In the hectic days of preparation of the Reagan administration's new economic program, Tuesday, Feb. 10, was crucial. On that day an issue that would establish the political tone of the entire program was up for resolution.
The way that issue was settled provides a glimpse of the early workings of the new administration -- a glimpse of some confusion and uncertainty, of political posturing, and ultimate decisiveness.
In the Oval Office that afternoon, President Reagan convened a meeting with David A. Stockman, his 34-year-old director of management and budget; Edwin Meese III, his counselor; James A. Baker III, his chief aide, and Lyn Nofziger, Reagan's political assistant. They were there to discuss Stockman's proposal to eliminate the difference between tax rates on "earned" and "unearned" income -- money earned from a job vs. money earned from dividends or interest on savings accounts.
At present earned income is taxed on a progressive scale up to 50 percent, while unearned income can be taxed at a rate of up to 70 percent. Stockman and the "supply-side" enthusiasts in the Reagan camp who want to unleash the private enterpise system with tax cuts believe the distinction should be eliminated at a stroke, thus discouraging many wealthy Americans from hiding their money in tax shelters and encouraging a spurt in productive investment.
That Tuesday afternoon in the Oval Office Stockman made his pitch for cutting the tax rate on unearned income. Everyone else in the room, according to sources who were present, disagreed with him. The other aides, all essentially political in outlook, argued that the appearance of evenhandedness was crucial to the Reagan program, and that a tax break like this one for wealthy Americans would go down badly in an economic package that would inevitably weigh heavily on the poor.
While this discussion went on in the Oval Office, a council of Republicans of the Nixon and Ford administrations, met nearby in the Cabinet Room. This group was an obvious antidote to the enthusiasms of the supply-siders, many of who thought that it had been convened for the purpose of countering their proposals.
Late in the afternoon, Reagan and the group that had been meeting with him joined the council of economists in the Cabinet Room. (Stockman, however, went back to his office.) During the four hours they had been discussing tax proposals, according to participants in the session, the economists had come to a consensus that it would be a political mistake to eliminate the higher tax bracket on unearned income -- although everyone in the room apparently agreed this was an economically desirable idea.
Instead, the economists agreed, it would be better to reduce both the top tax on earned income and the top rate on unearned income by 10 percent a year over three years in conjunction with reductions in personal and corporate income taxes of the same size that the administration already planned.
When Reagan joined the economists he told them he'd just been talking about whether the 70 percent tax on unearned income should be eliminated at a stroke, and he asked their advice. Arthur Burns, the former chairman of the Federal Reserve System, spoke strongly against making the change, essentially for political reasons. George Shultz, former secretary of the treasury and the chairman of this advisory group, expressed essentially a neutral position, according to sources present. The Rep. Jack Kemp, the politician most closely associated with supply-side economics and tax cuts, made an ardent statement against the idea recommending 10 percent annual reductions in the top tax rates instead.
Stockman felt the president was strongly on his side before that meeting with the outside economists. Other presidential aides dispute that view. In any case, Burns, Kemp, and others in the room -- among whom were Herbert Stein, Alan Greenspan, Milton Friedman, Charles Walker, all veterans of earlier Republican administrations -- reinforced the arguments Reagan had heard from his political aides, and the president decided not to tamper with the distinction between earned and unearned income.
The next day Reagan's economic aides sat down to consider the economists' suggestion that both the 50 percent cap on earned income tax and the 70 percent top level on unearned income tax be reduced 10 percent a year for three years.
They quickly realized that no one had tried to analyze how much revenue it would cost the Treasury to let the top tax on earned income fall to about 37 percent. This seemed like a risky proposition, so it was quickly decided to drop it. In the end, the Reagan tax program left the 50 percent maximum tax on earned income in force, and called for 10 percent annual reductions in the maximum tax on unearned income.
Political aides to the president took satisfaction from their belief that Reagan had remained true to his basic campaign promise to reduce taxes 10 percent a year for three years. However, contrary to campaign promises, the final proposal postponed personal tax cuts until July 1 of this year and made no mention of "indexing" tax brackets to the inflation rate, a move that would hold taxpayers in the same brackets even if their wages went up because of inflation.
In writing the tax package the new administration rejected advice from Republican leaders in both the House and Senate for the sake of presenting a "clean" bill generally consistent with Reagan campaign promises. The tax proposals are certain to be heavily rewritten now, an exercise that will likely provide the first serious test of the administration's skills in dealing with Congress.
The episode was a good example of the process that produced the Reagan administration's new economic package. That process was hectic, somewhat disorganized, marked by ideological disputes that were usually well-mannered, and ultimately remarkably effective, at least in terms of the new president's ambition to propose a radical change in federal budgetary and tax policy at the very outset of his administration.
Though indisputably a substantial shift from the Carter admnistration's policies, the new team's package of budget and tax cuts is less bold than either candidate Reagan's campaign rhetoric or the original plans of many of his associates, particularly Stockman. In interviews last week, key White House aides attributed all of the moderating changes to "politics" and practical considerations.
There was no shortage of intrigue, personal competition and backbiting during these hectic first weeks of the Reagan administration, but none of it broke into the open, and those who lost skirmishes seemed to accept defeat with grace or at least patience. Stockman, for example, shrugged off his setbacks on tax policy to friends, reportedly telling them he would get more chances later to argue his case.
Stockman was swamped by the hectic events of the last fortnight. In the last week before the president announced his program, he was so preoccupied with making the budget numbers come out as intended that he played a minor role in the most significant argument of the week -- over tax policy -- and lost control over the preparation of the economic report that accompanied his budget figures.
In a dispute over the economic forecast that the White House would use to accompany its new budgetary proposals, the administration was beset by "an iron triangle" of competing economic interpretations, according to one key official.
The "supply-siders" wanted a forecast that predicted healthy growth rates as a result of Reagan's proposed tax cuts, this source said, while the "monetarists" who are most concerned about controlling the amount of money in circulation wanted a forecast that showed a sharp decline in the growth of "nominal" gross national product.
Ordinarily, nominal GNP (which means total national economic activity unadjusted for inflation) grows briskly during periods of high inflation, because it reflects the inflation figure. But if the money supply is shrinking, nominal GNP cannot grow so fast, and the monetarists wanted a prediction that showed a shrinking money supply.
The only way to satisfy both groups, this source said, was to predict both high growth and very low inflation. But a forecast incorporating both of those predictions upset the third corner of the triangle -- those who worried about making a forecast so optimistic that it lost all political credibility.
In the end, one key White House official said, this dispute was resolved arbitrarily. The new team decided on a compromise prediction of healthy but not unprecedented growth, speedily declining inflation and steadily but modestly declining unemployment.
These figures are all essentially guesswork, this official acknowledged, adding in self-defense that the predictive models used by the Carter administration were so weak that they were chronically wrong even from month to month, let alone over a period of years.
The new administration also backed away from Stockman's initial plans for budget cuts, even as it did decide on proposed reductions that are making many interest groups howl. In December and January Stockman spoke of cutting $10 billion or $15 billion out of the current, fiscal 1981 budget, but the final Reagan package asks for $4.4 billion in cuts this year. Stockman is now said to feel that this was the maximum possible without "bringing down the government."
On monetary policy, drafts of the economic report prepared for Stockman were sharply critical of past Federal Reserve Board policy and, by implication, also of the current Fed chairman, Paul Volcker. The final document eliminated all such criticisms, and ardent supporters of a strong monetary policy say privately that Volcker could have been invited to help write the monetary policy section of Reagan's report.
In every major area, the conservative critics of the final package pick on points where politics obviously played a major role in the outcome. Jude Wanniski, a former editorial writer for The Wall Street Journal and a leading popularizer of supply-side economic thinking, noted this point in an interview last week, and even had an explanation for it.
"Richard Wirthlin," Wanniski said, referring to Reagan's political pollster, "continues to be a supply-side nemesis." Wirthlin's polls, he added, suggest that the public is afraid of dramatic tax cuts as a possible source of inflation -- a finding made by other polls, too.
Wanniski said Wirthlin "has a Ph.D. in Keynesian economics and never believed in this [supply-side] stuff anyhow." But there are no Ph.D's in the group of Nofziger, Baker, Gergen and the other political aides who also argued for some caution in the preparation of this first giant step of the new administration.