What Republicans Can Learn From 1986 Tax Reform

What Republicans Can Learn From 1986 Tax Reform
AP Photo/Ira Schwarz, File

The last time Congress passed major tax reform legislation, 1986, the goal was not a net tax cut. Rather, the explicit purpose was to raise the same amount of federal revenue with fewer economic distortions and greater simplicity and fairness. Congress is on its way to passing tax reform legislation that reduces total revenue by $1.4 trillion over 10 years. Based strictly on the current economic and fiscal context, the case for a net tax cut is not very strong today — just as it wasn’t in 1986.

The economy was growing rapidly in 1986, part of the recovery that followed the deep recession in 1981 and 1982. From January 1983 through December 1986, real GDP grew at an average annual rate of 5 percent. At the same time, President Reagan’s defense build-up and his signature tax cut of 1981 had pushed federal deficits to their highest levels since World War II, averaging 5.1 percent of GDP from 1983 to 1986. From 1950 through 1980, the average budget deficit was 1.2 percent of GDP.

With both large deficits and a booming economy, there was no real economic case for widening the budget deficit further in 1986. Plus, President Reagan already had gotten his tax cut in 1981. Revenue neutrality was the only thing that made sense in 1986—and it was the only way a bill was going to pass.

Though today’s economic and fiscal circumstances are different than they were in 1986, there are similarities. 

Today, the U.S. economy is also strong, even if it is not growing as rapidly as it was in 1986. The economy grew at an average annual rate of 3.l percent and 3 percent in the second and third quarters of this year, respectively. Real economic growth from 2010 through 2016 was weak compared to past expansions, averaging only 2.1 percent. And it remains to be seen whether the higher growth of 2017 will be sustained. Nevertheless, in October, the unemployment rate fell to just 4.1 percent, the lowest level in 17 years, and employment grew by 261,000 jobs. Most economists believe the U.S. is now at or very near full employment. The labor market is tight. The argument that there is still substantial slack in the U.S. economy, based on the slow recovery after the financial crash, is not terribly compelling. 

Meanwhile, the federal government’s fiscal position is even worse than it was in 1986. The reason for this is not because short-term deficits are higher but because the medium and long-term outlook is so much worse than it was 30 years ago.

In fiscal year 2017, the budget deficit was $666 billion, or 3.5 percent of GDP. That’s a sharp increase over the deficit of 2.8 percent of GDP just two years ago. The current deficit comes a short time after a massive run-up in debt during the financial crash. At the end of 2008, federal debt stood at 39 percent of GDP. At the end of 2016, federal debt had reached 77 percent of GDP. And federal debt is set to rise rapidly over the coming years, as the baby boom generation heads into retirement. The Congressional Budget Office’s most recent long-term forecast shows federal debt increasing to 102 percent of GDP in 2033 and to 150 percent of GDP in 2047.

By contrast, the tax cut now under consideration in the House is much smaller than some prior tax cuts. In 1981, the tax cut reduced federal revenue by about 2.9 percent of GDP. The House tax bill would reduce federal revenue by 0.7 percent of GDP in 2027. The legislation would increase the federal budget deficit by a total of about $1.7 trillion over the coming decade (including higher interest payments on the debt), or less than 1 percent of GDP over the period 2018 to 2027.

But what’s mainly different in 2017 compared to 1986 is the political context. President Reagan and congressional Republicans had no need in 1986 to support another tax cut. President Trump and House and Senate Republicans have a political imperative to keep their commitments to voters. They campaigned on cutting taxes, and now feel they must deliver on that promise, especially given their failure to pass health-care legislation.

The best argument for a net tax cut is that it is the only way to get an otherwise good tax reform bill through Congress. The trade-offs needed to reach neutrality might prove to be so unpopular as to make it impossible to pass a bill. And that would be a missed opportunity. Tax reform is badly needed, to clear away counterproductive provisions, broaden the base, lower rates, and encourage more investment and growth. Getting such legislation through Congress is highly valuable and shouldn’t be minimized.

The best-case scenario would be a two-step legislative process, with Congress following-up on the tax bill with another measure to lower future deficits with entitlement spending restraint. CBO projects that, under current law, the federal budget deficit will average 8.6 percent of GDP over the period 2038 to 2047; the tax bill might widen that deficit to 9.6 percent of GDP. 

If Republicans were to advance legislation to lower entitlement spending in 2040, by 2 or 3 percentage points of GDP, the net effect would be a vast improvement in the fiscal outlook, not to mention more solvent trust funds. Cutting entitlement spending by such a significant amount in 20 years would require significant reforms, such as raising the retirement ages for Social Security and Medicare, reforming disability programs to prevent abuse, and bringing more market discipline to the provision of health services. Unfortunately, there is very little prospect that this administration or Congress will push for such sensible, if controversial, changes in entitlement policy. 

Consequently, the tax bill now moving through Congress is a decidedly mixed bag. The legislation will improve the tax code, especially for corporations. And there will be an improved environment for business investment and growth. But the widening deficits caused by tax cuts are likely to precipitate a monetary response from the Federal Reserve that increases interest rates and perhaps slows growth. The end result could be much less bang for the U.S. economy than would occur if Republicans had as much zeal for cutting spending as they do for cutting taxes.

James C. Capretta is a RealClearPolicy Contributor and holds the Milton Friedman chair at the American Enterprise Institute.

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