Economics is a proud discipline. It has long seen itself as the premier social science and with the major natural sciences part of the core of the intellectual apparatus of modern society. It understands its methods as sound, serious, and extensive and its contribution to progress notable.
Just as income taxes were settling in good and high. (Photo by FPG/Getty Images)
Economics has been particularly proud of its record in explaining the central negative event of economic history since the industrial revolution, the Great Depression of the 1930s. Its inquiries into monetary policy, the gold standard, and “regime uncertainty” (its own term) have explained the event with dedication.
Economics almost always waves off taxation as significant among the causes of the Great Depression. When we wrote our income tax history of the United States, Taxes Have Consequences, it became apparent how problematic this oversight is. In 1912, no major nation had a significant income tax, and the corresponding size of governments was small. In 1929, every major nation had an income tax. At the margin, these were taking 25, 40, if not 50 percent of income. Then the tax rates went up. In 1932, the American top income tax rate was 63 percent.
Those with capital and a bent for investment faced keeping their business returns in whole as ever in 1912. Seventeen years later, they faced keeping much less than that. The world completely changed over the interregnum, 1912-29, concerning whether those who ordinarily would deploy capital would continue to do that. If returns after taxes are going to go from $1 on $1 to 75 cents on the dollar to 37 cents on the dollar, incredible changes will come to the deploying of capital (and therefore to employment, growth, etc. as well). The new income tax apparatuses across the major nations, in the 1920s, foretold a Great Depression unless the new normal got very small.
The United States had major tax rate cuts in the 1920s. Over 1921-28, tax policy moved in one direction, taking rates down. Every year of the period there was a federal budget surplus and a booming economy. In 1929, for reasons unclear, the government decided that that year’s tax cut would be a temporary rebate, one point off rates and announced in December even though the tax year was basically over.
Just as the economy had boomed as tax-rate cuts were certain prior to 1929, in 1929 the economy pulled up with word of the temporary rebate. The indication was that the floor of the American rate structure had now been established, 25 percent. If there was a dynamic, it would be in one direction, up (see 1932).
Those with capital realized that the new income tax era, only sixteen years old at that point, was for real. The previous eight years, 1921-29, had given the illusion that the income tax experiment was progressively vanishing. After 1929, it was clear that tax rates at the margin would stop falling and probably grow. The directness of this issue with respect to the coming of the Great Depression is remarkable.
Enter economics. The discipline, largely confined to universities, had helped income taxes come to be. Academic economics, especially in the United States, had cut its teeth in the nineteenth and early twentieth centuries on being anti-tariff. The tariff was the principal source of federal revenue prior to 1913, when the income tax began. Economists railed against the tariff, cogently, the whole while. Meanwhile the power brokers in Washington and business ignored them. At last in 1913, the drumbeat against the tariff succeeded, both because of the economists’ pressure and the nation’s exhaustion with the tariff as a headline political issue. The income tax was put in place.
Economics, in the several decades after 1900, was never anywhere near so vociferous against the income tax as it had been against the tariff. There were plenty of economists who thought a progressive income tax was sound policy. However well-argued these points may have been, the social status anxiety that economists always felt (and which is still manifested today) was never far from the surface. The political and business players in the tariff had always blown off economists as irrelevant egghead intellectuals. Economics used its antipathy to the tariff as a marker of what the inside players did not have: intellectual purity. The perfectness of their arguments about the tariff conferred to them a heady commitment to principles that the inside players could never have.
When politics flipped in 1913 and largely replaced the tariff with an income tax, economists were slow to turn their fire on the income tax, as they always had fired on the tariff, so much so that they never got around to the task. To the contrary, the discipline rolled over in acquiescing to income taxes. Income taxes with rates up to and past 25 percent became perfectly reasonable to the discipline in general.
The position was ridiculous. Tariff rates should be low to nonexistent but income tax rates can be 25 percent or higher? Economics did not realize that its position was ridiculous. Opposition to the tariff, which involved accommodation of the income tax, had brought economics into the general conversation of political economy in the United States. Tariff antipathy, was, as I have written recently, “the date that economics brought to the dance.” To have sounded off against an income tax after 1913 would have suggested that economists wanted to revive the tariff, were confused, or simply did not belong with serious policy players—conclusions which may well have been valid.
There was no effective scholarly economic opposition to income taxes, as they first established and then leapt off the 25 percent floor from the 1920s into the 1930s. The world’s investors, concerned, responded by saying that we are out. The Great Depression happened. Economists spent the next several generations rigorously identifying causes of the horrible event that were not taxes, to the point that today, the field, with its emphases on monetary causes, international transmissions, and liquidity traps, thinks its study in this area is one of its finest hours.
The most economics, across its comically large literature, comprehensively musters about taxes in this era is that they were part of “regime uncertainty,” a waffle term. It was certain after 1929 that 25-plus income taxes at the top, a completely new thing as of recently, were there to stay and then some. There was no uncertainty, but a dead certainty, that income taxes were for real. Investors and owners of capital said goodbye.
Economics was complicit in the establishment and maintenance of income taxes after 1912 and therefore was complicit some notable way in causing the Great Depression. A self-reflective field can productively rewrite the economic, policy, and indeed intellectual history of the 1910s, 1920s, and 1930s by starting to get this right.
