South-Western College Publishing - Economics  
The Reagan Cuts: Then and Now
Subject Federal Budget
Topic Fiscal Policy
Key Words Budget Deficit, Budget Surplus, GDP
News Story

President Reagan came to office with the uppermost item on his agenda being to shrink the size of the federal government. Soon after being elected, he pushed through Congress a significant cut in personal income taxes. He believed that the decrease in revenues would force the government to decrease expenditures and thereby cause a decrease in the size of government. He and many of his supporters believed that this was a permanent change in the size of the government sector. This year, twenty years after the Reagan tax cuts, taxes as a percent of GDP will be higher than during the last five years before Reagan came to office.

The erosion of the Reagan tax cuts were due to 1) the 1980s deficits, 2) the early 1990s forecasts, and, 3) the late 1990s boom. The 1980s deficits were the result of the lack of cuts to government spending while significant tax cuts were enacted. While some blamed Congress for its reluctance to entertain cuts in programs, others pointed out that even if all of President Reagan's proposed cuts were enacted, the deficit would only have fallen by 10 percent. The increasing budget deficts put pressure on the government to raise taxes. As early as 1982, Bob Dole pushed through Congress an increase in taxes.

As the federal deficits grew, funding for private sector investment dried up. The growing deficit and the decreased availability of funds for investment produced lowered economic growth. Long-term economic forecasts by the Office of Management and Budget (OMB) and the Congressional Budget Office (CBO) consistently overestimated both economic growth and federal revenues. The tendency of these organizations to produce rosy forecasts changed with the recession in the early 1990s. OMB and CBO's forecasts were for increasing deficits and lowered revenues. As a consequence, both presidential candidates proposed tax increases and by 1994-95 tax revenues were at the same level as during Jimmy Carter's term.

In recent years, production, income and asset price growth materially increased the wealth of many Americans. As these paper gains were translated into realized capital gains, federal revenues increased and pushed federal revenues to their current high level. The Reagan revolution was now completely undone.

(Updated May 1, 2000)

Questions
1. Describe the process that produces a federal budget for the U.S.
2. How does the size of the federal government deficit affect interest rates?
3. How does the size of the federal government deficit affect private sector investment?
Source J. Bradford DeLong, "Economic Scene: Reagan vs. the Great Government Whale: Or the triumph of legend over history," The New York Times, April 6, 2000.

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