Commentary

Cutting Edge

This article originally appeared in Techcentralstation.com on March 6, 2003.

During the last G7 forum, the heads of most European Central bank and finance ministers expressed deep skepticism about the Bush administration’s $690 billion tax cut proposal. Their criticism comes even as the growth rate for the entire Eurozone will have a hard time reaching a depressing 0.8% in 2003.

Instead of debating the Bush proposal, European finance ministers should try to cut taxes for a change. Those who argue that tax cuts are risky and not effective choose to ignore how well tax reductions in the past stimulated economic growth.

One example of that came in the 1920s, with tax reductions engineered by U.S. Treasury Secretary Andrew Mellon under Presidents Warren Harding and Calvin Coolidge. The 1920s tax cuts were the first federal experiment with supply-side income tax-rate cuts. The empirical evidence shows that they stimulated economic growth and increased government revenues.

The history of those cuts is informative.

When the U.S. federal income tax was enacted in 1913, the top rate was 7 percent. But by the end of World War I, rates had been increased at all income levels, with the top rate at 77 percent. After five years of high tax rates, rates were cut. Between 1921 and 1929, the combined top marginal normal and surtax rate fell from 73 percent to 24 percent.

Economic recovery was the objective of the Mellon tax reforms. High marginal tax rates, he believed, caused the tax base to contract - lower rates thus would boost economic growth. In 1924, Mellon noted: “The history of taxation shows that taxes which are inherently excessive are not paid. The high rates inevitably put pressure upon the taxpayer to withdraw his capital from productive business.”

Mellon received strong support from President Coolidge who argued, “The wise and correct course to follow in taxation and all other economic legislation is not to destroy those who have already secured success but to create conditions under which every one will have a better chance to be successful.”

Not surprisingly, critics called Mellon’s reforms “a giveaway to the rich,” much as today many assume that broad cuts in income tax rates benefit only the rich and thrust a larger share of the tax burden on the poor.

But the facts say otherwise. Internal Revenue Service data show that the across-the-board rate cuts of the early 1920s - including large cuts at the top end - resulted in greater tax payments and a larger tax share paid by those with high incomes.

Interestingly, the numbers show that as the marginal tax rate on those high-income earners was cut sharply from a maximum of 73 percent to just 25 percent, taxes paid by that group soared from roughly $300 billion to $700 billion per year. Also, the share of overall income taxes paid by that group rose from about one-third in the early 1920s to almost two-thirds by the late 1920s.

Mellon’s tax cuts allowed the U.S. economy to grow rapidly. Between 1922 and 1929, real gross national product grew at an annual average rate of 4.7 percent and the unemployment rate fell from 6.7 percent to 3.2 percent. The tax cuts restored incentives to work, save, and invest, and discouraged the use of tax shelters.

The rising tide of strong economic growth lifted all boats. At the top end, total income grew as a result of more people becoming prosperous, rather than a fixed number of high earners getting greatly richer. For example, between 1922 and 1928 the average income reported on tax returns of those earning more than $100,000 increased 15 percent, but the number of taxpayers in that group almost quadrupled. During the same period, the number of taxpayers earning between $10,000 and $100,000 increased 84 percent, while the number reporting income of less than $10,000 fell.

The 1920s started with high tax rates and an economic recession. As tax rates were cut in the mid-1920s, total tax revenues initially fell. But as the economy responded and began growing quickly, government revenues soared as incomes rose. By 1928, revenues had surpassed the 1920 level even though tax rates had been dramatically cut.

Sadly, Mellon’s non-interventionist policies and the idea that lower tax rates promote economic growth would soon be abandoned by the next President, Herbert Hoover, leading the United States into depression. Many monetary policy errors along with the implementation of the Smoot-Hawley tariffs combined to cause the dismal economy of the 1930s. In addition, President Hoover presided over the greatest peacetime tax increase in U.S. history. As he watched the top rate shoot up from 25 percent to 63 percent in less than two years, the Treasury Secretary resigned from his position after writing a series of letters warning about the damage these policies would have on the economy. And he was right. It did not take long for Hoover’s tax policies to kill incentives for work, investment, and entrepreneurship. While the U.S. unemployment rate sharply fell under the 1920s’tax cuts, it soared from 8.7 percent in 1930 to 17.2 percent in 1939.

President Bush’s current proposal to make phased-in rate cuts effective immediately, like the Mellon cuts, promises to expand the tax base. Critics of the Bush tax proposal should check their data before making statements about the ineffectiveness or the undesirability of tax cuts. In turn, European governments should consider rate cuts to stimulate their slowly dying economies, reduce unemployment and promote economic growth.

Veronique De Rugy is a fiscal policy analyst with the Cato Institute.