The Reagan Tax Cuts and NeoLiberalism

1
68
Reagan Tax cuts, economic

Introduction

Recently I’ve been bombarded by Economic articles expressing how neoliberalism had failed.
They said that the Reagan era of tax cuts just benefited the richest of Americans; thus, the use of neoliberalist economics is inadvisable.

While it is true that the 95th percentile of household earners did benefit the most from these tax cuts; mostly this wasn’t due to so-called inherent greed or “trickle-down economics.” Rather, it was due to the tax system implemented.

Tax cuts (and deregulation) did work during the Reagan administration – initially. However three problems can be identified from these so-called tax cuts.

The first issue that can be identified is that the Regan administration collected more taxes than the forecasts, which I’ve created.

Secondly, the tax cuts were not aggressive enough.

And lastly, the tax cuts were not across the board, as bracket creeps (explained later) essentially changed the overall favorability of tax cuts. Thus, this article will explore why the so called “Reagan tax cuts” were never realistically tax cuts.

 

Looking at Changes in Effective Taxes

We must begin by looking at the effective tax rates for each percentile of household incomes. I’ve decided to look at household income as my basis, as it provides the most complete data for analysis. By looking at real household income and the real household taxes payed between 1981 and 1989, the results are clear, as is shown below:

Percentile/year 1981 1982 1983 1984 1985 1986 1987 1988 1989 RESULT
10th Percentile 8.59% 7.72% 7.31% 7.57% 7.55% 7.43% 14.61% 16.30% 16.30% 7.71%
20th percentile 12.54% 11.29% 10.96% 10.87% 10.92% 10.87% 14.07% 16.30% 16.30% 3.76%
40th percentile 18.35% 16.98% 15.55% 15.25% 15.38% 15.49% 15.78% 16.30% 16.47% (1.88%)
Median/50th 20.92% 19.38% 17.70% 17.48% 17.61% 17.82% 18.02% 18.56% 18.86% (2.06%)
60th percentile 23.34% 21.63% 19.90% 19.79% 19.98% 20.17% 20.32% 20.79% 29.97% (2.37%)
80th percentile 29.91% 27.86% 25.81% 25.46% 25.63% 25.85% 25.59% 24.05% 24.21% (5.70%)
90th percentile 34.98% 32.83% 30.29% 30.04% 30.20% 30.48% 28.59% 26.26% 26.60% (8.38%)
95th percentile 39.43% 36.96% 34.20% 33.71% 33.88% 34.36% 30.77% 28.35% 28.60% (10.83%)
AVERAGE (2.47%)

 

The average changes in effective tax rate (across all household taxpayers), was only a reduction of 2.47%, while the average American household (50th Percentile) only saw a reduction in effective tax rates of 2.06% between 1981 and 1989.

However, the 95th percentile saw a decrease in the effective tax rate payed by 10.83%, while the 10th percentile (poorest American households) saw an increase in effective taxes payed by 7.71%!

 

Why is it that the vast majority of Americans only saw a small decrease in the amount of taxes payed, while the poorest of Americans saw a large increase in the amount of taxes being payed?

The reason for this is due to the tax schedule structure put in place during the Reagan administration, which lead to a phenomenon called “bracket creeping.”

What is bracket creeping? Bracket creeping is when your real income places you into a new (higher)tax bracket, thus reducing your effective purchasing power from what should’ve been your new  (higher)total potential purchasing power.

Take an example like this: imagine in year one your real income was 100,000USD, your tax rate was 20%, so your total purchasing power is 80,000USD. Now in year two, your real income is 103,000USD. Because you’ve fallen into a new tax bracket of 30% (as a hypothetical example), your new total purchasing power is only 72,100USD.

Because of an increase in your income (assume that nominal income also increases, rather than deflation in the economy), the new amount of tax payed now decreases your total disposable purchasing power.

From the following household earners, in their percentiles, we can see that their real income (as of 2015 PP) had increased during the Reagan administration.

Percentile Increase of real income 1981-1989
10th Percentile 9.34%
20th Percentile 11.26%
40th Percentile 13.17%
Median (50th) 11.85%
60th Percentile 12.46%
80th Percentile 15.57%
90th Percentile 18.53%
95th Percentile 22.68%
Average 14.36%

However, due to the effects of bracket creeping, we must look at the overall changes in real income after tax from 1981 to 1989.

Percentile Increase of real income after tax 1981-1989
10th Percentile 0.12%
20th Percentile 6.47%
40th Percentile 15.77%
Median (50th) 14.76%
60th Percentile 15.93%
80th Percentile 24.97%
90th Percentile 33.80%
95th Percentile 44.62%
Average 19.56%

Thus, as a result of the changes in real income after tax, we can see that the 10th percentile (poorest households of Americans) have only seen a 0.12% increase in their purchasing power, while the 95th percentile of Americans (richest households of Americans) saw a 44.62% increase in their purchasing power.

This is the result of bracket creeping; creating an imbalance of increases of purchasing power due to different changes in percentile earnings.

However, why is it that the higher you go in the percentiles, the less affected you are by bracket creep?

As a household earns more, the amount taxed is not proportionate towards the amount of income. Thus, those that are within the 95th percentile, and are earning more, would not “jump” between different tax brackets due to an increase of their income in the same way that other lower percentiles would.

 

Further Evidence that Tax cuts weren’t 100% a Reality

Let’s analyze the total amount of taxes gathered per household (individual income taxes, not total tax revenue). First, we must establish and forecast what taxes would be from 1981 to 1989. In order to do this, we must calculate taxes gathered per household from 1967 to 1979.

Year Tax Revenue per Household
1967 7179.98
1968 7524.17
1969 8887.56
1970 8525.83
1971 7568.56
1972 7870.96
1973 7889.77
1974 8036.05
1975 7399.67
1976 7393.65
1977 8108.88
1978 8508.22
1979 8804.37

 

When controlling for statistical outliers, we use a logarithmic to predict/forecast what the tax revenue per household would be from 1980 to 1990 (and thus use 1981 to 1989 as our basis of comparison).

In this table, we compare our forecasted results to the real Reagan administration results on tax revenue per household.

 

Year Real Tax/Household Forecasted Tax/Household %Difference
1981 8925.51 8139.99 9.65%
1982 8714.33 8152.77 6.89%
1983 8050.71 8164.75 (1.40%)
1984 7843.81 8176.05 (4.06%)
1985 8330.39 8186.74 1.75%
1986 8433.80 8196.89 2.89%
1987 8988.24 8206.54 9.53%
1988 8658.56 8215.73 5.39%
1989 9126.21 8224.53 10.96%
AVERAGE     4.62%

 

As shown, the Reagan administration earned on average 4.62% more revenue than forecasted with historical data. Additionally, prior to the Reagan administration (1 year before), tax revenues decreased to 8523.31USD per household, therefore by the end of Reagan’s first year, his administration had increased the amount collected per household.

One could use the excuse that when decreasing effective tax rates on average, there would be an increase the overall amount of taxes paid due to various different factors (the very basic and dumbed down description of the Laffer Curve).

However, when looking through the data from 1967 to 1990, the correlation between effective tax rates and increases in revenues are weak (although existing, 1975 was removed due to being a statistical outlier, the correlation result was negative 0.19)

Thus, we must dismiss the case (for now, unless new evidence is presented) that the decrease in average effective tax rates increased the total amount of taxes. From this, we can see that the overall amount of taxes gathered on a per household basis increased during the Reagan administration by nearly 1%, and that the Reagan administration gathered taxes higher than forecasted, and higher than his predecessor had.

 

Lessons to be learned and Conclusion

What we can learn from this is that in the overall picture, the effective tax rates on households, did not decrease dramatically in the way it is painted by opponents and supporters of the Reagan administration.

However the reason why the top percentile had a larger decrease in taxes (thus resulting in a larger increase in purchasing power) was due to the fact that they were not affected by bracket creeping.

The lower percentiles saw an increase in their real income, due to the substantial increase in economic performances during the Reagan administration; however, due to bracket creeping, this essentially destroyed their purchasing power.

From this, we learn that it wasn’t due to the so called negative effects of “trickledown economics” as many opponents of Reagan claim, but rather the fact that the structure of governmental taxation was ineffective towards those who could’ve seen a potential increase in their real purchasing power.

What is the solution for stopping bracket creeping, assuming we have another administration which restructures the tax schedule?
The obvious answer is that assuming that real incomes increase due to higher economic performance (like seen during the Reagan administration), all percentiles should see their effective tax rates reduced by the same amount.

A higher amount of tax benefits and tax exemptions should be put in place for lower percentiles in order to prevent bracket creeping.

Alternatively, this could also be a supporting argument towards a flat tax rate. A flat tax rate applied across different income earners would not distort any real gains in real incomes, thus as real incomes increase (due to increases of nominal income, not deflation of goods and services) this would translate into an increase in the overall purchasing power of all percentile households.

 

Calculation Disclaimer

(Note: all figures used have been adjusted for inflation towards 2015. Thus, the results displayed above show as little mistakes as possible. If any exist however, due to the vast amount of data calculation needed for this article, it may be possible that a non-sampling error has occurred, thus distorting the final results displayed above. Therefore, to the best of my knowledge, I believe that the information shown above is the result of correctly inserted data into my calculations.)

 

 

 

The following two tabs change content below.

Baland Rabayah

Baland Rabayah is a student of accounting and finance at Bangor University and is also pursuing a Graduate Diploma in Economics at the University of London. Baland holds a Diploma in Accounting and Finance from the Bahrain Institute of Banking and Finance. He plans to pursue to continue his studies by doing a master's in economic history and a PhD in Economics. Baland follows a mixture of Chicagoan and Austrian principles in economics, with his influences being Murray Rothbard, Ludwig von Mises, Friedrich Hayek, George Selgin, Lawrence H. White, Peter G. Klein, Ronald Coase, and Milton Friedman. He is currently part of the Being Libertarian Merchandise Project’s management, and runs his own investments. Baland is also the former CEO of MoreTech Bahrain, a start-up company which attempted to launch Bahrain's and the Middle East's first flagship smartphone. He is a racing enthusiast, and regularly races professionally in Bahrain's SWS races.