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Financial Research Publishing, Inc.

Money Forecast Letter

March, 2017

As the debate over tax reform begins, it could be useful to brush up on the

history of the Reagan tax cuts.

Financial Research Publishing Inc.Money Forecast LetterMarch, 2017Ashland, Massachusetts - March 2, 2017

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At long last, it appears that our new President and Congress are finally going to sit down to hammer out concrete legislation and a budget for fiscal year 2018.

I don’t mind telling you, I was getting nervous that Donald Trump was not up to the job for which we elected him. I expected that President Trump would need some time to get a handle on the job; even the most successful men in the private sector discover that governing is nothing like running a business. Fortunately, after a few false starts, it looks like he is starting to get it. At the very least, he now has a supporting cast that can help guide him through the political process. Congress too, appears ready to sit down and do the work we elected them to do. The only big question left relates to the Democratic Party. Up until the night of the President’s address to Congress, the game plan seemed centered on delay and denial. After the speech, the Republicans and the media (!) concluded that Donald Trump was up to the task of governing. However, until at least some Democrats decide to join in, the country still

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MARCH, 2017 3

faces the possibility of continued stalemate in Washington.

That would not just be a waste of an opportunity; it could prove fatal to the growing sense of optimism in the country, which in turn could derail this recovery and wipeout the remarkable gains we have seen in the stock market.

It is too early to be certain just what legislation will make its way through Congress during the rest of 2017. Certainly, there is an appetite for historic change. Tax reform, regulatory relief, changes or outright repeal of the Affordable Care Act and immigration reform are just four of the big tasks Congress have set for themselves. It seems that almost every day, the President, a Congressman, a Senator or a member of the President’s Cabinet goes before the cameras and informs the American people which important piece of legislation will come first and which will need to wait until later. To make matters worse, at the same time countless sources in both the public and private sectors claim to know what the Administration is thinking and how they want congressional action to unfold. I have no doubt that 95% of all this talk is meaningless bluster, put forth by self-aggrandizing figures hoping to leave the impression that they are an intimate part of Washington’s power structure. You can decide for yourself if you want to take any of these rumors seriously, I find myself ignoring almost all of it these days.

In the end, all that matters are the bills that Congress passes and the President signs. It will likely be months

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before any of the big four legislative initiatives make it to the President’s desk. In the case of the ACA reform effort, it would not surprise me if we had to wait until next January before we get to actual votes on reform.

If you ask my opinion, all this debate over what must come first is a waste of time.

If this Congress is serious about getting things done it should start small. Decide which bill has the greatest chance of bipartisan cooperation and move that to the top of the list. Opening lines of communication and forging alliances that get something done will make it easier to tackle the bill that comes next. After two or three successful efforts at crafting compromise legislation that garners a majority of votes in the House and at least 60 votes in the Senate, it is going to be a lot easier to keep the ball rolling when it comes time to debate the really tough issues. Right now, I suspect that immigration and healthcare reforms will prove the most contentious items, suggesting that maybe Congress should take a crack at regulatory relief and tax reform first.

President Trump has already taken the lead by using executive orders to begin rolling back some of the most destructive regulations holding back growth in the country. The approval of the Dakota Access and Keystone XL pipelines will provide a boost to the oil and gas industry and create much-needed jobs in America’s Heartland. His order that each new regulation must come with the repeal of two others should help reduce the roadblocks to future growth and his efforts to rein in some of the EPAs more

MARCH, 2017 7

aggressive tactics when it comes to what constitutes an actual waterway here in America, is also a good first step.

However, there is only so much a President can do using executive orders. Real reform requires legislation and that only happens when Congress decides that the election is really over and the time to govern has begun. Perhaps, if the Republicans begin marking up bills, the Democrats will conclude that their obstructionist agenda is not working and will at last seek a place at the table. I remain hopeful that enough Democrats want a chance to have a say on coming legislation that a patina of bi-partisanship might emerge. If it does, the newfound optimism here in America might just be justified.

Since I think that tax reform is both the most important task before Congress and the one most likely to attract bipartisan support, it would not surprise me if it turns out to be the first major piece of legislation to come up for a vote this year.

If I am reading the tarot cards right, the single biggest point of friction among those involved is between those who wish to lower rates and those who wish to preserve as many deductions (or “loopholes”) contained in the tax code as possible. Already I have seen Op Ed pieces laying the intellectual groundwork for the pro and con sides of this argument. Interestingly, those in favor and those opposed to lowering tax rates cite the Reagan tax cuts during the 1980s as proof that their position is correct. I think we should take another look at the Reagan tax cuts. Perhaps

MARCH, 2017 9

after all these years, we might finally have a dispassionate examination that determines whether cutting taxes by lowering the top marginal rates really can “pay for itself.”

Let’s start with a little history to set things up. Back in 1981, when Ronald Reagan took office, the top marginal individual income tax rate in America was 70%. President Reagan argued that high rates discouraged Americans from working harder to make more money. He also believed high rates encouraged tax avoidance schemes that misallocated capital. In the summer of 1981, the Economic Recovery Tax Act of 1981 became law. It phased in a 25% reduction in all tax rates over three years; lowering the top rate to 50% and the lowest rate from 14% to 11%. However, the act was about more than just lowering tax rates. ERTA also slashed corporate taxes, lowered estate taxes, and introduced the concept of adjusting tax brackets for inflation – although this particular item was deferred until 1985.

Few phrases have had a more useful shelf life than “Supply-Side Economics.” Opponents of efforts to lower tax rates have made it synonymous with wooly-headed thinking about tax cuts that “pay for themselves.”

The year after Ronald Reagan pushed through the first of his tax cuts, federal deficits ballooned. On page two, you see a chart that tracks the rise in annual deficits following the enactment of ERTA. At first glance, it certainly appears that the Reagan tax cuts more than doubled the nation’s

MARCH, 2017 11

annual deficit. In fact, to this very day, every schoolchild in America learns exactly that.

For some highly partisan opponents of tax cuts, the criticism of Reagan’s plan does not stop there. I wish to reproduce a small section of the official analysis of the 1981 tax cut that has found its way in to the Wikipedia page dealing with the Economic Recovery Act of 1981. “In the year after enactment of ERTA, the deficit ballooned, which in turn, drove interest rates from around 12% to over 20%, which, in turn, drove the economy into the second dip of the 1978-82 “double dip recession”. The Dow Jones average, which had been over 1000 before enactment of ERTA, fell to 770 by September 1982. Much of the 1981 ERTA was backed out in September 1982 by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), sometimes called the largest tax increase of the post-war period. The “Reagan recovery” began within weeks of enactment of TEFRA.”

Where do I begin? Let us start by looking at the chart on page two again. Notice that wide gray column that spans from the middle of 1981 to almost the end of 1982, that would be the recession of 1981-82 referred to in the Wikipedia quote. I am sure I don’t need to remind you about the causes of the second part of the “double-dip” recession that occurred in the early 1980s, but I will anyway.

When Ronald Reagan took office, he had a meeting with Paul Volker, who was then Chairman of the Federal Reserve. Volker explained to Reagan that his war on

MARCH, 2017 13

inflation was not yet complete. Jimmy Carter had hired him to tame inflation, but the recession he created in 1980 had only reduced the annual inflation rate from 14.6% to 9.4%. He wanted Reagan to greenlight a renewal of his war on inflation, one he was confident would finally get the job done. Reagan, knowing that no real economic recovery could begin until the Fed ended runaway inflation, readily agreed that Volcker must continue the fight. Volker again clamped down on excess money creation, which brought on a deep and protracted recession; one that coincidentally began right about the time that Reagan was signing the tax bill into law.

One can only wonder what American history would be like if Paul Volcker had succeeded in taming inflation before the summer of 1981.

If he had, the second half of the infamous “double-dip” recession may never have come. The plunge in government tax revenues that accompanies every severe recession would not have occurred and left-leaning economists and all the opponents of limited government would have lost their most effective argument against keeping marginal tax rates as low as possible.

Lost to history is this interesting fact, when Ronald Reagan promoted the idea of cutting marginal tax rates, he never argued that lower tax rates would produce an explosion in revenues that would fund expanded government spending programs.

MARCH, 2017 15

Reagan’s tax plan projected only modest increases in government revenue, which it turns out was very much in line with the Congressional Budget Office’s projection for post-tax cut revenues. Alas, the 1981 recession forever denied us ability to know what might have happened.

It is equally unfortunate that President Reagan signed the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) into law in September 1982. Yes, panic over rising deficits forced the President’s hand, but it forever gave opponents of lower tax rates the opportunity to label ERTA a mistake and TEFRA the solution. Simply put, this is not true. TEFRA did repeal accelerated depreciation deductions enacted the year before, but those deductions had not yet kicked in, making it impossible for them to contribute to declining tax revenues in 1982. Additionally, the changes to dividends and interest income were completely revenue neutral; they simply accelerated the collection of taxes through new withholding rules. In short, all the so-called fixes to the 1981 tax bill had zero impact on the size of budget deficits during the 1980s. That has not stopped Reagan’s political opponents from misrepresenting the reasons behind the surge in tax revenues that began in 1983.

Those who claim that Reagan’s reduction of marginal tax rates and increases in defense spending produced higher deficits and greater income inequality are playing fast and loose with the facts.

MARCH, 2017 17

Let’s take a look at a few more charts from the 1980s. On page four, you see the chart that tracks federal government tax receipts during the 1980s. Notice that tax revenues continued to climb all through the `80s, including after 1986 tax legislation slashed more tax loopholes out of the tax code while simultaneously lowering the top tax rate to just 28%. This chart refutes all those who say that cutting rates while broadening the tax base is responsible for rising budget deficits. On page six, you see the chart that tracks federal tax receipts as a percentage of GDP. This can be a very handy way to measure the effects of so-called tax cuts. Note that tax receipts climbed as a percentage of GDP after both reductions in the top rate.

As for tax fairness, the evidence suggests that the combination of lower rates and less income sheltering produced a dramatic shift in the distribution of the income tax burden.

Prior to the 1981 tax cut, the top 10% of income earners paid 48% of the income taxes collected. By 1988, that figure rose to 57.2% while the share of income taxes paid by the bottom 50% of taxpayers dropped from 7.5% to 5.7%. Most impressively, middle class taxpayers saw their tax burden fall from 57.5% to just 48.7%; this portion of the tax base effectively shifted to the top 1% – whose taxes climbed by 51% from 1981 to 1988.

On page eight, you see a summary of the top tax rate compared to per capita income tax revenue. This chart suggests that, absent the distorting effects of the 1981

MARCH, 2017 19

recession, lower marginal rates led to an increase in per capita taxes. At the very least, we can make the argument that lower rates did not lead to lower revenues.

So why didn’t America see a decline in its annual budget deficits – when measured in dollar terms or as a percent of GDP?

When attempting to answer that question, the obvious place to start is with the spending side of the equation. On page ten, you see the chart that tracks federal government spending during the 1980s. This chart should surprise no one, as it shows federal spending growing at a very aggressive clip during the whole decade. Critics of Reagan’s tax cuts only take time off from blaming rising debt levels on ill considered “tax cuts” to bash the out of control defense spending that drove those deficits. But did it really?

From 1981 to 1988, tax revenues climbed 53%, despite two dramatic decreases in tax rates.

During this same period, government spending increased faster than receipts. Between 1981 and 1988, overall spending rose 58%. On page twelve, you see the chart tracking defense spending. Obviously, spending under Reagan was greater than it would have been under Carter or Mondale, but at 68%, the defense budget growth was not that much faster than the growth in overall spending. On page fourteen, you see the growth in Social Security spending during the same period; it grew by 55% between

MARCH, 2017 21

1981 and 1988. On page sixteen, you see the chart tracking other government transfer payments; this grew 51% over the same period.

The chart on page eighteen deserves your particular attention. This chart tracks the growth in federal government interest payments back in the 1980s.

From 1981 to 1988, interest payments on the national debt climbed by 86% - from $162.7 billion to $303 billion. Keep in mind that this came at a time when the interest rate on the 10-year Government Bond was falling from 15.3% to 7.25%. If not for the successful war against inflation, that figure could have easily been twice as high.

I bring this last point up because I want you to be mindful of the situation we find ourselves in today. I ask you to look at the chart on page twenty. Note that the Federal government now has over $19 trillion in outstanding debt. That is $10 trillion more than we had at the end of fiscal 2007 and will soon begin rising by about $1 billion a year.

Thanks to the Fed’s campaign to drive interest rates down to historic lows, the country’s annual payments of interest remained fairly stable, despite the doubling of the debt since 2007. This year, the federal government expects to spend $303 billion on interest. That was up 26% from the year before, but even with the amount paid in 2007. Given the likelihood that long-term interest rates are heading higher this year and next, there is every reason to believe that


the interest payment portion of the debt will soon begin to swell. I have seen credible estimates predicting that a 1% rise in the average interest rate on government debt will increase annual interest payments to $574 billion by fiscal 2021. Since I believe that the average rate could rise by more than 1%, I fear we are looking at an annual price tag of $1 trillion dollars a year just to service our national debt.

Is that a lot of money these days? Consider this. Congress is now getting ready to argue over the defense budget for fiscal year 2018. The budget request from the President would increase defense spending to $603 billion. Yes, $1 trillion dollars is a lot of money and finding it will bring pain to America - unless we end our addiction to deficit spending.

There is one intriguing possibility currently under consideration at the Treasury.

Other countries have been experimenting with ultra-long Treasury bonds, which in some cases have locked in negative rates for the issuing countries. Because rates are still near historic lows right now, 50 or 100-year Treasury Bonds, combined with an effort to trim our annual deficits could shield the Treasury from rising interest costs for quite some time. Our new Treasury Secretary says he is actively considering the idea, so it won’t be long before we know if these ultra-long bonds might stave off at least one possible crisis facing the federal government. I will keep you posted on what comes of this idea.

— David C. Jennett

MARCH, 2017 23High Praise For The NewOverseas Intelligence Report

We decided to publish our new letter because so much important news was coming from overseas that we could not possibly find space to share it with you in the Money Forecast Letter. Obviously, there was no way of knowing whether this letter would prove useful to our readers, which is why it was very gratifying to receive this note from a new subscriber.

“I have been a long time subscriber to Money Forecast and have found it valuable. Your new international letter is of the same high quality. In the area that few travel (European economics) you give in-depth and easy to read views into European trends. Thank you,

B.B., Las Vegas, Nevada

Needless to say, this positive feedback was welcome confirmation that the Overseas Intelligence Report was proving useful to our readers and we are eager to encourage more readers to take a look at the letter. Below is an excerpt from a recent letter.

…So engrossed are we in this daily battle between President Trump and the Democrats, the media and even the Republicans, we have little time to take note of news from overseas. This is a mistake.

While the 2016 U.S. elections are now behind us, many of our most important allies are holding national elections of their own in 2017. The rise of populist parties across Europe is proving to be every bit as challenging to the entrenched powers of Europe as they proved to be here in America. The Post-World War Two order is being challenged at the ballot box and it would be wise to stay informed about the likelihood of more Trump-like upsets in the coming few months.

France

While the media here in America likes to paint Donald Trump as a populist, one really must visit France to get a true understanding of what real populism looks like.

Unlike America, France does not have a winner take all approach to

MARCH, 2017 24elections. Several parties will compete for votes in the first round of voting on April 23; the top two vote getters then face off on May 7. Marine Le Pen, leader of the Front National Party is the candidate most often compared to Donald Trump. She took control of the party from her radical father, Jean-Marie and steered the party away from the some of the more scary policies that made the National Front so feared. Le Pen is now riding the wave of anti-immigrant and anti-globalism sentiment growing in France to position herself as an early favorite to make it through to the second round of voting. She recently released a list of 144 “presidential commitments” that layout a blueprint for radical change. That list includes the departure from the European Union, more prisons, more police, an end to open borders and a demand that all Muslims in the country assimilate into French society by giving up all visual signs of their faith. Le Pen wishes to expand state control through a new industrial policy that favors manufacturers over the financial sector and she is promising to put strict limits on foreign investment, while taxing both imports and foreign workers.

Republican Party candidate Francois Fillion is a French Thatcherite who was an early favorite until allegations of a half-million euro no-show job for his wife led to a steep decline in his popularity. Fillion denies the charge, but it is unclear whether he can recover in time to make it to the second round of voting.

Normally, the fall from grace by the Republican candidate would guarantee the French Socialist Party a clear path to power…

Because we think the information inour new letter is so valuable, we want

to make you an irresistible offer.Subscribe now and we will send you the

entire above letter as a free bonus.Read the letter for three months (six issues).

If you don’t find it useful, simply cancel and we will refund you 100% of your money. You will

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