The Economics of Big Budget Cuts
April 21, 2011

(This item originally appeared at Forbes.com on April 21, 2011.)

http://www.forbes.com/2011/04/21/budget-cuts-taxes.html

Twice during the 20th century, the U.S. federal government had huge reductions in expenditures. Once was after WWI, and once was after WWII.

In the 1919 fiscal year, the federal government spent $18.493 billion. In 1920 this fell to $6.358 billion, in 1922 to $3.289 billion and in 1924 to $2.908 billion. The government ran a budget surplus every year from 1920 to 1930.

In the 1945 fiscal year, the government spent $92.712 billion. This fell to $55.232 billion in 1946, $34.496 billion in 1947, and $29.764 billion in 1948. The government ran a budget surplus in 1947-1949.

These cuts were accompanied by large layoffs of government employees, or “demobilization” as it is known. This was probably the primary reason for economic recessions in both cases.

Ideally, the natural recessionary effect of such dramatic changes in spending would be offset by some sort of positive action. To put it a little more bluntly: big tax cuts.

This is what happened in the early 1920s. Woodrow Wilson managed a minor tax cut, lowering the top income tax rate to 73% from 77% in 1919. Brackets also rose, so the 25% rate applied to income of $36,000, up from $28,000 previously.

Warren Harding followed up with a cut in 1922 that lowered the top rate to 58%, and the 25% rate applied to $38,000 of income. In 1923 the top rate fell to 50%, and in 1924 to 46%. The 25% rate now applied to $52,000 of income. Then came the big tax cut of 1925, in which the top rate fell to 25%, on income of $100,000. Businessmen would be able to see these cuts passing through the political process, and would actually react before their formal enactment.

The recession of 1920 was intense, but quite brief. The economic boom that followed was one of the best of the 20th century.

Some tax cuts followed the end of the war in 1945, but they were relatively minor. In the Revenue Act of 1945 the excess profits tax was repealed, the top income tax rate fell to 86.45% from 94%, and the corporate tax rate fell to 38% from 40%.

The Revenue Act of 1948 reduced individual income tax rates by another 5% to 13%, and increased the personal exemption. However, taxes were raised again in the Revenue Act of 1950, which roughly coincided with another recession. That wasn’t the only factor: 1949 was a scary time for business, as that year had both the first successful Soviet nuclear test and the Communist Revolution in China.

Eventually the situation stabilized, and the 1950s were quite productive. This may have been due in part to tariff reductions worldwide, beginning with the first round of the General Agreement on Tariffs and Trade in 1947, which involved 45,000 tariff concessions.

In 1949 another round of talks managed an additional 5,000 tariff concessions, and another 8,700 concessions followed in 1950. Although the U.S. had to wait until the 1964 Kennedy tax cut for another major reduction in rates, huge tax cuts in Germany and Japan beginning in 1950 probably helped the worldwide situation.

The successful solution was huge spending reductions, and, ideally, huge tax reforms with lower rates to allow greater economic activity.

This strategy–less spending, lower taxes–should be familiar as the “Reaganomics” plan of the early 1980s. In practice, little was accomplished in terms of spending reductions during the 1980s, in part because Congress was then dominated by Democrats. Republicans also wished to increase military expenditures at that time.

Margaret Thatcher had the same strategy. She is well-known for her rollback of the socialist state in Britain during the 1980s. Strangely, she is less well-known for her tax reforms, in which the top income tax rate fell to 40% from 83% and the corporate rate fell to 35% from 53%. Both Thatcher and Reagan were hugely popular.

This strategy is completely opposite of today’s “austerity” plans, which seek spending reductions and tax hikes. This piles one recessionary act upon another, guaranteeing miserable economic performance. Not surprisingly, this strategy is not very popular, so in practice little is accomplished on either front, and the offending government is typically replaced as soon as possible.

One often finds that reducing spending is politically impossible when the private economy is being pummeled by higher taxes. Everyone feeding from the government trough sees the private economy slashing its investment plans and laying off workers, and decides that they will do everything possible to prevent being thrown into that pit of despair. Meetings are held, people are paid, and nothing is accomplished. Thus, I would say that providing a major tax reform push to the private economy also helps grease the political wheels of spending reduction, in addition to its positive economic effects.

Our recent experience, as well as that of Japan in the 1990s or the U.S. during the Great Depression, is that wasteful government spending is mostly a waste. Government spending can be reduced by enormous amounts without serious consequences, and long-term beneficial effect, but in the short term this can result in an adjustment period with recessionary implications. Ideally, these recessionary factors should be overcome with positive tax reforms, which would also set the foundation for the economic expansion to follow.