The Effect of Individual Income Tax Rates on the Economy, Part 1: 1901 – 1928
by Mike Kimel
The Effect of Individual Income Tax Rates on the Economy, Part 1: 1901 – 1928
In 1913, the 16th Amendment to the Constitution led to the income tax system we know and don’t love today. Since that time, in fact, since way before that time, people have been arguing about the effect of taxes on the economy. Over the next few posts, I will take a systematic look at the relationship between individual tax rates and the economy going as far back as the data allows in the United States.
In most of these posts, I will measure the effect of the economy using growth in real GDP per capita. However, that series only dates back to 1929. So in today’s post, which will focus on the period up to December 1928, I will look at the recessions (using official dates from the NBER and compare that to top individual marginal tax rates as published in the IRS’ statistics of income historical table 23.
The graph below shows the top marginal tax rate (black line) and periods in which the economy was in recession (gray bars) going back to January 1901. (Note – the economy was in a recession from June of 1899 to December 1900, so January 1901 is a nice “clean slate” date at which to start.)
Figure 1.
I think the graph above lends itself to be division into three more or less discrete periods. The first is the pre-tax period from 1901 until 1912. The second is the “rising tax” period from 1913 through 1918, and the third is the “falling tax” period from 1919 to 1928.
Now, if you asked the typical economics professor or politician or conservative to rank three periods – no individual income taxes, rising individual income tax rates, and falling individual income tax rates – in terms of time spent in recession, you’d probably hear this back, “The economy will spend less time in recession when there are no income taxes, and the most time in recession when tax rates are rising.”
But that isn’t what the data shows. The time spent in recession is pretty comparable. The percentage of months under recession in the pre-tax period is 43.8%. The percentage of months under recession in the rising tax period is 40.3%. The percentage of months under recession in the falling tax period is 42.5%.
Now let’s talk some nuance. A recession is not a recession is not a recession. For instance, the recession that began in 1907 was pretty severe, and is often referred to as the Panic of 1907. The recession of 1918 was caused by the end of WW2. And then there’s one more detail worth mentioning, the elephant not in the room so to speak. The graph doesn’t show what happened in 1929, following just over a decade of tax cuts (in which time the top marginal rate fell from 77% to 24%), we had the Great Depression.
Next post in the series: The Great Depression and the New Deal
In 1929, before the Great Depression began, 71% of the population lived in poverty. So, I shall put it all out there and say that downturns are led by contractions in consumer spending. These contractions too, it is worth saying, are not all that difficult to notice as harbingers that are causal in regards to investors panicing. Then too, as workers earn less, investors earn more, and so, there is a reward for those investors who stay in the longest. Thus, once the selling begins, panics are not so much driven by ‘herd mentality’ as they are a tacit understanding that the cycle has reached a point that is obviously unsustainable.
I am also preparred to argue that the Agricultural Depression of 1921 was caused by a manipulation of US ag production at the end of WWI, and, that this was done to undermine the labor movement of that era, and, that the unintended consequence of that manipulation was the actual cause of the Great Depression. But, I’ve said all of that here before so I’ll leave it at that.
ray
Anyway… this is a good choice of subject matter; but, I don’t understand how the timing is established from when a tax increase/decrease is implimented until the time when those effects might be measured in some way? This, I suspect, has been worked out in some way but in my self-educated experience I am befuddled as to how something so complicated might me measured in terms of time considering how lengthy ROI can be?
The recession of 1918 was caused by the end of WW2.
By the end of the World War (or Great War) you mean.
To boot the tax increases of 1917 were also caused by the war. Tax rates continued high until the normalcy candidate won in 1920 that great president Warren G Harding. Just like the high tax rates of the 1940s were caused by the war as well, but were not reduced as fast after that war because of the cold war.
Mike,
Before rushing off to prove that marginal income tax rates mean this or that……why not try considering the number of people such rates apply to? The effect of a 90% marginal rate is going to be very different when 3 people are subject to it than when 30 million are.
I’ve heard somewhere about (but have no proof of at all) that that 80% rate in that chart appplied only to one John D Rockefeller for example. That’s probably urban myth but finding out what the income bands were, how many people fit into each one, would be useful I think.
The cold war continued up and down after Ike left office. The miniscule peace dividend did not come until GHW Bush had to raise taxes to begin paying off the Reagan lump up in war profiteering.
Tax rates were maintained after the big wars to pay off their war bonds, Truman and Ike did this, Kennedy had a better debt situation and could reduce taxes.
The cold war peaks were about the same outlay level in real dollars as today’s “war on thugs” to keep our unpopular puppets running the sand lots, only the profit margins today are immensely better in the socialized, fictional war planning military industry congress cartel and the war bonds today are in the SSTF which the ‘christians’ in congress think there is no need to pay them down or pay interest.
The aged, sick and poor pay for holy war, it is ordained.
It is faith, and if you don’t accept it you are not…………………….
rllove,
You’re probably right.
rllove,
I’m just going to illustrate the entire sample from 1913 to the present. If there is a correlation between lower taxes and faster economic growth, one presumes it will be evident. If there isn’t, one presumes that will be evident too.
beowulf,
Correct. My bad.
(Dan – can you correct that in the post and put a note at the bottom? Thanks.)
Lyle,
Yes. It turns out that in WW1 and WW2 the country decided the best way to deal with the threat was high taxes and a (more so in WW2) command economy rather than low taxes and laissez faire. In more recent wars that hasn’t been the case. Over the next few posts we can illustrate which produced more of the growth that is helpful in fighting a war (and in peacetime as well).
Tim,
1. I have the time to engage in one exercise at once. I intend to go through the entire sample period, focusing on what happened to the economy after each change in tax rates. If you decides that the period before 1929 was an exception because too few people paid taxes, that won’t apply to other periods.
2. I keep hearing about the Rockefeller thing too. I have never been able to confirm it or figure out where it comes from, and I’ve tried. What I can say is that the table listed in the post also tells you the amount of income to which the tax rate applied. Adjusted for inflation into 2010 dollars, it comes out in the 10 to 12 million dollar range through most of the period until 1921 (exceptions: about 40 million dollars in 1916 and 1917). After that, it falls to the low 7 figures, and from 1925 to 1931 its about 1.3 million. High, yes, but even 1916 is hardly John Paulson high, and he is no Rockefeller.
3. This table (http://www.irs.gov/pub/irs-soi/05in01an.xls) shows you how many people filed returns in thousands. In the first few years, it was about 350,000 but it grew rapidly over time. I presume it started with folks at the higher income levels, who presumably had the most ability to, er, cut back on work and go Galt if they got ornery about taxes.
4. The correlation between the top and bottom rates is 60% over the entire sample, and 85% for the 1913 to 1928 period on which this post focuses. Put another way… if you were among the folks paying taxes, and Rockefeller’s tax rate went up, so did yours.
5. Note that in the tax cut era, the tax base was at first broadened reaching 7.7 million returns in 1923. By 1928, that figure had fallen to 4.1 million.
Given all of this, it is possible (I cannot say for sure) that if more data were available, it could show that in the 1901 – 1928 period, low (or no tax rates) broadly applied produce at least as much time (a smidge more, in fact) in recession as very high tax rates applied to a tiny cohort. Again, I cannot say that that is what would fall out of data I haven’t seen, but it is compatible with items 1-4. The converse – a broader based tax results is consistent with less time in recession is not compatible with items 1-4.
Add in item 5 and it seems cutting tax rates and reducing the base did not prove particularly helpful in the period from 1901 – 1928.
I was going to make this same point. Without knowing how many people it applied to, or, say, average total rates of the top 5%, I’m not sure that the highest rate, all on its own, tells us all that much. It might point to a larger issue, but it doesn’t establish it.
Mike,
I thought we had this out when you made the claim that the changes in the Fed rate caused the 1921 recession. Changes in the marginal income tax rate will be swamped by events during this time that are beyond the control of the President of the US and/or IRS tax policy.
This gets back to econmics not being a science. There is not enough data nor science in economic theory that can let you pull out the effects of changes in marginal tax rates to GDP growth. Its not there.
This goes back to my simple question for economists: “In total 20/20 hindsight, If Clinton had raised taxes another 10% what effect would that have on the GDP growth during the ’90s?” Would GDP growth increased (and by how much) so Clinton underperformed the economy or would it have decreased (and by how much) which points to a limit to taxation/Government size that the economy can sustain.
And economics can’t answer that question. All you can tell me is what happened.
Economics = Astrology
Islam will change
buff,
1. I’ve stated before, I’ll state it again… economics is where astronomy was before Tycho Brahe showed up (or if you prefer, its where physics was before Galileo which is my father’s observation – he’s a physicist). What Brahe changed was that he kept track of the movement of the heavens with such detail that it was possible to compare that movement to events on the earth and show there is no correlation. In economics, there is this view that changes in taxes have effect X and Y and Z. I’ve been posting on this for years. This post is intended to look at all changes in federal taxes and see if there’s any relationship with X and Y and Z. Its part of my continued attempt to follow in the footsteps of a man whose approach to his chosen profession I greatly admire to the small extent I am able with the more limited resources at my disposal.
2. For a long time I also spent a lot fo time writing about the money supply, which I believe usually has more of an effect on the economy than taxes. I have mostly focused on taxation because I feel that is the bigger and easier target, where my limited abilities have the best chance of having an impact.
3. Additionally, it is worth noting… since 2007 the effect of MS has been a bit different than I’ve expected. I have some ideas… but I don’t have the complete model in my head right now. (I think a big thing that has to be considered, and I have no idea where I can get the data, is where the MS is targeted.) Its worth noting, Brahe built a model of the solar system… and he got it wrong. That doesn’t negate the work he did tracking the heavens. With apologies to Milton, they also serve who only stand and squint and record what they see, night after night after night.
4. Your question about Clinton. I’ve had that post over and over. The fastest growth rates seem to occur when the top marginal tax rate is somewhere in the 55% – 65% range. Had Clinton upped the tax rate to 49.9% rather than 39.9%, he would have brought it closer to the optimal growth level. My views, no doubt, are in the minority. I take heart from the fact that Tycho Brahe was hired as court astrologer, and yet his work documenting the facts brought about the split between astrology and astronomy. I like to think I’m doing my small bit to help in the development of something new that will one day split off from this field we call Economics.
Mike,
I actually agree with your charaterization of economics. You, or your fathers, description is pretty good analogy to where I see the state of the art of economics. Though I would point out that the study of the movement of the stars was probably far less difficult than what economics face (far less inputs, a clear way to define interactions etc). We are a long way from Hari Seldon’s days.
My disagreement with you has always been the idea that any one data, in this case marginal tax rates, determines GDP growth. If you could get enough data and facts behind you to just say that you can determine even 10% of the GDP growth by the marginal tax rate you would be in line for a Noble.
And this goes back to the state of economics. You state that by raising the top marginal tax rate into the 55% range Clinton could have brought us to an optimum growth rate. Which would have been ? GDP growth rate? And that’s the point. there is no mathematical or scientific evidence to back your supposition out. Worse your using data that can’t be compared. We really don’t know why Eisenhower’s GDP preformed so mediocre. There is nothing in the study of economics that you can say his leadership led to a under-performing economy for his time. Same with Clinton. We really don’t know if Clinton under or over performed the average or got to the optimum growth rates, for his time.
I hope one day we can get to the point where we can answer my question. But other than conjecture (and as you pointed out your ‘raise taxes more’ would put you in the minority), you will find people who will argue every side of this question. But right now we are not there – and not even close in the general public.
But I still like your idea of more money for the IRS enforcement division…
Islam will change
“the idea that any one data, in this case marginal tax rates, determines GDP growth”
But that is exactly what the right has been saying and acting on since Reagan if not before. “We need to reduce taxes so the economy can grow more.” And the best evidence is that they are wrong.
While there are clearly many more factors, it does make sense to keep looking at the linkage between marginal tax rates and GDP growth.
buff,
To second what Arne wrote downthread… this exercise (i.e., the five years worth of posts I’ve been writing) have been in reaction to hearing, over and over and over again, that the secret to faster economic growth, reducing the national debt, reversing male pattern baldness and a whole host of other ills was simply to cut taxes. You do realize that the dominant political party in this country since 1980 believes in just that, right?
If you want my policies on creating faster economic growth, I’ll give them to you. (I’ve said it all before.) In general the federal gov’t should,
1. have the fed increase the money supply as fast as it possibly can while maintaining inflation below 5% a year
2. put marginal tax rates as close to the optimum as possible
3. increase enforcement and punishment of white collar crimes, especially tax evasion and those producing massive externalities
4. run a surplus, with exceptions made for times of war or recession. On net, the gov’t debt should serve the purpose of many a family’s credit card, used for day to day operations and paid off in full at the month
That’s for starters.
I can’t take an analysis that puts so much weight on what happend in the Great Depression especially as the largest most violent War in the History of the Planet begins in the same period.
Start well after WWII…….it makes it much more valid.
Arne,
It depends on what taxes you are refering to. Obviously, Capital Gains and Corporate Taxes should be very very low while the effective individual tax rates should be maximized but still below 50% including any State Taxes.
If we look at where the majority of the revenue comes from…it comes from Individual Taxes. This mean that if we want to see any purpose in raising taxes, we should ensure that every single person pays taxes, and the real money will exist in the Lower and Middle Classes.
This is where the stalemate begins. The Left won’t budge on raising these peoples taxes…and you can not raise the taxes on the wealthy brackets enough to do any good.
Cuts in spending have much more bang for the buck. Couple that with some job creation and an increase in taxes and the deficit comes back into view. Of course…to get some job creation we need to alot of deregulation and to fix the corporate taxing structure and the Trade situation…which ensures that neither side is going to agree.
Darren,
Umm… this post doesn’t even cover the Great Depression. Next one will. Two posts later we begin the post WW2 era. I just want to cover everything.
Darren,
Lots of assertions. Everyone can make them. Back them up with data or a relatively impartial source. Otherwise they’re no better than anyone else’s assertions.
Mike,
And I have been hearing over and over that the secret to faster economic growth, reversing male pattern baldness, and a whole host of other ills is high taxes, increased size of the Federal government, increasing the control by the Federal government of both economic and personel liberty, and less open or accountable Federal government. On top of that the just as dominent political party is the historical war party and believes all that, or have you been missing it since 1980?
As for your personel ideas.
1) Not sure, but I would aim for inflation in the 2-3% range. 5% means your money is worth half as much every 14 years. Hard on fixed pensioners (but I forgot the other dominant party wants everyone on the Government dole so this may not be a problem)
2) Define ‘optimum’ (Which you have BTW, but the point is that I don’t see any type of consensus here, or even close)
3) I’m all for this. probably with more steroids than you are. Anyone with a net worth over $100M or making more than $10M/year income should ALWAYS be audited.(As should all congresscritters)
4) I’m all for this also – as is the Tea Party BTW. But this is definitely not in the either dominant parties plans.
I do note that both parties presume to know how to solve male pattern baldness…
Islam will change
Arne,
I agree with everything you just stated. I think the idea is to reduce the size and scope of the Federal government which has gotten out of hand. The tax issue is just the easy way to put it. (IMHO).
Mike – the data is there already with teh Obama tax cuts. If he had not cut the above $250K set that would have raised $0.9 Trillion vs $2.3T if they did everyone (I think – doing it from memory). Bottom line is the rich can’t cover the debt. Only making government smaller will do it. Now that doesn’t mean I don’t think we should raise taxes as long as it was in concert with really down-scoping the Feds.
And in many ways all the Sturm and Drang is a fight over the size and scope of the centralized Federal Government. How intrusive and overwelming will it be. Why does the Dept of Education need a SWAT team? What did I read, everyone violates 2-3 Federals laws dailey? The Feds are out of control.
Islam will change
“And I have been hearing over and over that the secret to faster economic growth, reversing male pattern baldness, and a whole host of other ills is high taxes, increased size of the Federal government, increasing the control by the Federal government of both economic and personel liberty, and less open or accountable Federal government.”
Umm… if you remember my stating a stronger endorsement of the Democrats than “marginally less ludicrous than Republicans” please point to it. Similarly, I’m not a fan of criminalizing what are usually termed victimless crimes, and I believe I’ve stated that in posts. As to accountability, once again, I think you’re ascribing someone else’s views to me.
As to the rest:
1. There are costs to everything, unfortunately.
2. I stated what I would want to see done, not what the consensus is. You yourself indicated that economics = astrology, so why would you then turn around and say: well, we can judge that proposal as unreasonable because nobody else believes it. And by the way, the moon is rising in aquarius or whatever.
4. No, the tea party is not for it. That’s like saying GW was for reducing the debt because he claimed he was, and please ignore everything he did to the contrary. Or saying Obama believes in dancing with the one what brought him.
buff,
There are ill-informed Democrats as well as ill-informed Republicans. I think you will find many informed Dems that are for reversing all of the Bush tax cuts – ignoring Obama’s pledge not to raise taxes on those making under $250K.
US total government is smaller than other developed countries. The assertion that the federal government has gotten out of hand is a talking point, not something that has been proven. Government do a lot of things I wouild like to see curtailed, but so does any large organization of humans.
When our representatives decide government should do something, they need to decide it should pay for it as well. Some of it needs to be over a longer run to deal with business cycles, but all of it needs to be paid for. Everyone needs to pay some, but those who benefit more (the business owners) need to pay more. When we do that we will end up with a government within acceptable bounds.
Arne,
“but those who benefit more (the business owners) need to pay more.”
They already do.
“I think when people take a look back at this moment in our economic history, they’ll recognize tax cuts work.” – George W. Bush, March 12th, 2008
Courtesy Barry Ritholz, The Big Picture
Well a reasonable argument can be made that current wars are more comparable to the Korean War than WWII. They are both examples of unpopular wars that arrived after a “peace dividend,” either the end of WWII or the end of the Cold war.
You are right. Business owners do pay more.
Can we now agree to roll back all of the Bush tax cuts?