Taxes Cut, Inflation Curbed : Huge Debts Cast Shadow Over Economic Revolution

By ART PINE

Aug. 23, 1988 12 AM PT

Times Staff Writer

WASHINGTON —

Ronald Reagan’s eight-year stewardship of the American economy will be a hard act to follow--in more ways than one.

By some standards, the Reagan economic revolution has been spectacularly successful. Inflation is now barely one-third of what it was when Reagan took office in 1980. Unemployment is at a 14-year low. Interest rates are sharply lower than when he took office, even though the prime rate has climbed 1.5 percentage points to 10% since May. The economy has created 15 million new jobs.

Income-tax rates have been slashed to the lowest levels in decades. A sweeping tax revision package has removed many of the tax code’s earlier inequities.

“You have to go back to Franklin Roosevelt before you find a President who has had as much impact,” said Paul W. McCracken, a University of Michigan economist who served as former President Richard M. Nixon’s economic adviser.

At the same time, the President’s policies have also created massive economic imbalances, which threaten to put an end to what is now the longest period of economic expansion since the 1960s. The imbalances could constrain and even preoccupy the next Administration, no matter what its stripe.

The new President will inherit an annual budget deficit in the range of $150 billion. Interest on federal borrowing is running at $152 billion a year, a staggering 14% of the total budget. And, because of a trade deficit that reached a record $170 billion last year, the United States has become a debtor nation. Too much consumption has pushed the economy near the point of overheating, intensifying inflationary pressures.

Consequently, the public’s sense of well-being about the present is accompanied by an anxiety about the future. Polls show more people believe that the economy is getting worse than believe it is getting better. As many fear it will be weaker in five years as expect it to be stronger.

Constraints on Successor

Whoever follows Reagan in office, whether Democrat Michael S. Dukakis or Republican George Bush, will encounter some serious constraints on his ability to strike out in new directions. He will have to work with Congress to pare back the federal budget deficit. He must keep the economy from overheating lest inflationary forces build back up and renewed demand for imports increases the trade deficit.

That is not precisely the economic legacy that Reagan and his conservative followers initially envisioned.

Reagan’s revolution was supposed to be won according to a strictly “supply-side” battle plan: The Administration was going to cut taxes sharply and pare back federal spending on domestic programs, thus reducing the role of government and giving the private sector more room to breathe. That, in turn, would spur production and bring in more tax revenues, eventually eliminating the budget deficit and taming inflation.

Recession Tamed Inflation

Inflation was indeed tamed, but that was largely the result of a deep recession in 1981 and 1982 that dampened demands for large wage increases and brought interest rates down. The lion’s share of the credit goes to Paul A. Volcker, then Federal Reserve Board chairman, who clamped down on money and credit policies, putting the economy through the wringer. Whatever credit Reagan gets from most analysts is simply for not interfering with the Fed.

“Ultimately, the Administration made Volcker’s job easier because they stuck with him,” says Henry R. Nau, a former National Security Council economic strategist now at George Washington University here.

Nor did production immediately shoot up in response to the supply-side revolution. As the Administration initially portrayed it, Reagan’s 1981 tax cuts were supposed to spawn a boom in investment, increase productivity dramatically and encourage Americans to save far more.

None of that happened. The savings rate has actually declined sharply from the pre-Reagan period. Investment is finally beginning to pick up, but mainly because exports are back on the rise and U.S. industry is having to expand to meet the overseas demand.

“I don’t see the supply-side results,” said Herbert Stein, who served as the Nixon Administration’s chief economic strategist. “I see a long period of expansion, which I attribute mainly to the nimbleness of monetary policy. But some of what his revolutionaries were looking for simply didn’t happen.”

No ‘Alternative Policy’

Supply-siders still insist that the Reagan era will stand as proof that their formula works. Paul Craig Roberts, a former Reagan Treasury Department official, argued in a recent Wall Street Journal essay: “The reason for supply-side’s permanence is more important than mere result. It takes a policy to dislodge a policy, and no one has an alternative policy. Indeed, no serious politician wants one.”

As for Reagan’s fiscal strategy--his deep tax cuts combined with defense spending increases and domestic spending cuts--it went awry almost as soon as it reached Congress.

The plan, which Vice President Bush--as a rival to Reagan for the GOP presidential nomination in 1980--had labeled as “voodoo economics” because it promised tax cuts, defense spending increases and balanced budgets all at once, was questionable enough on its own.

And Congress not only passed the new President’s proposals to slash tax rates for upper-income taxpayers and to cut capital gains taxes, but it also reduced taxes for a wide variety of other income groups. More significantly, it provided sweeping--some said unnecessary--new tax write-offs for investment in real estate and farms.

Slump Cut Revenues

The government lost far more from the tax cuts and the defense spending hikes than it gained from domestic spending cuts. In addition, the recession cut tax revenues by squeezing incomes, and it boosted government spending for welfare and unemployment programs.

The result, as Edward Guay, economist for Cigna Corp., recalls it, was a fiscal explosion. The annual deficit, already at record levels, nearly tripled between 1981 and 1983.

That finally blasted the United States out of its recession. With the government pumping more money into the economy in the form of expenditures than it was taking out in the form of taxes, a go-for-broke national spending boom spurred Americans to live beyond their means. Imports began surging ahead of exports.

With the United States buying everyone else’s goods, “the rest of the world was saved from having a very sluggish economy,” said Tadashi Nakamae, an economic consultant to some of Japan’s leading business conglomerates. “If there had been no U.S. expansion, Japan and Europe would have had a very difficult time.”

The budget deficit, in the view of most economists, contributed to the other Reagan deficit, the gap between imports and exports. Stimulated by the deficit, Americans spent more than they produced--and bought the difference abroad. The deficit sent government borrowing up sharply, thus increasing interest rates at home and contributing to the rise of the dollar, which made exports less competitive and imports an even bigger bargain.

Record Trade Deficits

Within a few years, the nation had amassed a record annual trade deficit that ultimately swelled to $170 billion. American manufacturers, unable to compete with foreign firms, found themselves forced to retrench far more than they ever thought they would, accelerating the restructuring of America’s manufacturing sector. America’s industrial capacity shrank visibly.

Yet, the Administration did little to come to grips with the budget. Reagan, adamantly opposed to increasing taxes or reducing defense spending, refused to compromise with Congress, which, in turn, refused to slash domestic social programs much more after 1981. Eventually, both sides decided to pass the buck to a fiscal robot--the Gramm-Rudman budget law, which trims back spending levels automatically if the deficit exceeds certain targets.

The dollar’s rise was finally arrested three years ago, but the trade deficit, although retreating from last year’s record, remains enormous. It has exerted tremendous pressure to raise barriers to imported goods, pressure that Reagan has not entirely resisted.

Although the President professes to be a free-trader, the Administration has imposed more trade barriers than any in recent memory. Textiles, autos, steel, machine tools, semiconductors, motorcycles--all received some form of protection from foreign competition.

As a consequence, said George Washington University’s Nau, “the next Administration, whether it’s Republican or Democratic, is going to have to be less free-trade oriented. And that’s totally contrary to the Administration’s philosophy.”

No Economic Cooperation

The trade deficit helped force Reagan to reverse his “America first” approach to international economic policy. At the outset, the Administration eschewed globalist economic cooperation and refused to intervene in foreign exchange markets. Donald T. Regan, Treasury secretary in Reagan’s first term, asserted that the United States and its allies should concentrate on combatting inflation and improving economic efficiency at home.

But, as American fiscal policies pushed the dollar to record heights, they intensified frictions between the United States and its economic allies. When James A. Baker III took over from Regan in the second term, he led a concerted international effort to help drive the dollar down and began a new system for policy coordination among the major countries.

Now the United States intervenes frequently in international currency markets to keep the dollar in check. It is a posture that the next Administration will find hard to avoid maintaining.

Views of Taxes Transformed

Regardless of the economic fallout from the budget deficits, one of their prime contributors--the 1981 tax cuts--apparently has transformed Americans’ views of taxes. Barry Bosworth, Brookings Institution economist and a Jimmy Carter Administration official, recalled that, before Reagan took office, the Republicans’ main role had been “mainly to just say no” to Democratic spending proposals--a posture that inevitably left the party with a negative image.

But Reagan’s successful marketing of broad-scale tax cuts “rejected that (role) and brought in a completely new thing for Republicans to grasp,” Bosworth asserted. “Tax cuts are the new GOP way not to be the bad guy. That creates a real dilemma for public finance. It was the Republicans who, by saying no, used to keep some degree of responsibility. But now that’s all gone as well.”

Some traditionalist Republicans agree. Stein, now an economist with the American Enterprise Institute, complains that Reagan’s new approach was more than simply rejecting the old GOP austerity posture. “It was denying that the objectives being pursued had any costs,” he says. He calls it “the transition from the old-time religion to the economics of joy.”

To many analysts, Reagan’s most enduring contribution to tax policy was not the tax cuts but the income tax overhaul he pushed through Congress in 1986, eliminating most of the so-called loopholes that had given voters the impression that the tax system was inequitable. Also, it reversed many of the provisions in the 1981 law--such as the special breaks for real estate investment--that had distorted the economy.

Carter Bill Hooted Down

The bill, a landmark by any measure, fulfilled a goal that had been eluding Democrats for years. When President Carter proposed a less sweeping bill than Reagan’s, it was hooted down by Congress as naive and visionary. John Makin, a fiscal expert at the American Enterprise Institute, calls the tax-revision bill “the real jewel in the Reagan crown.”

But the final proof of Reagan’s economic policies is in the results. And there the experts remain divided.

Lawrence Kudlow, a Reagan supporter who was chief economist at the White House Office of Management and Budget during the early Reagan years, contends that “the ultimate legacy of the Reagan Administration is the strong performance of the economy. In the end, whatever the theory, it’s the performance that counts.”

‘Debt Is So Enormous’

To Joseph A. Minarik, an Urban Institute fiscal expert, the legacy is the debt the Administration incurred along the way. “The debt is so enormous that it outweighs the relatively minor changes that the Administration has been able to make,” Minarik says. “As a result, we literally have to run faster just to stay in place.”

One prediction is more certain. As David Hale, chief economist for Kemper Financial Services of Chicago, said: “We’ll be debating about this Administration through the 1990s.”

THE REAGAN ECONOMY Unemployment has fallen

Annual average unemployment rate

‘88* 5.2* Percent

* as of July

inflation has been tamed

Annual average change in consumer

price index

‘88* 4.8* Percent

* estimate

and interest rates have tumbled

Average prime rate charged by banks’88* 10.0* Percent

* current