In 1931, the United States was facing an economic slowdown and as a result a rapidly growing budget deficit. The Roaring 20s were over, and while the new decade hadn't acquired a name, it was already presenting a challenge. Fortune Magazine addressed the problem in a December 1931 article, "Taxation". Spending less was not a realistic option. The government had responsibilities to the unemployed, to veterans, to its citizens in general and as an emerging world power. Borrowing more was an option, but it could not be the only option. Somehow, the government needed to raise more money, and all options had to be considered.
To start with, it might be helpful to look at where the U.S. federal government was getting money back in 1931. Between 1789 and 1900, the government had raised a grand total of $15,622,000,000 and spent perhaps a billion dollars more than that. That included the War of 1812, the Louisiana Purchase, the Mexican American War, the purchase of Alaska, the Civil War, the Reconstruction, the Spanish American War and perhaps a billion dollars towards the construction of the Transcontinental Railroad.
Talk about value for money.
Things changed in the 20th century. The nation was growing more urban and taking its place on the world stage, both things that cost money. After the Great War, there was a huge deficit. The new income tax with its 65% maximum marginal rate was raising money, but only so much. Most people were still not paying taxes. If you were earning $3,000 a year and headed a family with a spouse and two children, you would still be tax free. The editors of Fortune were uneasy. Three thousand dollars was twice the typical factory wage. Shouldn't everybody be paying something?
That was the view from the right wing in 1931. Interestingly, this was not very far from the view from the left. The miserable Excel chart below shows the sources of government income from 1931 and 2004.
There is one striking difference: the yellow box on the right. In 1931, about half of government revenue was from the personal and corporate income taxes. In 2004, this still comprised about 50%, but nearly 40% of government revenue was from social security taxes. Corporate income taxes dropped from 20% to 10%, but the big story in the tax picture involves personal taxes.
Social security was a major part of the New Deal under FDR, and it was a guaranteed retirement pension based on a flat tax on wages. This tax is regressive on theoretical grounds, a dollar is worth more when you earn less, and practical grounds, there is an annual contribution limit, above which no further taxes are owed. This regressive tax was expanded to include old age health care in the 1960s, and is now a major component of the federal budget. Basically, the social security tax pays for social security benefits.
This new tax also had a major impact on government spending. Guaranteed retirement pensions, disability pensions and old age medical insurance are now major components of the budget, and, as even George W. Bush and his minions in Congress discovered, they have a serious constituency. When the original strategy of night and fog failed, and social security reform was exposed to the light of day, talk of "reform" vaporized.
Still, it is ironic to find right wing prayers of 1931 answered by the left wing New Deal later that decade, though not exactly in the form they might have desired.
As we approach 2013, the hundredth anniversary of the income tax, it is interesting to ponder the government budget in earlier days. Import duties, cigarette taxes and tolls from the Panama Canal were much more important issues in terms of their impact on the federal budget.
While social security taxes are now universal, it is the income tax that gets the most debate, possibly because it is most heavily paid by the most heavily paid. Unlike middle class people, working class people, and poor people, wealthy people are influenced by money. At least that is the impression one gets from the typical income tax discussion. In fact, what is usually debated is not the middle range of the tax, but the high end, the extreme peak, marginal payments.
The usual argument is that high peak tax rates are bad for the economy. That is, if taxes on the extremely rich are too high, economic growth will suffer. At times, the peak marginal tax rate on income has exceeded 90%. For a typical family making $40,000 a year, a bit more than the median, having to sacrifice $36,000 a year for taxes would entail serious cutbacks. This gives the argument some resonance in unsuspected quarters.
Of course, 90% is a peak tax rate. People in the 90% bracket often pay a lower average tax rate. Another migitating factor is that ever since the mid-1920s capital gains have been taxed at around half the rate of earned income, and the wealthy often make money by selling capital assets rather than for services performed.
So, what is the actual story. Do high peak tax rates hurt the economy? In truth, it is hard to say, but it helps to look at the nearly hundred year history of taxes, government budgets and GDP growth.
The tax rates in 1913 were only one or two percent, but in 1917 it was time to go "over there" and fight the Great War. The United States put a million men in the field, along with trucks, horses, guns, planes, rations and who knows what else. The deficit soared, despite the increased tax rates.
When the war ended, the taxes remained high into the 1920s. The government ran a surplus and started to pay down its war deficit. Since all was going well, there were several tax cuts in the 1920s, and the law established different rates for earned income and capital gains. These were the Roaring Twenties with easy money, skyscrapers, fast cars, outlaw liquor and women at the ballot box.
Some people claim that the Great Depression was caused by monetary policy. Some claim that it was the tax cuts. Whatever the cause, the bottom dropped out in the late 1920s and the stock market crashed soon after. The miserable Excel chart is a bit cluttered, but you can see GDP growth flat lining after the latter tax cuts and then the big drop off the cliff as the Great Depression began.
FDR was elected in 1932, and in 1933, he raised taxes, particularly income taxes on the rich. Despite all the squealing, the economy began to grow. The Dow Jones Industrial Average bottomed out in 1933, so, as far as my father's generation was concerned, the Great Depression was a bull market for all its misery.
Then came the World War II: The Sequel. When the Japanese attacked Pearl Harbor, the nation mobilized. The peak tax rate was raised to a level beyond our present day imagination, and anyone who protested was an un-American fifth columnist, or a Republican.
When the war ended, the economy reeled, but taxes were not lowered. There was the GI bill to fund. After the shabby way that veterans of the Great War were treated, there was no way that WW II veterans were going to be dumped and abandoned. College tuition and VA loans cost money, but they built a new America.
Did the 90% marginal tax rate stifle growth in the 1950s? GDP growth went up and down into the 1960s. Somehow or another, the economy grew overall. Did the tax cut to a peak 70% marginal rate in the 1960s spur the economy? It's hard to say. They did call the 1960s the Go Go Years for a reason, but it might have been the boots.
At the end of the 1960s, there was the tax surcharge, basically a rate increase to pay for the Vietnam War. It may actually have spurred the economy, but unseen on this miserable Excel chart is the rising rate of inflation. Surely this had something to do with economic growth as well. In the early 1970s Nixon went so far as to impose wage and price controls. Needless to say, they were not very effective.
Aside from the surcharges and the imposition of the alternative minimum tax which would raise some people's marginal tax rates, taxes remained level through the 1970s. Despite much rhetoric to the contrary, the economy did well through the 1970s, especially if you were working and not living on your assets. Growth slowed as the 70s closed. Interest rates were rising to match inflation. A friend of mine was stuck with a 19.2% mortgage.
In the 1980s Saint Ronald Reagan cut taxes. The economy collapsed, but as the 80s progressed growth resumed. The government ran huge deficits building up the military, ostensibly to fight the moribund Soviet Union. Whether the buildup helped keep the Soviet Union together or accelerated its collapse is still open to debate, but the federal deficit was real.
In the mid-80s income taxes were cut again, but taxes on capital gains were raised. Because or despite this, the economy collapsed into recession in the late 80s. Yet another decade ended on a downslope into the recession of the early 90s.
In 1993, Bill Clinton did the unthinkable and raised income taxes. He also raised the minimum wage. The nation held its collective breath waiting for the apocalypse. The economy grew and the deficit shrank. Economists everywhere held their hands over their eyes and started humming loudly.
In the new century, taxes were cut again. Well, we've all seen what the economy looks like now. There is plenty of GDP growth, but work force participation has been falling and wages are stagnant, at best. There's a good chance it is all going to have to be restated in a few years anyway.
These are interesting times. Tax rates are scheduled to rise in a few years. Will the economy collapse or soar in response? We survived the millennium. There is a good chance we will survive this.
This recounting, interesting as it may be, of the history of the income tax still doesn't answer the question of how the peak marginal rate affects economic growth. That means that it is time for another miserable Excel chart in hopes that it might shed some light.
The chart below plots the peak marginal income tax rate against GDP growth in the following year. The chart looks pretty much the same with different lags, probably because the GDP growth rate changes often, but tax rates are only adjusted now and then.
Take a good look at the chart. There are data points all over the place, but the least squares linear fit trendline has a positive slope. This suggests that higher marginal tax rates are associated with higher growth rates. Maybe it's time to turn the supply side Laffer curve upside down? It's amazing what you can do with a miserable Excel chart.
If nothing else, the main risk of raising taxes is not that it will hurt the economy, but that anti-tax ideologues will use the tax increase to hammer your Congressional delegation. With the upcoming reversion of the tax laws, we will face a natural experiment in which taxes will be raised to Clinton era levels with minimal political expenditure. We may see early results by the income tax centennial in 2013. Given my Gross Domestic Product, I can hardly wait.