The Effect of Individual Income Tax Rates on the Economy, Part 3: WW2 and the Immediate Post-War Recovery

by Mike Kimel

This post is the third in a series that looks at the relationship between real economic growth and the top individual marginal tax rate. The first looked at the period from 1901 to 1928, the second from 1929 to 1940. This one will look at the period from 1940 to 1950.

Before I begin, a quick recap… both the 1901 – 1928 period and the 1929 – 1940 [link fixed] failed to show the textbook relationship between taxes and growth. In fact, it seems that for both those periods, there was at least a bit of support for the notion that growth was faster in periods of rising tax rates than in periods when tax rates were coming down. There were also a few other findings that might be surprising – the so-called Roaring 20s were a period in which the economy was often in recession. The New Deal era, on the other hand, coincided with some of the fastest economic growth rates this country has seen since reliable data has been kept. As we will see in this post, the period from 1940 to 1950, encompassing WW2 as well as the immediate post-war recovery, also is subject to a lot of popular misconceptions.

Real GDP figures used in this post come from Bureau of Economic Analysis. Top individual marginal tax rate figures used in this post come from the IRS. As in previous posts, I’m using growth rate from one year to the next (e.g., the 1980 figure shows growth from 1980 to 1981) to avoid “what leads what” questions. If there is a causal relationship between the tax rate and the growth rate, the growth rate from 1980 to 1981 cannot be causing the 1980 tax rate.

The following graph shows the growth rate in real GDP from one year to the next (black line) and the top marginal tax rate (gray bars) for the period from 1940 to 1950.

Finally, in the fourth decade we looked at in this series so far, we see a graph that doesn’t contradict textbook economics: growth seems to slow down as tax rates rise, reaching its lowest point (on the graph) when tax rates peaked. Then, after tax rates begin to fall, growth picks up again. So why do we see this negative correlation between tax rates and subsequent growth rates during the 1940 to 1950 period when we saw the opposite in the previous periods?

Well, as I’ve pointed out many times in the past, there is a quadratic relationship between tax rates and subsequent growth rates (kind of like the Laffer curve, but with real GDP growth taking the place of tax collections), and the fastest growth tends to occur when the top marginal rate is somewhere around 65%. (At this juncture I have to point out things can be true whether we like them or not. If you’re looking for a micro-foundations reason why raising tax rates can create faster economic growth, try this.)

In any case, tax rates in 1940 were at 79%, and they reached a high of 94% in 1944 and 1945. Clearly, at 79% the top marginal tax rates were already above optimum, and raising them simply moved them even farther away from the optimum growth rate. Conversely, cutting tax rates down to the low 80% following the end of WW2 moved tax rates closer to optimum.

But growth does not live by tax rates alone and the graph above hints at a few other misconceptions. Let’s start with a big one shared by folks on the left and the right, namely that World War 2 led to faster economic growth. In fact, many folks go so far as to say the economy suffered very slow growth until the outbreak of WW2, which as we saw in the last post in the series, is a comical claim. The graph below shows growth rates from 1938 to 1944. (Remember – for our purposes, growth is from t to t+1… thus, growth in 1938 is the percentage change between the 1938 real GDP and the 1939 real GDP.) As with Figure 2 in the previous post, the best ever year of the Reagan administration is also included for comparison purposes.

Notice… growth was already fairly quick from 1938 to 1939, and from 1939 to 1940… and then it really jumped from 1940 to 1941. Pearl Harbor was December 7, 1941, so most of that latter jump came before the American entry into the war. Now, one might say that somewhere around 1938 was the beginning of US involvement in WW2, what with Liberty Ships and the Arsenal of Democracy and all. Put another way, that big jump in growth came before the US was in the war, but as an administration whose policies had already generated several years of very rapid growth since 1933 took an increasing role in the economy. Apparently the economic policies followed were good enough to overcome even tax rates that were significantly above optimum.

Growth peaked between 1941 and 1942 and then began to shrink. In part, as we saw, that was because tax rates got too far above optimum. In part, on the other hand, it is because too much of the country’s labor pool was shipped abroad to fight in the war. But regardless… if the war had been a catalyst for jumpstarting the economy, the peak would not have occurred when it did… and growth would not have started accelerating so many years before the country’s entry into the war..

There’s one more myth that is worth tackling. That myth is that there was some sort of stupendous economic boom following WW2. And it only makes sense that there would be such a boom – the GIs came home, tax rates were cut in 1946 and again in 1948, government spending dropped, and rationing and price controls went by the wayside. And as Figure 1 shows, real GDP had a post-war nadir (I always wanted to use that word!!!) in 1947, and recovered after that. But it is important to put that recovery into context.

The graph below shows the rate of growth from 1947 (the bottom) to 1950 – the post-war miracle, as it were – and it compares it to the rate of growth from 1933 (the bottom of the Great Depression) to 1936, the heart of the New Deal.

As Figure 3 shows, there really is no comparison between the two recoveries. Whereas during the post war recovery, the economy grew almost 13% over three years following the bottom, it grew almost three times faster following the bottom in 1933. And from the previous post, we saw what happened during the rest of the 1930s. We’ll see what followed the post-War recovery in the next post on this series.

As always, if you want my spreadsheets, drop me a line. I’m at my first name which is mike and a period and my last name which is kimel at gmail period com.