Cato Policy Analysis No. 45 December 19, 1984

Policy Analysis

Deficits and Taxes:
Federal Budget and Fiscal Policy in the 1980's

by Thomas S. McCaleb

Thomas S. McCaleb is associate professor of economics at Florida State University and a former senior staff economist with the Council of Economic Advisers.


Executive Summary

The economic program proposed by the Reagan administration at its inception in 1981 was designed to reduce government spending and taxes relative to the economy's total output or gross national product (GNP). As a first step in implementing the program, the administration proposed a phased reduction in tax rates over the three years from 1981 to 1983. This was to be accompanied by reductions in the level of spending proposed by the Carter administration for fiscal year (FY) 1982. The tax reductions were in fact adopted by Congress, and a set of spending reductions was incorporated into the First Congressional Budget Resolution. The budget process for 1982 was never completed, however, and the 1981-82 recession intervened.

The net result of these efforts has been that tax rates are lower now than in 1980, but not lower than rates in 1979. The reductions in aggregate federal expenditures relative to GNP, however, have not materialized. Indeed, during the first three years of the Reagan administration, federal spending as a percentage of GNP increased to historically high peacetime levels. Because the decline in the rate of growth of tax revenues has not been matched by a decline in the growth of expenditures, the government's budget deficit in real terms has also reached unprecedented peacetime levels. The 1983 deficit was almost 6 percent of GNP. Projected deficits for 1985 and 1986 exceed 4 percent of GNP. These levels are of the same order of magnitude as those reached during the Great Depression of the 1930s. Without a reversal of the tax reductions or significant real spending cuts, the projected deficits will not fall below 3 percent of GNP until 1989.

The projected federal budget deficits have now become the central focus of economic policy. Furthermore, deficit mania has swept Wall Street, the national media, and even the groves of academe, where the National Bureau of Economic Research has launched a major project to investigate the impact of government budget deficits. The deficit issue poses three major questions: (1) Where did the deficit projections come from? (2) Where did the projected deficits come from? (3) Where will the deficit reductions come from?[1]

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