The tax cuts in the stimulus package will act against the spending to thwart the economic effect. Unless Congress passes tax INCREASES the country, and possibly the world, will continue to slide into a depression. Tax INCREASES are necessary, no alternative. Stimulus spending alone won’t salvage the disaster. The reasons are simple.
What is pushing the economy into depression is the eroding consumer demand. In essence, it is the reverse of the housing bubble that stimulated consumer demand. Now, the sliding consumer wealth stifles consumer demand. As demand slides, factories close, unemployed reduce spending, everyone else worries while cutting spending and increasing saving, even selling investments to put into savings.
There is a major myth that tax increases slow an economy and tax cuts spur economic growth. Actually this is nonsense, the reverse is actually true. Perhaps the best example is the actual data about the U.S. economy before and after the Great Depression. Tax rates were actually CUT from 73 percent in 1920 to 24 percent in 1929, precipitating the Great Depression. Only when taxes were substantially raised did the economy recover.
The 1920s started with a top income tax rate of 73 percent and when the rate dropped to 56 percent the economy grew okay for two years, but when the rate was lowered to 46 percent the economy grew at a much lower rate. Even with a drop to 25 percent the economy had a modest boom in the second year but grew at much lower rates the next two years.
Notice that in the table below there was another tax reduction to 24 percent in 1929, which resulted in the stock market crash and the beginning of the Great Depression. The tax rate increased back to 25 percent in 1930, but the large decline in economic activity is generally attributed to the Smoot-Hawley Act which crippled international trade.
Year |
GNP (1929 $M) |
chg |
Top Rate |
Event |
1919 |
70,271 |
|
73 |
|
1920 |
71,383 |
1,112 |
73 |
|
1921 |
68,355 |
-3,028 |
73 |
|
1922 |
73,150 |
4,795 |
56 |
|
1923 |
82,994 |
9,844 |
56 |
|
1924 |
85,222 |
2,228 |
46 |
|
1925 |
87,359 |
2,137 |
25 |
|
1926 |
93,438 |
6,079 |
25 |
|
1927 |
94,161 |
723 |
25 |
|
1928 |
95,715 |
1,554 |
25 |
|
1929 |
101,444 |
5,729 |
24
| Crash |
1930 |
91,513 |
-9,931 |
25
| Smoot-Hawley Act |
1931 |
84,300 |
-7,213 |
25 |
|
1932 |
70,682 |
-13,618 |
63
| Election year |
1933 |
68,337 |
-2,345 |
63
| FDR |
1934 |
74,609 |
6,272 |
63 |
|
1935 |
85,806 |
11,197 |
63 |
|
1936 |
95,798 |
9,992 |
79 |
|
1937 |
103,917 |
8,119 |
79 |
|
1938 |
96,670 |
-7,247 |
79 |
|
1939 |
103,736 |
7,066 |
79 |
|
1940 |
112,961 |
9,225 |
81 |
|
1941 |
126,237 |
13,276 |
81
| Pearl Harbor |
1942 |
122,571 |
-3,666 |
88 |
|
1943 |
121,918 |
-653 |
88 |
|
1944 |
126,633 |
4,715 |
94 |
|
1945 |
130,218 |
3,585 |
94
| End of war |
1946 |
151,895 |
21,677 |
86 |
|
1947 |
153,515 |
1,620 |
86 |
|
1948 |
158,828 |
5,313 |
82 |
|
1949 |
153,970 |
-4,858 |
82 |
|
1950 |
172,756 |
18,786 |
91 |
|
1951 |
178,565 |
5,809 |
91 |
|
1952 |
180,234 |
1,669 |
92 |
|
1953 |
184,993 |
4,759 |
92 |
|
1954 |
186,435 |
1,442 |
91 |
|
1955 |
202,248 |
15,813 |
91 |
|
|
The Smoot-Hawley decline lasted four years, and 1932 saw a large tax increase to 63 percent but the large drop in the economy that year was not likely due to the tax.
The 63 percent tax rate continued from 1932 through 1935 and the economy actually improved every year after the first. The 13,618 decline in the first year became a 2,345 decline the next year, a 6,272 increase the next year, and an 11,197 increase the last year, an increase in the economy greater than any year of the 1920s.
The 63 percent tax rate was increased to 79 percent for the years 1936 through 1939 and the economy showed strong growth for three of the four years. Then the tax rate was raised to 81 percent and there was even stronger growth for two years, the last of which was even larger than the 1935 record increase after that tax increase.
The last of these two years ended with the bombing of Pearl Harbor in December. The next year the tax rate was raised to 88 percent and the economy slumped mildly but this was likely more attributable to Pearl Harbor than the tax increase. The following year with the same tax rate saw only a slight decline and the next two years had an increase of the top income tax rate to 94 percent with good growth in the economy.
The 94 percent rate was cut to 86 percent the next year (1946) and the economy had a large increase, but this boom was likely attributable to the end of the war in the prior year (1946 was also the first year of the Baby Boom). The tax rate stayed at 86 percent the next year and the economy grew at only 7 percent of the prior year’s boom. But that increase was more in line with the prior years before the end of the war.
In 1948 the tax was lowered to 82 percent for two years and the economy grew in the first year but declined by nearly the same amount in the next year. The tax was then raised for two years in 1950 to 91 percent, a substantial increase, raised again in 1952 to 92 percent for two years, then lowered back to 91 percent for two years, and all of those years showed good economic growth. In fact, two of those years had the largest gains in the economy to that time, other than the 1946 end of war boom.
In summary, the four years prior to the Wall Street Crash were after a large income tax cut, but the next year saw another one point cut and the crash. The income tax the two years after the crash were back at the one point higher rate, and economy slumped with its largest slump in the year there was a large tax increase. But considering the pattern of the slumping economy, it seems perverse to blame the tax increase for that large slump, particularly when that same rate saw the slump turn around almost immediately.
The tax rate that went from 25 percent to 63 percent took effect in 1932 under the Hoover administration and was in effect for four years, the first two of which saw first a large slump and then a small decline, and then over the dozen years from 1934 to 1945 the tax rate grew substantially up to 94 percent yet the economy grew every year except three, and one of those was the year after Pearl Harbor.
The crash occurred after a tax CUT, the economy slumped primarily because of the Smoot-Hawley collapse of international trade, and the economy only recovered AFTER a large tax INCREASE. The economy increased seven of eight years prior to Pearl Harbor over periods of significant tax increases. It wasn’t the war that ended the Great Depression, it was tax increases.
The Monetary Effect
The reason that tax increases improve the economy while tax cuts restrain the economy derives from the velocity of money. Any economy functions by people exchanging money. Money that one person spends is received by a business that pays employees, who spend the money at other businesses that also pay employees. Thus the money that is in circulation passes from person to person in the economy.
However, people who receive income in this way do not spend all of it. They save some. Thus each time money is spent, it is received as income and some is spent and some is saved. Among the very poor, virtually none is saved, while among the very rich nearly all is saved. The rest of the population tends to react to interest rates, saving more when rates are high, less when rates are low.
Money that is spent circulates in the economy, while money that is saved becomes available for lending. In an economic downturn, people tend to be poorer and cautious. As a consequence, they tend to save more and spend less. This typically means that businesses borrow less for inventory and production, and this reduces the demand for loans, thereby lowering interest rates. Normally this decline in interest rates will mean some people start spending more and saving less, which increases demand until a balance is reached between consumers and suppliers.
In a severe economic downturn, however, the people become afraid to spend more, and are saving not for interest rates but for security. The subsequent increase in savings with a reduction in borrowing drives interest rates to very low levels. As consumers shrink spending, suppliers cut production and employment, which further creates fear and increases saving for security. The velocity of money falls and the money supply contracts.
In these conditions, the federal government has to raise taxes. The increase in taxes reduces the amount of money saved and increases the amount of money spent by the same amount. The federal government does not save money, so its spending is a direct injection to the economy, and since it typically pays for employment creation, the money it spends goes to the poor who tend to spend nearly all of it. Thus the velocity of money gets a large boost and the contraction stops.
At the same time, the increase in spending creates a demand for production loans to supply this new demand, and that starts to put the savings into constructive use. This in turn leads to increased employment and further spending. But it takes both a tax increase and federal spending. One alone won’t do it.
Consider what would happen if there was a tax cut during an economic downturn. The reduction in government spending means the need for production loans slumps, further reducing the need for savings, while most of the tax cut is saved since the windfall is kept for security, further increasing savings. The consequence is saving which is not put to productive use and which provides almost zero earnings for savers. Tax cuts only go to the already well off and employed, not to any stimulus, and they mostly save it and exacerbate the problem of excessive saving and insufficient spending.
Conversely, when an economy booms, the federal government both has increased revenues and people tend to spend more and save less. If the federal government continues to spend those increased revenues during boom times, the amount of savings available for investment to meet the spending demand becomes exhausted. Interest rates rise which tends to reduce borrowing for investment and leads some consumers to save rather than spend and the economy stalls.
The result is an economy where the consumers plus the government spending run into resource constraints. A tax cut then results in a reduction in federal spending and an increase in savings because the public saves much of the tax cut. This resolves the constraint on investment and expansion and the economy continues to boom.
The key is always that a tax cut increases savings while a tax increase stimulates spending. In a typical normal economy, an increase in spending means less savings, and the increased demand is met by increased borrowing which raises interest rates that lead some of the spenders to save more. This stabilizes the economy as the spending and borrowing reach a balance.
The Fiscal Effect
An economy functions on the basis of firms supplying a consumer demand. The consumer demand creates a market for a volume of goods and services that companies vie to provide. The companies seek their "market share" in providing goods and services and compete on the basis of their ability to provide lower prices for greater volumes.
Given any "profit per item" (profit margin) the more items the firm sells, the greater its total profits. Firms can lower prices to achieve greater volumes because their total profit will increase even if their profit margin decreases. As long as lower prices attract greater "market share" the firm can reduce prices.
Market share simply means that a firm can gain a larger profit from selling more items at a lower "profit margin" than fewer items at a higher "profit margin." This is different from "economies of scale" which mean that actual costs decline with larger volume. Firms that achieve high market share may ALSO achieve economies of scale that further increase their profits. Economies of scale occur because of transportation, manufacturing, and marketing advantages with higher volumes.
This is ALSO different from fixed cost amortization. All firms incur a combination of "fixed" and "variable" costs. Variable costs are those that increase with each item produced. Fixed costs are the same regardless of how many items are produced or sold. Fixed costs include machines, property, advertising and other costs that will be incurred before the product is even produced. As firms sell more items, the fixed-cost-per-item goes down. Variable costs stay the same for each item produced but if firms can achieve high volumes this means their fixed costs amortized over this larger volume are less per item. Thus volume increases can produce more revenue, lower variable costs through economies of scale and lower fixed costs per item, which allow further price cuts.
In a booming market, firms see larger profits from larger sales, from economies of scale, and from reduced fixed cost amortization. As a consequence, it is easy for marginal firms to exist in the market. However, firms carve out market share in varying degrees of profitability. As long as a firm is profitable it can serve a segment of the market. Even a zero profit firm can survive economically. The larger the market, the greater the opportunity for marginal firms to retain market share.
But when there is a "business recession" the total market volume declines. As a consequence, the total volume is smaller but the number of firms is the same. The result is that these firms now compete for market share but the fixed cost amortization and the economies of scale decline at the same time total revenues decline. This creates a "profit squeeze" that primarily affects marginal producers. Those firms begin to leave the market and their market share goes to the remaining firms.
As a consequence, firms scramble for business in the downsized market against each other waiting for the "shake-out" when enough firms are forced to leave the market because they lack profitability. The faster firms leave the market releasing enough market share to the remaining firms to make a significant difference in their profitability, the faster the recession begins to end.
When a shake-out occurs, the most "efficient" firms tend to remain. Efficient, in this sense, means firms that can operate profitably at the lowest volumes. As a consequence, when the other firms leave the market, these firms rapidly see their profitability improve because of their volume increase, the economies of scale, and the fixed cost amortization. Those firms that left the market were often the least efficient in the sense that they were barely profitable even in the boom market.
Raising taxes during a recession makes it even more difficult for a marginal firm to remain in the market. So it is true that raising taxes during a recession will drive some firms out of business. However, these are the least efficient firms that simply leave the market sooner rather than later, thus SHORTENING the recession. Tax increases during a recession drive out marginal firms and thus release their market share to the remaining firms. Those firms are the most efficient in the market. But because they are the most efficient, when the recession starts to end, they are better able to lower costs from economies of scale, amortization of fixed costs, and thus better able to expand the economy to new heights.