08/19/96 LESSONS OF THE REAGAN YEARS

LESSONS OF THE REAGAN YEARS
Would a Dole walk on the supply side work any better?
Ronald Reagan's political success made him a model for a generation of Republican pols. But his advocacy of tax cuts and supply-side economics has been regarded with more ambivalence by fiscal conservatives. Until now.
With his plans for a $548 billion tax cut, Bob Dole is following the path that Reagan laid out. The Economic Recovery Tax Act of 1981, which called for a $750 billion tax cut--more than $1 trillion in 1996 dollars--was supposed to spur growth and reverse the torpor of the 1970s. Dole hopes his economic plan will do the same.
Are there lessons in the Reagan experience? Looking back, the Gipper's massive tax cuts for business and individuals did make many Americans better off in the short run. Income rose sharply, as did personal consumption. But the gains came at the expense of bigger budget deficits, sluggish business investment, and lower savings. The budget deficit soared to over 6% of gross domestic product. Rather than increasing savings, as the supply-side advocates had hoped, the national savings rate dropped. And business spending on equipment hardly rose, despite a strong recovery (charts).
Overall, the supply-side policies of the early 1980s had the effect of emphasizing the short run over the long run and eroding the foundation of the economy. Dole's billion-dollar tax-cutting package would likely have much the same impact: an immediate improvement in living standards, followed by long-term deterioration in the economy's overall strength. ``An across-the-board tax cut is a way of encouraging consumption,'' says Alan J. Auerbach, an economist at University of California at Berkeley. ``We should be cutting spending without cutting taxes.''
Reagan, of course, was laboring under some handicaps that a Dole Presidency would not face. When Reagan proposed his big tax cut, domestic manufacturers were not prepared for foreign competition, and much of the economic stimulus from lower taxes in the early 1980s fueled an enormous surge of imports. The problem was worsened by the combination of Reagan's defense buildup and the tight monetary policy of the Federal Reserve. Together, these drove the dollar up by 50%, making U.S. industry globally uncompetitive.
Today, U.S. companies are in a much stronger position to take advantage of any increase in demand from tax cuts. Moreover, with inflation under 3% and seemingly quiescent, and government shrinking, the Fed probably won't have to hit the monetary brake so hard.
Still, there is little reason to believe that the ultimate effect of Dole's version of supply-side economics will be positive, even if the historical record suggests that Americans might get some very real short-term gains from a tax cut. In 1981, just before the tax cuts passed, federal revenues hit 21% of GDP, their postwar high. By 1983, that percentage was down below 19%. With a smaller tax bite, disposable income and consumption soared. Tax cuts for businesses and individuals translated into a more buoyant stock market. Adjusting for inflation, the Standard & Poor's 500-stock index rose by 87% from 1981 to 1987, far outpacing the 54% gain of the past six years.
By contrast, over the past six years, revenues taken in by the federal government have risen from 19.5% to 20.5% of GDP. Over the same period, income per capita, adjusted for taxes and inflation, has risen by only 6.5%, half the rate of the Reagan era. Little wonder Americans like the idea of lower taxes.
But the long-term effects of tax cuts on savings and investment--the things that matter for the future health of the economy--are much less positive. A supply-side tax cut puts more money into the hands of Americans who already spend 95% of every dollar they take in. Certainly, the $500 credit that Dole proposes to give families for each child will much more likely find its way into new shoes and child care than into a savings account.
Experts on savings behavior agree that cutting the marginal tax rate by 15% is not likely to boost household savings significantly. In the 1950s and 1960s, marginal tax rates were as high as 90%, much higher than today, observes Christopher D. Carroll, an economist at Johns Hopkins University, but Americans saved much more of their income. Says Carroll: ``It's hard to believe that there's a strong relationship between marginal tax rates and savings.''
In fact, the experience of the 1980s points the other way. Despite the creation of new savings incentives such as tax-exempt individual retirement accounts (IRAs), the national savings rate fell sharply after the passage of the 1981 tax cuts. The personal savings rate fell from 9% in 1981 to 5% in 1987. Simultaneously, the growing budget deficit ate up a much bigger share of the U.S. savings pool.
Perhaps the biggest danger of a tax cut is an immediate upward surge in interest rates, even before the cut takes effect. That's what happened in the 1980s, when real rates rose as high as 8% by 1984. With recent memories of double-digit inflation, investors feared that the cuts would lead to big budget deficits--as they did--and reignite inflation. The high rates made borrowing more expensive, and meant that equipment investment stayed at only 6% of GDP, compared with about 8% today.
ALL IN THE CUTS. The upward push on interest rates could be eliminated if the budget deficit shrinks. Tax-cutting by itself won't do the trick. Only about 15% to 20% of tax cuts come back in the form of increased revenues, estimates Joel B. Slemrod, a tax economist at the University of Michigan.
That's why the economic soundness of the Dole plan depends more on the ability to achieve its spending cuts, and less on its tax cuts. ``If they cut enough spending to balance the budget, then they could get a 0.2 to 0.3% gain in the growth rate,'' says Joel Prakken, an economist at Macroeconomic Advisers.
But as Reagan discovered, reducing spending, unlike cutting taxes, requires real sacrifice. From 1981 to 1987, real government spending on goods and services rose by 26%, despite an economic plan which required less spending. That, in the end, may be the most important lesson of the last supply-side experiment.
By Michael Mandel in New York