The Effect of Individual Income Tax Rates on the Economy, Part 2: The Great Depression and the New Deal, 1929 – 1940
by Mike Kimel
The Effect of Individual Income Tax Rates on the Economy, Part 2: The Great Depression and the New Deal, 1929 – 1940
This post is the second in a series that looks at the relationship between real economic growth and the top individual marginal tax rate.
Last week I had a post looking at the relationship between the state of the economy and the top individual marginal tax rate from 1913, the first year for which there were individual income taxes, to 1928. Because there is no official data on GDP for that period, I used recessions as a proxy for how well (or poorly) the economy was doing. I note that there was no sign whatsoever that the economy did better during periods when income taxes were non-existent (the post also looked back to 1901), or were low, or were falling, than when tax rates were high or were rising between 1901 and 1928.
This post extends the analysis to the period from 1929 to 1940, 1929 being the first year for which official real GDP data is available from the Bureau of Economic Analysis. 1940 is the end of FDR’s first eight years in office, and serves as a decent bookend to the New Deal era given America’s entry into WW2 in 1941. Top individual marginal tax rate figures used in this post come from the IRS.
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). In case you’re wondering, 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.
Notice that tax rates fell from 77% in 1920 and 1921 to 24% in 1929, the year the Great Depression began. (As noted in the last post, the so called Roaring 20s was a period when the economy was often in recession.)
In 1932, tax rates rose to 63%, and by 1933, the economy was growing quickly. That doesn’t match with what people believe, I know. It seems these days its commonly accepted that FDR, who took office in 1933, created the Great Depression or at least made it worse, and that only WW2 saved us. In part to address that issue, the graph below shows growth only during the New Deal era, 1933 – 1940 (no WW2!!!). To put the growth in perspective, I’ve added two lines. One represents the fastest single year growth during the Reagan administration, and the other shows the average of the single year growth rates during the Reagan administration. I figured it would be a good comparison, the Reagan administration being today’s gold standard for all that is good and pure.
As the graph shows, in all but two years from 1933 to 1940, the t to t+1 growth rate was faster than in every single year of the Reagan administration. In fact, the average of the yearly growth rates during this period was about a percent and a half faster than Reagan’s best year.
And yes, there was a sharp downturn shortly after the tax hike in 1935, but its hard to credit that tax hike with the downturn when immediately after the economy continued on a rocket trajectory.
Now, whenever I point something like this out, I get told the same thing (at least by folks who are smart enough not to argue with the data): the rapid growth in the New Deal era occurred simply because the economy was slingshotting back from the Great Depression, and if anything the New Deal policies slowed the recovery. The problem with that argument, of course, is that because the unfortunate events of 2007-2009 witnessed the biggest economic decline since the end of WW2, the economy should be primed for the fastest spurt of growth in the past 60 years. After all, the policies we’ve been following before, during and since that decline have not been very New Dealish at all: top marginal tax rates are 35%, not 63% or 79%, there are no work relief programs, and Glass Steagal Act, passed as part of the New Deal, borders on irrelevant. Yet I think its safe to say just about everyone is in agreement that sort of growth isn’t going to happen anytime soon.
It is also safe to say that for the first two periods covered in this series (i.e., 1901 – 1928 and 1929 – 1940), we once again haven’t seen any sign of the purported relationship between higher lower marginal tax rates and faster economic growth. No doubt that relationship shows up later on. Next post in the series: WW2 and the immediate post-War era.
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.
“we once again haven’t seen any sign of the purported relationship between higher marginal tax rates and faster economic growth.”
I’m not sure, you are saying that even though your present charts show a better growth of GDP during this period than Reagan, there is no relationship seen of higher taxes at this point would produce a better GDP rate of growth?
Daniel Becker,
Urgh. That should be “relationship between lower marginal tax rates and faster economic growth.”
Dan – can you change that for me in the post? Thanks.
Government spending shot thru the roof during the Depression, which of course, makes the GDP look strong. After the first trough, war plays a role in the numbers, and that brings back the arguement correlation does not equal causation.
Also, what were the Effective tax rates instead of the Marginal Rates?
Darren,
“Government spending shot thru the roof during the Depression, which of course, makes the GDP look strong.”
I dunno. Using figures from NIPA table 1.1.6, I get Gov’t spending / GDP = 14.8% in 1932 and 14.8% in 1940. It did reach as high as 16.1% in 1939, but that’s not such a big jump.
By contrast, Gov’t spending / GDP = 20.3% in 1980 and 20.4% in 1988, reaching as high as 21.3% in 1986. If you are attributing the growth in the 1930s to gov’t spending, shouldn’t growth have been much faster during the Reagan administration when gov’t spending was quite a bit higher?
As to what happened to the amount people paid and growth, I did that post a bunch of times. Here’s one example: http://www.angrybearblog.com/2011/07/post-tax-burdens-presidents-and.html
“After the first trough, war plays a role in the numbers, and that brings back the arguement correlation does not equal causation. “
The first trough in 1929? So which war was playing a role in the numbers in 1934, say? The data is for the United States, not Manchuria.
As to correlation and causation… you are correct that correlation does not imply causality. But lack of correlation does imply lack of causality. And what the posts are showing is lack of correlation. And we’ve been promised growth would follow tax cuts for a very long time. And I’ve been pointing to a distinct lack of correlation, at least in the direction promised, for a long time.
Mike,
“The first trough in 1929?”
No….I’m refering to the trough after the 1935 tax increase. We can see how fake the growth really was because Roosevelt cut spending in 1937, and GDP crashed. Shortly after this period by the end of 1938, the United States had already began it ramp up for war, not realizing yet that we would be involved within 2 years. Roosevelt order shipyards to begin massive manufacturing of cargo and military war ships after the extent of Japans Navy was revealed.
“And we’ve been promised growth would follow tax cuts for a very long time.”
O.K…..but we have not been promised that a tax cut causes consistant growth for an infinite number of years. We have the Bush Tax Cuts, right after the Dot.com Bubble collapse and a mild recession. Revenue and GDP came back shortly after the tax cuts and increased every year till the recession of 2007. That tax cut was a decrease in the tax base, which goes to show some pretty convincing evidence to the fact that a tax cut can be stimulative.
That was ten years ago, and it flat out does not make sense that those tax cuts would be responsible for growth or decline in the economy today. Business is skeptical now because they do not know what the tax and regulation structure for the future looks like. The majority of the revenue to the Federal Government comes from Individuals. To increase the revenue you have to grow the economy and decrease unemployment. Also, I think the marginal rate plays a minor role in comparison the the tax base. The Effective rates, or “better, high paying jobs” would also do wonders for revenue.
Your arguement comes off as unrealistic to me. Who really believes that if you raised the marginal rates to 60-70% that it would have a major impact on the economy as a whole?
You always have a bunch of information but it’s never exactly what i’m looking for. Sorry….