25 years after Kemp-Roth

Posted: Jul 11, 2002 12:00 AM
This Sunday is an important anniversary in the history of tax policy. On that day in 1977 -- 25 years ago -- then-Congressman Jack Kemp, Republican of New York, and then-Senator William Roth, Republican of Delaware, introduced what came to be called the Kemp-Roth tax bill. Enacted into law just four years later, this legislation fundamentally altered debate about economic policy in the United States that continues to the present day. The Kemp-Roth bill proposed cutting statutory tax rates by about 30 percent across the board. The bottom rate would be reduced from 14 percent to 10 percent, and the top rate from 70 percent to 50 percent. Both of these rates had been unchanged since the Kennedy tax cut of the early 1960s. In the meantime, however, there had been massive inflation. Between 1963 and 1977, the price level doubled, meaning that one needed twice as much income in 1977 to live as well as in 1963. This had the effect of raising the effective tax rate on most people. As workers got cost-of-living raises, they got pushed up into higher and higher tax brackets, as if their real income had increased. According to the Treasury Department, the average federal income tax rate on a family with the median income rose from 7.09 percent in 1965, after the Kennedy tax cut was fully phased-in, to 10.42 percent in 1977, when the Kemp-Roth bill was introduced. Over the same period, the marginal tax rate -- the tax on each additional dollar earned -- went up from 17 percent to 22 percent. In other words, a worker with the median income went from keeping 83 cents out of every $1 of pay increase to keeping just 78 cents. Kemp and Roth thought that this sharp rise in tax rates was largely responsible for the stagnation of the American economy in the 1970s. They believed workers and entrepreneurs needed to keep more of their earnings in order to stimulate growth, productivity and investment. They also thought that high tax rates were exacerbating inflation by reducing the supply of goods and services in the economy. Since inflation is too much money chasing too few goods, anything that increased production was per se anti-inflationary. At the time the Kemp-Roth bill was introduced, however, the dominant view among economists was that budget deficits were the primary cause of inflation. They favored tax increases, not tax cuts, and said that passage of the Kemp-Roth bill would be dangerously inflationary. Kemp and Roth responded that inflation resulted from the Federal Reserve creating too much money, not deficits, and that a tight monetary policy, which they supported, would reduce inflation regardless of how large the deficit was. Such a view was absolute heresy in 1977. The Congressional Budget Office, for example, believed that the money supply had nothing whatsoever to do with inflation, and that cutting tax rates would add fuel to it. CBO Director Alice Rivlin said that output would fall if tax rates were cut, because workers could work less and still get the same after-tax income. A commonly held view at the time was that it would either take decades to bring inflation down to tolerable levels or another Great Depression. Arthur Okun of the Brookings Institution reflected the views of most economists when he said in 1977 that the economy would shrink by 10 percent for every 1 percent fall in the inflation rate. To his credit, Ronald Reagan rejected the conventional view and supported Kemp-Roth, making it his principal campaign issue in 1980. Jimmy Carter, who endorsed the establishment's thinking, rejected tax cuts as inflationary. He said that inflation was just due to a lot of bad luck -- oil price increases by Arab countries, bad harvests and the like. Carter never once took responsibility for inflation's rise from 4.9 percent in Gerald Ford's last year to 13.3 percent in 1979 and 12.5 percent in 1980. Kemp-Roth was considered reckless even by Republicans -- George H.W. Bush called it "voodoo economics," and Senate Majority Leader Howard Baker, Republican of Tennessee, called it a "riverboat gamble." But Reagan pressed ahead with a tight money policy at the Fed and a sharp reduction in tax rates in 1981. And as he, Kemp and Roth knew would happen, the economy not only recovered, but inflation collapsed to about 4 percent throughout the 1980s. To this day, none of the economists who predicted hyperinflation from the Reagan-Kemp-Roth tax cut have ever acknowledged the gross error of their predictions. They just pretend that the whole thing never happened. Yet the 180-degree turnaround in the American economy from the 1970s to the 1980s took place and cannot be denied. Without Jack Kemp and Bill Roth, it might not have happened.