May 7, 2001 | EPI Issue Brief #157
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A Tale of Two Tax
recent history teaches about recessions
and economic policy
by Michael A. Meeropol
As slow growth continues in the U.S. economy,
one of the questions policy makers are asking is whether tax cuts can
be used to stave off a recession and, if so, how. The Bush Administration
claims that its tax cut proposal (conceived over a year ago) is the best
bulwark against an economic slowdown. Since supporters of such tax cuts
often invoke historical precedent, such as the fiscal policies of past
presidents, it is worth looking at previous attempts to mitigate recessions
through tax policy. A close comparison of other attempts to fight recessions
with tax cutsone enacted by President Gerald Ford in 1975 and the
other by President Ronald Reagan in 1981shows that approaches that
promote increased consumption by middle- and lower-income families have
provided the biggest boosts to flagging economies.
Present-day Republicans, however, are promoting
a tax cut that disproportionately benefits those with high incomes, the
rationale being that this will stimulate the economy by increasing saving
and investment. Critics of these cuts prefer smaller overall tax cuts
with greater focus on relief for lower-income individuals; it is these
lower- and middle-income families, critics argue, that are most likely
to spend any extra disposable income and hence stimulate the economy.
A look at recent history supports such claims.
Two major recent recessions1974-75
and 1981-82were accompanied by Republican-led tax cuts markedly
different from one another both in terms of who benefited and in their
long- vs. short-run focus. President Fords tax cut in 1975 was targeted
at low- and moderate-income families and helped to stimulate private consumption,
putting the economy back on its feet. By comparison, President Reagans
tax cut in 1981 disproportionately benefited those at the top of the income
scale and ultimately did nothing for the slumping economy until 1983.1
Fords winning strategy (1974-75)
In 1974, the United States economy fell into a deep recession. Unemployment
rose from 4.8% in the fourth quarter of 1973 to 8.9 % in the second quarter
of 1975. For over five quarters (from the end of 1973 through March 1975)
real GDP per capita fell at an annual rate of 3.8%.2 In response,
President Ford proposed a significant tax cut in early 1975, which Congress
passed by March of that year.
President Fords tax cut was clearly
focused on increasing consumption. Marginal rates were not cut, and instead
all taxpayers and their dependents received a credit of $30 (almost $100
in current dollars). In addition, the standard deduction was increased,
and a refundable earned income tax credit was enacted. As a result, some
beneficiaries of the 1975 tax cut carried no liability for federal individual
The federal budget was nearly balanced in
1974, with a deficit of less than 1% of GDP. That deficit, however, jumped
to 3.4% of GDP in fiscal year 1975 and 4.3% in the following year.4
It is clear that the 1975 tax cut, plus some increased spending in the
form of extended unemployment compensation benefits, helped raise the
federal deficit and increase aggregate demand. As a consequence, this
deficit increase was temporary; both deficits and debt as a share of GDP
fell at the close of the 1970s.
Much of Fords stimulus was provided
by an expansion in government expenditure, both on the refundable portion
of the earned income tax credit and on some extensive expansions of unemployment
compensation eligibility. Even though unemployment rose dramatically in
1974, the enactment of new legislation ensured that a higher percentage
of the unemployed actually received compensation in 1975 than at any other
time between 1967 and today. The high point was reached in April of that
year, when 81% of all unemployed workers received compensation. Even as
the economy recovered in 1976, the percentage of the unemployed receiving
compensation averaged 67%, in marked contrast to both previous and subsequent
rates. In fact, between 1967 and 1999, the 1975-77 period is the only
three-year period when coverage exceeded 52%.5
Tax and spending changes in 1975 were designed
as the first steps toward countering the 1974-75 recession and were heavily
weighted toward increasing the disposable income and consumption of moderate-
and low-income persons. Ironically, Alan Greenspan led President Fords
Council of Economic Advisers, which was responsible for developing this
The results of the plan were striking. First
of all, consumption as a percentage of GDP rose from an average of 61.7%
in 1974 to 63.1% in 1975. It stayed at that higher level through 1979.
Consumption as a percentage of disposable personal income rose from an
average of 88.3% in 1974 to over 90% in 1976 through the end of the decade.6
Meanwhile, investment as a percentage of GDP was lower in 1975 than it
had been in 1974. It did not recover to the 1973 level until 1977.7
In other words, as with most recession recoveries, consumption increases
led and investment increases lagged. The lesson to be learned is that
successful counter-cyclical fiscal policy requires tax and spending changes
that specifically target increased consumption. President Fords
stimulus package did just that by targeting the low- and moderate-income
families most likely to spend any extra income.
After establishing this strategy, monetary
policy was then designed to support the presidents efforts to stimulate
the economy. Nominal interest rates fell throughout 1974, and when they
began to rise in early 1975, the recovery was already well under way.8
President Fords exercise of counter-cyclical
fiscal policy worked. A recovery began in the second quarter of 1975.
Real GDP per capita had been negative for all of 1974 and was falling
at an annual rate of 6.7% in the first quarter of 1975. For the final
three quarters of 1975, beginning with the quarter when the temporary
tax cuts went into effect, the rate of growth of real GDP averaged over
4%. The rate of growth for 1976 was 3.8%. The unemployment rate fell to
7.7% in 1976 and continued to fall for the rest of the decade.9
The Reagan experiment (1981-83)
In 1981, before the recession had begun, President Reagan convinced
Congress to accept a three-year tax cut. He did not justify his proposal
as a way of combating recession but claimed instead that it would stimulate
the supply side of the economy by enhancing incentives to
work, save, and invest. The tax cut was heavily weighted toward reducing
the tax burden of higher-income taxpayers and corporations. Its impact
was also delayedvery little of the cuts actually took effect in
A recession began in the fourth quarter of
1981, as unemployment rose from 7.4% to 8.2%. By the fourth quarter of
1982, the unemployment rate peaked at 10.7%. Between October 1981 and
December 1982, the shrinkage in per capita GDP averaged 3.4% in annual
terms.11 In 1981 the economy needed a stimulus, just as in
1974-75, but this time none was provided. In fact, the federal deficit
as a percentage of GDP actually declined in 1981, due to increased revenues
resulting from bracket creep in the individual income tax
and from scheduled increases in the payroll tax for Social Security. Nor
was any extension of unemployment benefits passed.
The tax cuts of 1981 brought significant
reductions in income tax collections at the high end of the income spectrum
and a dramatic reduction in corporate taxes. However, the impact on consumption
was virtually nonexistent. In 1982the first year of 10% rate cutsthe
federal budget deficit rose dramatically. Consumption as a percentage
of GDP rose in 1982, but investment fell so much that the overall increase
in aggregate demand was insufficient to lift the economy out of its recession.
The recession lingered through the fourth quarter of 1982 and the unemployment
rate continued to rise, reaching its 10.7% peak in the fourth quarter,
just when the business cycle was in its trough.
Relative to 1975, the recession did not last
much longer. It did, however, do much more damage to the economy because
it was so much deeper. Unemployment was above 8% for only four quarters
during the 1974-75 recession, with the peak coming in the second quarter
of 1975 at 8.9%. In 1981-83, unemployment was above 8% for a full seven
quarters, stretching all the way into the first four quarters of the recovery.
(It is also worth noting that monetary policy may have been less expansive
in 1982 than in 1975 and 1976.)12
Even though Reagans tax cut was passed
before the recession of 1981 began, its impact wasnt even felt until
1983 when the recovery had already begun. That same year, the federal
deficit as a percentage of GDP reached 6.1%, as the second of the 10%
tax cuts went into effect. So, although 1983 saw growth in real GDP, unemployment
was almost as high in 1983 as in 1982, despite a continued increase in
the level of consumption relative to GDP. A policy change that might have
stimulated even more consumption, such as the passage of extended unemployment
benefits, did not occur in 1981. The percentage of unemployed actually
receiving benefits averaged only 45% in 1982 and 44% in 1983, far less
than the rates in the 1975-77 period.13
The experience of the 1981-83 recession contrasts sharply with the
policy changes made in response to the 1975 recession. The main differences
- the Reagan tax cut was backloaded. It
had its greatest impact in fiscal year 1983 (federal tax revenue actually
declined in that year).
- the Reagan tax cut was not focused on
the lower- and middle-income workers whose consumption must rise in
order to begin the process of recovery. It also was not combined with
significant expansion of transfer payments in the form of unemployment
compensation, as Fords tax cut was.
Consumption is the main driving force that
can get the economy out of a slump. Investors are notoriously conservative.
Once they get spooked by a recession, they usually wait for consumption
to rise again before committing to new investment projects. Investment
as a percentage of GDP usually doesnt rise until long after a recovery
is underway. The past tax cuts show that Fords cut induced an investment
recovery within one year, while the Reagan tax cut failed to induce any
recovery for almost two.
The parallels between President Bushs
proposal and Reagans earlier failure are indisputable. Like Reagan,
Bushs plan was designed well before the current signs of economic
slowdown. And as in 1981, Bushs plan tries to sell the merits of
supply-side doctrine that incentives can be improved by reducing marginal
tax rates for those subject to income tax. But the Bush proposal goes
even further than ReagansBushs cuts are even more concentrated
on higher-income families and are even more extremely backloaded.
As recent history makes clear, backloaded
tax cuts delay the impact on aggregate demand and mute efforts to fight
recessions. And tax cuts that neglect the individuals most likely to spend
extra income do not work well when the goal is to combat a recession.
A large share of any stimulus should be focused on low- and moderate-income
families. To this end, a plan along the lines of the recently proposed
prosperity dividend a proposal to issue each taxpayer
a one-time rebate of around $500 drawn from the federal budget surpluseswould
raise aggregate demand and have the best chance of heading off any imminent
1. For details of the Ford plan, see Economic Report
of the President (1976, 50-57). For details of the Reagan plan and
its impact, see Michael Meeropols Surrender: How the Clinton
Administration Completed the Reagan Revolution (1998, 79-81, 91-92).
2. See the web page for Surrender
(Meeropol 1998) at http://mars.wnec.edu/~econ/surrender/.
The unemployment rate and rate of growth of per capita real GDP data are
in Table W.4 found on that web page.
3. See Economic Report of the President,
1976, p. 51.
4. See Economic Report of the President,
1998, p. 373.
5. For data on the percentage of the unemployed
receiving compensation from 1967 to 1999, see Committee on Ways and
Means, U.S. House of Representatives 2000, Green Book, pp. 284-5.
6. See http://mars.wnec.edu/~econ/surrender/
7. For investment as a percentage of GDP,
see Table W. 4 at http://mars.wnec.edu/~econ/surrender/.
8. For the nominal federal funds rate, see
Table W. 2. For the nominal prime rate, see Table W.3.
9. For the nominal federal funds rate, see
Table W. 2. For the nominal prime rate see Table W.3.
10. See Table W.4.
11. See Surrender, pp. 79-81.
12. For data on consumption as a percentage
of GDP, see Table W.5 at http://mars.wnec.edu/~econ/surrender/.
For data on investment, unemployment, and the rate of growth of real GDP,
see Table W.4. For data on the federal budget deficit, see Economic
Report of the President (1998, p. 373). For the rate of growth of
the money supply and the nominal and real federal funds rate, see Table
13. For data on coverage of unemployment
compensation, see Green Book, op cit. For data on consumption,
see Table W.5. For data on investment and the rate of growth, see Table
14. For more details on the prosperity dividend
proposal, see EPIs reports Declare a Prosperity
Dividend: A Stimulating Idea for the U.S. Economy (2001) and The
Case for a Prosperity Dividend (2001) by Eileen Appelbaum and Richard
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