Ronald Reagan signed the first of two famous tax cuts on August 13, 1981. A few months later, one of his senior advisors gave an interview to the Atlantic Monthly where he revealed that the administration really didn’t care about cutting most people’s taxes. The tax cuts that affected most Americans, he explained, were “a Trojan horse to bring down the top rate” for the rich.
The Trojan horse was the giant wooden gift that the city of Troy received from the Greeks, only to find that Greek soldiers poured out of the horse once they were inside the city. In the Reagan administration’s metaphor, the “Greeks” were tax cuts for the rich, and the unwitting city of Troy was, well, the rest of us.
But it came at a price.
In the three decades preceding Reagan, the bottom 90 percent of Americans enjoyed a 75 percent increase in their inflation-adjusted incomes. In the three decades after Reagan, these same Americans enjoyed only 1 percent income growth, while the richest 1 percent saw their incomes grow by over 100 percent.
It wasn’t supposed to be this way. According to Reagan and his team, lower taxes were supposed to encourage the rich to work harder and invest more, thus benefitting the rest of us. If they know that less of their income will go to the IRS, the theory went, they have a greater incentive to work more hours. All of a sudden, each hour becomes more valuable to them. Economists call this the “substitution effect” because they substitute work time for leisure time.
But lower taxes also have an “income effect.” Because the IRS takes less from each paycheck, the rich can achieve a high income faster and therefore work less.
Even if the substitution effect outweighs the income effect, the rich won’t necessarily invest that money in productive American industries. They could invest it abroad – which they did, especially in Asia. Or they could invest it in ways that only benefit the rich – which they did, on Wall Street. Or they could invest it in ways that harm the economy – which they did, again on Wall Street. Or they could stockpile it for a rainy day – which they did, in corporations all across America.
So there were plenty of reasons to believe that “trickle-down economics” would not trickle down.
And it didn’t. When Reagan authorized the tax cut, 7.4 percent of the workforce was unemployed. Over the next sixteen months, it rose to 10.8 percent.
The weak economy plus the tax cuts took a bite out of tax revenue. In an effort to reduce the budget deficit, Reagan signed a tax increase in late 1982. The following year, the economy grew 4.5 percent, the stock market rose 35 percent, and unemployment fell to 8.1 percent.
Clearly the tax cuts didn’t stimulate the economy, but even after the 1982 increase, tax rates were still lower than they’d been before 1981. If Reaganomics had worked, the business cycle from 1979 to 1989 should have experienced much faster growth than, say, the business cycle from 1973 to 1979. And yet, both cycles had the same annual growth rate: 3 percent.
History has repeatedly demolished the case for this Trojan horse.
When the top marginal tax rate was 75-80 percent, the economy grew over 4.5 percent per year. When it was 50-75 percent, the economy grew 3.5 percent. When it was 35 percent, the economy grew less than 2 percent.
When the top rate was 69-80 percent, jobs increased 2.5 percent per year. When it was 50 percent, they increased 2 percent. When it was 35 percent, zero net job growth.
The tax cuts that George W. Bush signed in 2001 and 2003 were the ultimate Trojan horse. They boosted after-tax income for the middle class by 2.3 percent, but that pales in comparison to the 7.5 percent increase enjoyed by households with incomes over $1 million. In 2007, the average middle-class American paid 23.4 percent of their income to the IRS, while the richest 400 Americans paid an average of 18.7 percent in taxes. The Greeks have left the horse and taken over the city.
This time, the results were even worse. If trickle-down economics worked, the economic expansion from 2001 to 2007 should have towered over previous expansions, especially ones like the 1990s when Congress raised taxes twice. Instead, the post-2001 expansion ranked below average by every major measure: GDP growth, consumption, investment, net worth, wages and salaries, and employment. In the 2000s, the economy grew slower than during any previous decade or half-decade since the Great Depression.
The 2001-2007 expansion was so bad that the percent of the population employed actually declined while the economy was getting bigger. In 2001, 64 percent of the population had a job, down to 63 percent in 2007. Today, it hovers below 59 percent.
It was also the first post-WWII expansion in which household income declined. Poverty increased more than it had during any previous expansion. (During most expansions, poverty actually decreases.) And investment grew slower than it had in the 1990s after two tax increases.
In fact, the 1990s defied everything Reaganomics predicted. Unemployment fell to the lowest it had been since 1969, without generating inflation. Productivity growth exceeded the Reagan era, as well as the preceding decade. And, of course, the budget deficit turned into a surplus.
The Bush tax cuts eviscerated that surplus. Federal tax revenue, relative to the size of the economy, is now lower than it’s been anytime since the 1940s. The United States ranks near the bottom of the industrialized world in tax revenue. The average federal income tax rate for a middle-class household is the lowest it’s been in five decades — and it should stay that way. But there is no economic justification for cutting government spending that affects millions of Americans while cutting taxes for the rich. Without the Bush tax cuts, the current budget deficit would be almost 25 percent smaller.
In 2010, President Obama proposed eliminating the Bush tax cuts only for individuals with incomes above $200,000 and households with incomes above $250,000. In 2012, Congress should do exactly that: Keep the horse. Ditch the Greeks.
An abbreviated version of this post appeared in the South Florida Sun-Sentinel yesterday. My editor has asked me to write a new feature, where I debate Professor Chandra Mishra of Florida Atlantic University. Our first debate answers the question, “Should Congress let the Bush tax cuts expire in December 2012, as scheduled?”
In the abbreviated version, I made one mistake: At the end, I said, “Ditch the Trojans.” I should have said, “Ditch the Greeks.” In the metaphor, the “Greeks” are the tax cuts for the rich that Bush “snuck in.” The correct version appears above.