Raising taxes: 73% of nothing is nothing

President Francois Hollande recently increased the top income tax rate in France to 75 percent — for incomes in excess of €1 million. This is part of a wider trend with President Obama targeting the wealthy in his election campaign, promising to raise taxes on incomes in excess of $1 million. Shifting the tax burden onto the wealthy might be clever politics, but does it make economic sense? To gauge the effectiveness of this strategy we need to study tax rates and their effect on incomes in the 1920s and 1930s.

By the end of the First World War, Federal government debt had soared to $25.5 billion, from $3 billion in 1915. Income taxes were raised to repay public debt: 60 percent on incomes greater than $100,000 and a top rate of 73 percent on incomes over $1 million. When Andrew Mellon was appointed Treasury Secretary in 1921, he inherited an economy in sharp recession. Falling GDP and declining income tax receipts led Mellon to observe that “73% of nothing is nothing”. He understood that high income taxes discourage entrepreneurs, leading to lower incomes and lower tax receipts — what we now refer to as the Laffer curve. By 1925, under President Coolidge, Mellon had slashed income taxes to a top rate of 25 percent — on incomes greater than $100,000. The economy boomed, tax collections recovered despite lower rates, and Treasury returned budget surpluses throughout the 1920s.

US Income Taxes and GDP 1920 to 1940

Interestingly, Veronique de Rugy points out that taxes paid by those with incomes over $100,000 more than doubled by the end of the decade.

US Income Tax Rates and Tax Receipts in the 1920s

Andrew Mellon was a wealthy banker and investor: in the mid-1920s he was the third highest taxpayer in the US. His strategy of cutting income tax rates may appear self-interested, but showed an understanding of how taxes can stimulate or impede economic growth, and succeeded in rescuing the economy from prolonged recession in the 1920s.

A decade later, President Herbert Hoover spent liberally on infrastructure programs in an attempt to shock the economy out of recession following the 1929 Wall Street crash. By 1932 Hoover and Mellon raised income taxes to rein in the growing deficit. Tax on incomes greater than $100,000 was increased to 56 percent and the top rate lifted to 63 percent — on incomes over $1 million.

The budget deficit continued to grow. Higher tax rates were maintained throughout the 1930s, under FDR, but failed to achieve their stated aim and may have contributed to the severity of the Great Depression.

US Income Taxes and Budget Surplus 1920 to 1940

GDP rose steeply after 1934. Income tax receipts recovered to pre-crash levels but declined again after 1937, when President Roosevelt introduced payroll taxes. Increased taxes reduced the fiscal deficit but caused a double-dip recession: GDP contracted, income tax receipts fell and the deficit grew.

US Income Taxes and GDP 1920 to 1940

Comparing the 1920s to the 1930s it is evident that Barack Obama and Francois Hollande threaten to repeat the mistakes of the 1930s. Increasing taxes in the middle of a recession does not reduce the deficit. It merely prolongs the recession.

Sources:
Cato Institute: 1920s Income Tax Cuts Sparked Economic Growth and Raised Federal Revenues by Veronique de Rugy
National Debt History
Wikipedia: Andrew W Mellon
Wikipedia: Laffer Curve
The Politically Incorrect Guide to the Great Depression and the New Deal by Robert Murphy

36 thoughts on “Raising taxes: 73% of nothing is nothing

  1. […] back war debt from WWI. They had the opposite effect of that intended and reduced tax collections. Treasury secretary Andrew Mellon subsequently increased tax collections by reducing maximum tax rate…, with the famous quip: “73% of nothing is […]

  2. […] back war debt from WWI. They had the opposite effect of that intended and reduced tax collections. Treasury secretary Andrew Mellon subsequently increased tax collections by reducing maximum tax rate…, with the famous quip: “73% of nothing is […]

  3. Terry Hughey says:

    Most reputable economists consider the Laffer Curve the “Laughable Curve.” Laffer snookered the Reagan administration and he is still snookering some that are gullible. It has been pretty well shown that it was poor academic work and had no reputable data to back it up!

  4. Bruce H says:

    When I read comment from Warren Buffett that his secretary pays tax at a higher marginal rate than he does and he believes the rich should pay more I tend to think he is correct. It seems to be the deductions that are allowed to wealthier investors that gives them these tax advantages.

    • ColinTwiggs says:

      This is pure spin. Buffett managed to seize the moral high-ground by expressing concern that as a billionaire he pays tax at the same marginal rate as his secretary. If he was that concerned he could have donated a few $billion to poverty relief or an education fund for the less fortunate ….and called on other billionaires to do likewise.

  5. Alex Fletcher says:

    The real question should be not what percentage income tax should be paid but what kind of tax leads to a fair society with a justifiable distribution of wealth. In nearly every country about 5% of the people own at least 90% of the privately owned land. To quote Alan Kohler,(The moral bankruptcy of our ruling classes, August 13) Meacher wrote that the annual Sunday Times Rich List shows that the richest 1000 Britons increased their wealth by 155 billion pounds in the past three years, which is enough for them to pay off the British deficit and leave them with 30 billion. “Despite the biggest slump for more than a century, these 1000 richest are now sitting on wealth greater even than before the slump; their wealth now amounts to 414 billion pounds, more than a third of Britain’s entire GDP.”
    The starting point of the extreme wealth differential characteristic of the monopoly capitalism of the western world is that the value of land is untaxed or very minimally taxed (eg local government rates on site value) and its rising value over time accrues to private pockets and is unearned by the individual. The value of land is due to the community as a whole and is therefore a moral source for funds for community needs. It is recognized that it is the only tax that is an economic incentive but instead the tax burden falls on the individuals labour and savings which restricts economic activity.
    The above figures re land and wealth distribution are the underlying reasons why land value tax is so difficult to even get on the agenda for debate in the community or politics.
    Objection like the impact on pensioners who own their homes fails to take into account that it is the ineqitable wealth distribution in the first place that impoverishes a large proportion of the community and the public purse so that pensions for the aged and disabled are inadequate.
    The following is a link to a video “Realestate4ransom” made by Prosper Australia which explains the problem with the current taxation system and why LVT is the answer.

    http://realestate4ransom.com

    Other good links are http://en.wikipedia.org/wiki/Land_value_tax

    Re tax the “first principle” question is “Who owns the Earth?” How we hold the earth is how we hold eachother.

    • ColinTwiggs says:

      You are making the fatal mistake of confusing tax with welfare. Taxes should be seen to be fair — the same rate payed by all, according to Rousseau — and KISS to facilitate collection and minimize avoidance/evasion. As soon as you get idealistic with a tax system, it becomes impractical — creating opportunities for an army of accountants, tax lawyers and investment bankers like myself to make a good living by bending it to suit their clients needs.

      When you have collected the taxes, then concern yourself with how they should best be distributed to create a fair society.

      I am a great believer in equal opportunity rather than equal wealth/reward.

      • Alex Fletcher says:

        A change in the taxation system away from income tax, GST, etc to land value tax is a change from taxes being levied on what you produce to being levied on the value of resources you consume. You simply pay to the community for the benefits the community provides for you. Isn’t that fairer than than being penalised for working? Is not that equal opportunity?
        We have this to a very limited extent in the local government rates which are a form of resource rental but the wealthiest 20% of Australians own around 80% of the nations resources. The current tax system allows the wealthy to escape paying tax (through the use of managed investment schemes and/or tax havens for example) while collecting rents from the rest of us. You can’t move a nation’s natural resources like land, offshore. You can’t evade a Resource Rentals charge, just as you can’t evade paying your rates or mortgage, no matter whether you are wealthy or poor. If you default on your rates or mortgage your site can be reclaimed by the owner or the local authority and that would not change.
        Such a change in the tax system would not result in equal wealth/reward but would result in reward commensurate with effort. Who would not be extremely happy to receive what we earn? Trouble is, with direct and indirect taxes the average worker receives about 40% of what they earn. Many who attain the notorious degree of wealth accumulation attributed to the top few percent of the population actually earn about 10% of their incomes. Speculation should not be encouraged or rewarded.
        As for how the taxes should be distributed, with time there would be less distribution on unemployment benefits as land value tax is the only tax which is an economic incentive as land which would otherwise be held idle for speculation would be put to use in enterprise that would create employment.
        If you would like to read a more academic document on this try http://michael-hudson.com/ and the12/9/12 article “Incorporating the Rentier Sectors into a Financial Model”

      • ColinTwiggs says:

        Good post. Thank you.
        I am a great believer in consumption taxes rather than income taxes which act as a disincentive on production — if you tax someone 50% of their marginal income, there is less incentive for them to produce.
        The problem with land taxes is the compliance cost and assessment issues. If you impose taxes based on land value, every property has to be assessed and it is difficult to achieve a fair assessment of values. One example is a little old lady living in a house that has been re-zoned for hotel or high-rise apartments: do you tax her on the present use or the optimum use — which would force her to sell her home?

      • Alex Fletcher says:

        In reply to your comment of 14/9, annual assessment for land value has been done for decades in Australia wherever the existing property taxes require it, eg in QLD for the unimproved value. Hong Kong is an example where the marginal income tax rate is between 2% and a top of 17%. Such low rates are achievable because they have one third of all tax revenues from land revenues in leases and rates. Their system goes back at least to the seventies so has not been precluded by assessment difficulties.
        A consumption tax, like the GST, is still a tax on labour products and a restriction on economic activity. It is also enthusiastically avoided whenever possible.
        Land value tax at 6% paid yearly on annual valuations is considered high enough to have benefits to the economy. However nobel prize winning economist Joseph Stiglitz said “Our goal should be a tax of 100% on the rents associated with those natural resources sharing rising value of land with the community who helped create that value.”
        I agree that it would seem harsh that elderley people could be in a situation of having to move because of higher rates and that situation would be at most risk at the introduction of such a system and would depend on how it was implemented. They would also have many advantages though 1) their pensions purchasing power would be higher due to the removal of direct and indirect taxes. 2) Their granchildren would be more able to afford a house and less reliant on inheritance. 3) Increasing small business, employment opportunities and take home wages would decrease crime rates and make life safer.
        Our current system treats the elderley harshly and if they have to resort to reverse mortgages the next generation loses out on inheritance as well as having to be renters or mortgage slaves for a lifetime.
        Thank you for the opportunity to comment.

  6. Damien Lynch says:

    Colin, there is another view. I think you should stick to graphs and leave the partisan politics for somewhere else.

  7. Jan Stevens says:

    I would like to see these graphs for the 1950’s, when tax rates were as high as 90%.
    I believe we had solid growth in those years. My point is that there are many factors
    besides the tax rate that determine the rate of economic growth.

    • ColinTwiggs says:

      I agree that there are other factors beside tax rates that determine economic growth. But tax rates do make a large contribution. Take the failed welfare state experiment in Sweden as an example.
      I will do some research on US tax rates and GDP growth in the 1950s and 1960s.

  8. CHarles says:

    Very interesting. But the burning question is, why is it that the socialist mind can’t understand this? Why do we have to repeat this mistake over and over? Do we learn nothing from history?

  9. Bill Storey says:

    Your comments are most interesting, and of course controversial. Our biggest need now is to reduce federal spending and marginal tax rates at the same time that corporate subsidies, and much of the welfare establishment, are drastically reduced. Obama wants to spend us blind, much like Hollande (and FDR and LBJ, incidentally). Romney/Ryan want us to get federal spending back to no more than 20% of GDP from the current level of 24%. To do this, President Romney will have to broaden the tax base to include some people who are paying nothing now, and reform the major entitlements. The retirement age for Social Security will have to be raised, ObamaCare repealed and replaced by a competitive health insurance system that produces greater efficiencies, and which includes tort reform and interstate competition. Romney may be able to pull all tht off; Obama will keep us stagnant forever.

  10. Quentin Lewton says:

    It’s disingenuous to fail to mention Obama’s proposals are no where near as draconian. NOT even close as France’s or rates following WW I.

  11. Albin says:

    Have to say there’s a weird conflation of across the board “tax increases” impacting low and middle earners (e.g. Roosevelt raising payroll taxes) with Obama’s plans to trim the wick of tax advantages and cuts for the wealthy since Reagan, reaching an apotheosis under Cheney/Bush. As a practical matter, the recent “emergency” payroll tax suspensions and middle class tax relief could become affordable over the longer term if tax distribution were made fairer. For the 1% is always “my money” but “our taxes”.

    • ColinTwiggs says:

      I am a greater believer in flat taxes. If you earn one dollar you pay 20 cents, if you earn $1 million you pay $200,000. That was Rousseau’s proposal in the 18th century. Why is it now seen as unfair?

  12. edward congdon says:

    the US needs to raise the minimum wage. It needs to remove the dependence on tips for lower wage earners. This would increase the tax base. It would also give many poor better incomes, these people who have a higher propensity to consume. It would also cause the US $ to depreciate and make exports more competitive. It also could help to decrease the crime rate by desperate people

  13. zzpat says:

    There’s so much wrong with what you wrote it’s hard to know where to begin. Reagan increased taxes during a recession and Clinton gave us the largest tax increase in US history. After the Clinton tax increase, not only did we have balanced budgets, but we had a booming economy.

    Look at the Bush tax cuts and Bush debt. $5 trillion of new debt as he dropped taxes from over 20% of gdp to around 15%. If you want massive debt, you want tax cuts. If you want a balanced budget, you want far higher taxes – around 20% of gdp.

    • ColinTwiggs says:

      Are you saying that tax increases by Reagan and Clinton created jobs and lifted the economy out of recession? And the Bush tax cuts caused job losses and the GFC?
      You also seem to believe that the massive public debt spike was caused by tax cuts rather than stimulus spending during the GFC.

  14. Quote: “Shifting the tax burden onto the wealthy might be clever politics, but does it make economic sense?” I love this question and it’s one that is answered very well in Tony Robbin’s video – http://www.youtube.com/watch?v=jboTeS9Okak titled: “The National Debt and Federal Budget Deficit Deconstructed” He too asks the question “Is taxing the rich enough?” and the video goes on to illustrate …. (but I not going to ruin it for you). It’s worth every second of the nearly 20 minute on Youtube. A huge eye opener for me.

  15. Why are you using numbers from the 1920’s and 30’s? What about the effects on the economy of tax rates in the last 50 years? In the 30’s and 40’s we did not have the ability to outsource jobs, the internet, computers, etc. It was a totally different economy.

    Please use examples relevant to our times. I agree with Colin’s comment.

    Mr. Chianelli states re: flat tax rate “it’s fair and removes all loopholes.” It isn’t fair when you consider the fact that there is a certain amount of money necessary to eat,house one’s self and pay for health care, i.e. money necessary for basic survival. For the rich that is a very small part of their income. For the other social classes it is the majority of their income. Taxing income necessary for basic survival is quite different than taxing disposable income. That is the whole point of graduated income tax rates.

    The necessary cuts and increases in taxes should not come out of income that is necessary for survival: medicare, any income below what is considered the poverty level, inexpensive housing, etc. That is a generally accepted premise in advanced societies of the 21st century. A value added tax such as Sweden has except on food, medicine, medical care, housing (for homes valued less than 150K) is a more fair approach if one is to even consider a flat tax.

    Grover Lawlis, MD

    • ColinTwiggs says:

      “Please use examples relevant to our times”
      This is the second global financial crisis in the last 100 years: 1929 – 1939 (some would say 1945) and 2007 – present. What other times did you have in mind?

    • ColinTwiggs says:

      “Taxing income necessary for basic survival is quite different than taxing disposable income”
      How many people in the US live below the bread line? Certainly not enough to justify a progressive and inefficient tax system. Applying a flat tax rate to everyone and subsidizing those in poverty through welfare distributions like food stamps is far more efficient – and fair.

    • ColinTwiggs says:

      I am a great supporter of value added taxes like in Sweden or Australia, but both have made a big mistake in exempting selected items like basic food and medicine. That sends compliance costs sky-rocketing. Think of a business that orders supplies, some of which are exempt and some are not, and sells a number of items, some exempt and some not. Instead of applying one rate to sales and deducting the same rate from purchases, the business now has to track tax on individual items to calculate their tax liability. And vast tracts of legislation have to be written and complied with as to what items are exempt and what are not. Add a raisin to a loaf of bread and it is no longer exempt. Add more than a certain amount of sugar and will similarly be classed as non-exempt confectionery. You start having to specify the ingredients of each exempt item. Meat may be exempt, but what if you marinade it? Medicines are exempt but what about vitamins? Bandages are exempt but what about braces? Dental work may be exempt but what about cosmetic dentistry? The list is endless. The golden rule of taxation: KISS.

  16. What would be the arguments for or against a flat tax rate for everyone, with no deductions…it’s fair and removes all loopholes

  17. Colin says:

    You haven’t mentioned what rate Obama is proposing, what is it?

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