RESEARCH REPORTS. AMERICAN INSTITUTE for ECONOMIC RESEARCH. The Reagan Tax Cuts A Look at the Facts. Published by. Vol. LVIII No. 22 November 18, 1991

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1 Published by AMERICAN INSTITUTE for ECONOMIC RESEARCH Great Barrington, Massachusetts 123 Data from income tax returns do not support widely held beliefs concerning the effects of the "Reagan tax cuts." Federal income tax receipts have increased and more was paid by highincome taxpayers after the top rate was decreased to 28 percent from 7 percent. The fact that "the rich" now report more income and pay more taxes on it should be seen as a success of "Reaganomics" not as a reflection of its deficiencies. The year 1979 was the last nonrecessionary year in which the top Federal income tax rate was 7 percent. Preliminary data for 1989 income tax returns, which was the latest nonrecessionary year, were recently published. The following summaries of tax returns for these 2 years show the totals and averages for the top 5 percent of all tax returns ranked by Adjusted Gross Income (AGI) and all other returns: 1979 No. of Returns 92 Total Income Taxes 1979 dollars 1989 dollars Percent of Total Average Income Tax per Return 1979 dollars 1989 dollars Total,694,32 $214.5* $366.4*.% $2,314 $3, No. of Returns 112,279,818 Total Income Taxes 1989 dollars $457.8* Percent of Total.% Average Income Tax per Return 1989 dollars $4,77 * Billions. Top 5% of Returns 4,634,714 $8.9* $138.2* 37.7% $13,625 $23,271 5,613,995 $21.1* 43.9% $35,813 The Reagan Tax Cuts A Look at the Facts All Other Returns 88,59,588 $133.6* $228.2* 71.% $1,727 $2,95 16,665,823 $256.7* 56.1% $2,47 It is astonishing how much these actual data contradict the "conventional wisdom" regarding income taxes in general and the changes wrought by the "Reagan tax cuts" in particular. Perhaps the three most significant and widely held myths that are contradicted by actual data on income taxes are: Myth #7: 'The rich don't pay taxes." Higher income taxpayers have always paid substantial taxes, far more than the average taxpayer has paid, in both absolute terms and as a percentage of reported incomes. This was so in 1979 and even more so in Myth #2: "The Reagan tax cuts starved the government for revenue and are the reason for record budget deficits." Federal receipts from individual income taxes increased over 113 percent between 1979 and In constant (1989) 125 RESEARCH REPORTS Vol. LVIII No. 22 November 18, 1991 dollars the increase was nearly 25 percent, to $457.8 billion. Adjusting for the increase in the number of workers and taxpayers, the increase was much smaller, but nonetheless an increase, as the average tax per return increased 3.2 percent (again in constant dollars), from $3,952 in 1979 to $4,77 in Myth #3: 'The Reagan tax cuts favored the rich." The share of Federal income taxes paid on the top 5 percent of returns increased from 37.7 percent in 1979 to 43.9 percent in Even more astonishingly, the average tax due on the top 5 percent of returns increased from $17,499 in 1979 (equal to $29,82 in 1989 dollars) to $35,813 in 1989, an increase of 15 percent in current dollars and 2 percent in constantdollar terms. In fact, higher receipts from the top 5 percent of income tax returns accounted for more than twothirds of the entire increase in income taxes between 1979 and 1989: the average tax bill for the other 95 percent of taxpayers actually decreased 7 percent, in terms of constant dollars, between 1979 and We can only speculate on the reasons for the persistence of these beliefs, and the general disregard of data, such as the foregoing, on taxes actually paid by taxpayers. Some may quibble about the selection of the years for comparison and others may dispute the definition of "the rich" (for example, a reported adjusted gross income of slightly more than $75, in 1989 was sufficient to place one's tax return in the top 5 percent of all returns, which may or may not make one "rich" according to one's point of view). However, as shown in the accompanying chart, comparisons such as the foregoing lead to similar results whether one examines the top 1 percent, the top 5 percent, or the top 1 percent of tax returns: their share of taxes due increased between 1979 and If tax return data for other years before and after the 1981 and 1986 Tax Acts are examined, a similar shift in the burden would be found. With the top 1 percent of the returns consistently accounting for over 5 percent of the total income taxes paid, the notion that "the rich" pay no taxes is, and always was, nonsense. It would seem to be based purely on envy of and/ or malice toward those with high incomes, buttressed by the fact that the reports on income tax returns (the very same data we used above) indicate that each year the bizarre and Byzantine workings of the tax laws enable a handful of highincome taxpayers to pay no taxes. For example, in 1989 there were 61,987 individual tax returns filed with AGI's of $1,, or more. Their average AGI was $2.57 million. Of these, 61,918 had a total tax liability of $39.5 billion, or an average of $638, each (for an average effective tax rate of 24.8 percent, which was the highest of any income level). However, there were 69 such returns on which no tax was due, a fact that seems to cause apoplexy in some quarters. There is not a shred of evidence that these 69 taxpayers also paid no taxes for 1988 or 199. Our guess is that the

2 HIGHEST INCOME RETURNS AS A PERCENT OF ALL RETURNS The top 1 percent of taxpayers paid a larger share of income taxes in 1989 than in 1979; in both years, they paid over half of all income taxes due. Percent of Taxes Due Note: Returns are ranked by descending AC I. 1 Percent of Returns 1979 fact that they owed nothing for 1989 mainly reflected some sort of blunder in their tax planning, and that their total tax liabilities over the years actually were larger than if they had spread out their income, losses, deductions, etc. more evenly. In any event, these 69 taxpayers amounted to only.11 percent of all taxpayers with 1989 AGI's of $1 million. They were hardly representative of "the rich." The notion that the tax reform acts of 1981 and 1986 favored "the rich" would seem to rest entirely on the fact that the 1981 law reduced the top income tax rate from 7 percent to 5 percent, and the 1986 law reduced it further, to 28 percent. The rationale for these changes was simple: high tax rates inspire taxpayers to forego, postpone, or hide income, and it was expected that dropping the rates would encourage people to save and invest (propertyrelated income predominates at the higher levels) in ways that produce taxable income. That the "experiment" was a spectacular success, with the top 5 percent of returns shouldering 44 percent of the total income tax burden in 1989 when the top rate was 28 percent vs. only 37.7 percent 1 years earlier when the top rate was 7 pendent, is blithely ignored in most discussions. In this regard, envy would seem to be more powerful than any evidence. The notion that the reduction in tax rates served to reduce government revenues is simply not so. It can only be made to appear valid by assuming that the same AGIs would have been reported if the old rates has remained in effect. This is unrealistic, not only because it was clearly the lower rates that fostered the rapid growth of reported AGIs, but also because there can be little doubt that the 198's would have witnessed some sort of "tax relief no matter who had won the 198 elections. Throughout the decades prior to 1981 Congress reduced taxes many times. This was usually done to offset "bracket creep" (the fact that the application of progressive tax rates to inflated incomes made taxes go up faster than nominal income). With the significant exception of the "Kennedy" tax reforms (enacted after he was shot), these mainly involved adjusting the brackets and creating and enlarging "loopholes." The great change that was sought and largely obtained by President Reagan was to markedly reduce the rates, plug the loopholes, and index the tax brackets. As indicated above, if anything, this seems to have increased government receipts 1 from income taxes somewhat. The lower rates and plugging of "loopholes" were designed to be "revenue neutral," especially in the 1986 Act. That the amount diverted for the politicians' use no longer swells as the currency is debased, can only be seen as a reduction in revenues from the perspective of "inside the beltway." Not only has this aspect of "supply side" economics, lower tax rates prompting taxpayers to earn and report more income and pay more taxes, been studiously ignored by its critics, its very success has been used as evidence against it. The fact that higher bracket taxpayers have reported markedly higher incomes is often cited as evidence that "Reaganomics" has enabled the "rich to get richer." Have the rich gotten richer? It is clear that the highest income taxpayers are now paying more taxes and paying a larger proportion of all income taxes. They probably do have more left over after taxes. That is another important aspect of "supply side" policies, for it is higherincome households that provide most of the Nation's savings. Encouraging those savings to be channeled in the most productive investments, rather than squirreled away in taxshelters and other lowyield, but lightly taxed, holdings was a major rationale for bringing down the rates. Does that mean that the poor have gotten poorer? We don't know, and we don't think anyone else does either. Few data are as elusive and subject to manipulation as those on income distribution. Most such data overstate the disparities because they use pretax income and omit noncash income. Ignoring taxes overstates the resources available to taxpayers and ignoring food stamps, housing, and other subsidies understates the resources available to "the poor." A similar overstatement of disparities arises when estimates of income distribution are based on "households." Contrary to popular belief, higher income households tend to be larger, on average, than lowincome households. The top 2 percent of households, ranked by income, includes more than twice as many persons as the bottom 2 percent. "Intact" families with children predominate among the former category, whereas individuals living alone tend to be at the lower end. The lower end, in fact, presumably includes many individuals who are able to live by themselves with (untabulated) financial assistance from other family members, which can be a sign of affluence rather than poverty if the family was really poor, grandmother would move in and junior would stay at home. Perhaps even more misleading is the notion, implicit in most discussions, that the income distribution is static in some sense, i.e., that "the rich" and "the poor" are permanent categories of people. In our society, there is an astonishing mobility of individuals, with respect to the relative income level of the household in which they live. These changes reflect differences in earning power at different ages as well as changes in family status arising from divorces, deaths, marriage, remarriage, births, and children leaving home. Few stay at the very top of the income distribution for long. Among the 61,987 tax returns reporting AGIs of $1 million or more in 1989, 46,72 reported capital gains on Schedule D. These gains averaged $1.1 million per return, and the vast majority of those taxpayers probably reported substantially lower incomes before and after This is not to say that there are no people who are either very, very, rich or very, very poor, or that no one stays that way for long periods. The point is that most discussions of income inequality greatly overstate its significance to either the individuals concerned or to the Nation as a whole. The fact that "the rich" now report more income and pay more taxes on it should be seen as a success of "Reaganomics" not as a reflection of its deficiencies. 126

3 675 PRIMARY LEADING INDICATORS Turning points in these series typically lead businesscycle peaks and troughs by 3 to 6 months. All but one series (the 3month percent change in consumer installment debt) are above their cyclical lows, which indicates that the economy is likely to continue to grow. Some of the series have "flattened out" since August, however Ml MONEY SUPPLY (1> M2 MONEY SUPPLY {\)» _ PERCENT CHANGE >N SENSITIVE MATERIALS PRICES (6) 6 6 [6/91] 12 [a/91] 12 6 NBV ORDERS, CONSUMER GOODS (3) (Constant Dollars, Bill tons) * CONTRACTS & ORDERS, P. & E. (4) [7/91] INDEX OF HOUSING PERMITS (3) '5 '55 '6 '65 '7 127 '75 '8 '85 '9 6

4 PRIMARY LEADING INDICATORS (Continued) RATIO OF MANUFACTURING & TRADE SALES TO INVENTORIES (3) VENDOR PERFORMANCE (2) (Percent) x < INDEX OF STOCK PRICE${2) (Constant Dollars); AVERAGE WORKWEEK, MANUFACTURING (3) INITIAL CLAIMS, STATE UNEMPLOYMENT INSURANCE (3) (Thousands, Inverted) [8/91] PERCENT CHANGE M CONSUMER INSTALLMENT DEBT (4) [7/91] 1945 '5 '55 '6 '65 '7 '75 '8 '85 '9 Note: The number in parentheses next to the name of a series is an estimate of the minimum number of months over which cyclical movements of a series are greater than irregular fluctuations. That number is the span of each series' moving average, or MCD (months for cyclical dominance), used to smooth out irregular fluctuations. The data plotted in the charts are those MCDs and not the base data. The number in brackets is the latest month for which the moving average is plotted. 128

5 12 PRIMARY ROUGHLY COINCIDENT INDICATORS The highs and lows of these series help identify the peaks and troughs of business cycles. Currently, five of the six coinciders are appraised as expanding (the cyclical status of the employmenttopopulation ratio is indeterminate). However, the most recent monthly data for four series decreased. EMPLOYMENT <N NONACRICULTURAL ESTABLISHMENTS (1) 6 « INDEX OF INDUSTRIAL PRODUCTION {1987 = ) PERSONAL INCOME, MANUFACTURING (2) [8/91] [7/91] 6 3 MANUFACTURING & TRADE SALES (2} (Constant DoJIars, Billions) NONAGRICULTURAL EMPLOYMENT RATIO (2) 48 CROSS NATIONAL PRODUCT (1) '5 '55 '6 '65 '7 129 '75 '8 '85 '9 6

6 PRIMARY LAGGING INDICATORS Instead of peaking some months after overall business conditions peaked, as they usually do, most of the lagging indicators hit their highs well before the recession began. Currently, most of the laggers appear to be contracting, as we would expect in the early stages of a recovery AVERAGE DURATION OF UNEMPLOYMENT (2) (Weeks, Inverted* 8 [8/91] 4 MANUFACTURING & TRADE INVENTORIES (1) COMMERCIAL & INDUSTRIAL LOANS (1) RATIO OF CONSUMER INSTALLMENT DEBT TO PERSONAL INCOME (1) PERCENT CHANGE FROM A YEAR EARLIER IN INDEX OF LABOR COST PER UNIT OF OUTPUT 8 4 [8/91] " COMPOSITE OF SHORTTERM INTEREST RATES (1) (Percent) '5 '55 '6 '65 '7 13 '75 '8 '85 '9

7 BUSINESSCYCLE CONDITIONS: The AIER leading index "stalled" for a third month at 89, while the percent of coincident indicators expanding increased to this month. Both suggest that, statistically, continued business expansion is more likely than a renewed contraction. Despite a recent media blitz of bad news about the economy, and despite a concurrent erosion of "consumer confidence," consumer spending (aided by debt rescheduling) continues to propel the economic recovery. Among the primary leading indicators of businesscycle conditions, the underlying trends for the two monetary aggregates diverged further in September. The Ml money supply series, which is composed of noninterest bearing currency and demand and checkable deposits, increased and is appraised as clearly expanding. (This and all other dollardenominated series are reported in constant dollars.) On the other hand, the broader M2 money supply, which includes interestrate sensitive deposits, dropped $8.5 billion, or a seasonally adjusted annualized rate of 4.2 percent. The series contracted for the fourth consecutive month and its cyclical status remains indeterminate. In November, the Federal Reserve again interfered in financial markets in an attempt to arrest the deterioration of M2. Fed officials forced down the Federal funds rate on overnight interbank loans to 4.75 from 5. percent and the discount rate on direct lending to commercial banks to 4.5 from 5 percent. In turn, banks cut the prime lending rate on loans for their most valued corporate customers to 7.5 from 8 percent. Declining interest rates apparently have failed to induce new lending to or borrowing by consumers and business. Ironically, as savers reallocated funds from low interest bank accounts toward the higher yielding stock and bond funds, the THE STATISTICAL INDICATORS Direction of Change in Base Data Primary Leading jul. Aug. Sept. Oct. Ml money supplyt M2 money supplyt Chg. in sensitive mat. prices ' New orders, cons, goodst Contracts & orders, p. & e.t Housing permits Mfg. & trade sales/inv.t Vendor performance Stock pricest Average workweek, mfg. nc' Initial claims, unempl. ins.* Chg. in cons, instal. debt Percent expanding cyclically Primary Roughly Coincident Nonagr. employment Industrial production nc' Personal income, mfg.t Mfg. & trade salest Nonagr. employment ratio Gross National Producttq Percent expanding cyclically Primary Lagging Avg. duration of unempl.* nc Mfg. & trade inventoriest Com'l. & industrial loanst Cons, instal. debt/pers. inc. Chg. in labor cost/output Shortterm interest rates Percent expanding cyclically Cyclical Status 9/91 1/91 11/91? f? i??????????????????? ? 67?? 17? 67? _ 17?? tin constant dollars. * Inverted, q Quarterly, nc No change. 'Revised. Under "Direction of Change," plus and minus signs indicate, respectively, increases or decreases in monthly or quarterly data from the previous month or quarter, blank spaces indicate data not yet available. Under "Cyclical Status," plus and minus signs indicate expansions or contractions of each series as currently appraised; question marks indicate doubtful status when shown with another sign or indeterminate status when standing alone. 131 _ 17 AIER LEADERS PERCENT EXPANDING "CYCLICAL SCORE" OF AIER LEADERS 197 '8 '85 '9 Fed actually reinforced the contraction of M2 by promoting low interest rates, and the diversion of funds propelled the moving average of the constantdollar index of 5 common stocks prices to a new high. That series is clearly expanding. A further ramification of the downward trend in U.S. interest rates concerns debtors' "paying down" of consumer installment debts and refinancing of home mortgages, both of which carry high interest charges. In this respect, total consumer installment debt shrank $3.5 billion in September, and the 3 month change in consumer installment debt hit a new low. The series is clearly contracting. Further, effective mortgage rates dropped markedly over the last decade from a peak of 16.4 in 1981 to near a 14year low of 9.19 percent this September, according to the Federal Housing Finance Board. As a result, home refinancing surged in proportion to new mortgage credit. By rescheduling mortgage debt into lower monthly payments or a shorter loan maturity, homeowners reduced their debt exposure, saved on interest charges, and indirectly increased their "effective" disposable incomes. The outlook for consumption may improve considerably if this trend persists. However, conditions in the housing industry deteriorated sharply in September despite declining mortgage rates. The sales of new homes decreased 66,, or 12.9 percent, and the unsold inventory of new homes swelled to an 8.3 months' supply, according to the National Association of Realtors. While its moving average fell slightly, the index of housing permits remains appraised as probably expanding. In contrast, the manufacturing sector strengthened last month. New orders for consumer goods and materials rose $.8 billion in September, and the series' moving average was upgraded to clearly from probably expanding last month. The vendor performance series, a diffusion index of purchasing managers surveyed reporting slower deliveries, gained during September and is appraised as clearly expanding. The ratio of manufacturing and trade sales to inventories fell in August after robust backtoback gains in the preceding months, and the moving average for the series still is appraised as probably expanding. Despite decreases in their base data, the cyclical statuses of the moving averages of both the 3month rate of change in sensitive materials prices and contracts and orders for new plant and equipment remain indeterminate. The labor series also continued to expand. The 3month moving average of the average workweek in manufacturing series increased in September and is appraised as clearly expanding. Although its base data declined for the second consecutive month in September, the moving average of initial claims for unemployment insurance (inverted) remains appraised as probably expanding. The single upgrade for the new orders for consumer goods series left the percentage expand

8 ing of leaders for which a trend is apparent unchanged at 89 (8 out of 9) from last month. AIER's experimental cyclical score improved slightly to 51 from a revised 5 last month. Both scores continue to indicate economic expansion. Among the roughly coincident indicators, the moving average of the nonagricultural employment ratio increased in September, and the cyclical status of the series was upgraded to indeterminate from probably contracting last month. The Bureau of Labor Statistics revised nonagricultural employment for September upwards by 59, employees in addition to the 24, gain initially reported. Such an upward bias in monthly revisions is not uncommon during recoveries, since newly formed businesses are slow to report payroll information to the Federal agencies. Nonagricultural employment fell by 1, in October, and the cyclical status of the series remains appraised as clearly expanding. According to the Commerce Department's advance estimate, Gross National Product increased $24.2 billion, or an annualized 2.4 percent, in the third quarter of Although GNP remains below its previous peak and the advance estimate is subject to further revisions, the series warranted an upgrade to probably expanding from clearly contracting last month. As a result of these changes, the percent expanding of coinciders for which a trend is apparent increased to (5 out of 5) from 67 (4 out of 6) last month. Although an "official" date to mark the end of recession requires two consecutive quarters of increasing GNP, the roughly coincident indicators of employment, income and production confirmed again this month that the economy continues to expand. Among the primary lagging indicators, the average duration of unemployment (inverted) dropped to a new low in October, and the series' cyclical status was downgraded to clearly from probably contracting last month. With five series hitting new lows, the percent expanding of laggers remains unchanged at 17(1 out of 6) for the fourth consecutive month. We would expect the laggers soon to post modest increases to "confirm" that the economy has in fact passed through a trough and is well on the path of recovery. Consumer Behavior: "Attitudes" vs. Spending Consumer "optimism" often is viewed as crucial to a general recovery, since consumer spending accounts roughly for twothirds of Gross National Product. For the same reason, consumers' willingness to spend by assuming new debt is often cited as an indicator of economic activity. That is, they usually finance "big ticket" purchases, such as automobiles and other durable goods, with installment credit. The individual components of consumer credit, although fluctuating in tandem during past business cycles, recently have diverged. Total consumer installment debt has decreased markedly, which is attributable mainly to the automobile credit component that started to deteriorate almost 3 years ago, well in advance of the last recession. On the other hand, revolving and "other" installment credit behaved as a coincident indicator; the series peaked in July 199, flattened out, and dropped slightly thereafter. In fact, total consumer installment debt fails to incorporate important alternatives now available for consumer finance, such as car leasing for prospective buyers without a down payment or lowinterest home equity credit lines often used to consolidate highinterest debts or finance consumption. Moreover, although surveys of consumer optimism have been widely viewed as nearfuture indicators of spending, they are not reliable under every circumstance. For example, the Conference Board survey of Consumer Confidence and Expectations asks consumers to appraise current and future prospects for employment and the state of the economy, as well as whether now is a good time to purchase durable goods. Al 132 MEDICARE UPDATE Under a Federal law that took effect November 5th, people aged 65 and older cannot be denied private "medigap" health insurance coverage on account of poor health if they apply for it within 6 months after enrolling in Medicare Part B. From the standpoint of public policy, forcing insurers to provide coverage to people they consider uninsurable is one more step away from the principles of sound insurance. One likely consequence will be higher premiums for all consumers, including healthy individuals. If this happens and policymakers respond by introducing legal restrictions on insurers' ability to raise premiums, a further consequence might be that some insurers would drop out of the Medicare supplemental insurance market altogether. (State regulation of auto insurance already has prompted some insurance companies to withdraw from the automobile insurance markets in New Jersey and California.) From the individual consumer's perspective, we recommend that all eligible persons take advantage of the new law. Individuals with health problems that have made it difficult or impossible to obtain "medigap" insurance are precisely those who need it most, since they face a higher than average risk of requiring medical treatment. Consumers should carefully study available policies before making the decision to buy, however, since coverage and premiums vary widely. Our Economic Education Bulletin "How to Cover the Gaps in Medicare" offers advice on how to choose a policy, how to compare policies, and how to avoid common pitfalls of "medigap" insurance (price: $7). though not a "tight" relationship, changes in consumer attitudes are believed to correspond to fluctuations in consumers' debt spending roughly by 6 months, especially for purchases of durable goods. After surging in the aftermath of the Persian Gulf War, consumer optimism plummeted, which has raised concerns mat the economy is faltering. Surveys of consumer attitudes thus would suggest that consumer spending could have been expected to decrease. In fact, the most recent data (September) show that it surged to new highs. Personal consumption, which increased $14.9 billion at an annualized rate of 6.8 percent in September, was concentrated mainly in durable goods and services, and the moving average of that series increased for the seventh consecutive month. Moreover, disposable income of consumers increased $4.5 billion, or 1.9 percent, during the same month. Since overall debt continues to contract, the rapid growth of spending apparently was financed out of either disposable income or savings. In either event, consumers' actual spending behavior seems far more pertinent to the business outlook at this stage of the recovery than either surveys of consumer "optimism" or the conventional belief that a reluctance to spend by assuming new consumer debt at the current very high rates (in relation to interest charged on other types of debt) is an indication of consumers' indifference. Under present circumstances, their "unusual" behavior might properly be viewed as an indication of their sophistication. Of course, their behavior might change quickly and the outlook for the economy become more bleak. But so far, as with previous episodes, consumers are the driving force behind this recovery. Final fixing in London PRICE OF GOLD 199 Nov. 15 $ Nov. 7 Nov. 14 $354.5 $355.6 Research Reports (ISSN 34547) (USPS 31119) is published twice a month at Great Barrington, Massachusetts 123 by American Institute for Economic Research, a nonprofit, scientific, educational, and charitable organization. Second class postage paid at Great Barrington, Massachusetts 123. Sustaining memberships: 3116 per quarter or $59 per year. POST MASTER: Send address changes to Research Reports, American Institute for Economic Research, Great Barrington, Massachusetts 123.