A Tale of Two Tax Cuts: What recent history teaches about recessions and economic policy

A Tale of Two Tax Cuts: What recent history teaches about recessions and economic policy

(EPI Issue Brief #157) May 1, 2001

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 cuts-one enacted by President Gerald Ford in 1975 and the other by President Ronald Reagan in 1981-shows 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 recessions-1974-75 and 1981-82-were 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 Ford's 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 Reagan's 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

Ford's 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 Ford's 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 income taxes.3

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 Ford's 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 Ford's Council of Economic Advisers, which was responsible for developing this tax plan.

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 Ford's 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 president's 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 Ford's 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 delayed-very little of the cuts actually took effect in 1981.10

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 1982-the first year of 10% rate cuts-the 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 Reagan's tax cut was passed before the recession of 1981 began, its impact wasn't 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

Lessons learned
The experience of the 1981-83 recession contrasts sharply with the policy changes made in response to the 1975 recession. The main differences were that:

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 Ford's 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 doesn't rise until long after a recovery is underway. The past tax cuts show that Ford's 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 Bush's proposal and Reagan's earlier failure are indisputable. Like Reagan, Bush's plan was designed well before the current signs of economic slowdown. And as in 1981, Bush's 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 Reagan's-Bush's 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 surpluses-would raise aggregate demand and have the best chance of heading off any imminent recession.14

Endnotes
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 Meeropol's 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/ Table W.5.

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 W. 1.

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 W.4.

14. For more details on the prosperity dividend proposal, see EPI's 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 B. Freeman.

Talk of Lost Farms Reflects Muddle of Estate Tax Debate

In the April 8, 2001 New York Times article "Talk of Lost Farms Reflects Muddle of Estate Tax Debate," David Cay Johnston explains that the risk of family farms being lost because of the estate tax has been exaggerated by some advocates of the tax's elimination.

Correction Appended

Harlyn Riekena worried that his success would cost him when he died. Thirty-seven years ago he quit teaching to farm and over the years bought more and more of the rich black soil here in central Iowa. Now he and his wife, Karen, own 950 gently rolling acres planted in soybeans and corn.

The farmland alone is worth more than $2.5 million, and so Mr. Riekena, 61, fretted that estate taxes would take a big chunk of his three grown daughters' inheritance.

That might seem a reasonable assumption, what with all the talk in Washington about the need to repeal the estate tax to save the family farm. ''To keep farms in the family, we are going to get rid of the death tax,'' President Bush vowed a month ago; he and many others have made the point repeatedly.

But in fact the Riekenas will owe nothing in estate taxes. Almost no working farmers do, according to data from an Internal Revenue Service analysis of 1999 returns that has not yet been published.

Neil Harl, an Iowa State University economist whose tax advice has made him a household name among Midwest farmers, said he had searched far and wide but had never found a case in which a farm was lost because of estate taxes. ''It's a myth,'' Mr. Harl said.

Even one of the leading advocates for repeal of estate taxes, the American Farm Bureau Federation, said it could not cite a single example of a farm lost because of estate taxes.

The estate tax does, of course, have a bite. But the reality of that bite is different from the mythology, in which family farmers have become icons for the campaign to abolish the tax. In fact, the overwhelming majority of beneficiaries are the heirs of people who made their fortunes through their businesses and investments in securities and real estate.

The effort to end the estate tax -- which critics call the death tax -- gained ground when the House of Representatives voted Wednesday to reduce the tax and then abolish it in 2011. The bill faces an uncertain fate in the Senate.

The estate tax is central in the debate over taxes, not only because the sums involved are huge but also because to both sides it is a touchstone of national values. To those seeking to abolish it, the estate tax is a penalty for success, an abomination that blocks the deeply human desire to leave a life's work as a legacy for the children. It is also a complicated burden that enriches the lawyers, accountants and life insurance companies that help people reduce their tax bills.

To its supporters, on the other hand, the estate tax is a symbol of American equality, a mechanism to democratize society and to encourage economic success based on merit rather than birthright.

Yet for all the passion in the debate, the estate tax does not always seem broadly understood.

While 17 percent of Americans in a recent Gallup survey think they will owe estate taxes, in fact only the richest 2 percent of Americans do. That amounted to 49,870 Americans in 1999. And nearly half the estate tax is paid by the 3,000 or so people who each year leave taxable estates of more than $5 million.

In fact, the primary beneficiaries of the move to abolish the estate tax look less like the Riekenas and more like Frank A. Blethen, a Seattle newspaper publisher whose family owns eight newspapers worth perhaps a billion dollars.

''Being ever bloodthirsty, the I.R.S. will start with the highest value it can on my estate,'' said Mr. Blethen, the 55-year-old patriarch of the publishing family. The figure for his share will probably be several hundred million dollars, more than half of which would go to the government. Mr. Blethen is trying to avoid almost all those taxes through a plan also used by other wealthy families, but if he does not succeed his sons' interest in the business will be wiped out, he said.

Estate taxes are paid by few Americans because they are not assessed on the first $1.35 million of net worth left by a couple. Amounts above this are taxed at rates that begin at 43 percent and rise to 55 percent on amounts greater than $3 million. As the Riekenas and the Blethens have learned, there are many legal ways to reduce the value of one's wealth for estate tax purposes. So even for the largest estates, the tax averages 25 percent.

Family farmers are often cited as victims. As Senator Charles E. Grassley, an Iowa hog farmer and chairman of the Senate Finance Committee, put it, ''The product of a life's work leaches away like seeds in poor soil.''

Yet tax return data show that very few farmers pay estate taxes. Only 6,216 taxable estates in 1999 included any agricultural land and equipment, the I.R.S. report shows. The average value of these farm assets was $440,000, only about a third of the amount that any married couple could leave untaxed to heirs. What is more, a farm couple can pass $4.1 million untaxed, so long as the heirs continue farming for 10 years.

In Iowa, the average farm has a net worth of $1.2 million. Loyd A. Brown, president of Hertz Farm Management in Nevada, Iowa, which runs more than 400 farms in 10 states, said none of his firm's clients nor anyone he knew was facing problems because of the estate tax.

Just 1,222 estates in 1999 had enough in farm assets to make the farm property alone subject to estate taxes. But these farm assets amounted to one-tenth of these estates, suggesting that the tax applies mostly to gentleman farmers and ranchers, rather than to working farmers like the Riekenas, whose fortunes are tied up in their farms.

As the Riekenas were surprised to discover, avoiding the estate tax was easy. Their lawyer developed a simple plan that involved making gifts to their daughters and buying life insurance to offset any estate taxes that might be due if the parents died before most of the farm had been turned over to their daughters.

There is a real cost, of course -- payments to the lawyer and for the insurance. And in any case the paucity of affected farmers does not end the debate. Patricia A. Wolff, the Farm Bureau's chief lobbyist, said the organization made estate tax repeal its top priority because, while it has not surveyed its members, she was confident ''the majority of farmers and ranchers believe that death taxes are wrong and that it is wrong to tax people twice on what they earn.''

But Mr. Riekena and all two dozen other farmers interviewed across central Iowa -- every one a Republican -- said that while they favored increasing the amount that could be passed to heirs untaxed, they did not support the repeal proposed by President Bush and other leaders of his party. A few snickered or laughed when asked whether the estate tax should be repealed to save the family farm.

But Senator Grassley himself opposes the estate tax, in large part because he thinks that while a decision to keep or sell an asset is an appropriate trigger for a tax, death should not be.

He added another reason: ''I do not think that the function of government is to redistribute wealth.''

Indeed, that seems to be the fault line in the debate: should the government play Robin Hood with estates?

''If you worked hard and put your money away, you paid tax on it as you went along, so it's yours and you should be able to pass it on to your children without the government penalizing you,'' said R. Elaine Gunland, who grows grapes in Fresno, Calif., and whose family may owe estate taxes when she dies.

Mr. Blethen, the fourth-generation publisher of a newspaper started in 1896 with $3,000, says he speaks for many others in supporting repeal of the tax in the name of preserving family businesses.

''I firmly believe that family-owned businesses are the heart and soul of the country,'' said Mr. Blethen, who has created a Web site called deathtax.com.

Mr. Blethen says the estate tax benefits publicly traded companies at the expense of family-owned businesses. The reason is that the public companies can often buy family businesses at a discount because the owners did not raise the cash to pay estate taxes and must sell quickly at fire sale prices.

Mr. Blethen said some of the seven smaller papers his family bought in Washington and Maine came from families that had not planned carefully for the estate tax and decided it was easier to cash out.

''If you like corporate culture, and think America needs more of it, then you love the estate tax,'' he said. ''I think this march toward corporatism is not healthy and we lose innovation, jobs and charitable giving.''

Mr. Blethen said the estate tax also discouraged major new investments in family businesses late in the life of the primary owner because such investments consumed cash that might be needed at any time to pay estate taxes.

He said the estate tax also ''forces you into irresponsible gift making'' to heirs. He felt compelled to give half the future growth of his fortune to his two sons when they were not yet kindergartners even though he had no way of telling whether the boys would turn out to be industrious, as they did, or scalawags.

Despite his fierce opposition to the estate tax, Mr. Blethen does not support President Bush's current plan to repeal the tax because it would also exempt from capital gains taxes the profits on assets passed to heirs when those assets are sold. ''That's not fair,'' Mr. Blethen said.

He said Mr. Bush's proposal would have the perverse effect of encouraging the sale of family-owned businesses, because heirs would see death as their chance to sell tax-free and to diversify their portfolios, instead of continuing to bear the risks of holding a single enterprise.

Mr. Blethen thinks that rather than taxing an estate, taxes should apply when a business is sold. ''You want to defer those capital gains and let them grow so large that the family will keep the business to avoid the capital gains taxes,'' he said.

The debate does not divide neatly among rich and poor. Since February more than 800 wealthy Americans have joined in a public appeal to keep the estate tax. They argue that repealing the tax would further enrich the wealthiest Americans and hurt struggling families. They also argue that financial success should be based on merit rather than on inheritance.

Warren E. Buffett, George Soros, Paul Newman and William H. Gates Sr., father of Microsoft's chairman, William H. Gates III, are among the most prominent in that group, which also includes many people with holdings of just a million dollars.

Mr. Buffett said the estate tax fosters economic growth by encouraging Americans to rise based on merit, not inheritance. ''If you take the C.E.O.'s of the Fortune 500,'' he said in an interview, ''and put in the eldest son of every one of those who ran the place in 1975, the American economy would not run as well as letting the Jack Welches, who started out with nothing, rise to the top of General Electric.''

Back in central Iowa, Mr. Riekena had another reason. He said Washington was focused on the wrong issue when it came to saving family farms.

''For most farmers around here, the estate tax is not high in their minds,'' Mr. Riekena said. ''What we need are better crop prices.''

Photos: Harlyn Riekena, who owns 950 acres of farmland in Iowa, expects to owe nothing in estate taxes. (Suzanne DeChillo/The New York Times)(pg. 1); Frank A. Blethen, publisher of The Seattle Times, says the estate tax could cost his family many millions of dollars after his death. (Peter Yates for The New York Times)(pg. 24) Chart: ''Few Farms in Taxable Estates'' Estate tax opponents say the levy is destroying the family farm. But only the richest 2 percent of the 2.4 million Americans who died in 1999 left estate tax bills. Only one in eight of these taxable estates included any farm property. On average, only one in 40 taxable estates included enough farm land and equipment for the farm asssets alone to incur estate taxes. 49,870: Total number of taxable estates in 1999 6,216, or 12.5 percent, of the taxable estates had any farm assets 1,222, or 2.5 percent of estates, on average, might have had to pay taxes because of their farm assets. (Source: Internal Revenue Service)(pg. 24)

Correction: April 12, 2001, Thursday A front-page article on Sunday about farms and estate taxes referred incompletely to the position of Loyd A. Brown, president of Hertz Farm Management in Iowa. Mr. Brown said that while he did not know of anyone who had lost a farm because of the estate tax, he thought Congress should either eliminate the tax or increase the amount that could be inherited untaxed.