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March 10, 2016
A GOP Tax Cut in 2017? Lessons From History
by Martin A. Sullivan

Full Text Published by Tax Analysts®

This analysis first appeared in the March 7, 2016 edition of Tax Notes.

Perhaps because the 2016 primary campaign has been filled with morbidly fascinating political drama, the viability of Republican candidates' ambitious tax plans has gone largely unchallenged. Despite ever-rising deficits projected to add to a federal debt whose size was unimaginable a decade ago, Donald Trump, Florida Sen. Marco Rubio, and Texas Sen. Ted Cruz are all proposing multitrillion-dollar tax cuts.

Nobody on Capitol Hill who is familiar with fiscal policy is taking these plans seriously. But if the voting goes their way, might congressional Republicans be tempted to let themselves be swept up in the momentum of the new election triumph? Frustrated with the meager political benefits of revenue-neutral tax reform and emboldened by their newfound raw political power, could they seek to cut taxes?

History tells us that the beginning of a new presidency is a fertile time for bold new tax policies. It is interesting to note, however, that these first-year tax changes and circumstances in which they were conceived can vary substantially from one president to another. President Reagan obtained a huge supply-side tax cut. President Clinton raised taxes to reduce the deficit. George W. Bush cut taxes to absorb a surplus. President Obama cut taxes as part of a Keynesian, demand-side stimulus. Let's take a closer look and see how these historical perspectives can provide clues about the possibilities for 2017.

1981 Reagan Tax Cut

As a result of Federal Reserve efforts to combat double-digit inflation, the U.S. economy suffered a small recession at the end of the Carter administration. In January 1981 the unemployment rate was 7.5 percent, and inflation exceeded 12 percent. Because tax brackets were not indexed to inflation, the ever-rising price level was rapidly increasing federal revenue. Deficits were tolerated as being helpful stimulus.

In the Democratic-controlled Congress, Republicans Rep. Jack Kemp and Sen. William V. Roth Jr. were the leaders of the nascent supply-side movement. They proposed an across-the-board 33 percent cut in individual income tax rates, arguing that tax cuts would enlarge the economy by increasing labor supply and capital formation. At the time, the top individual rate was 70 percent. The corporate rate was 46 percent. Reagan campaigned on the promise to cut individual tax rates as proposed by Kemp and Roth. For business he vowed to increase incentives for capital formation by shortening the recovery periods for vehicles to three years, for equipment to five years, and for structures to 10 years.

Reagan's election victory over Carter was complemented by Republicans taking control of the Senate (by a 53-47 margin) and reducing the Democratic majority in the House by 34 seats. Soon after his inauguration, Reagan released a budget including his tax cuts. With optimistic assumptions about economic growth and pessimistic forecasts of inflation, the new administration projected elimination of the deficit by 1984. This was a revolutionary economic program. Previously, official Washington had been controlled by Democrats who adhered to Keynesian economic theory that stressed the usefulness of deficits for stimulated aggregate demand and employment.

After it became apparent that Southern Democrats (known as Boll Weevils) would join Republicans to approve the Reagan plan, Democrats in Congress began a bidding war. In the end, they proposed tax cuts even more expensive than the president's, but the Reagan plan prevailed. The Economic Recovery Tax Act of 1981 was signed into law on August 13, 1981.

Under the new law, individual rates were cut by 5 percent in 1982 and by 10 percent in each of the following two years. The top individual rate was reduced to 50 percent. Reagan's accelerated cost recovery system was codified, but the corporate rate remained unchanged at 46 percent. Importantly, beginning in 1985, individual tax brackets would be indexed to inflation. Approximately three-quarters of the estimated revenue loss was attributable to cuts in individual income taxes.

Almost immediately after the law's passage, the economy began a tailspin that eventually raised the unemployment rate to a postwar high of 10.8 percent in November 1982. This recession and large increases in defense spending blew any hopes of a balanced budget to shreds. In response, Congress enacted and Reagan signed into law tax increases in 1982, 1983, and 1984 that offset about half of the revenue loss from the Reagan tax cuts enacted in 1981. Nevertheless, as shown in Figure 1, between the end of 1980 and the end of 1988 the federal debt grew from 25.5 percent to 39.8 percent of GDP.

Figure 1. Historical and Projected Federal Debt Held by
the Public as a Percentage of GDP

Sources: Congressional Budget Office historical data; "The 2015 Long-Term Budget Outlook," June 16, 2015; and "The Budget and Economic Outlook: 2016 to 2026," Jan. 25, 2016. Latest projections only available through 2026; these are extrapolated by the author using the same growth from 2026 through 2036 as appears in the 2015 projections.

1993 Clinton Tax Hike

After his success in the first Iraq war, George H.W. Bush's approval rating skyrocketed to 89 percent in February 1991. For a while he seemed a shoe-in to win reelection. But a recession struck the domestic economy, and candidate Bill Clinton promised to focus on recovery "like a laser beam." (The first Clinton presidential campaign was the origin of the phrase "It's the economy, stupid.")

During the campaign, Clinton vowed to cut the deficit, raise taxes on the wealthy, and cut middle-income taxes. After his inauguration, Clinton dropped the tax cut from his economic program. Following the advice of his future Treasury secretary, Robert Rubin, Clinton gave top priority to deficit reduction. The idea was that deficit reduction would increase confidence, lower interest rates, and spur capital spending. In complete contradiction of Keynesian economics that had dominated Democratic thinking for decades, Clinton proposed tax hikes to boost the economy.

The Omnibus Budget Reconciliation Act of 1993 was signed into law by Clinton on August 10, 1993. It raised the individual tax rate to 36 percent and imposed a 10 percent surcharge to bring the top effective rate to 39.6 percent. Clinton proposed raising the corporate rate by 2 percentage points, to 36 percent, but Congress only agreed to a one-point increase. The law eliminated the income cap on the Medicare wage tax and permanently extended phaseout of personal exemptions and limits on itemized deductions. His original proposal for a broad-based energy tax was whittled down to a 4.3-cent-per-gallon tax increase.

Through the rest of the 1990s, the economy grew far beyond all expectations. From December 1992 to December 2000, the unemployment rate dropped from 7.4 percent to 4.9 percent. As a result of budget surpluses in 1998, 1999, and 2000, the federal debt as a percentage of GDP declined from 46.5 percent in December 1992 to 33.6 percent in December 2000. Clinton supporters claimed that the tough stance the president took on the deficit early in his administration was responsible, but the stock market boom fueled by new Internet technologies and rock-bottom oil prices undoubtedly played more important roles.

2001 Bush Tax Cut

In 2000 the Electoral College vote tipped in favor of George W. Bush after a razor-thin margin of victory in Florida, but there was nothing thin about the money flowing into Treasury. Federal revenue reached a postwar high of 20 percent of GDP in 2000. Two weeks after Bush took office, the Congressional Budget Office reported that the federal budget surplus would reach $281 billion (2.6 percent of GDP) in 2001 and continue growing to $889 billion (5.6 percent of GDP) in 2011. The total projected surplus for the 10-year budget window was $5.6 trillion.

As a candidate, Bush proposed large tax cuts in December 1999. Now with all this cash in the treasury and with many economists predicting a significant economic slowdown, it was an easy decision for Bush to push hard for approval of his tax plan. After some debate about the size of the tax cut, the original Bush proposal remained largely intact. There was some effort by moderate Republicans, including Treasury Secretary Paul O'Neill and Federal Reserve Chair Alan Greenspan, to add triggers that would make the continued phase-in of the cuts conditional on certain deficit targets being met, but these efforts were rebuffed. The Economic Growth and Tax Relief Reconciliation Act of 2001 was signed into law on June 7, 2001.

The estimated revenue cost of the legislation was $1.3 trillion (1 percent of GDP) over 10 years. Almost all of these tax cuts were directed to individuals. A reduction of individual tax rates, including a cut in the top rate to 35 percent, was phased in over five years ($875 billion), as was an increase in child credits ($172 billion). Saving incentives were expanded ($50 billion), and the estate tax was gradually phased out and repealed for a single year ($133 billion).

The legislation had two nagging legacies. First, by reducing regular income tax it accelerated the already expanding scope of the unindexed alternative minimum tax. Second, because it was enacted as part of budget reconciliation, it had to be scheduled to expire after 10 years.

2009 Obama Tax Cut

When President Obama was sworn into office, turmoil in the financial markets had pushed the United States into the worst recession since the Great Depression. President Bush and Congress had already put in place a tax cut designed to stimulate aggregate demand in May of 2008. Despite this, the economy shed 3.6 million jobs in 2008. It was clear to all except the most die-hard supply-siders that more stimulus was required.

Similar in many ways to Clinton in 1992, Obama campaigned on reducing the deficit, increasing taxes on the wealthy, and providing tax cuts to working families. But facing extremely different circumstances, he changed the mix of post-election priorities. Instead of giving priority to deficit reduction, Obama immediately pushed for individual tax cuts and increased spending.

With Democratic majorities in both houses of Congress, Obama signed into law the American Recovery and Reinvestment Act of 2009 on February 17, 2009, less than one month after his inauguration. This stimulus included approximately $500 billion of spending increases and $288 billion of temporary tax cuts. The two most significant components of the tax portion of the legislation were tax credits for 2009 and 2010 for low- and middle-income families, including a $400-per-person Making Work Pay tax credit, and a one-year extension of 50 percent bonus depreciation for property purchased in 2009.

Implications for 2017

According to estimates by the Urban-Brookings Tax Policy Center, the 10-year revenue loss from the Trump tax plan is $9.5 trillion (4.1 percent of GDP), the cost of the Rubio plan is $6.8 trillion (2.9 percent of GDP), and the cost of the Cruz plan is $8.7 trillion (3.8 percent of GDP). The Tax Foundation estimates are of similar orders of magnitude. Although comparisons are difficult because of differences in the timing, averaging, and phase-ins of tax cuts, it is clear that these candidates are proposing mega tax cuts of Reagan proportions (see Figure 2).

Figure 2. Revenue Effects of Major Tax Bills in First Years
of New Presidencies

Source: For 1981, 1993, and 2001 legislation, data are directly from Jerry Tempalski, "Revenue Effects of Major Tax Bills," Treasury Office of Tax Analysis working paper 81 (Sept. 2006). For 2009 legislation, revenue estimates are from the Joint Committee on Taxation, "Estimated Budget Effects of the Revenue Provisions Contained in the Conference Agreement for H.R. 1, the American Recovery and Reinvestment Tax Act of 2009," Feb. 12, 2009, JCX-19-09.

Because there is no budget surplus on the horizon, these cuts cannot be justified in the same way as the 2001 Bush plan. Nor can they be justified as Obama justified his tax cuts in 2009. Despite the lackluster rate of overall economic growth (the CBO is predicting only 2 percent annual growth for the next decade), the economy is fast approaching full employment. The current unemployment rate is 4.9 percent. There is no pressing need for demand-side stimulus.

Of the four post-inauguration episodes considered here, the fiscal and economic situation that the next president will face is most similar to that faced by Clinton in 1993. Yes, current deficits are relatively low and lower than they were in 1992. But federal finances are in a more precarious situation. The national debt as a percentage of GDP was 47 percent at the end of 1992. It is 74 percent now. The CBO expects the current deficit will double in the next 10 years despite the highly unrealistic assumption that discretionary spending (both defense and nondefense) will decline from 6.5 percent to 5.2 percent of GDP over that same period.

Given the current fiscal environment, and given the favorable economic developments that followed passage of the 1993 tax increases, a repeat of Clinton's deficit reduction program would seem to be the prudent course of action. But in 1993 Clinton just barely got approval of his plan by the slimmest of margins in both the House and Senate, and without a single Republican vote. Given the party's increasingly rightward tilt, Republicans, who will almost certainly control at least the House in 2017, are even less likely to accept a tax increase than they were in 1993.

If they win the White House, it would be stunning if Republicans did not propose a major tax cut. Given the political futility and lackluster economics of revenue-neutral reform, this will be a near-irresistible course of action. But how far can they go? Should they, like Reagan, swing for the fences and put their faith in supply-side economics? Reagan had to retreat from his antitax stance in 1982, 1983, and 1984. But would that be possible in 2018 if Grover Norquist is enforcing his no-tax-hike pledge?

More than likely, they would propose tax cuts more modest than those proposed by Reagan and more modest than they are proposing now. Those cuts cannot be too small, however. Increasing international competition means there must be business tax cuts. And if there are business cuts, politics demands that larger individual tax cuts must accompany them. If we learn anything from history, business-only tax cuts are not favored by Congress. That's because business-only tax cuts aren't favored by voters. According to a 2015 Gallup poll, 69 percent of Americans believe corporations should pay more tax. And enacting business tax cuts has probably become more difficult than in the past because of the surge in populist, anti-business sentiment among many conservatives.

If they push aggressively for tax cuts in 2017, there is a good chance Republicans in Congress will be creating a situation similar to that of Republicans in Kansas after their 2012 tax cuts. The revenue losses are real, but the hoped-for supply-side economic benefits don't materialize. This may be a risk they are willing to take, although the financial markets may not be so complacent.

The uncertainty surrounding the CBO's projections about the future of the economy and federal finances cannot be emphasized enough. Republicans could be lucky, as was Clinton in the 1990s, and we could get an unexpected spurt of economic growth. But if they are unlucky, as were both Reagan and Bush, the federal debt could reach stratospheric levels and Dick Cheney's dictum that "Reagan proved deficits don't matter" will be severely tested.

Further Reading

    Dennis S. Ippolito, Deficits, Debt, and the New Politics of Tax Policy (2012).

    Sheldon D. Pollack, The Failure of U.S. Tax Policy (1996).

    Donald T. Regan, For the Record: From Wall Street to Washington (1988).

    Paul Craig Roberts, The Supply-Side Revolution (1984).

    C. Eugene Steuerle, The Tax Decade: How Taxes Came to Dominate the Public Agenda (1992).

    C. Eugene Steuerle, Contemporary U.S. Tax Policy Paperback (2d ed. 2008).

    Ron Suskind, The Price of Loyalty: George W. Bush, the White House, and the Education of Paul O'Neill, (2004).

    Bob Woodward, The Agenda: Inside the Clinton White House (1994).

Correction, March 10, 2016: The cost of the tax plan proposed by Sen. Ted Cruz, R-Texas, is $8.7 trillion, or 3.8 percent of GDP, and not $19.5 trillion, or 8.4 percent of GDP, as was previously reported. Tax Analysts regrets the error.

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