The Reagan Tax Cuts Rate by Rate and the Tax Reform of 1986

Ask five people in Washington to explain the Reagan tax cuts and you will get six answers, and every one of them will be delivered with total confidence. One says they paid for themselves. Another says they blew a hole in the budget that has never been filled. A third says Reagan raised taxes, too, so what are we arguing about? A fourth says the whole thing was a gift to the rich.

Let me tell you something, folks. Almost all of those answers contain a piece of the truth, and almost none of them contains the whole thing. The Reagan record on taxes is not a slogan. It is three separate laws, passed in 1981, 1982 and 1986, doing three different jobs. Get them straight and you can win any argument about it, with friends or opponents.

I'm going to walk through each one with the numbers, give the critics their strongest case, and tell you where I think each side is right. If you want a shorter companion piece, read reagan's 1981 tax cut and the quiet end of bracket creep first and come back.

The world Reagan inherited

Start with what voters were living with in 1980, because the law makes no sense without it. Inflation had been in double digits for two years running. The prime rate, the interest rate banks charge their best customers, reached 21.5 percent at the end of 1980. The economy had slipped into a short recession in 1980, and a longer one was coming. And the tax system was working against ordinary families in a way that few people could explain but all of them could feel.

The reason was the combination of progressive brackets and inflation, known as bracket creep. Here is a hypothetical to show it. Suppose a worker earns $30,000 in a year when prices are stable. Next year inflation is 8 percent, and the boss, to keep up, gives an 8 percent raise: $30,000 times 1.08 is $32,400. The worker is no richer. The paycheck buys exactly what it did before. But the tax code does not see inflation. It sees a bigger number, and part of that bigger number falls into a higher bracket. The family pays a higher share of its income in tax and has no more purchasing power. That is a tax increase that nobody voted for. We wrote about it at more length in Inflation is the one tax that never needs a vote in Congress.

The top federal rate on income was 70 percent, and the bottom rate was 14 percent. A person in the top bracket kept 30 cents of the next dollar earned. Hold that number for a minute.

Law one: the Economic Recovery Tax Act of 1981

Congress passed the Economic Recovery Tax Act in the summer of 1981, and Reagan signed it on August 13. It was among the largest tax cuts in American history, and its main features were these:

1. Across-the-board rate cuts in three steps. Individual income tax rates were cut 5 percent in October 1981, another 10 percent in July 1982, and another 10 percent in July 1983. People call this a 25 percent cut, because 5 plus 10 plus 10 is 25. Compounded, it is slightly smaller, because each cut applies to the rate left over from the one before. Multiply 0.95 by 0.90 by 0.90 and you get 0.7695. The rates ended up at about 77 percent of where they started, a cut of about 23 percent. Both numbers are used, and now you know why they differ.
2. A lower top rate. The top rate fell from 70 percent to 50 percent, and the bottom rate from 14 percent to 11 percent.
3. Inflation indexing. Starting in 1985, the brackets, the personal exemption and the standard deduction would be adjusted for inflation each year. This is the quiet reform that ended bracket creep. It is also the one a conservative should defend loudest, because it means Congress can no longer raise your taxes by letting inflation do the work.
4. Business cost recovery. The law replaced the old depreciation rules with faster write-offs for equipment and buildings, called the Accelerated Cost Recovery System.
5. Savings and family provisions. It opened individual retirement accounts to all workers with earnings, and it created a deduction for two-earner married couples to soften the marriage penalty. The top rate on long-term capital gains fell to 20 percent. It also lifted the estate tax exemption in steps and made transfers between spouses free of tax.

Let me put the top rate in dollars. Take a hypothetical earner in the top bracket who gets $1,000 more. At 70 percent, she keeps $300. At 50 percent, she keeps $500. At 28 percent, which we will get to in a moment, she keeps $720. The point of supply-side economics was never mysterious: when you keep more of the next dollar, you work, save and invest more of them. Whether that effect is big or small is the debate.

What happened next

The economy did not take off. It went into a recession that began in July 1981 and lasted until November 1982. Unemployment peaked at 10.8 percent late in 1982. Anyone who tells you the 1981 tax cut produced an instant boom is skipping the recession.

Two things were going on at once. The Federal Reserve, under Chairman Paul Volcker, was squeezing inflation out of the system with very high interest rates, and that caused the recession. By the end of 1982 inflation was running below 4 percent, and the recession ended. The expansion that followed ran for years, and the economy grew by about 7 percent in 1984. Supporters credit the tax cut and the reduction in inflation together. Critics credit the Fed's policy and the Keynesian effect of the deficit, a stimulus in all but name. Honest economists have argued about the mix ever since. I'd say it was both, and I'd say that is no embarrassment to a conservative: low inflation and low tax rates are partners, not rivals. For more on this period, see Seven myths about Reagan's economy that both sides still repeat.

A worked example of what indexing does

Here is a toy tax code to show the mechanism. It is a hypothetical with invented round numbers, not the 1980s schedule. Say the first $20,000 of income is taxed at 10 percent and everything above that at 20 percent.

• Year one, no inflation. A worker earns $30,000. Tax: 10 percent of $20,000 is $2,000, plus 20 percent of the other $10,000 is $2,000. Total $4,000.
• Year two, 8 percent inflation, no indexing. The raise brings her to $32,400. Tax: $2,000 on the first $20,000, plus 20 percent of $12,400, which is $2,480. Total $4,480. Her tax bill went up 12 percent ($4,480 divided by $4,000 is 1.12) while her income, and her buying power, stayed where they were.
• Year two, with indexing. The $20,000 line moves up 8 percent to $21,600. Tax: 10 percent of $21,600 is $2,160, plus 20 percent of $10,800 (that is $32,400 minus $21,600), which is $2,160. Total $4,320, which is exactly 8 percent more than $4,000, the same as her raise.

The difference between the second and third lines is $160 a year, taken from this one worker without a single vote. Multiply that by tens of millions of households and you can see why indexing mattered more than the headline rates, and why it is the piece of the 1981 law that has lasted the longest.

Law two: the tax increase nobody mentions at the rally

Now for the part that surprises people. The federal deficit grew quickly in 1982. Revenues fell, spending on defense and benefits rose, and the recession cut into tax collections. In September 1982 Reagan signed the Tax Equity and Fiscal Responsibility Act, known as TEFRA, which raised revenue by closing and trimming some of the business breaks from 1981 and raising some excise taxes, among them the tax on cigarettes.

Conservatives are often sensitive about this, and they should not be. Reagan accepted the bill on the promise of large spending cuts to follow, reportedly about three dollars of cuts for each dollar of new taxes. The cuts largely did not arrive. That is a lesson about promises made by Congress, and it is one the party relearned in 1990, as we describe in Read My Lips and How the 1990 Budget Deal Led to the 1992 Defeat. Later in the decade there were other tax measures too, such as the payroll tax increases that were part of the 1983 Social Security rescue.

So when someone says Reagan only cut taxes, the answer is that he also signed increases. When someone says Reagan raised taxes and so the cuts were a fraud, the answer is that the 1981 rate cuts and indexing stayed in place. The truth is a record with more than one chapter.

Law three: the Tax Reform Act of 1986

This is the one conservatives should know best, and almost nobody does. The Tax Reform Act, signed on October 22, 1986, was a different kind of law. The 1981 act cut rates. The 1986 act traded lower rates for a wider base.

What that means in plain English: the tax code was full of deductions, shelters and special treatments that let some people with high incomes pay little or nothing. The 1986 act removed or limited many of them. In exchange, it lowered the rates on everyone. The headline numbers:

• The top individual rate dropped from 50 percent to 28 percent, fully in effect by 1988.
• The corporate rate dropped from 46 percent to 34 percent.
• The number of brackets was reduced to two main ones, 15 percent and 28 percent.
• The standard deduction and personal exemption rose, which took millions of low-income families off the income tax rolls entirely.
• Many tax shelters were closed, including a limit on the use of passive losses to cut taxes on other income.
• Capital gains were taxed at the same rates as other income.

The bill was designed to be revenue-neutral, meaning it was meant to raise about the same amount as before, with the loss from lower rates offset by a bigger base. The Senate passed its version 97 to 3 in June 1986, with Democrats and Republicans both involved in writing it. Our post the 1986 tax reform that lowered rates by closing loopholes gives the details, and the principle is one every Republican should keep in a drawer: lower rates and a broader base beat high rates and special favors.

The strongest case against

Let me state the opposing case at its best. It runs like this.

1. Rates went down, but the deficit went up. Federal spending did not shrink, defense spending rose, and revenue as a share of the economy fell. The debt, which stood at under a trillion dollars at the start of the decade, roughly tripled by its end.
2. The tax cuts did not pay for themselves. If they had, the deficit would not have grown. The best-known version of the idea, the Laffer curve, says that at some very high rate, cutting a rate can raise revenue. That may be true at 90 percent. It was not true at 50.
3. The benefits were unevenly spread. Larger cuts went to higher earners because they had higher rates to cut.
4. Growth was not unusual. The 1980s expansion was strong after 1982, but critics point to the recession that came before it, and to other periods of growth.

The reply

I'd answer on each point, and I'd concede where I must.

On the deficit: the critic is right that the tax cuts did not pay for themselves, and conservatives who say they did are overselling it. The official revenue estimates at the time scored the 1981 law as a large revenue loss, and the later record does not overturn that. The deficit peaked at about 6 percent of the economy in 1983 and fell for several years after. It grew from a combination of the tax cuts, a deep recession, the defense buildup, and a spending side that Congress, including Republicans, would not restrain. Democrats held the House for the whole decade, and Republicans held the Senate only until 1987. The remedy was to control spending, and as our essay A Balanced Budget Is a Moral Argument Before It Is an Accounting One argues, that is the part still unfinished.

On who benefited: the critic is right that higher earners got bigger dollar cuts, because they paid more tax to start with. But the 1986 reform took millions of low-income households off the rolls, and indexing protected every bracket from inflation. The share of income taxes paid by the top earners rose after the cuts, because lower rates brought income out of shelters and into the open.

On growth: a recession ending is not a miracle, but the length and depth of the expansion that began in 1982 is not nothing. Inflation went from double digits to the low single digits and stayed there. Mortgage rates that had averaged above 16 percent in 1981 came down, and families could plan again.

On the big question of revenue: nominal federal revenue grew through the decade. Adjusted for the size of the economy it fell for several years and recovered. Both statements are true, and they are not in conflict.

What it means for a family

If you take one lesson from this, take the structure. The three laws did three things: cut rates, protected against inflation, and cleaned up the base. A tax debate that talks only about rates is missing two-thirds of the reform. The next time a candidate says "cut taxes," ask three questions: which rates, protected against what, and paid for by what. And ask a fourth: what happens to spending?

The bottom line

• Reagan signed three tax laws, not one. The 1981 law cut rates and indexed the brackets, the 1982 law raised some revenue, and the 1986 law cut the top rate to 28 percent by broadening the base.
• The tax cuts did not pay for themselves, and conservatives lose credibility when they say they did. The best defense is the real one: lower rates, a stronger economy and indexing that stopped silent tax hikes.
• The deficits came from many sources, including a recession, defense spending and a Congress that would not cut. Fixing them still means controlling spending.
• When you read a tax proposal, look at the base as well as the rate. A low rate on a narrow base is a different thing from a low rate on a wide one.
• Check any number you hear on this subject against the Treasury, the Congressional Budget Office and the text of the laws themselves, all of which are public.