When Ideology and Tax Cuts Mix, the Economy Loses

June 28 (Bloomberg) -- One of the most important findings in my book “The President as Economist” is that ideology and good economic policy don’t mix, except by accident. Nowhere is this more evident than in tax policy.

The book examines several major tax cuts by postwar presidents and finds that prevailing economic conditions are a crucial determinant of whether a tax cut is effective. The design and magnitude of the cut also must conform to the economic conditions of the time.

I analyze the Kennedy-Johnson tax cut of 1964, the Reagan tax cut of 1981 and the George W. Bush tax cut of 2001. The comparisons show that an ideological approach, without regard to the country’s broader economic circumstances, can be costly.

When President John F. Kennedy assumed office in 1961, the economy was experiencing frequent downturns -- 1954, 1958 and 1960 were all recessionary years. Marginal tax rates were also extraordinarily high, topping out at 91 percent. Rarely did anyone pay such a rate, however, as tax revenue relative to gross domestic product vividly shows: Presidents Dwight D. Eisenhower and Harry Truman recorded the fourth- and second-lowest ratios of the 12 postwar presidents.

Little Downside

The Kennedy-proposed tax cut, signed by President Lyndon B. Johnson in February 1964, reduced the top rate to 77 percent and dropped it further to 70 percent in 1965. Corporate income tax rates fell to 22 percent on the first $25,000 of taxable income and to 48 percent on the remainder.

The major economic indicators suggest that the Kennedy-Johnson tax cut was effective, with little apparent downside. The frequent recessions disappeared (at least until 1970). The lower tax rates seem to have helped stimulate growth, which averaged about 4.5 percent for the next six years. The tax cuts also didn’t hurt the debt-to-GDP ratio, which fell to 37.6 percent in 1970 from 49.3 percent in 1964.

The context for President Ronald Reagan’s tax cut was the stagflationary economy he inherited from President Jimmy Carter. During the Carter administration, taxpayers were pushed into higher tax brackets, not because their real incomes had increased but because of inflation. Such “bracket creep” occurred without Congress voting to raise taxes and without any real increase in incomes.

Reagan set out to correct this. His 1981 tax cut took effect over three years, with rate reductions of 10 percent in each of the first two years and 5 percent in the third year. The top rate of 70 percent ultimately was lowered to 50 percent.

After the first year of the tax cut, 1982, the economy fell into a deep recession, with GDP dropping 1.9 percent and unemployment averaging 9.7 percent. At the same time, Federal Reserve Chairman Paul Volcker’s anti-inflationary monetary policy -- basically, high interest rates -- had a depressing effect on the economy. By 1984, the reduction of inflation and the full effect of the tax cuts had produced a GDP growth rate of 7.2 percent.

Growth continued at rates between 3 percent and 4 percent from 1985 to 1989. So there seems to have been a good growth response to both the tax cut and the reduction of inflation, which fell to 4.8 percent in 1989 from an average of 10.3 percent in 1981. But there was a serious fiscal downside. Despite the GDP growth, the debt kept climbing. From 1981 to 1989, the debt-to-GDP ratio increased every year, to 53.1 percent of GDP from 32.5 percent.

Too Generous

The conclusion: Although economic conditions were conducive to a tax cut, it was too generous. Even when the economy was growing robustly, high deficits persisted and the national debt increased.

By 2001, as George W. Bush took office, the expansion under President Bill Clinton was slowing; GDP growth was a sluggish 1.1 percent. At the same time, the debt-to-GDP ratio was steadily declining, to 56.4 percent in 2001 from 67.1 percent in 1995. Unemployment stood at 4.7 percent.

The economic case for tax cuts, therefore, wasn’t overly compelling. The national debt was still high, albeit going in the right direction. The economy was at near-full employment. In only one year, 2001, was growth below par, while four previous years showed growth rates in excess of 4 percent.

Still, Bush insisted that Americans were being “overcharged” and that tax cuts were needed. The Economic Growth and Tax Relief Reconciliation Act of 2001 lowered the existing 15 percent bracket to a new 10 percent bracket and reduced others, including the top bracket, by 2006. It increased the estate-tax exemption, phasing it out completely by 2010. The tax cut’s design favored the wealthiest taxpayers, even though it rebated $300 to individuals, $500 to single parents and $600 to married couples.

Presumably the Bush tax cuts were meant to reignite growth without harming the U.S. fiscal position or employment. Although other factors contributed to what followed, including a housing bubble that burst in spectacular fashion, growth averaged about 2.7 percent from 2002 to 2006 before collapsing from 2007 to 2009. The bias of the tax cut toward the wealthy -- unlike middle-class taxpayers, they tend not to spend tax-cut proceeds -- may explain the modest growth response.

The fiscal deterioration was dramatic: A $128 billion surplus in 2001 turned into a $157 billion deficit the next year. The shortfall grew to $378 billion in 2003 and then to $412 billion in 2004. Deficits then declined the next three years before soaring again in 2008 and 2009. The debt-to-GDP ratio, however, continued upward every year of Bush’s presidency, to 85.2 percent in 2009 from 56.4 percent in 2001.

These examples show that if the context is right and the tax cut is appropriately designed (Kennedy-Johnson), it will yield good results. If the context is right, but the tax cut isn’t well-calibrated (Reagan), the results will be mixed. If the economic context and the design aren’t right (Bush), a tax cut can be disastrous.

(Richard J. Carroll is an economist at the World Bank. This article, the third of three, is based on his new book, “The President as Economist: Scoring Economic Performance From Harry Truman to Barack Obama,” published in June by Praeger. Read Part 1 and Part 2. The opinions expressed are his own.)

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