There has never been agreement about what should be done to solve the ballooning U.S. debt problem. On one side are those who believe higher tax rates are required to bring in desperately needed revenue. On the other side are those who believe that raising taxes is a bad idea, especially during a recession, and that lower tax rates increase revenues by stimulating the economy. To gain some historical perspective, here’s a look at some of the key tax policies that have made headlines over the past three decades.
Key Takeaways
- Economists and government officials often debate the economic benefits of higher versus lower tax rates.
- President Ronald Reagan’s tax policies were based on supply-side or trickle-down economics, which focused on reducing tax rates for upper-income taxpayers.
- Under President Bill Clinton, the top income tax rate was increased to 36%, some itemized deductions and exemptions were phased out, and the corporate tax rate was raised to 35%.
- While President Obama pushed for higher taxes on the wealthy to decrease the federal deficit, President Trump focused his efforts on across-the-board tax decreases, a good portion of which benefitted upper-income taxpayers.
“Reaganomics”
When he ran for president in 1980, Ronald Reagan blamed the nation’s economic ills on big government and oppressive taxes. He said that the way to promote economic growth was to gradually reduce taxes by 30% over three years, concentrating most of it in the higher income brackets. It was known as “supply-side” or “trickle-down” economics, but the media dubbed it “Reaganomics.”
The theory was that upper-income taxpayers would then spend more and invest in businesses, driving economic expansion and job growth. Reagan also believed that, over time, lower rates would translate into higher revenue because more jobs mean more taxpayers. He essentially put into practice the economic theories of Arthur Laffer, who summarized the hypothesis in a graph known as the “Laffer Curve.” Congress hedged its bet by agreeing to a 25% overall rate cut in late 1981, and later, indexed rates for inflation in 1985.
Initially, inflation was reignited and the Federal Reserve hiked interest rates. This caused a recession that lasted for about two years. But once inflation was brought under control, the economy began to grow rapidly and 16.5 million jobs were created during Reagan’s two terms.
Reagan wanted to offset increased defense spending with reductions to entitlement programs, but that never happened. As a result, the national debt nearly tripled during his two terms, from about $998 million at the end of Carter’s last budget to $2.7 trillion.
So, while gross domestic product (GDP) rose approximately 34% during Reagan’s presidency, it’s impossible to determine how much of that growth was due to tax cuts versus deficit spending.
Clinton Years
President Bill Clinton’s tax policies provided insight into the impact of both tax increases and decreases. The Omnibus Budget Reconciliation Act was passed in 1993 and it included a series of tax increases. It hiked the top income tax rate to 36%, with an additional surcharge of 10% for the highest earners. It removed the income cap on Medicare taxes, phased out certain itemized deductions and exemptions, increased the taxable amount of Social Security, and raised the corporate rate to 35%.
During Clinton’s presidency, the economy added approximately 18.6 million jobs. The stock market went on a bull run, as the S&P 500 index rose approximately 210%.
Taxpayer Relief Act
When the Newt Gingrich-led Republicans wrested control of the House of Representatives in 1994, they ran on a platform known as the Contract with America. The provisions included commitments to reduce taxes, shrink the federal government, and reform the welfare system. By 1997, unemployment had dropped to 5.3% and the Republicans passed the Taxpayer Relief Act. Clinton resisted the bill at first but ultimately signed it.
This act reduced the top capital gains rate from 28% to 20%, instituted a $500 child tax credit, exempted a married couple from $500,000 of capital gains on the sale of a primary residence, and raised the estate tax exemption from $600,000 to $1 million. It also created Roth IRAs and education IRAs and raised the income limits for deductible IRAs.
While some economists believe that the tax cuts were better medicine for the economy, the second term for the Clinton administration had the benefit of the technology boom that produced the computer and Internet revolutions. Many of the high-tech jobs created by that boom were lost when the Nasdaq cratered after Clinton left office, bottoming out in Oct. 2002.
The Bottom Line
One interesting data point is the relative stability of tax revenue as a percentage of GDP, regardless of the existing tax policies over time. According to the World Bank, during the period 1981 to 2000, which encompassed both Reagan and Clinton, the tax revenue as a percentage of U.S. GDP hit a low of 9.9% and a high of 12.9%. This indicates that the best way to jump-start revenues is to grow the economy through stimulative tax policies.
President Barack Obama consistently pushed for higher taxes on the rich to help reduce the deficit. Later, President Donald Trump got a substantial tax decrease across the board, with the bulk of the cuts benefitting upper-income taxpayers.
Nevertheless, the debate continues on whether or not higher rates actually result in more tax revenues. The problem is that changes in tax rates can’t be analyzed in a static environment, although that’s how politicians tend to view them. The fact is that changes in rates alter behavior and most taxpayers will do whatever it takes to minimize their tax burden.
It’s easy to find evidence supporting contrary positions, but there’s a problem when analyzing historical data. We’ll never know what would have happened if the opposing position had been implemented during the same time frame and under the same conditions. The debate, no doubt, will continue.