As the latest attempt to preserve the sovereign debt bubble resolve the debt-ceiling issue careens toward its conclusion, the pundits, experts, et al are lamenting the refusal of the Republican majority in the House of Representatives to accept tax increases as part of any debt-ceiling/deficit-reduction deal. The arguments aimed at the GOP have only two problems: history and economics.
Yes, that’s harsh, but it’s also true. Here’s why.
History: This may surprise folks, but permanent tax increases after World War II are actually less than three decades old. Much of the 1940, 1950s, 1960s, and 1970s involved tax reductions, tax shifts, and a slew of temporary tax increases. The first sturctural tax increase since FDR came from none other than Ronald Reagan in 1982. Eight years later, George H. W. Bush agreed to another one. The last of the three came courtesy of Bill Clinton in 1993 (only one, Reagan, dealt with a split Congress, the other two had Congresses wholly controlled by the Democrats).
Reagan and Bush’s tax increases are repeatedly cited as the hallmarks of bipartisanship, reason, and common sense. The deficits of the time paled in comparison to our current trillion-dollar-figures (our budget didn’t hit 1T until 1987), but they were considered big back then, and Reagan himself – followed by his VP and anointed heir – swallowed hard and accepted some tax increases in order to reduce the deficit. That’s the story everyone sees, reads, and hears.
Here’s the part they missed: within three years of each tax hike, the deficit rose to record levels. Funny how that epilogue gets cut from the story.
The 1993 tax hike, meanwhile extended the post-recession “slowth” (think what we’re experiencing now) for another three years. Only by 1996 did the economy recover to a pre-recession state. The next year, Clinton and the Republican Congress agreed to the second of four major tax cuts in thirty years (1981, 2001, and 2003 being the other thrree) and the only one to be accompanied by spending cuts. The next four years saw the only federal budget surpluses in four decades.
So how did tax increase lead to record deficits two out of three times while a tax cut preceded a surplus boomlet? That goes to the economics. First off, we need to realize the importance the economy has on tax revenue. I did a quick regression on revenue and economic growth since Fiscal Year 1983 (when Reagan’s tax hike took effect), and I found that for each % of GDP growth in Year X, revenue rose 0.38% of GDP in Year X+1. That means a policy that reduces GDP growth by a 1% would in the current economy cost Washington $759 billion in revenue over the next ten years. So clearly, the economy has a tremendous effect on the federal revenues.
The question becomes how best to go forward from there. In the Old Keynesian model, tax increases are always better than spending cuts, because the tax multiplier is by theory lower than the government spending multiplier. However, those multipliers are coming into serious question these days. Numerous economists are putting the “multiplier” at less than 1 (making it an actual divider) and some even have it at zero. Thus, spending hikes have been found to be less effective – and spending cuts less damaging – than previously believed.
Meanwhile, on the tax side of the ledger, the supply-side revolution has forced economists to see both sides of the agreggate economy (instead of relentlessly focusing on demand, as Keynesians do). Tax reductions done properly can increase capital, and thus grow the economy without inflationary pressures by increasing aggregate supply. Thus any effect on aggregate demand that comes from spending reductions is counter by demand and supply increases from the tax cuts. Thus the economy can grow while government shrinks and the budget balance is initially unaffected, and the resulting growth can lead to increased revenue.
In certain cases, that increased revenue could cover some spending increases, or even the initial lost revenue from the tax cuts (thus was born the tax-cuts-pay-for-themselves argument, which was meant only for certain tax rate reductions by themselves, but ended up being used to hide spending hikes along with tax reductions).
Unfortunately, only once was this tax-and-spending-cut model adopted: in 1997. That surpluses followed for four years should have made its superiority clear. Sadly, it did not.
In fact, the lack of spending cuts is the where history and economics come together to explain why opposing tax increases now is the right idea – the spending cuts promised in 1982 and 1990 never materialized, while the reductions for 1993 were replaced in 1995 by the Republican Congress’ own plans to balance the budget and the eventual 1997 deal.
So, to recap, tax increases have been tried three times in 30 years: twice, they led to broken spending-cut promises and record deficits, and the third set of reductions were scrapped by a new Congress (albeit in favor of other cuts). Meanwhile the tax cuts of 1981 were followed by the 1982 hike, and the 2001-3 set of reductions came with massive spending hikes that at the time were records.
The one time spending reductions without tax increases were enacted, they actually came to fruition and led to our only budget surpluses since 1970. That should be the lesson learned today. Unfortunately, it appears that, for now, only the House Republicans have learned it.
Cross-posted to Bearing Drift
Posted by D.J. McGuire 
