Tax Facts – What Government Doesn’t Want You to Know

Warning: this blog post is about taxes. Taxes are an inherently boring topic, but useful if you want to understand something that will seriously impact your life. So, please read on if you want to learn the economics of what takes 40%-50% of your income. Otherwise, stop here and remain blissfully unaware.

There is a lot in the press these days complaining about the tax cut package passed by congress and signed by the President. Almost universally, the comments in the mainstream media have an agenda that appears to be almost perfectly tailored for the echo chamber created on each side of the aisle for the major news outlets’ political sponsors. However, a careful scrutiny of the history of US tax law (and tax rates) paints a very different picture of how these tax cuts will impact the United States insofar as its impact on the tax base and the demand-side of the economy.

While US tax law goes back to the very founding of the Republic and the tariff system created by Congress to fund it, personal income tax is a relatively new idea.  Although there was a brief period from 1861 to 1872 where a personal income tax existed to help pay for the civil war,  it wasn’t until the 16th Amendment was passed in 1913 that the government actually got the right to tax our incomes for the first time.

From 1913 until 1931 at the start of the great depression, the federal tax rate hovered at around 1.1% for the poorest families and while progressive (meaning wealthier families paid more than this), it was not punitive for rich people either, with 7% as the top bracket for people earning over $12mm a year in today’s dollars (adjusted for inflation).

However, from 1932 to 1941, Hoover and FDR had tax policies that, by any survey of the most liberal-minded economists, had disastrous results on the economy.  Tax revenue in 1931 was 834mm USD.  In June of 1932, Hoover decided that the worsening economy required government to start collecting more taxes to balance the budget.  Hoover almost tripled the top rate from 25% to 63%, and the low rate increased from 1.1% to 4%.

The amazing result was that tax revenue fell from $834mm to $427mm in 1932.  Why?  Well, when you take money from people’s pockets, they have less to spend.  Less spending results in less profits, and lower corporate tax collections (if companies are losing money, they don’t have profits to tax).  This fell further by 1933, with a mere $353mm in taxes collected as the economy continued to shrink and the government took more and more of the pie for itself (a concept economists call crowding out).  FDR raised them up to 76% when he took office (he raised the top rates to 76% by 1936) and unemployment spiked to 20%.  By 1937, FDR realized that his efforts to spend money to lower unemployment were only partially successful.  Unemployment was down to 15% but the government was spending huge amounts of money and creating large debts in the process.  

So why did this happen?  This has to do with the impact of taxes on the overall economy and the velocity of money. Since the government can only tax profits on money in circulation, the speed with which money moves around between firms in an economy have a major impact on taxes.  For example, if our economy only had four companies, and each company has $100 a year in profit on $200 in sales, then the economy would have $800 in sales, and $400 in profit to share. However, if the government taxes 50% of that profit, there is $200 less money for the companies to share with the economy, and the economy will shrink.  Now, think about how many times a single dollar is exchanged in a year between consumers and companies, and how each time the dollar is exchanged it creates a taxable event. More exchanges equals more taxes.

So if the government raises taxes very high, they reduce the number of taxable exchanges by the amount they took in taxes multiplied by the number of times those dollars would have been spent in a transaction. In short, the government is taking money so that it can’t be spent and then taxed.  While I’m not calling for the abolition of taxes so that we’ll have economic stimulus, it is a good idea to understand that when taxes go up, the economy goes down by a multiple of that tax collected.

However, at the time of these tax increases during the great depression, some Keynesian economists (those who believe that government expenditure is key to stimulating the economy) were shocked because these New Deal tax increases were increasing unemployment and New Deal spending wasn’t improving the economy to compensate.

Government spending was just helping us to limp along while incurring huge debts in the process since demand for government program spending far outstripped taxes collected.  Governments are like us, if they borrow a lot of money today, they will need more income in the future to pay off the debt and maintain their standard of living.  Sadly for us, when governments need to increase their income, they must raise taxes (taxes are the only way they get money legitimately).  So FDR decided to raise taxes again and again.  By 1940, the upper rate for wage earners was 94% for upper income earners, and 23% for anyone earning more than $500 a year.  Needless to say, the economy was so bad by this point, it took World War II to force dramatic changes in production and labor and end the depression.  At the end of WWII, Truman decided to start cutting government spending and lower taxes beginning in 1945.  Economists complained at the time that Truman was going to guarantee another depression, after all government spending is what they believed saved them from the depression getting worse, right?  Actually, Truman’s decision restored accountability in the economy and the nation grew to full employment in very short order.  Needless to say, the corporate tax rate was dropped from 90% to 38%, providing companies plenty of additional cash to grow and hire new workers.  In a recent survey, 2/3 of all economists agree that FDRs policies made the great depression worse and enabled it to stick around for a long time.

What does that mean for us today? Well, during the Obama administration taxes went up, and so did regulation (a quiet form of taxation because it raises the cost of doing business). So despite the Federal Reserve pumping unprecidented amounts of money into the economy through quantitative easing, the velocity of money (over 10 before Obama was elected) fell to just over 5 when he left office.

So, if we are to fix this, we need to have policies that would lower taxes and lower regulation to a sensible level. Both would be good ideas, if your goal is to grow the US economy. So when I hear people opposed to both of these, regardless of their intentions, we need to recognize that they are advocating policies that hurt the financial future of America’s families.

That is why it is all the more important to have sensible people in government who can not only enact policies that help working class families, but are able to explain these policies in a way that unites the American people behind them. Alas, that last part is what both parties appear to be lacking these days: leadership.