(Part 2 of Krugman)
4. From Reaganomics to Clintonomics
Ronald Reagan put supply-side theory into practice with his 1981 tax cut. The tax cuts were modest for middle-class families but very large for the well-off. Between 1979 and 1983, according to Congressional Budget Office estimates, the average federal tax rate on the top 1 percent of families fell from 37 to 27.7 percent.
So did the tax cuts promote economic growth? You might think that all we have to do is look at how the economy performed. But it's not that simple, because different observers read different things from Reagan's economic record.
Here's how tax-cut advocates look at it: after a deep slump between 1979 and 1982, the U.S. economy began growing rapidly. Between 1982 and 1989 (the first year of the first George Bush's presidency), the economy grew at an average annual rate of 4.2 percent. That's a lot better than the growth rate of the economy in the late 1970's, and supply-siders claim that these ''Seven Fat Years'' (the title of a book by Robert L. Bartley, the longtime editor of The Wall Street Journal's editorial page) prove the success of Reagan's 1981 tax cut.
But skeptics say that rapid growth after 1982 proves nothing: a severe recession is usually followed by a period of fast growth, as unemployed workers and factories are brought back on line. The test of tax cuts as a spur to economic growth is whether they produced more than an ordinary business cycle recovery. Once the economy was back to full employment, was it bigger than you would otherwise have expected? And there Reagan fails the test: between 1979, when the big slump began, and 1989, when the economy finally achieved more or less full employment again, the growth rate was 3 percent, the same as the growth rate between the two previous business cycle peaks in 1973 and 1979. Or to put it another way, by the late 1980's the U.S. economy was about where you would have expected it to be, given the trend in the 1970's. Nothing in the data suggests a supply-side revolution.
Does this mean that the Reagan tax cuts had no effect? Of course not. Those tax cuts, combined with increased military spending, provided a good old-fashioned Keynesian boost to demand. And this boost was one factor in the rapid recovery from recession that developed at the end of 1982, though probably not as important as the rapid expansion of the money supply that began in the summer of that year. But the supposed supply-side effects are invisible in the data.
While the Reagan tax cuts didn't produce any visible supply-side gains, they did lead to large budget deficits. From the point of view of most economists, this was a bad thing. But for starve-the-beast tax-cutters, deficits are potentially a good thing, because they force the government to shrink. So did Reagan's deficits shrink the beast?
A casual glance at the data might suggest not: federal spending as a share of gross domestic product was actually slightly higher at the end of the 1980's than it was at the end of the 1970's. But that number includes both defense spending and ''entitlements,'' mainly Social Security and Medicare, whose growth is automatic unless Congress votes to cut benefits. What's left is a grab bag known as domestic discretionary spending, including everything from courts and national parks to environmental cleanups and education. And domestic discretionary spending fell from 4.5 percent of G.D.P. in 1981 to 3.2 percent in 1988.
But that's probably about as far as any president can shrink domestic discretionary spending. And because Reagan couldn't shrink the belly of the beast, entitlements, he couldn't find enough domestic spending cuts to offset his military spending increases and tax cuts. The federal budget went into persistent, alarming, deficit. In response to these deficits, George Bush the elder went back on his ''read my lips'' pledge and raised taxes. Bill Clinton raised them further. And thereby hangs a tale.
For Clinton did exactly the opposite of what supply-side economics said you should do: he raised the marginal rate on high-income taxpayers. In 1989, the top 1 percent of families paid, on average, only 28.9 percent of their income in federal taxes; by 1995, that share was up to 36.1 percent.
Conservatives confidently awaited a disaster -- but it failed to materialize. In fact, the economy grew at a reasonable pace through Clinton's first term, while the deficit and the unemployment rate went steadily down. And then the news got even better: unemployment fell to its lowest level in decades without causing inflation, while productivity growth accelerated to rates not seen since the 1960's. And the budget deficit turned into an impressive surplus.
Tax-cut advocates had claimed the Reagan years as proof of their doctrine's correctness; as we have seen, those claims wilt under close examination. But the Clinton years posed a much greater challenge: here was a president who sharply raised the marginal tax rate on high-income taxpayers, the very rate that the tax-cut movement cares most about. And instead of presiding over an economic disaster, he presided over an economic miracle.
Let's be clear: very few economists think that Clinton's policies were primarily responsible for that miracle. For the most part, the Clinton-era surge probably reflected the maturing of information technology: businesses finally figured out how to make effective use of computers, and the resulting surge in productivity drove the economy forward. But the fact that America's best growth in a generation took place after the government did exactly the opposite of what tax-cutters advocate was a body blow to their doctrine.
They tried to make the best of the situation. The good economy of the late 1990's, ardent tax-cutters insisted, was caused by the 1981 tax cut. Early in 2000, Lawrence Kudlow and Stephen Moore, prominent supply-siders, published an article titled ''It's the Reagan Economy, Stupid.''
But anyone who thought about the lags involved found this implausible -- indeed, hilarious. If the tax-cut movement attributed the booming economy of 1999 to a tax cut Reagan pushed through 18 years earlier, why didn't they attribute the economic boom of 1983 and 1984 -- Reagan's ''morning in America'' -- to whatever Lyndon Johnson was doing in 1965 and 1966?
By the end of the 1990's, in other words, supply-side economics had become something of a laughingstock, and the whole case for tax cuts as a route to economic growth was looking pretty shaky. But the tax-cut crusade was nonetheless, it turned out, poised for its biggest political victories yet. How did that happen?
5. Second Wind: The Bush Tax Cuts
As the economic success of the United States under Bill Clinton became impossible to deny, there was a gradual shift in the sales strategy for tax cuts. The supposed economic benefits of tax cuts received less emphasis; the populist rationale -- you, personally, pay too much in taxes -- was played up.
I began this article with an example of this campaign's success: the creator of Mallard Fillmore apparently believes that typical families pay twice as much in taxes as they in fact do. But the most striking example of what skillful marketing can accomplish is the campaign for repeal of the estate tax.
As demonstrated, the estate tax is a tax on the very, very well off. Yet advocates of repeal began portraying it as a terrible burden on the little guy. They renamed it the ''death tax'' and put out reports decrying its impact on struggling farmers and businessmen -- reports that never provided real-world examples because actual cases of family farms or small businesses broken up to pay estate taxes are almost impossible to find. This campaign succeeded in creating a public perception that the estate tax falls broadly on the population. Earlier this year, a poll found that 49 percent of Americans believed that most families had to pay the estate tax, while only 33 percent gave the right answer that only a few families had to pay.
Still, while an insistent marketing campaign has convinced many Americans that they are overtaxed, it hasn't succeeded in making the issue a top priority with the public. Polls consistently show that voters regard safeguarding Social Security and Medicare as much more important than tax cuts.
Nonetheless, George W. Bush has pushed through tax cuts in each year of his presidency. Why did he push for these tax cuts, and how did he get them through?
You might think that you could turn to the administration's own pronouncements to learn why it has been so determined to cut taxes. But even if you try to take the administration at its word, there's a problem: the public rationale for tax cuts has shifted repeatedly over the past three years.
During the 2000 campaign and the initial selling of the 2001 tax cut, the Bush team insisted that the federal government was running an excessive budget surplus, which should be returned to taxpayers. By the summer of 2001, as it became clear that the projected budget surpluses would not materialize, the administration shifted to touting the tax cuts as a form of demand-side economic stimulus: by putting more money in consumers' pockets, the tax cuts would stimulate spending and help pull the economy out of recession. By 2003, the rationale had changed again: the administration argued that reducing taxes on dividend income, the core of its plan, would improve incentives and hence long-run growth -- that is, it had turned to a supply-side argument.
These shifting rationales had one thing in common: none of them were credible. It was obvious to independent observers even in 2001 that the budget projections used to justify that year's tax cut exaggerated future revenues and understated future costs. It was similarly obvious that the 2001 tax cut was poorly designed as a demand stimulus. And we have already seen that the supply-side rationale for the 2003 tax cut was tested and found wanting by the Congressional Budget Office.
So what were the Bush tax cuts really about? The best answer seems to be that they were about securing a key part of the Republican base. Wealthy campaign contributors have a lot to gain from lower taxes, and since they aren't very likely to depend on Medicare, Social Security or Medicaid, they won't suffer if the beast gets starved. Equally important was the support of the party's intelligentsia, nurtured by policy centers like Heritage and professionally committed to the tax-cut crusade. The original Bush tax-cut proposal was devised in late 1999 not to win votes in the national election but to fend off a primary challenge from the supply-sider Steve Forbes, the presumptive favorite of that part of the base.
This brings us to the next question: how have these cuts been sold?
At this point, one must be blunt: the selling of the tax cuts has depended heavily on chicanery. The administration has used accounting trickery to hide the true budget impact of its proposals, and it has used misleading presentations to conceal the extent to which its tax cuts are tilted toward families with very high income.
The most important tool of accounting trickery, though not the only one, is the use of ''sunset clauses'' to understate the long-term budget impact of tax cuts. To keep the official 10-year cost of the 2001 tax cut down, the administration's Congressional allies wrote the law so that tax rates revert to their 2000 levels in 2011. But, of course, nobody expects the sunset to occur: when 2011 rolls around, Congress will be under immense pressure to extend the tax cuts.
The same strategy was used to hide the cost of the 2003 tax cut. Thanks to sunset clauses, its headline cost over the next decade was only $350 billion, but if the sunsets are canceled -- as the president proposed in a speech early this month -- the cost will be at least $800 billion.
Meanwhile, the administration has carried out a very successful campaign to portray these tax cuts as mainly aimed at middle-class families. This campaign is similar in spirit to the selling of estate-tax repeal as a populist measure, but considerably more sophisticated.
The reality is that the core measures of both the 2001 and 2003 tax cuts mainly benefit the very affluent. The centerpieces of the 2001 act were a reduction in the top income-tax rate and elimination of the estate tax -- the first, by definition, benefiting only people with high incomes; the second benefiting only heirs to large estates. The core of the 2003 tax cut was a reduction in the tax rate on dividend income. This benefit, too, is concentrated on very high-income families.
According to estimates by the Tax Policy Center -- a liberal-oriented institution, but one with a reputation for scrupulous accuracy -- the 2001 tax cut, once fully phased in, will deliver 42 percent of its benefits to the top 1 percent of the income distribution. (Roughly speaking, that means families earning more than $330,000 per year.) The 2003 tax cut delivers a somewhat smaller share to the top 1 percent, 29.1 percent, but within that concentrates its benefits on the really, really rich. Families with incomes over $1 million a year -- a mere 0.13 percent of the population -- will receive 17.3 percent of this year's tax cut, more than the total received by the bottom 70 percent of American families. Indeed, the 2003 tax cut has already proved a major boon to some of America's wealthiest people: corporations in which executives or a single family hold a large fraction of stocks are suddenly paying much bigger dividends, which are now taxed at only 15 percent no matter how high the income of their recipient.
It might seem impossible to put a populist gloss on tax cuts this skewed toward the rich, but the administration has been remarkably successful in doing just that.
One technique involves exploiting the public's lack of statistical sophistication. In the selling of the 2003 tax cut, the catch phrase used by administration spokesmen was ''92 million Americans will receive an average tax cut of $1,083.'' That sounded, and was intended to sound, as if every American family would get $1,083. Needless to say, that wasn't true.
Yet the catch phrase wasn't technically a lie: the Tax Policy Center estimates that 89 million people will receive tax cuts this year and that the total tax cut will be $99 billion, or about $1,100 for each of those 89 million people. But this calculation carefully leaves out the 50 million taxpayers who received no tax cut at all. And even among those who did get a tax cut, most got a lot less than $1,000, a number inflated by the very big tax cuts received by a few wealthy people. About half of American families received a tax cut of less than $100; the great majority, a tax cut of less than $500.
But the most original, you might say brilliant, aspect of the Bush administration's approach to tax cuts has involved the way the tax cuts themselves are structured.
David Stockman famously admitted that Reagan's middle-class tax cuts were a ''Trojan horse'' that allowed him to smuggle in what he really wanted, a cut in the top marginal rate. The Bush administration similarly follows a Trojan horse strategy, but an even cleverer one. The core measures in Bush's tax cuts benefit only the wealthy, but there are additional features that provide significant benefits to some -- but only some -- middle-class families. For example, the 2001 tax cut included a $400 child credit and also created a new 10 percent tax bracket, the so-called cutout. These measures had the effect of creating a ''sweet spot'' that could be exploited for political purposes. If a couple had multiple children, if the children were all still under 18 and if the couple's income was just high enough to allow it to take full advantage of the child credit, it could get a tax cut of as much as 4 percent of pretax income. Hence the couple with two children and an income of $40,000, receiving a tax cut of $1,600, who played such a large role in the administration's rhetoric. But while most couples have children, at any given time only a small minority of families contains two or more children under 18 -- and many of these families have income too low to take full advantage of the child tax credit. So that ''typical'' family wasn't typical at all. Last year, the actual tax break for families in the middle of the income distribution averaged $469, not $1,600.
So that's the story of the tax-cut offensive under the Bush administration: through a combination of hardball politics, deceptive budget arithmetic and systematic misrepresentation of who benefits, Bush's team has achieved a major reduction of taxes, especially for people with very high incomes.
But where does that leave the country?
6. A Planned Crisis
Right now, much of the public discussion of the Bush tax cuts focuses on their short-run impact. Critics say that the 2.7 million jobs lost since March 2001 prove that the administration's policies have failed, while the administration says that things would have been even worse without the tax cuts and that a solid recovery is just around the corner.
But this is the wrong debate. Even in the short run, the right question to ask isn't whether the tax cuts were better than nothing; they probably were. The right question is whether some other economic-stimulus plan could have achieved better results at a lower budget cost. And it is hard to deny that, on a jobs-per-dollar basis, the Bush tax cuts have been extremely ineffective. According to the Congressional Budget Office, half of this year's $400 billion budget deficit is due to Bush tax cuts. Now $200 billion is a lot of money; it is equivalent to the salaries of four million average workers. Even the administration doesn't claim its policies have created four million jobs. Surely some other policy -- aid to state and local governments, tax breaks for the poor and middle class rather than the rich, maybe even W.P.A.-style public works -- would have been more successful at getting the country back to work.
Meanwhile, the tax cuts are designed to remain in place even after the economy has recovered. Where will they leave us?
Here's the basic fact: partly, though not entirely, as a result of the tax cuts of the last three years, the government of the United States faces a fundamental fiscal shortfall. That is, the revenue it collects falls well short of the sums it needs to pay for existing programs. Even the U.S. government must, eventually, pay its bills, so something will have to give.
The numbers tell the tale. This year and next, the federal government will run budget deficits of more than $400 billion. Deficits may fall a bit, at least as a share of gross domestic product, when the economy recovers. But the relief will be modest and temporary. As Peter Fisher, under secretary of the treasury for domestic finance, puts it, the federal government is ''a gigantic insurance company with a sideline business in defense and homeland security.'' And about a decade from now, this insurance company's policyholders will begin making a lot of claims. As the baby boomers retire, spending on Social Security benefits and Medicare will steadily rise, as will spending on Medicaid (because of rising medical costs). Eventually, unless there are sharp cuts in benefits, these three programs alone will consume a larger share of G.D.P. than the federal government currently collects in taxes.
Alan Auerbach, William Gale and Peter Orszag, fiscal experts at the Brookings Institution, have estimated the size of the ''fiscal gap'' -- the increase in revenues or reduction in spending that would be needed to make the nation's finances sustainable in the long run. If you define the long run as 75 years, this gap turns out to be 4.5 percent of G.D.P. Or to put it another way, the gap is equal to 30 percent of what the federal government spends on all domestic programs. Of that gap, about 60 percent is the result of the Bush tax cuts. We would have faced a serious fiscal problem even if those tax cuts had never happened. But we face a much nastier problem now that they are in place. And more broadly, the tax-cut crusade will make it very hard for any future politicians to raise taxes.
So how will this gap be closed? The crucial point is that it cannot be closed without either fundamentally redefining the role of government or sharply raising taxes.
Politicians will, of course, promise to eliminate wasteful spending. But take out Social Security, Medicare, defense, Medicaid, government pensions, homeland security, interest on the public debt and veterans' benefits -- none of them what people who complain about waste usually have in mind -- and you are left with spending equal to about 3 percent of gross domestic product. And most of that goes for courts, highways, education and other useful things. Any savings from elimination of waste and fraud will amount to little more than a rounding-off error.
So let's put a few things back on the table. Let's assume that interest on the public debt will be paid, that spending on defense and homeland security will not be compromised and that the regular operations of government will continue to be financed. What we are left with, then, are the New Deal and Great Society programs: Social Security, Medicare, Medicaid and unemployment insurance. And to close the fiscal gap, spending on these programs would have to be cut by around 40 percent.
It's impossible to know how such spending cuts might unfold, but cuts of that magnitude would require drastic changes in the system. It goes almost without saying that the age at which Americans become eligible for retirement benefits would rise, that Social Security payments would fall sharply compared with average incomes, that Medicare patients would be forced to pay much more of their expenses out of pocket -- or do without. And that would be only a start.
All this sounds politically impossible. In fact, politicians of both parties have been scrambling to expand, not reduce, Medicare benefits by adding prescription drug coverage. It's hard to imagine a situation under which the entitlement programs would be rolled back sufficiently to close the fiscal gap.
Yet closing the fiscal gap by raising taxes would mean rolling back all of the Bush tax cuts, and then some. And that also sounds politically impossible.
For the time being, there is a third alternative: borrow the difference between what we insist on spending and what we're willing to collect in taxes. That works as long as lenders believe that someday, somehow, we're going to get our fiscal act together. But this can't go on indefinitely. Eventually -- I think within a decade, though not everyone agrees -- the bond market will tell us that we have to make a choice.
In short, everything is going according to plan.
For the looming fiscal crisis doesn't represent a defeat for the leaders of the tax-cut crusade or a miscalculation on their part. Some supporters of President Bush may have really believed that his tax cuts were consistent with his promises to protect Social Security and expand Medicare; some people may still believe that the wondrous supply-side effects of tax cuts will make the budget deficit disappear. But for starve-the-beast tax-cutters, the coming crunch is exactly what they had in mind.
7. What Kind of Country?
The astonishing political success of the antitax crusade has, more or less deliberately, set the United States up for a fiscal crisis. How we respond to that crisis will determine what kind of country we become.
If Grover Norquist is right -- and he has been right about a lot -- the coming crisis will allow conservatives to move the nation a long way back toward the kind of limited government we had before Franklin Roosevelt. Lack of revenue, he says, will make it possible for conservative politicians -- in the name of fiscal necessity -- to dismantle immensely popular government programs that would otherwise have been untouchable.
In Norquist's vision, America a couple of decades from now will be a place in which elderly people make up a disproportionate share of the poor, as they did before Social Security. It will also be a country in which even middle-class elderly Americans are, in many cases, unable to afford expensive medical procedures or prescription drugs and in which poor Americans generally go without even basic health care. And it may well be a place in which only those who can afford expensive private schools can give their children a decent education.
But as Governor Riley of Alabama reminds us, that's a choice, not a necessity. The tax-cut crusade has created a situation in which something must give. But what gives -- whether we decide that the New Deal and the Great Society must go or that taxes aren't such a bad thing after all -- is up to us. The American people must decide what kind of a country we want to be.
Paul Krugman is a Times columnist and a professor at Princeton. His new book is ''The Great Unraveling: Losing Our Way in the New Century.'' |
