The Income Tax Is the Root of Much Evil

Taxes Have Consequences: An Income Tax History of the United States
By Arthur B. Laffer, Brian Domitrovic, and Jeanne Cairns Sinquefield
Post Hill Press, 2022, xxv + 413 pp.

Taxes Have Consequences is a good book that could have been better. The authors are leading defenders of “supply side” economics, which attracted much attention during the 1980s, when the “Laffer curve” of the book’s senior author aroused great interest and to an extent guided policy under Ronald Reagan. Even if the movement’s time of greatest fame has passed, it contributed ideas of lasting value, though some of lesser merit as well, and its influence revived during the administration of Donald Trump, who contributes a foreword to the book.

The main idea of the supply-side movement is that high marginal income tax rates have a negative effect on economic productivity; when tax rates fall, the economy prospers, and when they rise, it sinks. The authors present a comprehensive history of income tax rates and their effects on the economy from World War I to the present, and they cover not only federal taxes but also taxation at the state and local levels. Along the way, we gain many valuable insights, and the authors merit praise for their assiduous research, but they go too far in their principal claim. For them, tax rates are the veritable key to the economic history of the twentieth century.

Their treatment of the Great Depression illustrates both the strengths and weaknesses of the book. In their view, the prosperity of the Roaring Twenties was the real thing and the temporary and hardly serious fall in the stock market in October 1929 could easily have been reversed by tax cuts. Instead, the Smoot-Hawley Tariff, which imposed the highest tariff rates in American history, and the increase in taxes foolishly supported by President Herbert Hoover, plunged the economy into a disaster that did not fully end until after World War II.

They say, “Economic growth in the 1920s—as the tax cuts at the top were prepared, implemented, and sustained from 1921–29—was among the strongest and most resplendent in American history. . . The American people in general enjoyed a prosperity on a mass level unlike anything seen before. Cars, suburbs, radios, airplanes, movies, home appliances—all these fruits of private investment surged in production and abundance as the nation experienced what is now recalled as the most legendary episode in the annals of mass affluence—the Roaring Twenties. . . In his 1978 book The Way the World Works, Jude Wanniski chronicled how the declines, and smaller advances, in stocks from late 1928 through the spring of 1930, inclusive of the October 1929 crash, closely followed the progress and hiccups of the [Smoot-Hawley] tariff bill in Congress. Indeed, despite the 1929 crash, stocks rebounded in early 1930 and approached their 1929 levels. [What happened to the close correlation here?] The market’s fate was not sealed—until, in June, the Senate narrowly passed the bill and President Hoover signed the tariff into law. Only following these developments did stocks tumble for good, as the economy spiraled into what became the inaugural ‘Great Contraction’ phase of the Great Depression.”

Readers of The Austrian will naturally wonder about the response of the authors to Murray Rothbard’s classic analysis in America’s Great Depression showing that the inflationary policy of the Federal Reserve System in the 1920s resulted in an artificial boom that led inevitably to economic collapse. Rothbard applies Austrian business cycle theory to reach his conclusion; have our supply-side authors found a flaw in this theory? Or do they object to the details of Rothbard’s application of the theory? They do neither. They do not mention the book, or Austrian business cycle theory, at all. When you are defending a view of the causes of the Great Depression, isn’t it a good idea to weigh your view against competing explanations? The authors evidently do not think so; of the competing theories, they discuss in detail only Keynesianism, about which they have some useful things to say. They dismiss the monetarism of Milton Friedman and Ben Bernanke, saying that Arthur Laffer and Brian Domitrovic have refuted it elsewhere, but the reference is not publically available. The gist of their response is given the importance of the tax data, there is no need to look elsewhere: “The problem with the monetary interpretation of the Great Depression is that the tax history is so pronounced. . . It is difficult to see how the huge, pangovernmental tax impositions on the conduct of economic activity cannot be the first candidates in any assessment of responsibility for the extended economic crisis of the decade after 1929.” But one needs an extended look at the arguments for other theories to determine the force of this claim, and we do not get it here. To say that “there are correlations between the debate on the Smoot-Hawley tariff and the state of the stock market” does not suffice to show that fear of the tariff caused the Depression.

In their view, a growing economy depends primarily on the investment decisions of wealthy entrepreneurs, especially the wealthiest of these investors. Faced with large increases in marginal tax rates, investors will devote resources to schemes of tax avoidance, of which the authors list a great many. Among the most important of these is the purchase of tax-free bonds. Without these tax increases, the entrepreneurs would invest in risky but potentially profitable enterprises that would lead to growth, but high marginal tax rates require them to give much of their gains to the government. Hence their reluctance to invest and their search for safe and secure outlets for their money. Another of the tax dodges is providing lavish offices and expense accounts to high corporate executives instead of raises in salary, which are subject to high marginal tax rates. The authors use this point against the contention of Thomas Piketty and Emmanuel Saez that inequality between the top earners and others diminished during the 1950s, a period of very high marginal tax rates. Piketty and Saez allege that the prosperity of the decade supports the imposition of high rates today. Our authors challenge both parts of this: if the value of nonmonetary compensation is taken into account, inequality diminished less than Piketty and Saez think, and the decade was one of sluggish economic growth.

You might object that because people are reluctant to pay even low taxes, the rich might still devote some time and effort to tax avoidance—after all, a small percentage of a large income is a substantial amount—and that maybe marginal tax increases aren’t as destructive as Laffer and his associates believe. But the authors don’t agree. In their view, the rich are content to pay a low level of taxes and because of this, a phenomenon highlighted by the Laffer curve arises. Low marginal tax rates may generate as much tax revenue as higher rates. “The strategy adopted by high earners and the rich, over the long era of the income tax, [was] to keep the tax portion of their total income level in any tax-rate environment, no matter if income tax rates were high or low. . . The lower the rates of the income tax, the more high earners said, ‘Forget about it,’ earned plenty however they wished, and paid taxes at the published rates.” The authors convincingly argue that the tax policy of Franklin Roosevelt exacerbated the severity of the Great Depression, and they show in great detail another impediment to recovery, the rise in state and local property and income taxes during the 1930s. But their account of the causes of the Depression is less satisfactory, and not only because the authors fail to address the Austrian theory of the business cycle. The way in which they set up their model of how wealthy people respond to tax increases is anecdotal and not rigorous. Further, they do not argue extensively for their view of the importance of the superrich in investments that lead to economic growth, and again rely largely on assertion and anecdote.

Another problem with the authors’ theory emerges, ironically, as they make a good point. Challenging the common opinion that World War II ended the Great Depression, they rightly note that civilians during the war weren’t well off. “World War II ended the Great Depression: this has been the standard view in economics and public policy commentary since the 1940s. This view is badly incorrect. The essence of the Great Depression was a massive decline in the average standard of living in the United States. In no way did World War II improve upon this situation. In important respects, the standard of living went down from late Great Depression levels during the World War II years.” The Keynesians argue that the massive government spending during the war increased aggregate demand, but what this ignores, the authors say, is that most of this spending was for defense, and this did not help the civilian standard of living. To the contrary, people on the home front had to pay high taxes, and consumer goods were scarce. The need to maintain, as much as possible, their standard of living made people work harder, and made the economy more productive.

This seems plausible, but at the same time, it presents a problem. If marginal rates rise, people may respond in two opposite ways, in what economists call the “income effect on labor” and the “substitution effect on labor.” If your tax rates go up, you might say, “I have to work harder so that I can still buy the consumer goods I want.” If you do this, you are responding to the income effect. You might, on the other hand, say, “I now have to give more of what I earn to the government. For that reason, I’m going to work less.” If you act in this way, you are responding to the substitution effect. The authors argue that civilians during the war responded to the income effect, while during the Great Depression, and at other times, business executives responded to the substitution effect. They have reasons for these claims, but there is a more general problem for their theory that they don’t solve. Because people can respond to tax increases in these two opposed ways, the theory allows one to claim that regardless of the response—more or less work—tax increases are responsible. This makes the theory vacuous, and to avoid this calamity, the authors need to set out clear criteria for when each effect arises. They fail to do so.

Despite the theoretical weaknesses of the book, the authors are right that lower marginal tax rates increase economic productivity. Sometimes arriving at the right conclusion matters more than how you got there.