Tax Cuts Did Not Cause the Reagan Deficits

Tax Cuts Did Not Cause the Reagan Deficits

Authored by: Matt Palumbo

There’s no denying that in economic terms, the Reagan years were nothing short of spectacular – a modern roaring 20s, thanks in large part to tax reform. But even most conservatives praising Reagan for his economic record acknowledge a fault during the Reagan years; an explosion in deficits and the national debt.

And indeed, there was plenty of debt. While Jimmy Carter’s deficits averaged $57 billion a year (or 2.4% of GDP), Reagan’s averaged $167 billion, or 4.2 percent of GDP.

By the end of his administration, Reagan had added $1.86 to the national debt, and you don’t need to take a guess at what liberals blame for the soaring deficits: tax cuts.

When you account for other variables, practically none of the Reagan deficits can be attributed to tax cuts, however.

Defense Spending and the Deficit

Democrats can blame their new-found foe for a healthy chunk of the Reagan deficits; those damned Russians. Since Reagan beefed up America’s military during the Cold War, spending was well above the baseline.

While $2.2 trillion would’ve been spent on defense during the Reagan administration had he let the budget increase according to its baseline, Reagan spent $800 billion on top of that, or $3 trillion total.

Thus, the increase in defense spending alone explains away 43 percent, or nearly half of the Reagan deficit.

Inflation and the Deficit

Unfortunately for the American taxpayer, our tax brackets are not indexed to inflation. Thus, someone who sees their income rise only proportional to inflation is actually losing money, because they’re paying more taxes on the same amount of “real” income. The government benefits from this, of course.

During the hyperinflation of the Carter years, “bracket creep” was a real problem; taxpayers being pushed into higher tax brackets due to inflation, not because they were really earning more.

The opposite happens when inflation comes crashing down. When inflation fell sharply during the Reagan years, so did tax revenue.

Because inflation plunged from 13% in 1980 to 4% by 1982, far faster than anyone had expected, nominal incomes and revenues came in lower as well. According to the American Enterprise Institute:

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%.

The Recession of 1980-82

While Paul Volcker’s Federal Reserve succeeded in reducing inflation, that isn’t to say it wasn’t harsh medicine. While hikes in interest rates will reduce inflation, they’re also contractionary in the short term for the economy. An aggressive Federal Reserve would succeed in squelching inflation – but caused a recession in the early 80s as a result.

From the beginning of 1980 to the end of 1982, the unemployment rate increased from 6 percent to 11 percent. A near doubling in the number of people unemployed means less tax revenue, and more people on the government dole. It was during this period that the federal deficit as a percent of the economy ballooned from 2 percent (in the beginning of the 80s) to 7 percent by mid-1983.

In total, the 1980-82 recession reduced federal revenue twice as much as the Joint Committee on Taxation estimated the entire Reagan tax cuts would in 1982.

Conclusion

Despite the initial adverse effects that the reduction in inflation had on tax revenues, they increased greatly under Reagan in the face of a massive reductions in rates. The entirety of the debt accrued under Reagan can be attributed to an increase in defense spending, reverse bracket creep, and an early recession caused by the Federal Reserve.

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