Reaganomics Vs. Obamanomics: Fallacies Offered By The Left

By Peter Ferrara
Blogs.Forbes.com

From watching and participating in debates over the years regarding Reaganomics, patterns of logical fallacies and factual errors repeatedly arise among critics on the Left.  As the troublesome facts demonstrating the failures of Obamanomics accumulate, we find that almost religiously minded supporters of President Barack Obama can’t deal with those facts, and exhibit analogous logical fallacies.

But if we are ever to restore traditional American prosperity, we must get beyond those fallacies and errors.

Most fundamentally, many insist that they do not understand how tax rate cuts promote economic growth.  As discussed in my column last week, Reagan reduced the top marginal tax rate from 70% when he entered office, all the way down to 28%.  He cut all the other income tax rates by 25% across the board.  Then in the 1986 tax reform, he consolidated all the lower rates into a single 15% rate, effectively the income tax rate for the middle class.

The tax rate, particularly the marginal tax rate, which is the tax rate that applies to the last dollar earned, determines how much the producer is allowed to keep out of what he or she produces.  For example, at a 25% tax rate, the producer keeps three-fourths of his production.  If that rate is increased to 50%, the producer keeps only half of what he produces, reducing his reward for production and output by one-third.   Incentives are consequently slashed for productive activity, such as savings, investment, work, business expansion, business creation, job creation, and entrepreneurship.  The result is fewer jobs, lower wages, and slower economic growth, or even economic downturn.

In contrast, if the tax rate is reduced from 50% to 25%, what producers are allowed to keep from their production increases from one-half to three-fourths, increasing the reward for production and output by one half.  That sharply increases incentives for all of the above productive activities, resulting in more of them, and more jobs, higher wages, and faster economic growth.

Moreover, these incentives do not just expand or contract the economy by the amount of any tax cut or tax increase.  For example, a tax cut of $100 billion involving reduced tax rates does not just affect the economy by $100 billion.

The lower tax rates affect every dollar and every economic decision throughout the economy.  That is because every economic decision is based on the new lower tax rates.  Indeed, the new lower tax rates affect every dollar, or unit of currency, and every economic decision throughout the whole world regarding whether to invest in America, start or expand businesses here, create jobs here, even work here, because all these decisions will be based on the new lower tax rates.  Tax rate increases have just the opposite effect on every dollar and economic decision throughout the economy and the world.

In addition, marginal tax rates do not just affect the incentives of those to which the rates currently apply.  They also affect those to which the rates may apply in the future.  For example, consider a small business owner.  If he invests more capital in the business to expand production, or hires more workers to increase output, that may result in higher net taxable income.  It is the tax rate at that higher income level, not at his current income level, that will determine whether he undertakes the capital investment, or hires more workers.

These are the reasons why the dramatic reductions in tax rates under President Reagan were the central factor in creating the dramatic turnaround in the economy that grew into the astounding, historic, 25-year Reagan boom, though the change in monetary policy was critical as well.

The most intellectually coherent argument of the critics is that the Reagan boom was really just the effect of the large deficits during his years in office.  The largest of those was $221 billion in 1986.  But borrowing $200 billion out of the economy to spend $200 billion back into the economy does nothing to promote the economy on net, nor does it do anything to change the fundamental incentives that drive the economy.  That has been proven over and over, in America and around the world, for decades.  That continues to this day, for if government deficits were the key to promoting economic growth, today’s economy would be booming more than ever, with President Obama’s own 2012 budget projecting a deficit for this year of $1.65 trillion, or $1,645 billion for the numerically challenged.

The Reagan boom was extended to 25 years with the help of other rate cuts.  The Republican Congressional majorities, led by House Speaker Newt Gingrich, cut the capital gains rate by nearly 30% in 1997.  President Bush cut the Clinton era tax rates as well, with the bottom rate slashed by a third to 10%, and the top rate cut to 35%.  Bush also cut the capital gains tax rate by 25%.

Critics have the most fevered difficulties in dealing with the facts regarding the effects of these Bush tax cuts.  They quickly ended the 2001 recession, despite the contractionary economic impacts of 9/11, and the economy continued to grow for another 73 months.  After the rate cuts were all fully implemented in 2003, the economy created 7.8 million new jobs and the unemployment rate fell from over 6% to 4.4%.  Real economic growth over the next 3 years doubled from the average for the prior 3 years, to 3.5%.

In response to the rate cuts, business investment spending, which had declined for 9 straight quarters, reversed and increased 6.7% per quarter.  That is where the jobs came from.  Manufacturing output soared to its highest level in 20 years.  The stock market revived, creating almost $7 trillion in new shareholder wealth.  From 2003 to 2007, the S&P 500 almost doubled.  Capital gains tax revenues had doubled by 2005, despite the 25% rate cut! That should not have been a surprise.  Capital gains revenues rose sharply after the Gingrich capital gains cuts in 1997.

President Obama likes to pretend that a third of his trillion dollar stimulus involved tax cuts too.  But those “tax cuts” all involved temporary tax credits which are economically no different from increased government spending.  Indeed, a majority of the Obama “tax cuts” were “refundable” income tax credits, which involve sending a government check to people who do not even pay income taxes, economically indistinguishable from increased government spending.  That is why even the federal government’s own official beancounters account for such refundable credits in the federal budget as spending rather than tax cuts.  Such tax credits do not have the incentive effects of rate cuts explained above.

When President Reagan came to Washington in 1981, the top 1% of income earners paid 17.6% of all income taxes.  By 2007, after a quarter century of tax rate cuts under Reaganomics, the top 1% paid 40.4% of all income taxes, close to twice their share of income.

In part, that was because at the lower tax rates the higher income earners took so much more of their incomes in more flexible taxable income rather than in tax exempt forms.  That has been erroneously disparaged as the rich getting richer under Reaganomics, when it was just the same income in different forms.  At the lower rates, upper income earners did invest and otherwise work to earn more, which of course is exactly the desired effect of the rate cuts, and so paid higher taxes on the resulting incomes.  This is why Jack Kemp always used to say if you want to soak the rich, cut their tax rates.

Indeed, by 2007 that 40.4% of income taxes paid by the top 1% of income earners was more than the income taxes paid by the bottom 95% combined.  That is because Reagan and his Republicans cut taxes sharply for those lower income earners as well.

The origins of the Earned Income Tax Credit (EITC), which has done so much to reduce income tax liabilities for lower income people, can be found in Ronald Reagan’s famous testimony before the Senate Finance Committee in 1972, where he proposed exempting the working poor from all Social Security and income taxes as an alternative to welfare.  As President, Reagan cut federal income tax rates across the board for all taxpayers by 25%.  He also indexed the tax brackets for all taxpayers to prevent inflation from pushing workers into higher tax brackets.

In the Tax Reform Act of 1986, President Reagan reduced the federal income tax rate for middle and moderate income earners all the way down to 15%. That act also doubled the personal exemption, which benefitted the more moderate income workers the most.

Newt Gingrich’s Contract with America adopted a child tax credit of $500 per child that reduced the tax liabilities of lower income people by a higher percentage than for higher income people.  President Bush doubled that credit to $1,000 per child, and made it refundable so that low-income people who do not even pay $1,000 in federal income taxes could still get the full credit.  Of course, as explained above, those credits did not involve pro-growth incentives.  But they did reduce taxes for more moderate income workers.  Bush also adopted a new lower tax bracket for the lowest income workers of 10%, reducing their federal income tax rate by 33%.  By contrast, he cut the top rate for the highest income workers by just 11.6%, from 39.6% to 35%.

The end result of these Reagan Republican tax policies is that federal income taxes were abolished for the poor and working class, and almost abolished for the middle class.  Many conservatives do not think it was a good idea to exempt so many from paying any income taxes at all.  Nevertheless, the point is that the charge that the Republicans only cut taxes for the rich is factually groundless.

Some critics falsely argue that Reagan increased payroll taxes which are paid much more by lower and moderate income workers.  The payroll tax rate increases of the 1980s were adopted under President Carter and the Democratic Congress in 1977.  The Greenspan Commission Social Security rescue plan adopted in 1983 only advanced a couple of these already scheduled payroll tax rate increases by a year or two.  But the ultimate plan for payroll taxes is to phase them out entirely in favor of lower cost personal accounts to finance the benefits currently financed by those taxes, as discussed in previous columns in this space.

Next week I will discuss the causes of the 2008 financial crisis, and the following week I will answer the question as to what should the alternative be to Obamanomics.

Peter Ferrara is Director of Policy for the Carleson Center for Public Policy and Senior Fellow for Entitlement and Budget Policy at the Heartland Institute.  He served in the White House Office of Policy Development under President Reagan, and as Associate Deputy Attorney General of the United States under the first President Bush.  He is the author of America’s Ticking Bankruptcy Bomb, forthcoming from HarperCollins.