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“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.
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