Reagan, Tax Cuts, and GDP

January 4, 2012

By State of thought

In honor of the GOP’s idol, President Reagan, lets take a look at the effect of his tax cuts for the top marginal rate. When we looked at the course of the past 80 years as a set, it looks as if there isn’t a particularly clear correlation between top marginal tax rates and GDP growth. But what if we weren’t looking close enough? After all, the last few decades seemed to have a noticeable symmetry.

Where should we look? For President Reagan, whose tax cuts came into play around 1982, we should see those rates working their magic on the economy by two years later in 1984. The rates would continue any effect after President Reagan left office, so lets keep looking up through 1992.

Inspiring, don’t you think? Apparently that GDP growth going down in about the same slope that top marginal tax rates were going down must have been what they meant by “trickle-down.”

Of course, that might not be entirely fair. We should probably look at the President’s entire term and see what happened in case we can credit the tax cuts immediately with a big initial boost that gradually faded.

As seen in the chart of 1980 to 1992, there is indeed a big spike in GDP growth immediately after the tax cuts begin. Yet that conflicts with what we see in the rest of the chart. Why would lowering taxes correspond with expansion in one section of the chart and contraction in another? In this case, we need additional data: the Fed rate. The Fed ramped up interest rates brutally high for the early 80s in order to tame massive inflation. The Fed rate had been slowly ratcheted up over 1978 and 1979. The rate for 1979 started at 10% and went up to almost 14%. For 1980, the rate averaged 13%. For 1981, the rate averaged over 16%. The prime interest rate even ventured into the 20s in 1982. These high rates did tame the inflation, but in doing so they brought on the recession of 1981-1982 because they made it much harder to borrow to invest for growth. Naturally, when the brutal interest rates were eased back down in 1982, there was some pent up thirst for financing just waiting for lower interest rates.

What can we draw from 1980 through 1992 as far as taxes and GDP? If these years are indicative of anything, it is that under relatively normal interest rates lowering the top marginal tax rate appears to come with a corresponding drop in GDP. Whereas during a period of extreme high interest rates, there appears to be no correlation between top marginal tax rates and GDP because of the growth-blocking effect of extremely high interest rates.

For the Gipper, unfortunately, that top marginal tax cut play doesn’t seem to have been a win.