Reagan's 1981 tax cut and the quiet end of bracket creep

Picture a machinist in a Midwest plant in the late 1970s. He is a hypothetical one, a composite of the American payroll. His boss calls him in and says the company is giving him a ten percent raise. He drives home grinning. His wife asks what the fuss is about, and he says, "We got a raise." Then prices at the grocery store climb ten percent over the same year, because that is what prices were doing, and the raise buys exactly what last year's pay bought. He is no richer. That part everybody understands. What almost nobody understood was the next part, and it was the part Washington was counting on: the raise pushed him into a higher tax bracket, so the government took a bigger bite out of the same purchasing power. He ran in place, and Uncle Sam collected a toll for the privilege.

That is bracket creep. Ronald Reagan's first big tax law, signed in August 1981, is remembered for the rate cuts, and the rate cuts deserve their reputation. But the clause that outlived the arguments was the quiet one, written to take effect in 1985, which tied the brackets to inflation. This post tells the story in order, takes the deficit objection head on, and explains why a provision that never made a bumper sticker may be the most important thing the 1981 law did for a working family.

The squeeze of the 1970s

By the end of the 1970s the American tax code had a design flaw that nobody in Congress had to vote for, because it ran on autopilot. The brackets were written in dollars. Inflation, which ran at double digits in 1979 and 1980, made dollars smaller every month. A family whose real income stood still moved up the rate schedule anyway. The top rate on investment income stood at 70 percent, and the top rate on wages had been held to 50 percent since the early 1970s, but the point was never only the top. The code had 14 brackets running from 14 percent to 70 percent, and a growing share of ordinary households were climbing through them on nominal raises.

Add the rest of the decade: gas lines, a stock market that went nowhere, interest rates that put a mortgage out of reach for a young couple, and a national mood the President of the day himself described as a crisis of confidence. Economists of the era were wrestling with a combination of high inflation and weak growth that the old textbooks said could not happen together. The Democrats who ran Congress had no great appetite for fixing it by cutting rates, in part because inflation was quietly raising revenue for them without a recorded vote. I have a name for that arrangement. It is a tax increase with no fingerprints.

Bracket creep, with the arithmetic

Let me show you the mechanism, because it is simple and it is the whole argument. This is a toy tax system, invented for illustration, with two brackets: 10 percent on the first $20,000 of income and 20 percent on every dollar above that.

A worker earns $20,000. His tax is 10 percent of $20,000, which is $2,000. He keeps $18,000.

Now inflation runs at 10 percent and his employer gives him a 10 percent raise, to $22,000. Nothing real has changed; $22,000 buys what $20,000 bought a year earlier ($22,000 divided by 1.10 is $20,000).

His tax is now $2,000 on the first $20,000, plus 20 percent of the extra $2,000, which is $400. Total: $2,400. He keeps $19,600. Adjust that for the 10 percent rise in prices and it is worth $19,600 divided by 1.10, which is $17,818.18 in last year's dollars. He used to keep $18,000. He is $181.82 poorer in real terms after receiving a raise.

If the brackets had been indexed, the $20,000 line would have moved to $22,000, his tax would have been 10 percent of $22,000, or $2,200, and he would have kept $19,800, which is $18,000 in last year's dollars. Same as before. No gain, no loss, which is exactly what a pure inflation raise ought to be.

Multiply that by tens of millions of households and you see why a government might come to love inflation. Inflation was a growth stock for the Treasury. For more on that idea, see Inflation is the one tax that never needs a vote in Congress.

What the 1981 law actually did

The Economic Recovery Tax Act of 1981, known by its initials as ERTA, was signed by Reagan on August 13, 1981. It did several things at once, and a fair account lists them.

1. It cut individual income tax rates across the board in three stages. The rate reductions were 5 percent in the fall of 1981, then 10 percent in 1982, then another 10 percent in 1983. They compound: 0.95 times 0.90 times 0.90 equals 0.7695, so a rate that started at 100 ended at about 77. People call it a 25 percent cut, and the rounder number is the headline, but the compounded figure is about 23 percent.
2. It lowered the top rate from 70 percent to 50 percent, so that the top bracket on investment income came down to what the top bracket on wages already was. The bracket schedule that had run from 14 to 70 percent now ran from 11 to 50 percent once fully phased in.
3. It brought the top rate on long-term capital gains down to 20 percent, from 28.
4. It created a faster depreciation schedule for business equipment, the Accelerated Cost Recovery System, which let a company write off a new machine faster. Capital investment was the point; the 1970s had starved it.
5. It opened Individual Retirement Accounts to every worker with earnings, not just those without an employer plan.
6. It added a deduction for two-earner married couples to ease the marriage penalty, and it indexed the tax brackets to inflation beginning in 1985.

Those last words are the story. Most of the rest of the law could be, and was, trimmed or rewritten by later Congresses. The indexing clause stayed.

The bidding war in Congress

The bill is a case study in how a President with a mandate and a minority in one chamber gets his way. The House was Democratic, with Tip O'Neill as Speaker and Dan Rostenkowski chairing Ways and Means. Reagan went on television in late July 1981 to make his case directly to the voters and asked people to contact their representatives. They did. Conservative southern Democrats, nicknamed the Boll Weevils, broke with their leadership. The bill that carried the day in the House bore the names of two members, Barber Conable of New York, a Republican, and Kent Hance of Texas, a Democrat.

The Democratic leadership offered an alternative, a smaller cut with different features, and for a few weeks Washington held something like an auction. The Democrats had a problem: they could not credibly argue that Americans were overtaxed and also argue that the cut should be small. Reagan's version won on the floor in both chambers. I would not claim this was a clean victory for principle on every line; the final bill carried business breaks and favours that made reformers wince, and I will come back to that in the 1986 story, the 1986 tax reform that lowered rates by closing loopholes. But the shape was his.

Where did the idea come from? The across-the-board cut traces back to the Kemp-Roth bill, introduced in the late 1970s by Representative Jack Kemp of New York and Senator William Roth of Delaware, which called for a 30 percent cut over three years. The man's story is in Jack Kemp, the quarterback who sold the party on growth. The philosophical frame came from the supply-side economists, and the most famous drawing in that school is examined in The Laffer curve explained, and the claim it never actually made.

The quiet clause: indexing

Back to our machinist. Starting with tax year 1985, the dollar amounts in the brackets, along with the standard deduction and the personal exemption, would rise each year with a measure of inflation. A raise that only matched prices would stay in its bracket.

There are four reasons this provision matters more than the headline.

1. It removed a hidden tax increase. Without indexing, any rise in prices would raise real taxes on every household in the system with no vote by anyone.
2. It forced the argument into the open. If Congress wants to take more, it must now raise a rate or narrow a deduction and put its name on it. That is not a conservative trick; that is accountability, and it is as old as the idea of taxation by consent.
3. It cooled the incentive to love inflation. A government whose revenue rises with inflation has a financial reason to look the other way. After indexing, the bracket part of that reason was gone.
4. It protected the lowest earners. People think bracket creep is about the rich. It is not. A family at the bottom of the schedule is hurt when the personal exemption and the standard deduction lose real value.

The strongest argument against indexing, and it deserves a fair statement, is that it makes the budget less flexible. Revenue no longer grows on autopilot, so Congress must decide to spend less or tax more on the record. Liberal critics said this would starve the government. A conservative answers: yes, the point was to require a decision.

1982: the walk-back nobody remembers

Here is the part that the bumper-sticker version of history leaves out. In 1982 Reagan signed the Tax Equity and Fiscal Responsibility Act, TEFRA, a law that raised revenue by closing business preferences and tightening compliance, and which rolled back some of the 1981 business provisions. It was negotiated with Congress, with Senate Finance Committee Chairman Bob Dole at the center of the Republican side of the work. The President accepted it on the promise of spending cuts that, in the event, did not arrive in the amounts promised. Further tax increases of smaller scale came in 1983 and 1984, including the payroll tax increases in the Social Security rescue of 1983.

I raise it for two reasons. First, honesty: a defender of the 1981 law should not pretend Reagan was blind to the budget. He signed revenue raisers when he judged the deficit outlook demanded it. Second, it answers the liberal who says "supply-siders believe every cut pays for itself." This President signed tax increases within a year of his big cut. The record does not fit the caricature.

The Volcker recession

Reagan took office when the Federal Reserve, under Chairman Paul Volcker, was squeezing money growth to break inflation. The squeeze worked, and it hurt: interest rates reached levels that devastated homebuilding, farming and manufacturing, and the country went through a deep recession in 1981 and 1982 in which the unemployment rate climbed to about 10.8 percent by the end of 1982. That figure is a matter of Bureau of Labor Statistics record that you can verify yourself.

Critics point to this and say the tax cut failed, because the economy shrank right after it passed. That has the timing wrong in an important way. Two of the three stages of the rate cut had not happened yet; the second and third arrived in July 1982 and July 1983. The recession ended in November 1982, and growth in 1983 and 1984 was strong. Does the tax cut deserve all the credit for that? No honest person would claim it. The Federal Reserve's inflation fight is why prices came under control, and the lower rates helped the recovery by leaving more of each new dollar in the hands of workers and employers. For the long version of the monetary story, read How Paul Volcker broke inflation and why it hurt so much.

The deficit objection, answered with the record

Now the objection that counts. The federal deficit grew during the Reagan years. The tax cut contributed, the defense buildup contributed, and the recession contributed, and the spending side of the ledger did not shrink the way the President wanted. Liberals say the supply-siders promised the cut would pay for itself, and it did not.

Here is the best answer I can give, step by step.

1. The law was not designed on the premise that it was free. The government's own scorekeepers treated it as a revenue reducer. Some of its backers oversold the growth effect, and the administration's early budget forecasts were too rosy. That was a mistake, and a conservative should say so.
2. Revenue dipped in the recession and then climbed. In dollars, federal collections rose in each year from 1984 through the end of the decade. The deficit was caused by spending that grew faster than the economy could pay for, including defense spending the President wanted and domestic programs a Democratic House refused to cut. Both parties own that.
3. The fix was not to repeal indexing. Look at what Congress did afterward. It passed the 1982, 1983 and 1984 revenue measures, and in 1986 it passed a tax reform that lowered rates further. If the rate cuts had been the deficit's only cause, those later bills would have reversed them. They did not.
4. The alternative was the old arrangement. If you want to reduce a deficit by letting inflation push families into higher brackets, you are choosing a tax increase that nobody voted for. A conservative can argue that a deficit should be closed by cutting spending or by raising a tax openly, but not by a hidden one.

The fair concession: the conservative movement paid a price in credibility for the deficits of the 1980s. Many Republicans, then and since, have argued that rate cuts must be paired with spending restraint. That is a legitimate internal argument, and the movement has had it in every decade since. For the larger picture of how this compares with other GOP tax bills, see Republican tax cuts side by side, from Harding all the way to Trump and Seven myths about Reagan's economy that both sides still repeat.

What to do with this at the dinner table

A few practical points, if someone corners you over the holiday ham.

• When someone says "tax cuts for the rich," ask which one. The 1981 law cut every bracket, and the 1985 indexing protected the lowest.
• When someone says "it blew up the deficit," agree that the deficit grew, then ask what else changed: defense, the recession, spending. Then ask what they would have done instead.
• When someone says "Reagan never raised taxes," correct your own side. He signed TEFRA. The facts are better than the folklore.

The bottom line

• Bracket creep is a tax increase that happens when prices rise and nobody votes. The 1981 law, by indexing the brackets from 1985, ended that for the federal income tax.
• The rate cuts were large, phased in over three years (5, 10 and 10 percent, a compounded 23 percent), and the top rate fell from 70 to 50 percent. The law also made saving and investing cheaper.
• Defend the law with the full record: Reagan signed TEFRA in 1982 and other revenue bills after it, and the deficit grew for reasons that include spending. Your credibility with the other side depends on saying so.
• When Congress next proposes to change a bracket or a deduction, ask whether it will be done with a recorded vote or in the dark. Check the bills yourself at Congress.gov or on our bills page.
• Your own paycheck is the test. If your raise only matches prices, indexing is what keeps you from sliding into a higher bracket for nothing. Ask any politician who talks about "fairness" whether he would repeal it.