Lessons From the Great Inflation of 1973-81

Then as now, what drove higher prices was excess demand owing to runaway government spending. Ronald Reagan and Paul Volcker understood.

By Phil Gramm and Mike Solon. Excerpts:

"The buildup to the Great Inflation started in 1966, when Congress, at the urging of the Johnson administration, expanded funding for both the war in Vietnam and the War on Poverty. This “guns and butter” policy produced a double-digit surge in federal spending. By 1973 inflation was running at 8.7% and would average 9.2% for nine years—far surpassing average inflation of 3.3% between 1946 and 1972 and 2.7% from 1982 through 2019. During the 1973-81 Great Inflation, even after adjusting for inflation, federal revenue rose by an average 4.1% a year. The share of the economy taken by the federal government in taxes rose by nearly one-eighth, from 17% to 19.1%.

That’s astonishing, because Congress never voted to raise income taxes during that period. In fact, after LBJ’s 1968 temporary tax surcharge, which didn’t slow inflation, Congress cut federal income taxes in 1971, 1975, 1976 and 1977. So how did taxes rise at a record pace? Surreptitiously and automatically through inflation and bracket creep. As the Congressional Budget Office explained in 1980, “taxpayers with two dependents . . . earning $15,000”—around $57,000 in 2022 dollars—“and filing a joint return would pay $294 more in federal income taxes—a 23.8% rise in tax liability—if the family’s adjusted gross income and itemized deductions rose by 13.3%,” the inflation rate of 1979. With 16 tax brackets and 9% inflation over the period, bracket creep increased taxes as a share of gross domestic product by 2.1%, dwarfing the later Clinton and Obama tax increases combined.

But record tax increases couldn’t keep pace with spending. Annual real federal spending increased by 4.3%, defense fell by 0.1%, and social spending exploded by 6.3%. As a share of GDP, total spending rose by 2.6%, defense fell by 1.5%, and social spending rose by 4.1%, almost a one-third increase in the share of national income being spent by the federal government on social spending. Compare that with the New Deal: Social spending rose by a then-unheard-of 2% of GDP from 1933 through 1939. "

"When Reagan took office in January 1981, the inflation rate was 12.5%. The tax burden and the level of federal spending were both postwar highs, respectively 19.1% and 21.6% of GDP. By the end of the Reagan presidency, real average annual federal spending growth had declined to 2.5% from 4.3% and social spending growth to 1.9% from 6.3%. Real annual defense spending growth had risen to 4.3% from minus 0.1%. As a share of the economy, total federal spending had fallen by 1% and social spending by 1.5%; defense spending had risen by 0.5%."

"By fall 1982, inflation had been cut in half, and by the end of Reagan’s first term it was reduced to normal levels, where it remained until the 2020s."

"By 1984 runaway inflation was over, real GDP growth hit 7.2%"