Lessons from the Great Depression: Taxes

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6 MIN READ - An important dispatch from the Cautious Optimism Correspondent for Economic Affairs and other Egghead Stuff

CO has been watching with great interest the Republican Congressional and Trump White House tax proposals. Predictably, critics have again complained that cutting taxes for the largest taxpayers—the wealthy and corporations—is not only unfair to the bottom 80% of Americans who pay just 5% of income taxes (source: OMB via Washington Examiner), but that it will bring harm to what was until recently a very slowly recovering economy.

Meanwhile the financial crisis and worst of the Great Recession are fading in the rear-view mirror, even as tax policy was also a heated topic of discussion then, and pundits, politicians, and academics persistently invoked the Great Depression as their guide—arguing the critical importance of understanding the fiscal mistakes of the 1930’s if we were to avoid another Great Depression or Japan-style malaise. Well it’s true a great deal can be learned from the tax failures of the 1930’s, so what exactly are those lessons?

The prevailing story for decades has been that in the wake of the October 1929 stock market crash, Herbert Hoover stubbornly clung to a dogmatic policy of laissez-faire, refusing to intervene and even slashing the federal budget at a time when the country needed (according to Keynesian economists) expansionary stimulus. As early 1930’s budget cuts dominated the post-2008 conversation and taxes weren’t discussed as much, the constant barrage of stories about Hoover’s alleged refusal to involve the federal government strongly suggested he was motionless on taxes as well or even cut them. The conclusion, we are told to accept, is Hoover’s refusal to recruit the powers of the federal government tragically and avoidably transformed the Recession of 1929 into the Great Depression. That’s the New York Times/CNN/education system version.

But even a passive glace at 1929-1933 tax policy reveals that narrative is a baseless myth. What really happened was quite different:

In 1932, with the economy reeling and a combination of falling tax receipts and profligate spending (more on spending in another CO installment on the Great Depression) Herbert Hoover was confronted with the problem of growing deficits. For every dollar of federal revenue, Washington was spending $2.47 and deficits were reaching 4.5% of GDP. By comparison, during the worst budgets of the George W Bush administration, the annual deficit peaked at 3.5% of GDP. And during the 1930’s a deficit of either magnitude was considered inconceivable and alarming.

Hoover felt strongly the deficit had to be closed. But instead of urging Congress to pull back on spending (as we’re told to believe by most newspapers and economists) he attempted to bridge the gap by signing the Revenue Act of 1932—the greatest peacetime percentage tax hike in American history, then or ever since.

For starters, Hoover targeted the rich. The top marginal income tax rate was raised from 25% to 63%. Yes, you read that correctly: the top rate surged from 25% to 63% or a tax liability increase of 150% in the middle of a depression (see link or pretty much any online historical table of marginal tax rates).

http://www.taxpolicycenter.org/statistics/historical-highest-marginal-income-tax-rates

The working and middle classes weren’t spared either. Although their 1930’s tax brackets were very low by today’s standards (1.5% to 5%) the Hoover hike to a range of 4% to 8% inflated Americans’ tax bill by  60%-166% depending on which bracket they had previously populated.

Furthermore, as Murray Rothbard recounts in his classic book “America’s Great Depression”:

“The corporate income tax was increased from 12 percent to 13 percent, and an exemption for small corporations eliminated; the estate tax was doubled, and the exemption floor halved; and the gift tax, which had been eliminated, was restored, and graduated up to 33 percent.”

…and furthermore…

“Many wartime excise taxes were revived, sales taxes were imposed on gasoline, tires, autos, electric energy, malt, toiletries, furs, jewelry, and other articles; admission and stock transfer taxes were increased; new taxes were levied on bank checks, bond transfers, telephone, telegraph, and radio messages… … The raising of postal rates burdened the public further and helped swell the revenues of a compulsory governmental monopoly. The letter rates were raised from 2¢ to 3¢ despite the fact that the Post Office’s own accounting system already showed a large profit on first class mail. Postage on publishers’ second class mail was raised by about one-third, and parcel post rates on small parcels were increased by 25 percent.”

It's no wonder then that the year following the Revenue Act of 1932 was the worst in American economic history—then or ever since as well. The bottom figuratively fell out from under the country, with real GDP plummeting to 1922 levels and the unemployment rate rising nearly eight points in a single year, from 18% to nearly 26%. By comparison in the twelve months following the October 2008 financial crisis unemployment rose by 3.5 points to its peak of 10.0% in October 2009 (source: Bureau of Labor Statistics).

So while Hoover has been roundly criticized by mainstream economists and the media for years for closing the deficit at a time when (according to them) deficits were a necessary stimulus, they almost never criticize him for the record tax hike. In fact, not only are they not critical of the tax hike, they’re virtually silent on it which should make us all a bit suspicious about the motives behind such a glaring omission. After all, a 60%-160% tax hike on all of America during a deep recession isn’t some insignificant fiscal move unworthy of discussion. Do they really want us to learn the lessons of the Great Depression or just the ones they like?

Now to the extent that today’s left-leaning economists are ever forced to acknowledge Hoover’s tax hikes (which is rare), a common fallback to the next line of defense goes something like this: “Well a lot of other things were happening after the 1932 Revenue Act that caused the fallout in 1933. There was a major banking crisis early that year for example.”

And that’s true. However even if you suspend disbelief momentarily and accept that the huge tax hikes of 1932 contributed very little to the 1933 plunge, all one has to do is fast forward to 1936 for more evidence. Franklin Roosevelt enacted another large tax increase that year with the Revenue Act of 1936. The “Soak the Rich” tax was introduced, raising the top tax rate to 79%. Capital gains taxes were hiked from 17.7% to 22.5%. Corporate taxes were raised from 13.75% to 15%. And a new “Undistributed Profits Tax” of up to 27% was levied on corporations.

So it’s not surprise that the following year America fell into depression again, the Depression of 1937-38 (also referred to as “America’s only depression within a depression”) which was the third worst dip of the 20th century. Unemployment, which had been slowly recovering due to the stabilizing banking system, about-faced and rose six points in a single year (14% to 20%).

So it seems unlike progressive claims that massive tax hikes, especially on the wealthy, ushers in rapid recovery and quick prosperity, history and reality show instead that it creates worsening and prolonged depression.

And despite the ongoing myth that Herbert Hoover’s stubborn adherence to laissez-faire policy and tax cuts caused the Great Depression, the truth is the opposite. Hoover launched record tax hikes, and as we will cover in the next installment on the Great Depression, was also a profligate spender. In other words: he ballooned the size of government both in the tax and spending columns, not to mention also with wage, trade, and regulatory policy. Not only are the myths myths, they frame a diametric opposite portrait of what really happened.

So when the next recession comes to America—or even while politicians, academics, and journalists argue the merits of the current Trump tax package—remember the real lessons of the Great Depression. Double-digit tax hikes on the rich and higher federal spending, aka. bigger government, while a drag in a growing economy, leads to extended and more painful slumps when applied during recessions or fragile recoveries. We know because it happened in the real world—outside the halls of academia and CNN’s editing room.

Note: For those interested in demolishing more longstanding myths about Herbert Hoover’s lack of depression-fighting policies, CO’s Economic Affairs Correspondent highly recommends reading Part III of Austrian economist Murray Rothbard’s masterful “America’s Great Depression,” available free in PDF format.

https://mises.org/library/americas-great-depression