Compaq and Cisco Systems.
Economists have argued to what degree Reagan’s economic policy drove the boom of the 1990s, but his tax program undoubtedly set in motion powerful forces of change that would result in both short- and long-term economic gains. On the other hand, critics of so-called “Reaganomics” point out that his tax cuts and the effects of steady economic growth disproportionately benefitted the wealthy, and increased the gap between the nation’s rich and poor.
Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) is federal legislation passed in 1982 to cut the budget deficit through federal spending cuts, tax increases, and reform measures. The legislation reversed some elements of the Economic Recovery Tax Act of 1981 (ERTA). Both pieces of legislation were passed early in the presidency of Ronald Reagan.
- The Tax Equity and Fiscal Responsibility Act of 1982 was the biggest tax increase in U.S. history, when adjusted for inflation.
- The legislation quickly followed and was a response to the Economic Recovery Tax Act of 1981, which was the biggest tax cut in U.S. history.
- Following the passage of ERTA, the U.S. fell into the second half of a "double dip" recession, and the U.S. budget deficit was soaring.
- TEFRA was steered to passage by Republican Senator Bob Dole.
Historian: Tax Law A Turning Point For Reagan
Thirty years ago today, President Ronald Reagan signed the Economic Recovery Tax Act, the first major tax cut during his presidency. Guest host David Greene talks with Reagan historian Douglas Brinkley about the act's legacy and how it still affects American discourse on taxation.
DAVID GREENE, host: Well, one thing voters at the Iowa straw poll heard this week from nearly every Republican candidate was a promise not to raise taxes. That idea has been synonymous with the Republican Party for years now, but it wasn't always that way.
DOUGLAS BRINKLEY: Well, from 1932 to 1980, there was a belief that the federal government could solve your problems.
GREENE: Historian Douglas Brinkley says for most of the last century, government was seen as a good thing.
BRINKLEY: That's what FDR stood for in his hundred days in the New Deal.
President FRANKLIN D. ROOSEVELT: It can be accomplished in part by direct reporting by the government itself.
GREENE: After FDR, people thought government could create solutions to national problems.
BRINKLEY: Like Social Security or the Fair Deal programs of Truman.
BRINKLEY: . interstate highways.
UNIDENTIFIED MAN #1: Our American dream, a futurama on wheels, can come true.
BRINKLEY: . the St. Lawrence Seaway.
UNIDENTIFIED MAN #2: (Unintelligible) of the project that has been recommended by every American president since Warren Harding.
BRINKLEY: . Kennedy going to the moon.
President JOHN F. KENNEDY: . of landing a man on the moon and returning him safely to the earth.
BRINKLEY: . Jimmy Carter creating a Department of Energy, Richard Nixon creating the Environmental Protection Agency. It was bipartisan. There was a national belief that the federal government can make your life better.
GREENE: But then came the presidential election of 1980. Ronald Reagan tries something new.
President RONALD REAGAN: Now, so there will be no misunderstanding, it's not my intention to do away with government. It is, rather, to make it work.
BRINKLEY: It became Reagan's boilerplate campaign stump line.
REAGAN: . to stand by our side, not ride on our back.
BRINKLEY: Get government off our backs.
GREENE: This worked for Reagan, Brinkley says. People were upset about some failed great society programs. The welfare system wasn't working. Schools were in decline. And so shortly after Reagan is elected, 30 years ago today, he signed a law called the Economic Recovery Tax Act.
REAGAN: This represents $750 billion in tax cuts over the next five years, and this is only the beginning.
GREENE: That single law, Douglas Brinkley says, was a turning point for Reagan's presidency and the future of the Republican Party.
BRINKLEY: And it's because Reagan threw down a gauntlet with the Economic Recovery Tax Act of '81 in which he started a rhetoric that was anti-federal government as president of the United States, this notion that enough is enough.
REAGAN: . and mark an end to the excessive growth in government bureaucracy and government spending, government taxing.
BRINKLEY: Reagan had made it part of the DNA of the Grand Old Party. And since then, as this season will tell you, there's not a Republican that's going to talk about tax raising. As we speak, every Republican candidate for president is somewhere right now talking about cutting taxes. That is part of the 30-year legacy of the Economic Recovery Tax Act, which Reagan had signed into law.
GREENE: We've been looking back 30 years to the tax cuts of 1981 with Douglas Brinkley. He's professor of history at Rice University, and he joined us from member station KUT in Austin. Professor, thank you for being with us.
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1981 Omnibus Budget Reconciliation Act
The Omnibus Budget Reconciliation Act of 1981 (OBRA 1981 or Gramm-Latta II) and the Economic Recovery Tax Act of 1981 (ERTA 1981 or the Kemp-Roth Tax Cut) comprised the first budget of the administration of Ronald Reagan (for FY82). Together the two bills established Reagan's fiscal priorities as tax cuts, reductions in domestic discretionary spending, and increased military spending. OBRA 1981 was passed using the reconciliation process created by the 1974 Congressional Budget and Impoundment Control Act.
During his presidential campaign Ronald Reagan proposed three fiscal policies: 1) increased defense spending 2) cuts in non-defense appropriations and 3) tax cuts. In 1980 Reagan appointed David Stockman, a young Congressman from Michigan and committed supply-sider, to head the Office of Management and Budget. Soon after Reagan entered office Stockman proposed a budget for the 1982 fiscal year that would implement all three policies.
At the time the U.S. Senate was controlled by Republicans and the House by Democrats. However, the Democrats included a number of conservative southerners who agreed with many of Reagan's proposals. In response to Stockman's budget, Representative James Jones (D-Ok), chairman of the House Budget Committee, tried to draft his own budget to keep the Democratic coalition together. However, Representative Phil Gramm (D-Texas) leaked information to the Reagan administration about Jones' plan, which led the administration to propose a counter-budget, cosponsored by Gramm (he later lost his position on the Budget Committee, resigned his seat, and ran as a Republican for his vacant seat) and Representative Delbert Latta (R-OH), that passed Congress via reconciliation in the summer of 1981. Perhaps the centerpiece of Reagan's budget was the tax cut, officially known as the Economic Recovery Tax Act but better known as the Kemp-Roth Tax Cuts, named after the bill's sponsors: Representative Jack Kemp (R-NY) and Senator William Roth (R-DE). The tax cuts slashed marginal rates for individuals and made deep cuts to corporate taxes.
The Omnibus Budget Reconciliation Act of 1981 included steep increases in military spending, steep cuts in non-defense expenditures, and a large tax cut (legislated through ERTA 1981). Although the Reagan administration predicted that the combination of spending and tax cuts would reduce the federal deficit, the deficit exploded under Reagan.
This was partially a result of slow economic growth, which was in turn precipitated by the Federal Reserve's moves to reduce the money supply so as to curb inflation. On the whole, however, the ballooning federal deficit was caused by declines in tax revenue. As a result of the tax cuts, revenues for the federal government dropped $200 billion by 1986 and contributed to consecutive budget deficits and a massive increase in the national during the Reagan and George H.W. Bush presidencies.
David W. Brady and Craig Volden, Revolving Gridlock: Politics and Policy from Carter to Clinton (Westview, 1998), 43-99.
John William Ellwood, "Congress Cuts the Budget: The Omnibus Reconciliation Act of 1981," Public Budgeting & Finance (Spring 1982): 50-64. http://onlinelibrary.wiley.com/doi/10.1111/1540-5850.00549/abstract
Iwan Morgan, The Age of Deficits: Presidents and Unbalanced Budgets from Jimmy Carter to George W. Bush (University of Kansas, 2009), 76-121.
David A. Stockman, The Triumph of Politics: Why the Reagan Revolution Failed (HarperCollins, 1986).
Joseph White and Aaron Wildavsky, The Deficit and the Public Interest: The Search for Responsible Budgeting in the 1980s (University of California, 1989).
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Economic Recovery Tax Act of 1981
- Phased-in 23% cut in individual tax rates over 3 years
- The top rate dropped from 70% to 50%
- Indexed individual income tax parameters (beginning in 1985)
- Created 10% exclusion on income for two-earner married couples ($3,000 cap)
- Phased-in increase in estate tax exemption from $175,625 to $600,000 in 1987
- Reduced windfall profit taxes
- Allowed all working taxpayers to establish IRAs
- Expanded provisions for employee stock ownership plans (ESOPs)
- Replaced $200 interest exclusion with 15% net interest exclusion ($900 cap) (begin in 1985)
T he 1982 Tax Equity and Fiscal Responsibility act abolished the accelerated depreciation amendments, and the 15 percent interest exclusion was repealed before the 1984 Deficit Reduction Act took effect. The maximum cost of credit calculation was increased from $2000 to $2400 for one child, and from $4000 to $4800 for two or more children. The credit rose from 20 percent or a maximum of $400 or $800 to 30 percent, or less, of $10,000. The 30% credit is diminished by 1% for every $2,000 of earned income up to $28000. At $28000, the credit for earned income is 20%.
Deduct This: History of the IRA Deduction
Studebaker was a manufacturing company that started in 1852 in South Bend, Indiana, making wagons for farmers, miners, and the military. Ten years after the first gasoline-powered car was tested in the U.S., Studebaker entered the car manufacturing business and it was, at one point, the largest automobile maker in the world. By the 1960s, however, the company was having financial and labor difficulties and the last Studebaker car rolled off the assembly line on March 16, 1966.
Studebaker had a legacy that was bigger than cars. In the 1960s, as Studebaker was shuttering its plants, the company realized that its pension plan was so poorly funded that it could not afford to pay all its employees their pensions. As a result, thousands of workers received no pension or only part of their pensions.
As a result of that story and others like it, the public began to put pressure on Congress to do something to protect pension plans. In 1974, Congress enacted the Employee Retirement Income Security Act, often referred to as ERISA.
ERISA was huge. It regulated pension plans, retirement plans and other benefits, including health care plans.
One of the key components of ERISA was the individual retirement account, or IRA. As originally contemplated, taxpayers could contribute up to $1,500 per year and reduce taxable income by the amount of the contributions. Additionally, the amount inside the IRA would grow without being immediately taxed, a concept referred to as "tax deferred."
Since the point of ERISA was to protect workers with benefit plans, initially, IRAs were restricted to those workers who were not already covered by a qualified employment-based retirement plan. This all changed under Reagan's 1981 Economic Recovery Tax Act ("ERTA") which removed that restriction. Under ERTA, all taxpayers who were age 70½ or less could contribute to an IRA. Also under ERTA, taxpayers could contribute up to $2,000 for their own IRA and $250 for a nonworking spouse and receive a tax deduction.
IRAs did not survive Reagan's next set of tax reforms unscathed. Under the Tax Reform Act of 1986 ("1986 TRA"), deductions were phased out for high-income taxpayers who were covered by an employment-based retirement plan or had a spouse covered under such a plan.
Ten years later, however, the Small Business Job Protection Act of 1996 ("SBJPA") expanded the scope of the IRA. Under SBJPA, the limits for contributions for nonworking spouses were increased from $250 to $2,000. The following year, the Taxpayer Relief Act of 1997 ("1997 TRA") made even more significant changes. The phase-out limits for high-income taxpayers were increased and the rules were tweaked to allow more taxpayers who were not covered by an employment-based retirement plan to make contributions.
The 1997 TRA also introduced the Roth IRA, named for Sen. William Roth (D-DE). Roth IRAs are a special type of retirement accounts that allow for contributions to be made out of after-tax assets. Since the tax is already paid on those assets, there's no tax on the withdrawals. There is, however, also no corresponding distribution deduction on your tax return.
IRAs continued to expand under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA boosted contribution limits for IRAs to $5,000 per qualifying person per year. In addition, EGTRRA allowed for "catch-up" contributions of up to $1,000 for taxpayers aged 50 and above. EGTRRA was only temporary, however, and was slated to expire at the end of 2010.
Today, assuming you qualify, you can make an IRA contribution and take a deduction under §219 of the Tax Code:
In the case of an individual, there shall be allowed as a deduction an amount equal to the qualified retirement contributions of the individual for the taxable year.
Phase out and other limitations still apply. It's always a good idea to check with your tax professional for all of the details.
You can generally make a contribution right up until Tax Day and have it count for the prior taxable year. So, for example, for 2011, you can make a contribution all the way up to April 17, 2012 (yes, Tax Day in 2012 falls on a weekend). The deduction is taken on the front page of your federal form 1040 (downloads as a pdf) at line 32 ,or line 28 for the self-employed though different rules apply.
Don't let the term "deduction" throw you. The IRA deduction is available whether you claim the standard deduction or itemized your deductions on a Schedule A. Since the IRA deduction is taken on the front page, it's considered an "above the line" deduction. "Above the line" deductions are also called adjustments to income since they reduce your taxable income.
The idea behind the IRA deduction, of course, is to encourage people to save. I'm not sure, in practice, if the deduction significantly adds to the appeal of the IRA since it's been my experience that most taxpayers tend to make the contribution primarily for the deferral, not the deduction. It does, of course, make me curious: do you make contributions for the deferral, the deduction or some other reason?
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Historian Argues Ronald Reagan's 1981 Tax Cut Led To Trumpism
Is it possible that the Economic Recovery Tax Act of 1981, followed by the Tax Reform Act of 1986, the legacy of Ronald Reagan is where it all went wrong? That is the case that John Komlos makes in his paper recently released onto SSRN - Reaganomics: A Historical Watershed. It wasn't morning again.
U.S. President Donald Trump give two thumbs up after speaking during a national security strategy . [+] speech at the Ronald Reagan Building in Washington, D.C., U.S., on Monday, Dec. 18, 2017. Photographer: Jim Lo Scalzo/Pool via Bloomberg
© 2017 Bloomberg Finance LP
It Wasn't The Stupid Economy
Professor Komlos is an economic historian with PhDs in history and economics from the University of Chicago. He worked with Nobel laureate Robert Fogel, which impresses the hell out of me, so I have to take him seriously, even though I love ERTA and TRA 1986. Those acts are why public accounting was good to me, despite the fact that I dress poorly, can't stand golf and have a below average knowledge of sports.
The gist of the article is that the decreases in marginal tax rates did not boost the economy. Rather the benefits of tax cuts went disproportionately to the top tier. This has led to despair among the working classes (i.e. Hillary Clinton's deplorables) and the election of President Trump, which Professor Komlos thinks was not such a good thing. But what about her e-mails?
Of course, it is a longer story than that. A lot of the focus is on rising inequality, which began to increase a bit in the seventies from historic lows, but then:
The real shock came three years later when the trend was unleashed that extended into the next century: in 1981 the top 0.1% of the income distribution received 1.8% of total income, by 1982 2.5%, and by 1983 2.7%. So by 1983 the share of income of these 80,000 households doubled compared to 1977. Henceforth the floodgates were open and remained open: by 1988 their share reached 5.4% and by 2000 7.3% From 1.3% to 7.3% of national income is a game changer of immense historic proportions. (References omitted)
And Goodbye To The Unions
It wasn't just the tax cuts. There was also breaking PATCO, the air traffic controllers union which marked the beginning of a long term decline in union membership.
Unions had been the backbone of the middle class, especially the lower-middle class. They ensured that a share of the profits went also to workers and not only to executives and shareholders. Collectively workers could threaten to strike, thereby exercising sufficient countervailing power to obtain for themselves a little more than a living wage—a share of the rents the corporation was earning. Without such countervailing power most workers without a college education, especially those who had no special skills—were left on their own . The upshot was devastating to this segment of the middle class. (References omitted )
The Seven Deadly Consequences
Professor Komlos traces the effects to the present day like this.
We argue that a) Reaganomics did not come to an end in 1989 its legacy continues to the present day b) it initiated a path-dependent process which would have been difficult to reverse c) the skewed distribution of income increased the political power of the top 1% d) they used this power to further their interests which included advocating for laissez-faire economic policies including globalization, financialization, and the IT revolution e) the rise in inequality increased the frustration of the less skilled and less educated because they were experiencing downward social mobility f) hence, relative incomes mattered in generating frustration g) desperate people are easier to manipulate and will do desperate things including voting for an unqualified presidential candidate who promises to end their misery this is linked to the phenomena of deaths of despair documented by Case and Deaton (2017). (References omitted )
His most depressing observation is that we may be stuck in a downward spiral.
The growing number of millionaires also had the financial resources at their disposal to make sure that their dominant position was maintained economically, politically, as well as ideologically. So, the country and its economy was practically locked into the path defined by Reaganomics with seven major negative legacies.
Those seven legacies are inequality, "hollowing out" of the middle class, business-friendly regulation at the expense of workers and consumers, deficit financing becoming endemic, disparaging the government, oligarchy which is transform country into a plutocracy and neglect of blue-collar workers.
So how did that elect Donald Trump?
Hopelessness is a mighty political force and therefore it should not be so surprising that after the failed promises and benign neglect of three Republican and two Democratic administrations spanning a third of a century, the have-nots came to believe that only a strongman will change the course of the ship of state. The uneducated, those who experienced the alienation of downward social and economic mobility, or the disappointment of wage stagnation for a generation while others were living the lifestyle of the rich and famous, those who were clobbered subsequently by the tsunami of hyperglobalization, and those who were evicted from their homes while the Lords of Finance were being pampered, were ripe to revolt and turn against the establishment elites. Trump was able to harvest the anger of those who reached for the American Dream and found a nightmare instead. (References omitted )
Although I think Professor Komlos makes a strong case and I have strong reasons for respecting his intellect, his analysis does not resonate that strongly with me.
President Trump may be giving a last hurrah to a form of patriotism that is fading with my generation. That is something that I sensed when I attended one of his rallies in Worcester. Among people I know the two reasons for voting for Trump were abortion and "What about her emails?", neither of which is addressed by Professor Komlos. I have a theory on that based on my brief experience of Professor Komlos's milieu.
Things Scholars Might Not Get
As I noted I am very impressed by Professor Komlos's credentials particularly his association with Robert Fogel. As it happens I had hoped to be associated with Fogel and went pretty far down the path. I majored in history at the College of the Holy Cross, which is not too shabby. And I am better at math than most liberal arts graduates, which is saying practically nothing and even most CPAs, which is not saying much.
So when I heard Professor Fogel speak about the new field of cliometrics (Clio was the Greek muse of history. I know you knew that, but you have to consider the other readers), I was very excited. He wrote something about a program he was getting going at the University of Chicago. When I got to the University of Chicago in 1975, I learned that the program was a trial balloon that popped when he left for Harvard.
It could have been worse. I got to take a course on the antebellum South in which I could listen to John Hope Franklin mocking Fogel's observations on how enslaved people were treated. Other than that, things did not go well for me.
**FILE** In this October 2005 file photo, Duke University historian and African-American scholar . [+] John Hope Franklin attends to one of his many orchids in the greenhouse behind his home in Durham, N.C. Franklin died Wednesday, March 25, 2009, at the age of 94. (AP Photo/Karen Tam, File)
The observation that I would make relates to a few conversations I had with professors at minor events at which they mingled with graduate students. I have never met a collection of people more out of touch with popular culture than those guys. Contemporary American popular culture that is. I'm sure there was somebody who knew seventeenth century Midlands England popular culture inside out.
Regardless, Reaganomics: A Historical Watershed is well worth reading, regardless of whether it will give you an "Ah Hah!" moment or raise your blood pressure.
The Laffer Curve: Past, Present, and Future
The story of how the Laffer Curve got its name begins with a 1978 article by Jude Wanniski in The Public Interest entitled, "Taxes, Revenues, and the 'Laffer Curve.'"1 As recounted by Wanniski (associate editor of The Wall Street Journal at the time), in December 1974, he had dinner with me (then professor at the University of Chicago), Donald Rumsfeld (Chief of Staff to President Gerald Ford), and Dick Cheney (Rumsfeld's deputy and my former classmate at Yale) at the Two Continents Restaurant at the Washington Hotel in Washington, D.C. While discussing President Ford's "WIN" (Whip Inflation Now) proposal for tax increases, I supposedly grabbed my napkin and a pen and sketched a curve on the napkin illustrating the trade-off between tax rates and tax revenues. Wanniski named the trade-off "The Laffer Curve."
I personally do not remember the details of that evening, but Wanniski's version could well be true. I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me to illustrate the trade-off between tax rates and tax revenues. My only question about Wanniski's version of the story is that the restaurant used cloth napkins and my mother had raised me not to desecrate nice things.
The Historical Origins of the Laffer Curve
The Laffer Curve, by the way, was not invented by me. For example, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."
A more recent version (of incredible clarity) was written by John Maynard Keynes:
The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues (per dollar of tax base) will be lowered by the amount of the decrease in the rate. The reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment--and thereby the tax base--by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious.
Figure 1 is a graphic illustration of the concept of the Laffer Curve--not the exact levels of taxation corresponding to specific levels of revenues. At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues because no one would willingly work for an after-tax wage of zero (i.e., there would be no tax base). Between these two extremes there are two tax rates that will collect the same amount of revenue: a high tax rate on a small tax base and a low tax rate on a large tax base.
Using the Kennedy tax cuts of the mid-1960s as our example, it is easy to show that identical percentage tax cuts, when and where tax rates are high, are far larger than when and where tax rates are low. When President John F. Kennedy took office in 1961, the highest federal marginal tax rate was 91 percent and the lowest was 20 percent. By earning $1.00 pretax, the highest-bracket income earner would receive .09 after tax (the incentive), while the lowest-bracket income earner would receive .80 after tax. These after-tax earnings were the relative after-tax incentives to earn the same amount ($1.00) pretax.
By 1965, after the Kennedy tax cuts were fully effective, the highest federal marginal tax rate had been lowered to 70 percent (a drop of 23 percent--or 21 percentage points on a base of 91 percent) and the lowest tax rate was dropped to 14 percent (30 percent lower). Thus, by earning $1.00 pretax, a person in the highest tax bracket would receive .30 after tax, or a 233 percent increase from the .09 after-tax earned when the tax rate was 91 percent. A person in the lowest tax bracket would receive .86 after tax or a 7.5 percent increase from the .80 earned when the tax rate was 20 percent.
Putting this all together, the increase in incentives in the highest tax bracket was a whopping 233 percent for a 23 percent cut in tax rates (a ten-to-one benefit/cost ratio) while the increase in incentives in the lowest tax bracket was a mere 7.5 percent for a 30 percent cut in rates--a one-to-four benefit/cost ratio. The lessons here are simple: The higher tax rates are, the greater will be the economic (supply-side) impact of a given percentage reduction in tax rates. Likewise, under a progressive tax structure, an equal across-the-board percentage reduction in tax rates should have its greatest impact in the highest tax bracket and its least impact in the lowest tax bracket.
Timing of Tax Cuts
The second, and equally important, concept of tax cuts concerns the timing of those cuts. In their quest to earn after-tax income, people can change not only how much they work, but when they work, when they invest, and when they spend. Lower expected tax rates in the future will reduce taxable economic activity in the present as people try to shift activity out of the relatively higher-taxed present into the relatively lower-taxed future. People tend not to shop at a store a week before that store has its well-advertised discount sale. Likewise, in the periods before legislated tax cuts take effect, people will defer income and then realize that income when tax rates have fallen to their fullest extent. It has always amazed me how tax cuts do not work until they actually take effect.
When assessing the impact of tax legislation, it is imperative to start the measurement of the tax-cut period after all the tax cuts have been put into effect. As will be obvious when we look at the three major tax-cut periods--and even more so when we look at capital gains tax cuts--timing is essential.
Location of Tax Cuts
As a final point, people can also choose where they earn their after-tax income, where they invest their money, and where they spend their money. Regional and country differences in various tax rates matter.
The Harding-Coolidge Tax Cuts
In 1913, the federal progressive income tax was put into place with a top marginal rate of 7 percent. Thanks in part to World War I, this tax rate was quickly increased significantly and peaked at 77 percent in 1918. Then, through a series of tax-rate reductions, the Harding-Coolidge tax cuts dropped the top personal marginal income tax rate to 25 percent in 1925. (See Figure 2.)
Additionally, in 1965--one year following the tax cut--personal income tax revenue data exceeded expectations by the greatest amounts in the highest income classes (See Table 6).
These data have all sorts of limitations. Each state has a unique budgeting process, and no one knows what assumptions were made when projecting revenues and expenditures. As California has repeatedly shown, budget projections change with the political tides and are often worth less than the paper on which they are printed. In addition, some states may have taken significant budget steps (such as cutting spending) prior to FY 2003 and eliminated problems for FY 2003. Furthermore, each state has a unique reliance on various taxes, and the incentive rate does not factor in property taxes and a myriad of minor taxes.
Even with these limitations, FY 2003 was a unique period in state history, given the degree that the states--almost without exception--experienced budget difficulties. Thus, it provides a good opportunity for comparison. In Figure 6, states with high rates of taxation tended to have greater problems than states with lower tax rates. California, New Jersey, and New York--three large states with relatively high tax rates--were among those states with the largest budget gaps. In contrast, Florida and Texas--two large states with no personal income tax at all--somehow found themselves with relatively few fiscal problems when preparing their budgets.
Impact of Taxes on State Performance Over Time
Over the years, Laffer Associates has chronicled the relationship between tax rates and economic performance at the state level. This relationship is more fully explored in our research covering the Laffer Associates State Competitive Environment model.8 Table 10 demonstrates this relationship and reflects the importance of taxation--both the level of tax rates and changes in relative competitiveness due to changes in tax rates--on economic perforance.
Combining each state's current incentive rate (the value of a dollar after passing through a state's major taxes) with the sum of each state's net legislated tax changes over the past 10 years (taken from our historical State Competitive Environment rankings) allows a composite ranking of which states have the best combination of low and/or falling taxes and which have the worst combination of high and/or rising taxes. Those states with the best combination made the top 10 of our rankings (1 = best), while those with the worst combination made the bottom 10 (50 = worst). Table 10 shows how the "10 Best States" and the "10 Worst States" have fared over the past 10 years in terms of income growth, employment growth, unemployment, and population growth. The 10 best states have outperformed the bottom 10 states in each category examined.
For all the brouhaha surrounding the Maastricht Treaty, budget deficits, and the like, it is revealing--to say the least--that G-12 countries with the highest tax rates have as many, if not more, fiscal problems (deficits) than the countries with lower tax rates (See Figure 7). While not shown here, examples such as Ireland (where tax rates were dramatically lowered and yet the budget moved into huge surplus) are fairly commonplace. Also not shown here, yet probably true, is that countries with the highest tax rates probably also have the highest unemployment rates. High tax rates certainly do not guarantee fiscal solvency.
Tax Trends in Other Countries: The Flat-Tax Fever
For many years, I have lobbied for implementing a flat tax, not only in California, but also for the entire U.S. Hong Kong adopted a flat tax ages ago and has performed like gangbusters ever since. Seeing a flat-tax fever seemingly infect Europe in recent years is truly exciting. In 1994, Estonia became the first European country to adopt a flat tax, and its 26 percent flat tax dramatically energized what had been a faltering economy. Before adopting the flat tax, Estonia had an impoverished economy that was literally shrinking--making the gains following the flat tax implementation even more impressive. In the eight years after 1994, Estonia sustained real economic growth averaging 5.2 percent per year.
Latvia followed Estonia's lead one year later with a 25 percent flat tax. In the five years before adopting the flat tax, Latvia's real GDP had shrunk by more than 50 percent. In the five years after adopting the flat tax, Latvia's real GDP has grown at an average annual rate of 3.8 percent (See Figure 8). Lithuania has followed with a 33 percent flat tax and has experienced similar positive results.
Russia has become one of the latest Eastern Bloc countries to institute a flat tax. Since the advent of the 13 percent flat personal tax (on January 1, 2001) and the 24 percent corporate tax (on January 1, 2002), the Russian economy has had amazing results. Tax revenue in Russia has increased dramatically (See Figure 9). The new Russian system is simple, fair, and much more rational and effective than what they previously used. An individual whose income is from wages only does not have to file an annual return. The employer deducts the tax from the employee's paycheck and transfers it to the Tax Authority every month.
Due largely to Russia's and other Eastern European countries' successes with flat tax reform, Ukraine and the Slovak Republic implemented their own 13 percent and 19 percent flat taxes, respectively, on January 1, 2004.
Arthur B. Laffer is the founder and chairman of Laffer Associates, an economic research and consulting firm. This paper was written and originally published by Laffer Associates. The author thanks Bruce Bartlett, whose paper "The Impact of Federal Tax Cuts on Growth" provided inspiration.
1. Jude Wanniski, "Taxes, Revenues, and the `Laffer Curve,'" The Public Interest, Winter 1978.
2. John Maynard Keynes, The Collected Writings of John Maynard Keynes (London: Macmillan, Cambridge University Press, 1972).
3. The White House, Economic Report of the President, January 1963.
4. Walter Heller, testimony before the Joint Economic Committee, U.S. Congress, 1977, quoted in Bruce Bartlett, The National Review, October 27, 1978.
5. Laffer Associates' most recent research paper covering this topic is Arthur B. Laffer and Jeffrey Thomson, "The Only Answer: A California Flat Tax," Laffer Associates, October 2, 2003.
6. For our purposes here, we have arrived at the value of an after-tax dollar using the following weighting method: 80 percent--value of a dollar after passing through the personal tax channel (personal and sales taxes) 20 percent--value of a dollar after passing through the corporate tax channel (corporate, personal, and sales taxes). Alaska is excluded from consideration due to the state's unique tax system and heavy reliance on severance taxes.
7. U.S. Census Bureau, "State Government Tax Collections Report," 2002.
8. See Arthur B. Laffer and Jeffrey Thomson, "The 2003 Laffer State Competitive Environment," Laffer Associates, January 31, 2003, and previous editions.
Biden’s Pandemic Relief Bill Is One of The Biggest One Year Tax Cuts in Modern US History
Talk about playing against type: The tax cuts in President Biden’s American Rescue Plan (ARP) are among the biggest one-year tax reductions in modern US history. The bill passed by Congress last week would reduce taxes by nearly $500 billion in fiscal year 2021 alone, according to the congressional Joint Committee on Taxation. That’s roughly equal to 2.25 percent of Gross Domestic Product (GDP).
As a share of the economy, the Biden tax cuts are 70 percent larger than the tax reductions in any single year of the 2017 Tax Cuts and Jobs Act (TCJA), a tax cut that President Trump falsely and repeatedly touted as the biggest ever. The ARP tax reductions are larger than in the first year of President’s Reagan’s 1981 Economic Recovery Tax Act (ERTA).
The only tax cuts that were bigger, on an annual basis, were those in 1945 and 2010—also proposed by Democratic presidents. Most of my historical revenue comparisons are based on a paper by then-Treasury career staffer Jerry Tempalski.
No doubt, these historical assessments get complicated. Some insist that many of the ARP tax cuts are not tax cuts at all, but rather government transfer payments that happen to be administered through the tax code. And there is the matter of timing. For example, most of the roughly $500 billion in ARP tax cuts were for only one year, with nearly all revenue effects spread over fiscal years 2021 and 2022. By contrast, the TCJA had more staying power. It was designed to cut taxes by about $1.5 trillion over 10 years (eight years for the individual tax cuts that are due to expire in 2025).
Reagan’s 1981 tax cuts would have been bigger as a share of GDP on an average annual basis than Biden’s, except that Congress ended up offsetting many of them with tax increases in 1982 and 1983.
But beyond quibbling about some of the historical tax cuts, it is instructive to think about what Biden and congressional Democrats have done. The party that stereotypically favors tax increases has instead approved a massive tax cut—aimed largely at low- and moderate-income households. And it did it without a single vote from Republicans, the party usually closely associated with tax cutting.
And the fiscal impact will be significant. In 2020, even before the latest round of tax cuts, the federal government collected only about 16.3 percent of GDP in taxes, among the lowest shares since the 1970s. The tax cuts in the ARP will bring down to about 14 percent, a level not seen since 1950.
More importantly, Democrats have made no secret of their enthusiasm for making permanent many of the temporary tax changes in the ARP. Not the Economic Impact Payments, of course. Assuming widespread vaccines really do break the back of the pandemic we likely have seen the last of those for a while.
But expansions of the Child Tax Credit, the earned income tax credit (EITC), the child and dependent care tax credit (CDCTC), along with bigger tax subsidies for people who buy insurance on the Affordable Care Act health exchanges would collectively reduce taxes by more than $125 billion in fiscal 2022, according to JCT. As a result, extending those provisions alone would approach the 10-year size of the TCJA.
Of course, nothing about the future is certain. Congress may not extend the more generous refundable credits, though history suggests it will. It may offset some of March’s tax cuts with future tax increases—indeed Biden wants it to.
And economic reality often intervenes even when tax law does not change. For example, the Joint Committee on Taxation estimated that TCJA would cut taxes by about $217 billion in fiscal year 2021. As a result of the pandemic, it almost certainly did not, though we never will know what would have happened absent COVID-19.
Some surely will dispute either Tempalski’s numbers or mine. But the point remains: At the urging of a Democratic president, a Democratic Congress has enacted an historically huge, though time-limited, tax cut. And if Biden and congressional Democrats get their way, it could continue for some time to come.