Supply-Side Amnesia

BERKELEY – In the spring of 1980, Harvard University economist Martin Feldstein taught (alongside Olivier Blanchard) one of the best macroeconomics classes I ever took. Two and a half years later, Feldstein joined US President Ronald Reagan’s cabinet, where he chaired the Council of Economic Advisers until July 1984.

While in the White House, Feldstein waged a persuasive but lonely bureaucratic campaign against the Reagan administration’s 1981 income-tax cuts, arguing that they had been too big, and would prove economically painful if not corrected.

Feldstein’s position was not popular among other Reaganites. Rather than heed his warnings, Reagan’s chief of staff, James Baker, convinced others in the administration to stay the course, so that they would not have to admit that the president’s signature tax-cutting initiative had been a mistake.

Baker and his cohort won the political debate. The Reagan tax cuts remained in place, and created a federal budget deficit that would not be tamed until President Bill Clinton started to bring spending and revenues back into line in 1993. Clinton accomplished this feat despite unanimous objections from every Republican in the US Congress.

The Reagan-era deficits helped the US economy recover from the 1981-82 recession. But after 1984, growth slowed, because resources that should have been allocated for investment were instead spent on consumption, particularly among higher-income earners.

Ultimately, the Reagan tax cuts hammered manufacturing in the Midwest, creating what is now known as the “Rust Belt.” As it happened, this is precisely what Feldstein had warned about. He had argued that prevailing economic conditions implied that wider budget deficits would result in higher interest rates and a stronger dollar, making it harder for US manufacturers to compete with imports.

I believe that if Feldstein’s warning had been heeded in 1982-84, America would be stronger and happier today. I was thus dismayed at his recent expression of optimism that under today’s Republican-led Congress, “a tax reform serving to increase capital formation and growth will be enacted,” while arguing that “any resulting increase in the budget deficit will be only temporary.”

I would respond to Feldstein with three questions. First, when in recent memory has a Republican-sponsored tax cut not created a deficit? Second, when have those deficits been “temporary,” apart from the occasions when later Democratic administrations reduced them by reversing the underlying tax cuts (as Clinton did after Reagan, and Barack Obama did after George W. Bush)? And, finally, when have investments stemming from Republican tax cuts ever raised more in national savings than has been depleted by the ensuing budget deficits?

The answer to all three questions is simple: never.

A pro-growth, revenue-neutral tax-reform package might be possible in the United States if it were designed by a bipartisan group of centrists, which is what happened with the Tax Reform Act of 1986. Such a bill today would need to promise lower tax rates for those who are heavily taxed, and only limited tax increases for those who are lightly taxed. And any changes made would need to translate into relatively large growth benefits.

Unfortunately, the tax-reform effort currently underway in the US is not backed by a group of bipartisan centrists, but by right-wing Republicans who believe that taxes are an affront to billionaires’ liberties. Rather than starting from the center and making appeals to both sides, congressional Republicans are starting from the right and feinting toward the center. At the end of the day, cutting taxes for the wealthy is their top priority, regardless of whether such cuts lead to more domestic investment.

Feldstein’s language in describing the current Republican tax-reform effort is telling. “The House Republican plan would cut the top tax rate back to 30% or lower,” he writes, before listing a few “mights”: the bill “might…eliminate the estate tax”; and it “might eliminate tax deductions for state and local taxes, and tax some of the fringe benefits that are currently excluded from taxable income.” Further down, he claims that the bill “would reduce [the corporate-tax] rate to 25% or less,” which, he asserts, is “likely to boost domestic corporate investment.”

But whether the Republican plan “would” do something depends largely on those “mights.” The bill might yield a net benefit for all or most Americans, or it might be a handout to the super-wealthy. Given that the effort is being led by hard-right Republicans who care more about cutting taxes than holding down deficits, my bet is on the latter outcome – the one Feldstein warned about in the early 1980s.

J. Bradford DeLong, a former deputy assistant US Treasury secretary, is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. 

By J. Bradford DeLong

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