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or other government programs. Yet the chaos created by the oil price shocks, the new floating exchange rate regime, and lax monetary policies by the Federal Reserve reverberated into budget politics. Suddenly tax cutting, shrinking civilian government, and rolling back welfare policies became the vogue and the diagnostic basis for policy change. There was no turning back. However dubious was the interpretation of the economic mayhem of the 1970s, a political reality had resulted: government lost its aura of competency. Probably this alone was fatal to the economic consensus that had guided the country for almost forty years.

The Reagan Revolution

The political coalition that put Reagan into office was determined to create a lasting legacy of a smaller federal government (“to curb the size and influence of the federal establishment”), and in this it partly succeeded. There were four main instruments of the Reagan Revolution: tax cuts on higher incomes, restraints on federal spending on civilian programs (at least relative to the growing economy), deregulation of key industries, and outsourcing of core government services. All four of these major policy changes took hold in the 1980s and are still in place today.

At the aggregate level, the Reagan Revolution did not shrink the federal public administration, but it probably did stop it from expanding. The federal civilian bureaucracy had 2,109,000 full-time-equivalent civilian employees in 1981, the same in 1988, and nearly the same over the next twenty years, with an expected 2,101,000 full-time-equivalent civilian employees in 2011.14

In terms of taxation, total federal revenues as a share of national income in 2007, before the financial panic, stood at 18.5 percent, virtually unchanged from the start of the Reagan administration. Total spending in 2007 stood at 19.6 percent of GDP, slightly lower than the 21.7 percent of GDP in 1980. Civilian spending was 13.9 percent of GDP in 2007, down slightly from 14.8 percent of GDP in 1980.

The larger shift from Reagan onward was across the categories of domestic spending.15 As we saw in Figure 4.2, discretionary civilian spending declined from 5.2 percent of GDP in 1980 to around 3.6 percent of GDP in 2007 (before a temporary recession-related boost). Mandatory spending, mainly transfer programs to individuals such as Medicare, Medicaid, Social Security, and veterans’ benefits, grew slightly, from 9.6 percent of GDP in 1980 to around 10.4 percent of GDP in 2007. Thus the Reagan Revolution set into motion a squeeze on government investments in areas such as education, infrastructure, energy, science and technology, and other productivity-enhancing areas, while leaving mostly untouched the growth of transfers to individuals for health care and retirement.

Demonizing Taxation

The deepest political impact of the Reagan era was the demonization of taxes. Taxes are rarely popular, especially in the United States, a country that was founded on a tax revolt. Taxes not only take money out of pockets; they are widely seen by Americans as a denial of freedom itself. The standard libertarian line is that since government collects around a third of national income, it’s as if Americans are indentured to the government, even its slaves, during January through April of each year. Accurate or not, the anti-tax sentiment is ingrained in the American political discourse.

Reagan’s main target was to reduce the top marginal tax rates on rich taxpayers. The history of the top marginal tax rates is shown in Figure 4.3. The federal income tax is a recent invention, just one century old. At the start, the highest marginal tax rate was a very modest 7 percent, but within a few years, and due to America’s entry into World War I, the top marginal tax rate soared to 77 percent in 1918. In the 1920s, the conservative administrations of Calvin Coolidge and Herbert Hoover brought the top rate back down to 25 percent, where it stood at the time of the Black Tuesday stock market crash on October 29, 1929, that marked the onset of the Great Depression.