Usually, nobody has a cabinet meeting and decides: “our recession strategy will be to spend more money and raise taxes.” I don’t think anyone, Keynesian or classical, would put that on the top of their policy dream list. It just happens that way — the policy cycle of “stimulus” and “austerity.”
I make a big deal of the tax hikes of the 1930s — first the Smoot Hawley Tariff, and then the Hoover tax hike of 1932 — mostly because they are largely ignored by economists who would rather believe that it was all a mysterious aftereffect of a decline in stock prices. Stocks go down, and everyone loses their “animal spirits,” and poof! — ten years of tragedy leading to a World War. You would think that people would find that a little simplistic. (On the other hand, I think economists like it because it places no blame on the government. Economists know on which side their bread is buttered.) Also, it was not just U.S. policy, but very similar policy around the world. Virtually all countries had tariff hikes of a similar scale as the Smoot Hawley Tariff (60% tariff on just about everything), and also many countries had domestic tax hikes on the scale of the 1932 Hoover hike. In fact, Hoover was imitating policies in Britain and Germany, who were really the first with the big domestic tax hikes.
I would love to get more details on the British tax hike of 1931, and also the final Weimar tax hike, which was so unpopular that it led directly to the rise of the National Socialist party in Germany. I actually asked a professor of British tax history about this, and got … nothing. He didn’t know. Eh? So, if you know of a source with this info, let me know.
Instead, this week we will look a little more closely at U.S. tax policy during the 1930s. I think you will end up with an idea of why the Great Depression dragged on and on into the 1940s.
The Smoot-Hawley Tariff
The Smoot-Hawley Tariff began as an agricultural tariff. Farmers weren’t participating in the great economic boom of the 1920s. Indeed, it appears that the introduction of motorized tractors resulted in agricultural overcapacity. About 1/3rd of farmland, in those days, was set aside for horse pasture. The horses then pulled the plows and wagons. When horses were replaced with motorized tractors and trucks, the farmland available for growing crops increased by 50%. At least, that is one story — there is a slight decline in corn, wheat and soybean prices toward the end of the 1920s, but not a lot. To gain congressional support for the tariff, however, the supporters started to add products from other Congressmen’s districts. This all began in 1920s — Herbert Hoover campaigned on an increased tariff for agricultural products in 1928. After his victory, in 1929 Hoover asked Congress for a new tariff in which rates for agricultural products rose and rates for industrial products declined.
In May 1929, the House passed a tariff in which rates for both agricultural and industrial good increased. This went to the Senate, which then debated the tariff. The initial stock market decline in 1929 lines up exactly when tariff supporters in the Senate got enough votes to pass the tariff — by adding more and more items to the list of goods subject to the tariff. In May 1930, the House passed the new bill. At first, Hoover opposed the bill, calling it “vicious, extortionate, and obnoxious.” However, in U.S. history, the Republican party has typically been tariff supporters, while the Democratic party has been in favor of lower tariffs. Republicans have often seen tariffs as a type of economic support, as it protects existing businesses from foreign competition. In the initial downturn of 1929-early 1930, the tariff was then seen as an additional economic booster. Hoover was pressured by his own party to pass the tariff into law, and he did so in June 1930. The new tariff applied to over 20,000 goods and imposed a 60% rate on more than 3,200 products, quadrupling previous rates.
Between 1929 and 1934, with tariffs blasting higher worldwide, world trade decreased by 66%.
The 1932 Revenue Act
This was followed in 1932 by the Revenue Act of 1932. This raised the top income tax rate from 25% to 63%, with increases on all incomes above $6,000. The estate tax rose to 45% from 20% and the corporate tax rate rose from 12% to 13.75%, and exemptions were reduced. Exemptions for individuals were reduced, with the basic exemption for a married couple falling from $3,500 to $2,500. This was aimed at bringing 1.7 million new taxpayers into the income tax system. However, the big increases were in excise taxes, which were expected to raise 51% of the $912m in increased revenue expected by the tax hike. (In actuality, revenue declined as the economy imploded.) This was the result of a debate that began with the idea of introducing a new national sales tax, in an effort to “broaden the tax base.” Ultimately, the national sales tax idea was abandoned with the argument that tax rates should fall higher on luxuries than on necessities.
The 1934 Revenue Act
In 1934, tax rates were adjusted slightly to put higher rates on lower incomes. The top rate remained at 63%. However, the rate on $10,000 rose to 11% from 10%, and the rate on $50,000 rose to 34% from 31%. The estate tax rose to 60%.
Wikipedia on the Revenue Act of 1934
The Revenue Act of 1935
Yet more tax hikes. Rates on incomes over $50,000 were raised, with the top rate going to 79%. Corporate taxes were increased, and the estate tax rose to 70%. “We have not yet weeded out the overprivileged,” Roosevelt told Congress.
Social Security Act of 1935
In addition, 1935 saw the introduction of the Social Security system, along with the first payroll tax. The original rate was 1%, on both employer and employee (2% total). It was raised to 3% (1.5%+1.5%) in 1950.
The Revenue Act of 1936
The Revenue Act of 1936 established an “undistributed profits tax” on U.S. corporations. The normal rate on corporations was 15%. However, there was a surtax of up to 27% on undistributed profits, producing a combined rate of 42% on undistributed income of more than 60% of total net income. It appears that personal income taxes were increased slightly. The top rate remained 79%, and the rate on income of $50,000 was 35%.
The Revenue Act of 1938
There was another Revenue Act in 1938. Personal income tax rates remained unchanged. It is not clear what happened in this act. The full text is available here:
The Revenue Act of 1940
In the Revenue Act of 1940, income tax rates rose again, and exemptions fell. The basic exemption for married couples fell to $2,000 from $2,500. The basic corporate tax rate rose from 19% to 22.1%. The income tax rate on income of $8,000 rose to 12% from 10%; the rate on income of $50,000 rose to 48% from 35%. The top rate remained unchanged at 79%.
The Second Revenue Act of 1940
Once wasn’t enough? The Second Revenue Act of 1940 created a corporate excess profits tax of 50%, and increased the basic corporate tax rate to 24% from 22.1%.
Wikipedia on the Second Revenue Act of 1940
This is only a rough outline of tax policy in the 1930s. We could use a lot more info on excise taxes (which were big), plus more info on exemptions and other quirks of the tax code besides just the simple rates.
However, we should add to this the rather dramatic concurrent developments in state-level taxes. Here is a good primer on state taxes, many of which increased dramatically during the 1930s:
Click on it and read it. It is only one page. You can see a great many new state income, sales and excise (liquor, cigarette) taxes were imposed during the 1930s.
As you can see, taxes headed significantly higher through the 1930s. And the Depression continued. The Depression is commonly considered to have ended with World War II, but this is not really the case. What happened is that unemployment declined, and production increased, due to astronomical levels of government spending. In 1943, the U.S. federal government spent 43% of GDP. This decline in unemployment was welcome, since it is not the average decline in income that is really the problem, but rather the large numbers of people who have no income at all. Or, at least, it was welcome until you died on some foreign battlefield. Most of World War II was fought by the Russians vs. the Germans on the eastern front in 1941-1943, with the U.S. eventually joining Britain to harass Germany’s western flank. The U.S. did not participate in the European war in size until the invasion of Italy in September 1943, followed by the landing in northern France in June 1944. Some people today think that the U.S.’s involvement in World War II was not really necessary. In the summer of 1941, public opinion was 70% opposed to becoming involved in the European war. Whatever supposed good came from killing people and blowing stuff up in Europe and the Pacific — arguably, a more violent version of Keynes’ “digging holes and filling them back up” — the result was increased hardship for most U.S. citizens. Wartime meant little availability of consumer goods. Statistics on consumption of basic supplies like butter show a dramatic falloff during the 1940s during wartime, even compared to the depressed 1930s. In short, people were poorer — as one would expect if the government is directing 43% of the economy to something like waste. The government’s fiscal path was also unsustainable. The 30%-of-GDP federal deficit of 1943 couldn’t go on forever. As it was, the U.S. ended the war with a federal debt/GDP ratio of about 120%.
In 1930, federal tax revenue amounted to 4.2% of GDP. It was probably a little higher than that in 1929, as recession tends to depress this figure. In 1934 — after all the tax hikes — it was 4.8% of GDP. It then rises to 7.6% of GDP in 1941. We have seen that often, the government doesn’t really decide how much tax revenue it receives. The people have an idea of how much they want to pay the government, and that’s how much they pay, no matter if tax rates are high or low. Although the much higher taxes accounts for some of this rise in revenue, I also think it reflected the increased government services provided by the New Deal. The fact of the matter is, many of Roosevelt’s policies were popular, and were perceived as a long-awaited solution not only to the immediate problems of the 1930s, but also the long-standing problems of 19th century capitalism. Even libertarians today don’t complain too loudly about things like unemployment insurance or even Social Security, certainly not at 1930s rates of 1%. We like to have a bit of a safety net, and recognize the advantages even to capital and businesses of such an arrangement — in principle, if not always in exact implementation. Thus, I think we can see some of this tax revenue rise as a reflection of a greater willingness to pay taxes, to fund a greater range of government services. Today, even libertarian Hong Kong has a revenue/GDP ratio of 12.8%. (I think Hong Kong has about the best balance of government services, sensible tax policies and libertarian principles in the world today.)
During World War II, U.S. citizens got used to a much larger government, and tax revenue as a percentage of GDP rises to a peak of 20.9% in 1944. There was a sort of step-function, from the roughly 4%-of-GDP level of the 1920s to the roughly 18.5%-of-GDP average that has persisted since World War II, whether tax rates go up or down. A basic principle of the Laffer Curve is that people will not resist paying taxes if they feel that this is the highest and best use of their money. Thus, taxes won’t have that much of a negative economic effect. For example, if the government provides health care services that are better (because universally available) and cheaper (just look at any developed country outside the U.S.) than private-sector options, it makes sense that the taxes to fund this health care wouldn’t be perceived as a burden.
The U.S. economy did not immediately revive after the end of World War II. Indeed, it was rather moribund all the way until 1950, a good five years later. In 1948, it probably appeared that the Great Depression was still dragging on much as it had in the late 1930s, punctuated rather unpleasantly by a World War. The change around 1949-1950 was due to a lot of things, notably developments on a global basis. It seems to me that the boom of the 1950s and 1960s began with the big tax cuts in Germany and Japan, but that in turn reflected a broader policy shift — from one of crushing the war’s losers into oblivion (the Morgenthau Plan), while communism spread in China and eastern Europe, to a happier policy (the Marshall Plan) of rebuilding the capitalist economies of Germany, Japan, Italy and so forth. Everything looked a lot brighter on a global level, and not just because of tax rates.
You can see here that the bull market of the 1950s and 1960s did not begin until the end of 1949, coinciding exactly with the change from the Morgenthau Plan framework to the Marshall Plan framework. Until then, stock prices remained roughly where they were in 1937.
Not only did stock prices not go up, but 1949 was the peak of the Great Bond Bull Market of the 1930s and 1940s. Prospects for business looked so crappy that people were happier with a “safe, secure” 2.0% yield on the ten-year Treasury bond than they were with the 6% dividend of U.S. stocks.
In short, people in the U.S. got used to a bigger government, and higher taxes. The adjustment period of the imposition of the new taxes was over. It didn’t bother them anymore, and indeed it probably seemed necessary to fund the military (protect us from communism!) and the various social services that had emerged as a result of the New Deal. Not to mention that immense wartime debt. Diverting roughly 18.5% of GDP to the federal government now seemed acceptable. Thus, although tax rates in the 1950s and 1960s (and today) were in fact much higher than in the 1930s, this provided a tolerable environment for growth and prosperity.
This hypothesis does not imply that further tax hikes from here will be ultimately met with open arms. Going from a federal government of 4% of GDP (more like 1% before 1913) to 18.5% was perhaps an acceptable path, but that doesn’t mean that U.S. citizens will accept a government that intends to increase its tax revenue to 25% or 35%. Depending on how the government behaves, it is possible that people will conclude that even 18.5% is much too high a figure for this collection of liars, criminals and thieves, and we could see revenue/GDP fall to 10% even as tax rates rise, as tax evasion becomes commonplace. As I mention in my book, citizens will accept even astronomical tax rates if they believe “it’s worth it.” In the ultimate crisis — typically a military invasion by a foreign power that is perceived to be tyrannical, such as the German invasion of Russia in 1941 — citizens will sometimes give up essentially everything they have in the defense effort, a “tax rate “of 90% if you want to put it in those terms. Of course, this willingness to be taxed disappears immediately after the danger is passed. On the flip side, people may not accept any taxes at all if they feel that they get nothing out of the deal, and that the government has no legitimacy. The American Revolution represented a tax revolt against taxes that were very modest by today’s standards.
Thus, I think a “spend more money and raise taxes” approach would probably be even more of a failure today than in the 1930s. There is nothing that we particularly need to spend money on today, not even a national health care system in the U.S., which could easily be funded out of the 7.5% of GDP that U.S. governments (all levels) are already spending on healthcare. If anything, we should be spending less money on the military and all forms of waste and graft, with various “bailouts” on the top of the list.
Lastly, I would point to the “stimulus/austerity” cycle as it has played out in Japan. It’s still going on there, with taxes rising ever higher, accompanied by many plans to reduce spending, which go out the window and are replaced by new “stimulus” plans as soon as the economy begins to groan under the new taxes.
November 1, 2009: Japan’s New Government
May 26, 2009: The Japan Baloney
May 24, 2008: Japan: Silly Self-Destructive Behavior
May 18, 2008: Japan: Tax Hikes are No Fun
May 11, 2008: Japan: Now What Are We Going To Do?
And of course the Japanese economy continues to stink, just as the U.S. economy stank in the late 1930s — this even after the big problem of the 1990s, monetary deflation, has largely been relieved. Just as is the case for the 1930s, people still blame this stagnation on the decline in asset markets in the early 1990s, about 17 years ago. You would think that 17 years would be enough time to figure out what is happening right under their noses.