For half a century, Keynesians have emphasized changes in tax rates and spending by government as cures for macroeconomic problems. The conventional wisdom before the Keynesian Revolution was that taxation and spending should be adjusted to balance the actual budget at all times. Then the economy would automatically adjust to a noninflationary full employment equilibrium. A problem with putting this idea into practice is that higher tax rates may yield lower tax revenues, and vice versa, because tax rate structures influence our major tax base—income. Failure to understand this led President Hoover and the Congress to raise tax rates in 1932, exacerbating the economic collapse of 1929–1933.
The Tax Increase of 1932
Keynesians and new classical economists agree that a fetish for balancing the budget was one reason why the economy, following what should have been a minor recession in 1929, continued tumbling downward until 1933. Their explanation for the intensity and duration of the Great Depression is that President Hoover and the Congress reacted to a minor recession-caused deficit (like the $50 billion for AE0 and T0 in Figure 5) by raising tax rates. This further depressed National Income and tax revenues, which resulted in attempts to balance the budget through still higher tax rates, and so on.
Figure 10 presents the actual relationships between expenditures and net tax revenues (after subtracting transfers) to real Gross Domestic Product for 1929–1933. We have superimposed curves showing government spending and taxes before and after the tax rate increase of 1932. This tax increase was designed to generate roughly one-third more revenue in fiscal 1932 than in 1931. Policymakers failed to realize how severely higher tax rates could depress GDP. (Real GDP quickly fell by roughly 20 percent.) Keynesians interpret Figure 9 as evidence that massive withdrawals of funds arising from these higher tax rates inhibited Aggregate Demand and added to the severity of the Great Depression. Some new classical economists see this as proof that, even in the 1930s, high tax rates stifled Aggregate Supply.
FIGURE 10 The Tax Increase of 1932
Actual government purchases and net taxes (taxes minus transfers) are traced from 1929 to 1933, using a Keynesian framework to scrutinize the tax hike of 1932. A modest deficit in 1931 persuaded Congress and President Hoover to increase tax rates in an attempt to balance the budget. The unfortunate result was a leftward shift in the net tax function and a decline in equilibrium income. That the budget balanced by 1933 was cold comfort.
Note: government purchases;
º taxes minus transfers.
The Tax Cut of 1964–1965
Keynesians recommend tax rate cuts or increased government purchases when a recession causes even a slight cyclical budget deficit. The idea that cutting tax rates might stimulate Aggregate Demand and National Income and tax revenues first gained wide acceptance in the 1960s. President Kennedy's economic advisors viewed the 1950s as a lethargic period hampered by high tax rates that created fiscal drag. They argued that cuts in tax rates would stimulate growth, reduce poverty and unemployment, and generate higher tax revenues.
A massive tax cut enacted during the Johnson Administration supported these predictions. Keynesian (demand-side) reasoning was used to sell these tax cuts politically, although some supply-side arguments were also used. A 1964–1965 tax cut broadly reduced tax rates. Personal income tax rates dropped from brackets of 18–91 percent to brackets of 14–70 percent. Taxes on corporate income were cut from 52 to 48 percent. The results of this experiment with broad cuts in tax rates are shown in Figure 11. The economy, and hence the tax base, expanded so rapidly that the 1964 deficit actually gave way to a small surplus in 1965. New classical economists naturally interpret this success as evidence that the economy was on the wrong side of the Laffer curve, and that tax revenue was stimulated as Aggregate Supply grew.
FIGURE 11 The 1964–1965 Tax Cut
In 1964–1965, tax rates were cut substantially, shifting the net tax schedule from T0 to T1. Income, employment, and tax revenues all rose, converting a deficit in 1964 into a small surplus in 1965.
Note: = government purchases;
º = taxes minus transfers.
These examples provide evidence that putting fiscal policy to work is more complex than our simple theory suggests. Whether changes in tax rates will reduce budget deficits depends on the state of the economy and the initial level of tax rates. The Kennedy-Johnson round of tax cuts suggests that if the economy is poised for growth, tax cuts may simultaneously stimulate growth and reduce deficits. Another possibility is that cuts in tax rates may stimulate economic growth while budget deficits explode, as President Reagan discovered in the 1980s.
Recent Budget Deficits
The American economy followed a rocky path through the 1970s, with budget deficits at new record levels almost each year. (Our most recent budget surplus was experienced in fiscal year 1968–1969.) By the 1980s, dismay about the growth of federal spending had become epidemic. President Reagan had campaigned on a platform to slash tax rates and a multitude of government programs. It proved, however, far harder to restrain spending growth than to cut tax rates. A major reason was that the Reagan administration wanted to expand military budgets and cut domestic spending, while many in Congress were determined to increase domestic spending and opposed bigger defense budgets. Both sides won on their spending priorities, but both lost in attempts to halt types of spending they opposed. Consequently, annual deficits exploded from the $80 billion range of the late 1970s into the $250 to $350 billion range in the early 1990s.
The Tax Cuts of 1981-83
During the 1970s, the supply-side wing of new classical macroeconomics gained the ears of prominent politicians who blamed Keynesian fiscal policies for rising deficits, rapid inflation, and high unemployment. President Reagan sought, and the Congress passed, a 25 percent tax cut in 1981, phased in over three years. At the same time, eligibility for transfer payments was tightened, and the growth of nonmilitary government spending was cut slightly. Advocates of these policies hoped to stimulate Aggregate Supply so much that inflation and unemployment would fall quickly. They also hoped that tax revenues would be so responsive to economic growth that budget deficits would abate.
This approach yielded income far below the optimistic predictions that had accompanied supply-side rhetoric. Restrictive monetary policy during 1981–1983 did reduce inflation, but unemployment rose and the economy only slowly recovered from the deep Recession of 1981–1983. Annual federal budget deficits seemed stuck around the $300 billion mark. Figure 12 illustrates that the 1981–1983 tax cuts may have increased the structural deficit by shifting the net tax function downward and to the right.
FIGURE 12 The 1981–1983 Tax Cuts and the Structural Deficit
Tax cuts enacted between 1981 and 1983 appear to have increased the structural deficit. Growing federal outlays coupled with a flatter net tax function (T1983-93), quickly bloated the budget deficits. Tax reform in 1986 flattened the progressivity of income tax rates, but it was "revenue neutral" and so was not intended to cure massive deficits, which are projected to persist.
(Note: = government outlays;
º = taxes minus transfers.
Deficit Reduction Plans in the 1990s
Deficits have been political issues since long before the Civil War. A "Balanced-Budget" Amendment has been in the hopper for decades. Congress passed the Gramm-Rudman Act of 1986, in hopes that a legal target date for a balanced budget would limit the growth of federal spending. However, circumstances (e.g., recession during 1990-1991 and spending on the Gulf War) activated clauses that largely rendered the law moot. Congress enacted additional "Deficit Reduction Laws" in 1990 and, again, in 1993, perhaps foreshadowing a chain of repeated attempts to legally mandate a balanced budget. Someday, one of these laws may be successful.
Despite campaign promises of "no new taxes," President Bush sharply departed from the supply-side philosophy of the 1980s, succumbing to political pressure to raise taxes in 1990. His Deficit Reduction plan was intended to reduce cumulative federal deficits by $500 billion by 1995. Higher federal taxes were levied on income, gasoline, cigarettes, alcoholic beverages, luxury goods, and airline tickets. Nevertheless, tax revenues failed to grow because of an economic slowdown—a classic example of a cyclical deficit. The deficit for 1991 was almost $350 billion—roughly $1,400 in new federal debt for every American piled up in just one year.
An eerily similar deficit reduction act was passed shortly after Bill Clinton took office. Again, tax hikes (this time, primarily in the form of higher marginal taxes for upper-income Americans) were keys to the plan, along with major cuts in defense spending. And again, the goal was to reduce the cumulative deficit by roughly $500 billion over a five year period. But unlike the blockage of President Bush's plans by the recession of 1990-1991, President Clinton's plan may prove at least partially successful if the economy continues to rebound. The lesson here may be that structural deficits (under the control of federal policy makers) and cyclical deficits (which depend on economic trends) both come into play to determine the economic health of the nation and the fortunes of politicians.
Here we examined government spending and tax policies from both Keynesian and new classical perspectives. Our stress on the differences between these schools of thought is intended to help you understand how government spending and tax policies may influence unemployment, inflation, and rates of economic growth. Keep in mind, however, that nearly all economists now agree about large parts of economic theory. For example, there is broad agreement that incentives shape economic behavior, and that both Aggregate Demand and Aggregate Supply are important. Economists also tend to agree that fiscal policy matters, and that monetary policy—the subject of the next part of this book—also matters. After you have learned more about money and monetary policy, we will re-examine in greater depth the potential problems posed by persistent deficits and a growing national debt, and the perspectives of different schools of thought on these and other macroeconomic problems.