A ‘Reformed Drunk’ on Tax Relief

This op-ed originally ran in the The Wall Street Journal on April 18, 2003. Copyright The Wall Street Journal

Our newspapers and television screens are filled with stories of combat and victory, images of empty torture chambers and cheering crowds, and concerns about what happens next, after all the statues and bullies have fallen into the Iraqi dust. This is understandable and proper. Issues of war and peace always come first. But very soon it will be time to emphasize our economy here at home.

The marvelous capabilities of our military depend on the strength of that economy. So does the quality of our lives and the lives of our children and grandchildren. In fact, it’s not too much to say that many people around the world are indirectly dependent on the U.S. economy, which is the engine of global prosperity. Strengthening our economy is, therefore, of tremendous importance, both from a practical perspective and a moral one.

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While our economy is growing today, it is growing slowly. Too many companies struggle and too many Americans look for work. There’s wide agreement on the need to promote growth, but fundamental disagreement on how to achieve it. Count me among those who believe the best way to promote economic growth is to further reduce marginal income tax rates.

I say this with respect for serious critics of tax-rate reduction, who believe that a balanced budget should trump tax relief. I respect them because I once sincerely subscribed to the same fiscal theology. But I was wrong. That’s why I often refer to myself on this issue as a “reformed drunk .” The success of the tax-rate reductions we achieved during President Reagan’s two terms in office in the 1980s sobered me up.

One of the advantages of age and experience is being able to remember things that others never knew or have forgotten, such as stagflation — the combination of stagnation and inflation. In 1980, the year before President Reagan took office, the “misery index” — obtained by adding inflation (13.5%) to unemployment (7.1%) — reached 20.6%. Newsweek said President Reagan had inherited “the most dangerous economic crisis since Franklin Roosevelt took office 48 years ago.” Economic pessimists saw this as a permanent new reality and preached about the limits of growth.

But President Reagan, fortunately and correctly, was optimistic about America’s future. His economic policy had several elements — deregulation, free trade and sound money among them — but the centerpiece was marginal tax relief. In 1980, the government claimed 70 cents out of every dollar of income at the top rate. With the help of Republicans and common-sense Democrats in Congress, we cut that rate to 50% in 1981. This rate was still too high, but was the best we could do. Then in 1986, President Reagan cut that rate to 28% as part of comprehensive tax reform.

The results were nothing short of miraculous. In November 1982, the economy didn’t just begin to grow, it began to boom. GDP growth for 1984 (7.3%) was the highest since 1951 and has not been matched since. We can now look back on 21 years of growth with only seven down-quarters: Three in 1990-1991 during the crisis over Iraq’s invasion of Kuwait and the aftermath of the savings-and-loan workout. One in the first quarter of 1993. And three more in 2001, following the dot-com bust.

Why do marginal tax-rate reductions promote growth? For the very simple reason that people work harder and invest more freely when they get to keep more of their money. It’s Common Sense 101. How hard will you work for only 30 cents out of every extra dollar you earn? And how much harder if you get to keep 78 cents of that extra dollar? Although the numbers differ, the same principle applies at every step of the rate structure. And the extra growth means increased tax revenues for the Treasury.

When President George W. Bush was sworn in, he inherited not only a weak economy, but also a top marginal rate close to 40 cents on the dollar. Once again, with the help of his own party and discerning Democrats, a Republican president won legislation to reduce marginal rates, but with an unfortunate concession: Despite the need for prompt economic growth, the reductions were phased in over five years.

And so the president now quite correctly calls for the acceleration of all rate reductions to January 1 of this year. The other elements of the president’s tax plan are also good. But the single most important thing we could do now to promote economic growth is to accelerate the rate reductions.

Those who oppose rate reductions recite the mantra of “fiscal discipline.” They’re right about deficits: They do matter. But they’re wrong to sacrifice growth for fiscal discipline: We need both.

In a perfect world, fiscal discipline would include spending restraint. Thanks in large part to the efforts of Sen. Phil Gramm and others, we had some form of spending restraint from the mid-’80s to the mid-’90s. In today’s real world, unfortunately, Congress’s appetite for living beyond its means is unchecked by legal or institutional barriers. Yet if we endlessly try to match unrestrained high spending with high taxes on the revenue side, we join a race we cannot win and we risk the health of our economy.

By contrast, the paradoxical lesson of the ’80s is that when marginal rates are too high, cutting them is — thanks to the resulting economic growth — a win-win policy for both taxpayers and the treasury. This is not voodoo economics; it’s hard, cold reality.

Mr. Baker served as treasury secretary under President Reagan, and secretary of state under the first President Bush.