Executive Summary: The Reagan administration must coax enough of its economic program out of Congress to provide a fair test of supply-side theory. This can be accomplished if Reagan draws the line against those who would dilute the program, have it fail, and then blame the theory for failure. Opposition is much weaker than the White House imagines, leading it to negotiate with itself. Consensus-seeking by Ed Meese dilutes bolder Treasury/OMB tax plans, encouraging opposition to chip away at the President's program. The influence of the Old Guard, Bush contingent encourages Meese to sell the program without a theory, an "all-schools" approach. The coalition of theorists Keynesian, monetarist, classical will fracture as the tax, spending and monetary components of the package diverge. Demand-management Democrats must see the Reagan program fail or face submergence in the 1982 elections and beyond.
Selling the Reagan Program
The most important thing about the economic program announced by President Reagan February 19 is that he and the rest of the world identify it as a test of "supply-side" theory. General acceptance of a "test" not only influences the congressional struggle over its provisions, but also sets up the conditions for economic debate for years to come, depending upon perceptions of success or failure as the experiment unfolds. In other words, the key players are well aware of the historic importance of the Reagan experiment, which means their behavior may be different than it would be were this merely an economic maneuver bearing upon the here and now. The political horizon is broader than usual; more power is at stake than in a normal contest over taxes and spending.
The last comparable experiment in the United States was the Kennedy economic program of 1962-64, which was viewed as a test of "The New Economics." The theory was that the economy was held back by the "fiscal drag" of too-high tax rates, which should be reduced for business and individuals. Liberals and Democrats generally supported the tax cuts, conservatives and Republicans generally opposed them as being fiscally irresponsible. They were a wondrous success. On June 13, 1966, U.S. News & World Report observed:
The unusual budget spectacle of sharply rising revenues following the biggest tax cuts in history is beginning to astonish even those who pushed hardest for tax cuts in the first place.
Tax reductions put into effect from 1962 through 1965 had been advocated as the cure for "fiscal drag."
The theory: High tax rates were such a brake on business that the economy could not generate the tax revenues needed to balance the big federal budget.
The prescription: Cut taxes and, in time, reach a budget balance.
In four years, tax reductions were ordered on an unprecedented scale. Rates were reduced for individuals and businesses. Tax deductions for depreciation were speeded up. Special tax credits were offered for business investments. Excises were eliminated or cut.
All told, relief from the annual burden of federal taxes was granted in the total of about 20 billion dollars.
The steepness of the revenue rise that followed was never predicted by the advocates of "the new economics."
Since the year that ended in mid-1962, budget revenues have risen from 81.4 billion dollars to 103.9 billion a gain of 22.5 billion.
Next year, the one starting July 1, the prospect is for 116.2 billions in budget revenues. That figure predicted by the Joint Tax Committee of Congress would mean a gain of nearly 43 percent, in just five years.
The enormous success of the program had a profound, negative impact on subsequent economic events. The neo-Keynesians, who took and received credit for the Kennedy program, became entrenched "wise men." Policymakers, journalists and opinion leaders, who do not have time to learn the argot or logic of economic theory, simply accepted the correlation between Keynesian promises and programmatic success as proof of the underlying theory. Conservative Republican economists also became influenced by the correlation and drifted into the Keynesian world. After all, it worked, didn't it? And the reason it worked, we were told, was that taxpayers, now with more money in their pockets, would spend most of the increase and the effect of this increased demand would ripple through the economy.
Walter Heller, President Kennedy's chief economic adviser, on Oct. 28, 1963, told a Senate subcommittee how it would work:
The process by which an $11.1 billion tax cut can add as much as $30 billion to total demand has been frequently described and needs only to be summarized briefly here.... Since consumer spending on current output has remained close to 93% of disposable income in each of the past dozen years, one can safely project that consumer spending would rise by about 93% of the rise in disposable incomes, or by over $9 billion. But this is far from the end of the matter. The higher production of consumer goods to meet this extra spending would mean extra employment, higher payrolls, higher profits, and higher farm and professional and service incomes. This added purchasing power would generate still further increases in spending and incomes in an endless, but rapidly diminishing chain. The initial rise of $9 billion, plus this extra consumption spending and extra output of consumer goods, would add over $18 billion to our annual GNP not just once, but year-in and year-out, since this is a permanent, not a one shot, tax cut.
The spectacular success of the policy cemented the theory of aggregate demand into place. The Keynesian vision of what would happen following the tax cuts was supported by mere assertion, but it did seem logical and it seemed to work as described. The Keynesians had "proven" that the government could manipulate consumer demand through fiscal policy. If the problem is recession and unemployment, the government would increase the amount of money in the system via one shot tax cuts, permanent tax cuts or spending increases. Inflation (viewed as rising prices) would be halted by draining purchasing power from the system, via tax hikes or spending cuts. The repeated failure of policies flowing from this theory since 1965, however, does not seem to have disturbed those who believed it worked in the early 1960s. Perhaps the most passionate opponent of the President's tax-cut policy for 1981 is Sam I. Nakagama, the chief economist for Kidder, Peabody & Co., who predicts in his February 3 newsletter that "If Kemp-Roth is enacted on the currently envisioned schedule, a financial and monetary crisis will not be long in arriving." According to Nakagama, "Kemp-Roth is a Pro-Consumption Tax Cut," not a supply-side cut:
In fact, the across-the-board tax cuts will primarily have the effect of stimulating consumption. Far from backing a supply-side tax program, President Reagan is advocating a Keynesian demand-boosting fiscal program of the most extreme sort. The Kemp-Roth advocates make no secret of the fact that they are advocating a repeat of the Kennedy-Johnson tax cuts of 1964-65. Yet, that tax-reduction program which President Kennedy proposed in 1963 and President Johnson pushed through in 1964 was sold to the Congress with the argument that the tax cuts would boost business activity by stimulating consumption expenditures.
To the supply-siders, though, the Keynesian's basic premise is not only wrong, but on reflection, nonsense. A change in tax rates cannot by itself change the nation's aggregate income. Fiscal policy cannot alter the amount of money in the consumer's pocket, in aggregate. For every $1 increase in disposable taxpayer income from a tax cut, initially there will be either $1 less for recipients of federal spending (if spending is also reduced), or $1 less in disposable income for the buyers of federal bonds sold to finance the federal deficit (if spending is not reduced). Aggregate income is not changed by a change in the tax rates. And yet Keynesians who insist that Kemp-Roth will be inflationary cannot answer President Reagan's simple question, which strikes at the heart of Keynesian theory: Why is it inflationary for the citizen to spend his own money, but not inflationary for the government to spend it after taxing it away from him?
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As long as the Keynesians don't have to answer such questions, as long as they do not have to defend their theory and explain why it has not worked since the early 1960s, they can continue to chip away at the Reagan program. The least they can hope for is a program diluted to the point where its effects are inconclusive. At best, they could expect Congress to react to their warning of inflation and financial disaster by whittling it down to a point where it surely would fail overwhelmed by the continuing impact of inflation on the progressive tax schedules. This would be nice, especially if supply-side theory could be blamed for furthering economic distress.
At the moment in this clash of theories, the demand-siders are in much better shape than they ever could have expected. The supply-siders already have lost a dispiritingly high percentage of skirmishes within the administration itself. Worst of all, Washington seems to have been afflicted with a collective amnesia in the past month or so, Democrats and Republicans alike forgetting what the 1980 campaign was all about.
A review of 1980 reminds us that Jimmy Carter ran on a platform of austerity and Reagan was the candidate of growth, with the Kemp-Roth 30 percent tax cut at the heart of his strategy. Reagan won big, remember? Yet now the public-opinion pollsters are telling the politicians that there is not a majority sentiment in the land for the tax cut. The public prefers a balanced budget, say the pollsters, who always seem to pose their questions within a Keynesian framework, i.e., "Would you rather combat inflation with a balanced budget or would you fight unemployment with a tax cut?" Reagan's own pollster, Richard Wirthlin, remains a supply-side nemesis, as he was in 1980. Wirthlin, who has a PhD in Keynesian economics, continues to find and report that people prefer a balanced budget to a tax cut, as if the two were mutually exclusive. The Congress, which thinks Keynesian in overwhelming numbers as does most establishment opinion finds comfort in these polls while conveniently forgetting November 5. Austerity is fashionable and Washington is fascinated with David Stockman's budget-cutting program; the popular wisdom is developing that it will be easier for Reagan to get his budget cuts through Congress than to salvage much of Kemp-Roth.
It's not hard to understand. The Washington establishment will do anything to keep Kemp-Roth from passing, knowing full well that it will succeed and that, unlike 1963-64, nobody will be able to hide its reason for succeeding. Classical economics will be back in vogue and public and private bureaucrats, with their claims of superior knowledge over how to manage our lives and incomes, will be exposed. Facing this horrifying prospect, the elites will even throw Stockman his spending cuts while retreating in the hope of slowing down the supply-siders.
They can succeed for awhile. Stockman himself has been a mild disappointment to the supply-siders, slowing down to pick up the nickel-and-dime spending cuts thrown in his path, meanwhile diluting his commitment to Kemp-Roth. Once he donned the green eyeshade of the OMB accountant, Stockman became hypnotized by the ledgers.
It was Stockman who finally persuaded Reagan to push the effective date of Kemp-Roth to July 1, when Reagan had pledged a January 1 date. This stretches the 30 percent cut over four years instead of three. Indexing was dropped too, a frightening development, for it begins to seem as if Reagan may accept "bracket creep" as a way of getting a bit of revenue. Stockman's sudden passion for revenue also led him to propose eliminating the oil depletion allowance, which Reagan fortunately would not swallow.
The Reaganites were thus "negotiating with themselves," diluting their mandated program before it even got to Congress. This only radiates internal weakness and self-doubt, and the Congress that had been looking docile now sat up, looking for other openings to exploit White House weakness. A further blow to the supply-siders came when Reagan decided to reject the recommendation of OMB and Treasury that "unearned income" be treated as "earned income" for tax purposes, a move that would have dropped the maximum tax rate on investment income to 50 percent from 70 percent. Once again, the White House negotiated with itself. Reagan was reported to be ready to sell the idea to the public. But the White House political counselors lined up against it on the grounds that it would be criticized as a "rich man's tax cut." Of course, it would have, but the public would have supported Reagan. The rates above 50 percent produce almost no revenue, and merely subsidize an enormous tax-shelter industry. Wirthlin would be hard pressed to find more than a small minority of citizens who favor a tax rate of more than 50 percent on anyone. But the President had arrayed against him Ed Meese, Jim Baker, Martin Anderson, David Gergen, and Lyn Nofzinger. When the President gave in, the class warfare arguments against Kemp-Roth immediately intensified on Capitol Hill.
Despite all the mushiness around the White House, it would not take much resolve to get Congress into line. There is much less opposition to the economic program even Kemp-Roth than the White House imagines. There are taunts and jibes from organized labor, the poverty lobby, the old liberal coalition. But it all seems pro forma. "Clearly, the Democrats lack an alternative policy," says Norman Miller, Washington bureau chief of The Wall Street Journal "The mildness of their criticism of the President's economic proposals is remarkable."
The liberal Democrats especially have been so decimated in the last two elections that it must strike them as close to suicidal to contest a popular Reagan. House Majority Leader Tip O'Neill and Ways and Means Chairman Dan Rostenkowski are doing a lot of huffing and puffing against the Reagan tax program at least Kemp-Roth. But if it were put to a vote on the House floor, it would pass easily, because it is the centerpiece of the Reagan program. The only reason it has been diluted already, the only reason it might be further diluted, is timidity at the White House among the high command.
The Democrats and establishment Republicans will still attempt to kill Kemp-Roth by diluting it before it gets to the floor. The only strategy likely to succeed is a shameless one for the liberals, but they are proceeding anyway. The New York Times on February 26 editorialized support for this strategy, which had already been in the works: Offer liberal support for business tax cuts in exchange for dilution of Kemp-Roth! As The Times put it: "Mr. Reagan may have felt politically hemmed in by his campaign promise of across-the-board tax relief. But Congress, especially the Democratic majority in the House, has no such obligation. Indeed, those who most want to give Mr. Reagan's supply-side economics a fair chance would do well to redesign the President's tax cut to his measure." Rep. Jack Kemp has already observed this strange phenomenon. In a recent television debate with Jerry Wurf, head of the state and municipal employees union (AFSCME), Kemp found himself under attack for supporting tax cuts for people while Wurf insisted on more tax cuts for business, along state capitalist, reindustrialization lines.
The chief worry of the supply-side strategists is Edwin Meese III, Reagan's chief of policy development and, because of his long association with Reagan, the most influential of all Reagan's advisors. The worry is not that Meese opposes supply-side ideas, but that his style is to seek consensus among all contending factions. In a sense, he would like to sell policy without any theory, knowing it is always impossible to reach consensus among theorists. We can recall the observation that a camel is a horse designed by a committee. The President's economic program is one that fits no particular theory, but all schools recognize something in it for them. It is the "all schools" approach, and the congenial Mr. Meese never looked happier than when he commented on "Issues & Answers," Feb. 22, that "All schools of economic thought" supported the program, without adding "more or less."
The neoclassical supply-siders are not opposed to cutting $41.8 billion or more out of the 1982 budget, but if the cuts were done and nothing else, the government would grow much faster and so would the deficit. Imagine the President announcing, tomorrow morning, that he had decided overnight that Kemp-Roth was inflationary, and there would be no marginal tax-rate reductions until the budget was balanced. With hopeful expectations of relief dashed, private commerce would go into a tailspin, and as fast as David Stockman tried to cut the budget, it would increase automatically beyond his knife.
Similarly, supply-siders do not find business tax cuts distasteful, but relatively inefficient. The 10-5-3 accelerated depreciation that was plugged into the President's program by Mr. Meese, to satisfy Charls Walker and the Business Roundtable, does reduce part of the government wedge. But if it passed all by itself, or even in conjunction with Stockman's budget cuts, there would be no noticeable response from the economy. Ten-Five-Three is aimed entirely at increasing the investment yield on physical capital, things, rather than human capital, people. In the long run, business benefits much more from tax cuts that reward intellectual expansion, i.e., personal income tax reductions.
There are, of course, no liberal Keynesians around arguing for greater spending and higher deficits to reduce the high level of unemployment. All Keynesians are now of the conservative, commercial stripe. We cannot increase the amount of money in the pockets of people in general, across-the-board, because they will spend it on frivolities. We must "target" tax cuts to responsible consumers, i.e., businessmen, who will invest the increased disposable income on capital goods (again, presumably "things," machines, buildings, etc.). In Mr. Meese's "all schools" approach, the Keynesians see something of their flavor.
The monetarists are happiest of all with the Reagan program, because they don't particularly care what the administration does with fiscal policy. The monetarists know that fiscal policy cannot by itself alter disposable aggregate income by $1. And because they are generally free marketers, the monetarists are happy that the tax and spending cuts applied to a fixed aggregate pie will leave less for government and more for the private sector. They really are thrilled, though, that President Reagan has reached an accord with the Fed and Paul Volcker to get control of the quantity of money.
This fits in wonderfully with the Meese "all schools" approach. The monetarists get what they want. But it is most depressing to supply-siders, who believe the monetarists have amply demonstrated here, and to Margaret Thatcher, that the monetary authority cannot control the quantity of money, and it doesn't necessarily improve economic efficiency if they hit their targets by accident. Supply-siders believe the monetary authority can fix the price of money (the dollar as a store of value) by restoring a fixed exchange rate of the dollar and a specified weight of gold. Fixing the value of the dollar also facilitates its use as a medium of exchange. President Reagan would love to return to a gold standard, but the establishment loathes the idea. It would explode the notion that the inner elite at the Fed, supported by hosts of academic M1A and M1B brewmasters, could manage the money better than the masses can. (Remember, with a fixed dollar/gold price, the government cannot manipulate the quantity of money. The people alone control it by creating or extinguishing money around the dollar/gold benchmark.)
The supply-siders have the sense that Meese inclines to their populist approach on matters economic. But his inclination is overwhelmed by the establishmentarian influence at the White House. The Californians, after all, handed over enormous power to the George Bush crowd, and this has been felt keenly on economic policy. David Gergen, for example, was the Bush aide who coined the phrase "Voodoo Economics" to disparage Kemp-Roth and supply-siders. He is White House staff director, whose office is a dozen feet from the Oval Office. His patron, James Baker III, is chief-of-staff and occupies the office between Gergen's and the President's. Like Meese, Martin Anderson inclines toward the supply-siders, but the incline is overwhelmed by the Keynesianism of his patrons, Arthur Burns and Alan Greenspan. Murray Weidenbaum, thought to be a neutral in these theoretical struggles, has also weighed in heavily with the commercial Keynesians from his influential perch as Chairman of the Council of Economic Advisors.
The "all schools" approach parallels Franklin Roosevelt's in 1933, when FDR gave all the theorists a shot. He devalued the dollar in response to the monetarists, set up the National Recovery Administration for the state capitalists, called on London summit conference for the free-traders, and began planning tax and spending policies in early conformity with Keynesian doctrine. The theoretical schools jockeyed until interrupted by war.
The chances that the Meese "all schools" approach will last more than a few weeks or months are not great. The supply-side political advocates, Kemp and Stockman, have been compromised to a breaking point, trying to be "practical" and go along with the "all-schools" approach. Kemp began his break over the "unearned" income fiasco, complaining to The New York Times of White House timidity. A sweet telephone call from Reagan got him back on board, but at least Meese knows where his consensus is weakest. The awful price the supply-siders pay for this "consensus" is Kemp-Stockman silence on gold and monetary reform. Maybe Kemp will get his tax cuts if he doesn't mention gold. Maybe Stockman will get his budget cuts if he doesn't mention gold. They are silent, knowing there is nothing that could blow up the Meese "all schools" strategy quicker than a whispered four-letter word to Reagan. The high command successfully kept Lewis Lehrman out of any position within shouting distance of the Oval Office for this reason, knowing Lehrman, the supply-side candidate for Treasury Secretary, would shout the offensive four-letter word.
The financial markets seem to respond to the "all-schools" approach with continued crabwise movement, immobilized. In trying to satisfy all theories, the Reagan administration will satisfy none, and the economy will at best sit on dead center. We continue to observe that Reagan thinks of himself as a supply-sider and announces himself as such. But the program that has been designed for him has only one distinct supply-side component, the Kemp-Roth bill. Even that has been watered down. But if it is not diluted further, it is powerful enough to pull the rest of the program with it. By 1982, Meese would be able to peel away the competing schools and perhaps permit a certain four-letter word to be spoken in the White House.
Will Kemp-Roth be further diluted? Reagan reportedly has advised the GOP leadership that he is prepared to veto legislation that does so. But we can't be sure of that. Too much is at stake for the establishment to permit a solid test of the supply-side theory if they can prevent it. It would mean for the first time in 50 years classical doctrine would dominate public policy, replacing the notion that government somehow is superior to the sum of its parts.