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208 IRET Congressional Advisory 1 (2006)

handle is hein.taxfoundation/iretcgadv0205 and id is 1 raw text is: INSTITUTE FOR RESEARCH ON THE ECONOMICS OF TAXATION IRET is a non-profit 501 (c)(3) economic policy research and educational organization devoted to informing the public about policies that will promote growth and efficient operation of the market economy. August 1, 2006 Advisory No. 208 IMPORTANT TAX ANNIVERSARIES: ERTA'S 25th AND INDEXING'S 20th August 13 marks the twenty-fifth anniversary of President Reagan's signing of the Economic Recovery Tax Act of 1981 (ERTA). That Act reduced marginal personal income tax rates across the board, phased in over four calendar years, to increase incentives to work, save, and invest. ERTA also introduced tax indexing, the practice of adjusting personal exemptions, the standard deduction, and the tax brackets for inflation each year to keep inflation-driven income increases from pushing taxpayers into higher tax brackets. That provision was effective in 1985. When people filed their tax forms in April 2006, it was the twentieth time that they received the protection that indexing offers against bracket creep. ERTA's rate cuts and indexing were part of the Reagan economic policy that brought an end to the stagflation of the 1970s, and led to a seven-year expansion that created some eighteen million jobs. Many tax rate changes have been enacted since, some for the better, others not. The indexing feature is the last remaining, largely unchanged, major piece of the original 1981 tax cut, and one of the most important for economic growth and job creation. The 1970s Problem: Stagflation During the 1970s and the start of the 1980s, the United States experienced a period of stagflation, which is slow economic growth combined with inflation. Four recessions marked the era. Unemployment trended up. Inflation and interest rates soared well into double digits. Real after-tax wages were falling. Each business cycle through 1980 seemed to leave us worse off. (See chart 1.) The Keynesian economic theory of the time could not offer a solution. It viewed all economic policies as working by increasing or decreasing aggregate demand. To fight inflation, government would raise taxes, cut its spending, and slow the growth of the money supply, all policies set on stop to reduce private or public sector spending on goods and services. GDP would be expected to slow and unemployment to rise in the process, until inflationary expectations were wrung out of the system. To fight unemployment, the government would cut taxes, increase its spending, and create money at a faster pace, all policy tools set on go. Inflation would be expected to increase, lowering real wages to encourage hiring. This trade-off, that there had to be more inflation to get lower unemployment, was known as the Phillips Curve, which helped put the dismal in the Dismal Science. The Insight: Inflation-Driven Tax Rates Were Strangling Hiring and Investment At the time, there were fifteen taxable brackets for a married couple, with tax rates ranging from 14 percent to 70 percent (capped at 50 percent on wages). The dollar amounts that separated one tax bracket from another were not adjusted for inflation. Neither were the personal exemption and the standard deduction. The brackets were not very wide in percentage terms, especially compared with double digit inflation. With inflation and a cost of living increase, more of a worker's income was subject to tax, and the taxable portion spilled over into higher tax rate brackets. Average and marginal tax rates rose. e~em kfl A * * gg~ 8 ~eg

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