By Robert E. Wright
The Great Depression had many causes, including massive deflation. So today’s economic situation is more like the inflationary 1970s. That said, the Depression still teaches lessons, the most important of which are that the government should not raise taxes during an economic downturn, and price level stability should be the Fed’s highest priority.
When the Depression was still just another business cycle recession, the U.S. government implemented a massive tax hike on imported goods. Passed in June 1930, not even a year after the Great Crash of October 1929, the Smoot-Hawley Tariff increased the two deadweight losses associated with tariffs, i.e., it decreased domestic consumption and encouraged the inefficient production of goods that per Ricardian comparative advantage should have been produced abroad. It also sparked retaliatory tariffs that hurt U.S. exporters, which included many farmers already suffering under higher real (deflation-adjusted) debt burdens. Broke farmers then broke their local banks.
Also economically destructive was the Revenue Act of 1932, which increased the corporate tax rate from 12 to 13.75 percent and increased the tax rate of individual Americans earning $2,000 or more taxable income per year. Some economists argue that the 1932 tax hike, the largest in U.S. history to that time, along with others in 1936 and 1940, had nothing to do with the extent of the Depression. But they are wrong both empirically and theoretically.
Economic historians Gary Walton and Hugh Rockoff characterized the tax hikes as “taking a steam bath to reduce a fever,” but given the cooling effects on the economy I would liken it to taking a cold shower to cure impotence.
Empirically, the income tax rate increases between 1930 and 1940 were huge, jumping 350 percent for those earning $20,000 per year, and 767 percent for those earning just $2,000 per year. Lower exemptions also began converting it from a “class” tax that hit only the well-to-do to a “mass” tax that bit everyone.
And new taxes bit too! The 1932 act created a new gift tax, and in December 1933 alcohol went from being tax free (and illegal) to taxed. Tax officials soon began raiding breweries and distilleries, and also stepped up enforcement of tobacco taxes by restricting some clever workarounds. In 1934, it also cracked down on taxpayers and preparers. “The purpose of these regulations,” Treasury officials noted, “is to enable the taxpayer to fix the responsibility for the return where it belongs” and “to insure a higher degree of accuracy” in tax returns (“For Release to Morning Newspapers,” 16 Jan. 1934, U.S. Treasury Press Releases, Vol. 11, 1933-34: https://fraser.stlouisfed.org/title/press-releases-united-states-department-treasury-6111/volume-11-586849.) Excise taxes were also increased, and various state taxes increased, too. Moreover, in 1937 the Social Security payroll tax went into effect for a significant percentage of the workforce.
Theoretically, raising tax rates or tax revenue during a contraction makes no sense. At best, taxes just reallocate who decides how money is spent. That is why John Maynard Keynes and his sundry minions urged governments during downturns to borrow and spend, not tax and spend. Moreover, economists of all stripes concede that taxes create deadweight losses (less total wealth), with estimates running from a few percent to a third depending on the details of the situation.
At worst, higher tax rates decrease effort and innovation. Why work faster, harder, or smarter just to lose up to 69 percent of the next dollar earned (the 1940 rate on incomes above $100,000)? Indeed, as tax rates increased over the 1930s, federal revenue from income taxes plummeted, forcing the U.S. government to run Keynesian-style deficits, which it could do thanks to low nominal interest rates, plenty of “dry powder” (borrowing capacity), and a great credit history.
In the 1970s, by contrast, inflation meant that the U.S. government could not stimulate the economy through deficit financing without increasing inflation expectations and its own borrowing costs. Despite repeated recessions, stagflation, and economic malaise, the U.S. government increased taxes anyway, albeit surreptitiously. Inflation itself was a tax on cash balances, and “bracket creep” forced many Americans to pay higher real taxes, a point that commentators like NBC radio financial journalist Wilma Soss repeatedly stressed. In 1985, the year before Soss passed, the IRS finally indexed income taxes, albeit imperfectly.
Today, the Inflation Reduction Act (IRA) will increase taxes on corporations, also known as Job Birthing Entities, and everyone else too via even stricter enforcement of current IRS income tax codes. It’s maybe projected to reduce federal deficits over time, but in the here and now its effect on an economy already contracting smartly for two consecutive quarters will not be helpful.
The accurate belief that it’s a bad idea to raise taxes during a downturn partly explains the recent “recession definition war.” If there is no recession, then a tax increase sounds Keynes kosher, and the IRA’s deficit reduction projections may even garner some conservative support. Adherents of the so-called Modern Monetary Theory (MMT), who purportedly believe that inflation can be tamed through higher taxes, apparently did not recall that inflation and stagnation can occur simultaneously. I am sure its scribblers are busy weaving tales claiming that the unfolding economic debacle is not the result of “real” MMT, just like they claim that Sri Lanka’s recent economic and political crisis was not rooted in that same destructive policy.
But words and theories cannot change economic reality. Call the contraction a recession or not, believe the tenets of MMT or not, it is not a propitious moment to raise taxes. Nor is it a particularly good time to decrease them because that could fuel inflationary fires. The federal government is such a huge portion of the economy today that it can easily, much too easily, negatively influence business investment decisions by implementing dubious policies. The best it can do right now is to announce that no major policy changes will be implemented until the Federal Reserve gets inflation under control, which it could do more easily if it had more independence from political actors and a single mandate instead of its current dual mandate.
After that, and after the economy begins to grow again in real per capita terms, the government can begin cutting costs and reducing deficits without raising taxes, and maybe even by cutting them, as Trump did. Maybe it will reform Social Security in a Pareto improving fashion, and begin to run surpluses as it once often did in peacetime. That would cut the national debt to GDP ratio and rebuild the nation’s store of “dry powder,” i.e., some borrowing power that could be used during a bona fide emergency, like a major war, widespread natural catastrophe, or other large macroeconomic shock.
The dysfunctional DC Swamp proffers instead another misnamed, ill-timed measure.
Originally published by the American Institute for Economic Research. Republished with permission under a Creative Commons Attribution 4.0 International License.
More great content from Budget & Tax News