Higher taxes would choke recovery (update)

One year later we have the received narrative for the market crack-up of 2008: Exhibit A – The bankruptcy of Lehman Brothers.

And now we know what saved the economy: Exhibit B — Massive liquidity from the Federal Reserve — in contrast to the Great Depression era central bankers who put the squeeze on monetary policy.

Okay. Let’s poke a few holes.

The Lehman bankruptcy, whose anniversary we have been celebrating for the past month, was certainly no heart-warming event. But it wasn’t the straw that broke the camel’s back. University of Chicago economists John H. Cochrane and Luigi Zingales demonstrate that the economy didn’t hit the panic button until former Treasury Secretary Hank Paulson and Fed Reserve chairman Ben Bernanke went to Capitol Hill and yelled “Fire!”

concern turns to panic

When Paulson and Bernanke speak, the markets panic

Notice in the graphic (above) that a critical measure of confidence in the banking system — the Libor -OIS spread — didn’t really begin rising to record levels until after Paulson and Bernanke went before Congress to argue for the TARP legislation, which they said was needed to keep the economy from collapsing. Similarly, the price of insurance on Citibank bonds (aka, credit default swaps) didn’t jump to Olympian heights after the Lehman bankruptcy; it was only after the mouths roared before Congress. In general, my experience in  covering the market reveals that this is typical. Politics is more often than not the catalyst that roils the markets big time. And credit markets are the leading indicator. That was true in 1987 and it was true in 2008.

Next: Tight money killed the incipient recovery in the 1930s. Economist Arthur B. Laffer begs to differ:

The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I’d give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s.

via Arthur B. Laffer: Taxes, Depression, and Our Current Troubles – WSJ.com.

And, of course, here’s a graphic to show what happened to just the top federal tax rates during the Depression projected through to 2015. Note: this does not include rising city, state or sales taxes.

top tax rates

I am no big fan of big deficits (and both the NYTimes and Clusterstock both ran pieces similar to mine last week on the dangers of our deep debt hole — Clusterstock featured the same graphic). But now is not the time to raise taxes to either fund new programs or whittle our mountain of debt.

More from Laffer on the tax hikes that began in the Hoover Administration and continued during the Roosevelt years:

…beginning in 1932 the lowest personal income tax rate was raised to 4% from less than one-half of 1% while the highest rate was raised to 63% from 25%. (That’s not a misprint!) The corporate rate was raised to 13.75% from 12%. All sorts of Federal excise taxes too numerous to list were raised as well. The highest inheritance tax rate was also raised in 1932 to 45% from 20% and the gift tax was reinstituted with the highest rate set at 33.5%.

But the tax hikes didn’t stop there. In 1934, during the Roosevelt administration, the highest estate tax rate was raised to 60% from 45% and raised again to 70% in 1935. The highest gift tax rate was raised to 45% in 1934 from 33.5% in 1933 and raised again to 52.5% in 1935. The highest corporate tax rate was raised to 15% in 1936 with a surtax on undistributed profits up to 27%. In 1936 the highest personal income tax rate was raised yet again to 79% from 63%—a stifling 216% increase in four years. Finally, in 1937 a 1% employer and a 1% employee tax was placed on all wages up to $3,000.

Furthermore, state taxes surged as well, from 7.2% of GDP in 1929 to 12.3% in 1932.

Bernanke has declared the end to the recession. Technically, he may be correct. But the economy is in a precarious state: The huge deficit threatens dollar stability and our ability to fund our spending; unemployment means consumers won’t bailout the economy anytime soon. Raising taxes to fulfill the Obama Administration wish-list is tempting but clearly unwise.

In another post I’ll address a critical need: Allowing the economy to correctly price in the housing overhang. And that won’t win any votes.


8 thoughts on “Higher taxes would choke recovery (update)

  1. Hi, Nancy.

    I’m not sure what your economic background is, but there are a couple pretty major fallacies in this post, I’m afraid.

    First, the easy one: it’s not Luigi Gonzales at the University of Chicago, but Luigi *Zingales.* But that’s merely a quibble. I’ve probably mispelled a few things myself.

    Second, Zingales and Cochrane didn’t “demonstrate” that Paulson and Bernanke caused the financial crisis of last fall; rather, they *opined* that this was the cause. I.e., they wrote an opinion, in the Wall Street Journal Opinion page, rather than publishing peer-reviewed research that would demonstrate this connection.

    Third, the logical fallacy of their opinion, and yours, is that correlation = causality. It does not. You might as well say that a man running from his house yelling “fire” is the cause – moments later – of his house being engulfed in flames. If you, and Cochrane and Zingales, want to play “shoot the messenger,” I suppose that’s up to you. But it is merely an opinion, I’m afraid, and a rather weak one.

    Fourth, Cochrane and Zingales present a rather stunning “straw man” argument: that all our financial troubles were the result of Lehman Brothers being allowed to fail. No one is arguing that. The most anyone is saying about letting Lehman Brothers go under is that it aggravated the systemic problems more than anticipated, and that the damage done was worse than the positive benefits of letting an over-leveraged entity suffer the consequences of imprudent risk.

    [BTW – I’m not saying I agree or disagree with that opinion; rather, I’m just clarifying it as being much less dramatic than how Cochrane and Zingales characterize it.]

    The fifth logic problem accounts for the rather strong headline. Of course, Arthur Laffer popularized the famous Laffer Curve in the 1980’s, arguing that – past a certain point – raising taxes decreases federal revenue. But this depends, of course, on which side of the Laffer curve we are on. I think it is clear that with our tax rates – particularly those on the highest margins – being so historically low, we are on the safe side of the Laffer curve, in terms of tax increases on revenues.

    But the main lesson of the Great Depression is not tax policy, but rather a combination of government taxes, debt, and spending. When Hoover and Roosevelt were raising taxes, it was because they were desperately trying to balance the budget. They also, at first, cut quite a bit of spending. This is unwise, during a deep recession. Instead, we should promote counter-cyclical policies, such as increasing spending, to off-set the damage a deep recession can do to even well-managed companies.

    That’s why the stimulus package was passed, and why it has so far been successful.

    The final problem with your logic – and Laffer’s, perhaps – is the simplistic idea that the issue of taxes is binary: raising taxes will choke the economy and lowering taxes will save it. It is not a binary choice … there are a wide variety of possibilities, such as small tax hikes on certain segments of the population a year or two from now. This, by the way, is all that is currently being argued, even from the most inflation-panicked segment of economists and pundits.

    Furthermore, most economists agree that cutting taxes is a poor stimulus measure, and does not “pay for itself” in the current low-tax environment. Tax cuts haven’t paid for themselves with increased revenue for – literally – decades. Probably not since the Kennedy Administration; or during the Thatcher years in England, where the highest rates were greatly lowered from the exorbitant 98% (for capital gains) and 83% (for income).

    The reverse is also true: small, prudent tax increases – after the recovery is well under way – will lower the deficit without “choking” growth. This would be, in fact, a responsible hedge against future inflation that may come soon, due to the high costs of the stimulus package, the bailouts, the war in Iraq, and the irresponsible deficits of the Bush years.

    Anyway, that’s my view of things. Cheers.


    • Ted,
      Thanks for your nuanced response – and apologies for the delay in my response; I’ve been away.

      First, I think you’re right that it was a “combination of government taxes, debt, and spending” that contributed to the deepening and extension of the Great Depression. The Laffer OpEd caught my eye because I feel we are on the cusp of a big spending program just as we have building deficits to bail out the economy. Taxes probably need to rise to lower the deficit as well as to pay for what has been; I shudder to think about paying for new programs at this juncture. Debt as a percent of GDP has been rising relentlessly (my last post) which makes this downturn more difficult to manage in terms of government spending. (And, BTW, The Economist has an excellent roundup this week on the struggles Great Britain is having in managing its programs, deficits, and taxes. A good read: http://www.economist.com/opinion/displaystory.cfm?story_id=14505529)

      Lehman was an important event in terms of helping to shift market sentiment. But I think memory has altered the role of Lehman vs the pre-TARP testimony on the Hill. I find the course of the Libor-OIS spread most interesting: It tells you how banks feel about lending to one another. And it wasn’t until Paulson and Bernanke presented their case for TARP that the bottom nearly fell out. I object to the role Lehman has assumed in the economic crisis narrative. But that doesn’t mean I don’t think it was important. I would write a different lead to the story and it would be about the p.r. blunders of the politicians in D.C. It’s funny, I was recently at an exhibit about the history of money and the controversy over funding the Civil War. In the exhibit, it became abundantly clear that even back then Lincoln understood his p.r. role. He didn’t have Twitter (or True/Slant) to promote his views, but he still understood the power of the pen.

      As for causality, you’re right that some numbers can be coincidental (Libor-OIS happened to gap out when Paulson/Bernanke said we were on the edge of catastrophe). In this case, I think it’s fair to link the two. And thanks for finding my typo — I fixed it.

      As for my background? I don’t have enough training to blow up a global economy — only the real experts can do that!

      • LOL … yeah, I don’t have enough training to wreck things, either. Just a BS in economics and a nice lesson in supply and demand from when I was 9, collecting comic books.

        It’s still a good point, about the dangers of bad p.r., and I do think the message to Congress couldn’t have helped things. So much of the marketplace is driven by perception, how could it not cause a panic to some degree?

        But I’m not sure what else could have been done. They needed the money and the authority from Congress to stop a looming crisis. They had to convey a strong message to Congress, and they couldn’t do it privately. It was a dire situation, and glossing over the depth of the potential downside … well, it might have keep the Libor-OIS spread from continuing up, or it might not have. But it certainly would have impacted their ability to get the unprecedented amount of money and power from Congress.

        In the end, of course, it’s really unknowable, unless you are truly well-versed in these things, which I am not. And even with a deep understanding, it rises to merely educated guess-work.

        That’s the problem with preventing a crisis, I suppose … you only know it worked if nothing happens. Which is exactly the same result as if there isn’t a crisis in the first place.



  2. Ms. Miller,

    Most people would argue that the late 1950’s and early 1960’s were some sort of acme of economic growth and vibrancy for the US and the world. However, the top personal tax bracket was a staggering 91% and the top business tax bracket was 50%. In contrast, in the last 1920’s and early 1930’s tax rates were very similar to what they are now. The tax rates begin increasing under the Roosevelt administration and peaked under the Eisenhower administration. I would suggest that taxes, might actually stimulate the economy if structured and spent correctly. So perhaps this exactly the right time to raise taxes.

    • David,
      A very interesting observation. It’s also interesting to note that debt as % of GDP was lower and the savings rate was higher. So the high taxes were part of a different economic climate. But I will think about your comments more.

    • Bob,
      Such a great chart- thank you. And so important to look at now just as Bernanke has declared an end to the recession. GDP may grow, but unemployment is likely to breach 10% and stay stubbornly high for sometime. The question is how long will it take for unemployment to come down. This leads me back to the Depression era.

      After the tax hikes of the Hoover administration, unemployment hit nearly 25% the following year; that was the peak. But it averaged 20% or so through 1935 and remained in the high teens through 1939. 1940 was the first year of single-digit unemployment — 9.9%.

      So this gets back to the comment from tedsaid: do we credit higher taxes with growth (as per your chart) or with punishing the stock market and wage earners? And let’s not forget about the central bank induced inflation that probably had a role to play in those GDP numbers.

      Thanks for the contribution.

      • hi nancy,

        thanks for your response.

        one additional comment re: “. . do we credit higher taxes with growth . . ”

        i certainly didn’t mean to imply that raising taxes was the cause of the GDP growth after 1932. i only wanted to make the point that raising taxes doesn’t preclude growth.

        what actually caused the growth after 1932? i don’t know. there are just too many variables.

        i enjoy your blog. best of luck to you.


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