History lesson: Do big tax cuts pay for themselves?

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“It’s not just economic theory but economic history. … The bottom line is we will be able to fill any deficit hole with additional revenues. And we basically saw the same during the Reagan tax cut, frankly the Kennedy tax cut. You can even go back to the Coolidge tax cut. We will be able to raise more revenues.”
— Rep. Jeb Hensarling (R-Tex.),
in an interview with Bloomberg News, Nov. 30, 2017

During an interview about a proposed “trigger” to stem tax cuts if the budget deficit unexpectedly widened, Rep. Jeb Hensarling (R-Tex.) made a reference to economic history that caught The Fact Checker’s attention.

Hensarling, chairman of the House Financial Services Committee, dismissed the trigger as a “uniquely bad idea” because it would leave businesses uncertain about their tax rates. Moreover, he predicted that “we will be able to fill any deficit hole with additional revenues,” citing the tax cuts engineered by Calvin Coolidge, John F. Kennedy and Ronald Reagan. He said that if a deficit widened, it could be handled with spending cuts, but he indicated he was not worried.

“If I thought that this would exacerbate the deficit, I would not support it,” he said. But the economic growth that would be created “will be more than enough to make up the static $1.5 trillion [deficit] over 10 years that this is being estimated.”

In making this claim, Hensarling is relying on the past when the present offers little support for his position.

The Joint Tax Committee produced a “dynamic score” — taking into account expected economic growth — of the Senate tax bill and found that only $400 billion of the $1.5 trillion would be recouped. Other private forecasters generally found similar results, with all suggesting at least an increase of $1 trillion in the deficit over 10 years. A letter by top Republican-leaning economists expressed support for the tax legislation but clearly indicated economic growth would not make up the entire gap: “The increased growth, in turn, would lead to greater taxable income and federal tax revenues, which would reduce the static cost of lost federal tax revenue from the reform.”

So what does the economic history show?

The Facts

We’re going to focus mostly on the Reagan era, as that is more recent and probably more relevant. The Coolidge tax cuts were almost a century ago, when the United States was just emerging as a world power and did not have much of a welfare state. Even the Kennedy cuts came before the creation of Medicare and the expansion of Social Security, which has boosted payroll tax collections.

All three tax cuts involved significant reductions in individual income tax rates — which is not a feature of the current tax legislation, though corporate rates would be significantly reduced.

Coolidge tax cuts
These cuts were engineered by Treasury Secretary Andrew Mellon under President Warren Harding, who died in 1923, and Coolidge. The top tax rate was 77 percent (for income above $1 million) and then was sharply cut in a series of tax acts in 1921, 1924 and 1926. Eventually the top tax rate fell to 24 percent by 1929.

Veronique de Rugy, now with the Mercatus Center, says income tax revenues initially fell, in part because of a recession, but then the economy revived and revenues soared as incomes increased. (Generally, the government had budgets surpluses during the Coolidge years.)

Joe Thorndike, a tax historian and director of the Tax History Project at Tax Analysts, said that “tax cuts did seem to increase the amount of taxes collected from wealthy taxpayers, as well as their share of overall revenue. But that’s partly because those same wealthy taxpayers were reaping a large share of the benefits from all that economic growth.”

He said it’s wrong to assume, even with the growth, that the tax cuts paid for themselves: “Did the 1920s tax cuts bolster economic growth? Probably. Did that growth help defray the cost of the tax cuts? Probably. Did that growth cover the full cost of those tax cuts? No.”

As Thorndike put it: “Historically, tax cuts have tended to generate some economic growth that in turn helps cover part of the cost of the cut itself. But to my knowledge, no major tax cut has ever generated enough growth to pay for itself completely.”

Kennedy tax cuts
Kennedy proposed the tax cuts, but they were enacted into law in 1964 by Lyndon B. Johnson after Kennedy’s assassination. The tax bill reduced the top individual tax rate from 91 percent to 70 percent and cut the corporate tax rate from 52 percent to 48 percent. Note how much higher the rates were then compared to the top rates today — 39.8 percent individual and 35 percent corporate. In calling for a tax cut, Kennedy even described a top rate of 65 percent as “more sensible.”

The economy also boomed after the tax cut, but the cause and effect is disputed. When the Congressional Budget Office examined the question in 1978, it concluded that “most of this rise [in revenues] was due to economic growth that would have taken place even without the tax cut.” The tax cut reduced revenues by $12 billion on an annual basis, but CBO models indicated that only between $3 billion and $9 billion was recaptured through additional revenue.

Reagan tax cuts
Reagan inherited the 70 percent top tax rate and, through the Economic Recovery Tax Act of 1981, slashed it to 50 percent. His 1986 tax overhaul brought the top rate down to 28 percent, but we will focus on the impact of first tax cut because the second one was designed to be revenue-neutral.

A complicating factor is that although Reagan cut taxes in 1981, he also raised taxes 11 times during his presidency — including major hikes in 1982, 1983, 1984 and 1987. A Treasury Department analysis of the impact of tax bills since 1940 found that the tax increases helped make up more than half of the revenue loss in the 1981 tax cut.

This record makes it all but impossible to determine how much of the 1981 tax cut was actually recouped with revenues generated by the tax cut. But we can also look at what officials believed at the time — and it turns out that Reagan officials did not believe the tax cuts would pay for themselves.

Bruce Bartlett, a former Treasury Department official who helped craft the 1981 tax cut as a congressional aide at the time, in a 2011 article for Tax Notes reproduced the Reagan administration and CBO scores of the Reagan tax plan. Both predicted revenues would fall as a result of the tax cut. But both estimates turned out to be off the mark about the extent of the fiscal impact because the 1981-1982 recession turned out to be deeper than expected and inflation fell more rapidly than expected. That steep decline in revenues is a major reason why Reagan boosted taxes just one year after his tax cut.

“When the Reagan Administration sent its tax bill to Congress in early 1981, it did not incorporate any growth effects into its revenue estimate,” Bartlett noted. “The numbers sent to Congress assumed that it would lose 100 cents on the dollar.”

Moreover, William A. Niskanen, a member of Reagan’s Council of Economic Advisers, co-wrote a paper in 1996 that defended Reagan’s economic record but also said it was “one of the greatest enduring myths” that Reagan officials believed tax cuts would pay for themselves. “This was nonsense from day one, because the credible evidence overwhelmingly indicates that revenue feedbacks from tax cuts is 35 cents per dollar, at most,” Niskanen wrote, noting that “the Reagan administration never assumed that the tax cuts would pay for themselves.”

Reagan’s own 1990 budget, his last one, concluded that the “net effect” of 1981 tax cut was a reduction in revenue by $613 billion over five years; all but $367 billion was recouped by Reagan tax increases, the budget document said. This estimate was made in 1988, meaning it incorporated whatever growth occurred in the 1980s.

A spokeswoman for Hensarling noted that the economic growth after the three tax cuts was 3.2, 5.8, and 4.7 percent, respectively. She said the lawmaker’s remarks must be considered in full context. “There is no model that can definitively predict future events and outcomes,” she said, adding “he says if there was a deficit issue in the future, we should be looking at spending cuts rather than tax increases.”

The Pinocchio Test

There is little dispute that tax cuts will promote economic growth. But contrary to Hensarling’s claim about “economic history,” there also is little support for the idea a tax cut “will be able to fill any deficit hole with additional revenues.” Hensarling, like many Republican boosters of the tax cut, suggests a tax cut means a free lunch. But that’s simply not the case, based on the available data.

Hensarling, to his credit, acknowledges he would seek to cut spending if the deficit got too large, rather than raise taxes as Reagan did. But he should not suggest economic history provides enough evidence that such difficult choices will not be necessary. His certitude suggests Four Pinocchios, but given that history involves uncertainty and interpretation, we will keep it at Three.

Three Pinocchios

 

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