Commentary

Lower Taxes, Greater Growth

This article originally appeared in the National Post on March 19, 2003.

When the U.S federal income tax was enacted in 1913, the top rate was just 7%. By the end of World War I, rates had been greatly increased at all income levels, with the top rate jacked up to 77% for income over US$1-million. After five years of very high tax rates, rates were cut sharply under the Revenue Acts of 1921, 1924 and 1926. The combined top marginal normal and surtax rate fell from 73% to 58% in 1922, and then to 50% in 1923 (income over US$200,000). In 1924, the top tax rate fell to 46% (income over US$500,000). The top rate was just 25% (income over US$100,000) from 1925 to 1928, and then fell to 24% in 1929.

Treasury secretary Andrew Mellon knew that high tax rates caused the tax base to contract and that lower rates 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.” He received strong support from president Calvin Coolidge, who argued that “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.”

It is often assumed that broad cuts in income tax rates only benefit the rich and thrust a larger share of the tax burden on the poor. But detailed 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. As the marginal tax rate on those high-income earners was cut sharply from 60% or more (to a maximum of 73%) to just 25%, taxes paid by that group soared from roughly US$300-billion to US$700-billion per year. The share of overall income taxes paid by the group rose from about one-third in the early 1920s to almost two-thirds by the late 1920s. (Note that inflation was virtually zero between 1922 and 1930, thus the tax amounts shown for that period are essentially real changes).

The tax cuts allowed the U.S. economy to grow rapidly during the mid- and late 1920s. Between 1922 and 1929, real gross national product grew at an annual average rate of 4.7% and the unemployment rate fell from 6.7% to 3.2%. The Mellon 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 many 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 US$100,000 increased 15%, but the number of taxpayers in that group almost quadrupled. During the same period, the number of taxpayers earning between US$10,000 and US$100,000 increased 84%, while the number reporting income of less than US$10,000 fell.

The decade of the 1920s had started with very high tax rates and an economic recession. Tax rates were massively increased in 1917 at all income levels. Rates were increased again in 1918. Real GNP fell in 1919, 1920 and 1921 with a total three-year fall of 16%. (Deflation between 1920 and 1922 may also help explain the drop in tax revenues in those years).

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

The tax cuts of the 1920s were the first federal experiment with supply-side income tax rate cuts. Data for the period show an initial decline in federal revenues as tax rates were cut, but revenues grew strongly during the subsequent economic expansion. After the cuts, total tax payments and the share of total taxes paid by the top income earners soared.

Veronique de Rugy is a fiscal policy analyst at the Cato Institute.