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FRBSF
WEEKLY LETTER
April 20, 1990
The Burden of Reagan Debt
During the Reagan Administration the national
debt nearly tripled. Will this debt be a burden on
future generations? Or did Reagan fiscal policy
so enhance productivity that future generations
actually may be better off? This Letter addresses
this issue using a medium-scale econometric
model of the
economy to simulate the economic effects of Reagan fiscal policy. This model
is described in the Federal Reserve Bank of San
Francisco Working Paper, No. 89-01.
u.s.
The rise in debt
Immediately upon taking office in 1981, President
Reagan presented to the Congress a program to
counter the high inflation and low productivity
growth that existed at the time. This program
caiied for reductions in personal tax rates and
business taxes to spur saving and investment,
spending cuts to curtail the size of government
and reduce the budget deficit, reductions in the
burden and intrusion of federal regulations, and
a new commitment to a stable monetary policy.
Another important priority of President Reagan
was to step up the increases in defense spending
that had begun under President Carter. To offset
these spending increases, President Reagan
sought substantial cuts in nondefense-related
federal spending. Although Congress went along
with the tax cuts, it resisted any significant
spending cuts in nondefense areas. Consequently, the spending side of the budget did
not work out as planned by the Administration.
Impacts of Reagan fiscal policy
Whether the Reagan fiscal program ultimately
placed a burden on future generations is a matter
of debate. One widely held view is that it was
counter-productive to the original goals of higher
saving and investment. According to this view,
the lower tax rates did not increase personal
saving, but instead stimulated consumption,
while the larger budget deficits "crowded out"
at least some productive investment in the private
sector. And because little of the increase in government spending was for investment, the overall
effect of the Reagan program was to reduce the
capital stock relative to what it otherwise would
have been, thereby reducing productivity, real
wages, and real GNP for future generations.
Proponents of this view recognize that the
Reagan fiscal program attracted significant
capital inflows from abroad, which reduced the
extent to which the budget deficits crowded out
private investment. However, they argue that it
was the higher interest rates associated with
increased government borrowing that attracted
the foreign capital. Consequently, these inflows
of funds created a burden on future generations
because the government generally did not use
the money to create a larger capital stock that
would generate higher future income to service
the higher foreign debt.
An alternative interpretation of the inflow of
foreign capital is that it occurred in response
to enhanced business investment opportunities
Instead, the federal budget deficit as measured
created by the Reagan fiscal program. According
..... ona-higl+-€lmplQ¥me.nt-ba£.i£l'Ose.from.at:'l.ap~...... .. tQ.tb.4;.¥i@w,-beG<uJs€l-tb€l-Reagan program· in~···proximately balanced position in 1980 to four
volved significant deregulation and the Tax Act of
percent of GNP in 1986. The share of tax receipts
1981 included tax cuts for the business sector, the
in GNP dropped about one percentage point,
Reagan program stimulated business investment.
and federal spending on goods and services and
Indeed, the accelerated depreciation provisions
federal transfer payments rose by three percentcontained in the 1981 Tax Act reduced the effecage points of GNP. Then, between 1986 and
tive tax rate on business investment in equipment
1988, modest cutbacks in spending on goods
from 13 percent in 1980 to only one percent in
and services and increases in taxes reduced the
1985 and the rate on business investment in
deficit to a more moderate 2.4 percent of GNP.
structures from 62 percent to 39 percent.
FRBSF
Although the Tax Reform Act of 1986 raised the
tax rate on equipment back to 14 percent, it also
reduced the tax rate on structures further, to 29
percent. Moreover, because of possible efficiency gains from the 1986 Act, the productivity
of investment could have increased, raising both
the economy's current output and its capacity to
produce in the future.
Proponents of the first view argue, however,
that business investment could have been discouraged if the rise in market interest rates due
to increased government borrowing had outweighed the effect of a lower effective tax rate
on the cost of capital for business investment.
Moreover, they point out that the decline in marginal income tax rates for households probably
discouraged investment in residential structures
and other consumer durables by the household
sector. The Tax Act reduced the top marginal rate
from 70 percent to 50 percent, and the marginal
tax rate of the average individual from 30 percent
to a current value of 23 percent. Because interest
payments are tax deductible, a lower marginal
income tax rate produced a higher after-tax interest rate, raising the cost of capital for households. So, while the effect of changes in the tax
code on the cost of capital may have encouraged
business investment, it discouraged household
investment.
productive capacity. The latter estimate was not
significantly affected by Reagan fiscal policy.
The difference between this simulation assuming
neutral fiscal policy and another simulation that
assumed actual fiscal pol icy is then the measure
of the impact of Reagan fiscal policy.
In the simulation, monetary policy was assumed
to be conducted so as to achieve the same path
for the unemployment rate as actually occurred.
In practice this would not have occurred exactly.
But since the goal of the Reagan Administration
and the Federal Reserve was to reduce the rate
of inflation from double digits to more moderate
levels, monetary policy would have been fairly
restrictive in any case, resulting in an unemployment rate close to its actual level during the
period, regardless of the stance of fiscal policy.
The results of this simulation suggest that
although the Reagan program reduced taxes to
stimulate investment, it also raised real interest
rates as a result of the increase in federal borrowing. As shown in Chart 1, under the neutral,
or unchanged, fiscal policy, the real bond rate
would have been one to tvvo peicentage points
lower than it actually was. (Of course, the nomina! !evel of the yield on i~aa~rated corporate
bonds declined in the 1980s as the inflation
premium in interest rates declined, but the
real rate rose.)
Chart 1
Real AAA Bond Rate
12
Reagan Fiscal
Policy
Measuring the effects
Reagan fiscal policy could have been beneficial
to future generations if the increase in indebtedness to foreigners had been matched by a large
enough increase in the capital stock. But if the
policy caused foreign debt to rise and the capital
stock to fall, there would be a burden on future
generations. To measure the effects of Reagan
fiscal policy, an econometric model was used
to simulate what would have happened to the
ec-onom{wifl1outthe Reagan fiscal revolution.
In the model, investment is significantly affected
by various taxes, and household consumption
depends on current and past income, as well as
on wealth. Compared to alternative theories, the
hypothesized consumer behavior is particularly
well supported by the data from the 1980s.
in this simuiation all federal tax rates were
held constant at their 1980 values, and federal
government spending was allowed to grow only
as fast as the model's estimate of the economy's
Percent
10
8
6
Unchanged
Fiscal Policy
80
82
84
86
4
88
The model allows us to investigate the impact
of lower taxes and higher real interest rates on
the three main investment sectors of the economy. First, the net effect of Reagan fiscal policy
on total residential investment was to reduce it.
In the case of owner occupied housing, lower
marginal tax rates and higher interest rates both
worked to discourage housing investment by
raising the after-tax cost of housing capital. For
rental housing, the effective tax rate on new
investment on balance went down, but higher
real interest rates discouraged investment here
as well.
The story is similar for household spending
on consumer durables. Both the tax effects and
the interest rate effects of Reagan fiscal policy
worked to discourage consumer spending on
durables, and the simulation confirms that without Reagan fiscal policy consumer spending on
durables would have been higher.
In contrast, the simulation shows that the tax incentives for nonresidential fixed investment were
strong enough to offset the effect of higher real
interest rates by a small margin. Thus, Reagan's
fiscal expansion acted to raise business fixed
investment somewhat.
Taking these three investment sectors together,
the cumulative reduction in investment in housing and consumer durables exceeded the cumulative stimulus to nonresidential investment over
the period from 1981 to 1988 by $20 billion in
1982 dollars, based on the results presented in
Chart 2. In other words, Reagan fiscal policy is
estimated to have reduced the capital stock by
$20 billion, implying that the Reagan budget
deficits were partially financed by a crowding
out of private domestic investment.
-
Chart 2
Effects of Reagan Fiscal Policy
Billions
1982 Dollars
100
Net foreign
/ ' -..-'......
Capital Inflows / '
,,
...
I
,
-'
80
60
20
"
o
Private Domestic
Investment
-20
..-+ -40
88
rr""""T"'T"'................""T"'T"'..................................,..........,...,..,....................
82
84
Burden on future generations
Cumulating the total effects through 1988, we
arrive at a total burden on future generations of
$390 billion in 1982 dollars, of which $20 billion is the reduction in the capital stock and
$370 billion is the increase in indebtedness to
foreigners. This is equal to 9112 percent of the
nation's current output, or $2,762 current dollars
for every member of the adult population. This is
what it would cost for the current generation to
eliminate the burden on future generations by
restoring the lost capital stock and paying off
the foreign debt that has been incurred.
Alternatively, future generations will have to pay
the interest on this burden-in the form of reduced output and consumption, as well as actual
interest payments to foreigners. At a current real
bond rate of approximately six percent, that
would come to a payment of $165 per year in
current dollars for every member of the adult
population, forever.
40
...... .,.'
80
used either directly or indirectly to finance the
higher level of government borrowing. Net capital inflows would have increased even with an
unchanged fiscal policy because of the strong
growth of the U.S. economy as it pulled out of
the 1982 recession. But by 1988 Reagan budget
deficits had increased annual net capital inflows
by nearly $90 billion in 1982 dollars, also shown
in Chart 2. Thus, the effect of Reagan budgetary
policies was to add $90 billion of indebtedness
to foreigners in peak years, and lesser amounts
in other years, without increasing the domestic
capital stock so as to provide any more income
to service this debt.
86
The remaining portion of the budget deficits were
--fjnanced-byforeign-investors:A:swehaveseen,Reagan budget deficits put upward pressure on
real interest rates in the United States. These, in
turn, attracted capital from abroad which was
Of course, there was also a benefit associated
with the Reagan fiscal revolution-namely,
higher consumption for the current generation.
But this tradeoff would be worthwhile only if,
in fact, we wished to better our own economic
welfare at the expense of future generations. To
begin to reverse this intergenerational inequity,
the Bush Administration has proposed running
budget surpluses by the mid-1990s.
w.
Throop
Adrian
Research Officer
Opinions expressed in this nevJs!etter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.
Research Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120
@FedFRASER