Myths of the Clinton Economy and Tax Policy

If you take what Democrat politicians and spokespeople say literally you would believe that the Clinton Administration inherited a bad economy and by the magic of raising taxes on upper income people he turned the economy around. Nearly eight years of prosperity emanated from that brilliant policy. It even results in some amazing years of balanced budgets. So by this reasoning higher tax rates lead to prosperity.

This stands against the evidence of four other administrations: Kennedy, Reagan, Bush I and Bush II. Three of these made significant tax cuts and the economy prospered. One of them, i.e. Bush I, raised taxes and the economy was very sluggish leading to conditions for the Clinton victory.

So what are we to conclude? Why was the Clinton economic policy so different? The mystery is actually fairly easy to understand when one looks at the broader economic conditions in the Clinton years. First of all there is way too much credit and blame given to presidents concerning the economy. Presidents can’t abolish the business cycle. The Bush I recession was a correction to the economic boom of the middle to late Reagan years. One key element of this aftermath was the savings and loan crisis. Bush the elder had the thankless task of cleaning up this mess. He then compounded his problem by agreeing to a tax increase that was poorly thought out. By the time Bush the elder was voted out office, the economy was growing nicely but there hadn’t been time to have the improving GDP result in more jobs.

So Clinton came into office with an economy that was destined to be good even without new initiatives. However, Clinton slapped the economy with a tax rate increase that was that was three times as high as Bush I’s. So why didn’t this kill the recovery that Clinton inherited? The key fact at that time was rather high “real” interest rate, i.e. interest rate minus inflation. What saved the Clinton economy was a cleaver deal the administration made with then Fed Chairman Alan Greenspan. The Fed would hold down short term interest rates which are those which it can most affect and the Treasury Department would refinance the national debt with shorter term notes rather than long-term bonds. By removing the U.S. government from the long-term debt market interest rates came down in that sector as well. So this monetary policy counter balanced the high tax policy allowing the recovery to continue.

It often said that it is “better to be lucky than good” and so it was with President Clinton. The other part of “good Clinton economy” was due to a revolution in microprocessor technology that was coincident with his term of office but had nothing to do with any of his policy initiatives. This increase in cheap computing technology resulted in a complementary explosion in software development and the internet. Wave after wave of new companies were started to exploit these new technologies. Initial Public Offerings raised massive amounts of capital. The stock market soared and the massive increase in short term capital gains, bonuses, and increased salaries brought hundreds of billions into the Treasury. With spending held in check by a Republican Congress, the government started running surpluses.

So the Clinton experience gives little support for the concept that high tax rates are good for growth. It only shows that if conditions are just right they aren’t necessarily a show stopper. President Obama doesn’t have the luck of President Clinton. He can’t use reduced interest rates to counter balance the tax increases that will come in 2011 unless the current tax rates are continued. To address the dilemmas of the current economic situations we must address the end of the Clinton era and the Bush II years to set the stage. I plan to address this in a subsequent posting.