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Coolidge Lessons for Today

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May 24, 2013 – Comments (6)

Board: Berkshire Hathaway

Author: rclosch

Amity Shale’s biography of our 30th President is an interesting read because it deals with an important piece of the economic history of the twentieth Century, and because it is well written, if a bit biased in Coolidge’s favor.

Coolidge's taxation policy was that of his Secretary of the Treasury, Andrew Mellon. Together they essentially invented supply side tax cuts. Mellon’s story may well be a better story than Coolidge’s, and I recommend his Biography Mellon: An American Life written in 2006 by David Cannadine to anyone interested in the economic history of the United States from 1850 to 1930. Mellon was from Pittsburgh and the driving force behind the growth of Mellon Bank and (acting as a venture capitalist) much of the rapid industrial expansion of western Pennsylvania in the last half of the 19th Century.

When the federal income tax was enacted in 1913, the top rate was just 7 percent. By the end of World War I, rates had been greatly increased at all income levels, with the top rate jacked up to 77 percent (for income over $1 million). Mellon who started at treasury under Harding felt that taxes should be lower and fewer people should have to pay them. After five years of very high tax rates, rates were cut sharply under the Revenue Acts of 1921, 1924, and 1926. The combined top marginal rate fell from 73 percent to 58 percent in 1922, and then to 50 percent in 1923 (income over $200,000). In 1924, the top tax rate fell to 46 percent (income over $500,000). The top rate was just 25 percent (income over $100,000) from 1925 to 1928, and then fell to 24 percent in 1929.

Tax Cuts

Mellon’s the tax cuts allowed the U.S. economy to grow rapidly during the mid- and late-1920s. Between 1922 and 1929, real gross national product grew at an annual average rate of 4.7 percent and the unemployment rate fell from 6.7 percent to 3.2 percent. The Mellon tax cuts restored incentives to work, save, and invest, and discouraged the use of tax shelters.

Data for the period show an initial decline in federal revenues as tax rates were cut, but revenues grew strongly during the subsequent economic expansion. After the cuts, total tax payments and the share of total taxes paid by the top income earners soared. The Country experienced surpluses of $100 million in 1925, $375 million in 1926 and nearly $600 million the next year. Detailed Internal Revenue Service data show that the across-the-board rate cuts of the early 1920s-including large cuts at the top end-resulted in greater tax payments and a larger tax share paid by those with high incomes. As the marginal tax rate on those high-income earners was cut sharply from 60 percent or more to 25 percent, taxes paid by that group soared from roughly $300 million to $700 million per year. The share of overall income taxes paid by the group rose from about one-third in the early 1920s to almost two-thirds by the late 1920s. In addition to these tax cuts, Coolidge proposed reductions in federal expenditures. At the end of World War I, the national debt stood at $27 billion, nine times its level before the war. But by the end of the Coolidge administration, the country's debt had been reduced to just $17.65 billion.

The Mellon economic policy worked really well in the twenties, but in the thirties it was a disaster. Though out the twenties the government was lowering taxes, governmental spending and the national debt, and the economy became stronger and stronger. I have no problem with this it is exactly the behavior I prefer in a strong economy. So score a few points for the Tea Party. The irony is that 1929 was tea Party heaven. Taxes had been going down since 1920, government spending was going down, and for the prior three years Washington was actually taking in more than it was spending, this was exactly the same policy that in the thirties turned a market crash into the depression.

Now Europe, having carefully studied history, has decided the Mellon-Hoover economics is the best way to deal with their debt problems. A decision that has sent their weaker members into a depression to rival or exceed what the thirties provided in this country. Spain and Greece already are experiencing unemployment numbers equal to what we experienced in the thirties. The cumulative loss in GDP will by the end of this year reach 5.7% in Spain, 7.9% in Portugal, 8.3% in Italy, and 23.5% in Greece. Having made their bed Europe may discover the recovery will be harder and longer than they expected, and the price may include the exit of some of these countries from the Euro. The lesson for the tea party is that while cutting government spending and taxes may work really well in a strong economy by increasing the rate of GDP growth. It is a big mistake when the economy is struggling.

Pragmatism leads us to the view that may well be that Keynes was right, and there is a difference between government debt and private sector debt. Mellon was a conservative banker who felt that what worked for private business should be an example for the public sector, but if the private sector and the public sector are both contracting at the same time unemployment increases inflation becomes deflation, economic growth halts. Deflation is a big problem for a country with lots of debt, because with money becoming more valuable debt burden becomes larger even if the country has balanced its budget, and balancing the budget becomes very difficult as revenue decreases.

What works in one economic environment can be very bad policy when conditions reverse. Cost cutting and balancing the budget may be a good idea when the economy is expanding, but recent experience with this policy in Europe has shown very poor results. Fiscal policy should try to be counter-cyclical with spending increasing in a poor economic, and contracting during an expansion. Unfortunately the American political system does not deal well will this kind of complexity with one party demanding constant spending and the other constant budget cuts. The chance congress will ever get their timing right on fiscal policy is approximately zero.

6 Comments – Post Your Own

#1) On May 24, 2013 at 12:08 PM, Goofyhoofy (< 20) wrote:

I do hope readers here will follow the link to the original discussion. There is much wrong with this analysis, the worst being how wonderfully supply side economics worked in the 20's. It didn't. It enriched a tiny few while much of the country went backwards. (That history remembers the glittery parties is not surprising, much of the failure was in rural areas, with bankrupt farms, banks, and local communities footing the bill for the wild excesses of Wall Street.)

It was in the late 1930s, and lasting until the 1980's that "the great compression" happened, where the great middle class was born and where the benefits of capitalism flowed to all segments of society. Since the 1980's we have again embarked on a course of stealing from the poor and rewarding the rich - the bailout of the bankers only the most obvious example.

The policies of the 1920's, far from being superior, merely papered over the real troubles until tottering like a top heavy building the economy came crashing down. (And then the gold-bugs and deficit scolds really came out in force and made things worse.)

Bah. 

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#2) On May 24, 2013 at 12:29 PM, Mega (99.95) wrote:

Goofy

You're arguing against a strawman. rclosch did not claim that the 1920s were utopian, merely that economic growth was positive. Meanwhile, you only offer anecdotal evidence. Numbers beat anecdotes.

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#3) On May 24, 2013 at 1:37 PM, dennisk101 (< 20) wrote:

As the marginal tax rate on those high-income earners was cut sharply from 60 percent or more to 25 percent, taxes paid by that group soared from roughly $300 million to $700 million per year.

The math here just does not work.  It implies that high-income taxpayers earned $500 million (at the 60% rate) and $2800 million after the rate was cut to 25%.  Income quintupled in a year or so?  If the tax numbers are correct, the only explanation is not that income was so much higher (whether or not as a result of the rate reduction) but rather that more income was reported.  Better reporting is, of course, good, but it should not be confused with macroeconomic stimulus.

Dennis

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#4) On May 25, 2013 at 9:39 AM, ETFsRule (99.94) wrote:

"The math here just does not work.  It implies that high-income taxpayers earned $500 million (at the 60% rate) and $2800 million after the rate was cut to 25%.  Income quintupled in a year or so?"

The tax rate was cut in stages. He mentions taxes being cut from 60% to 25%. I think he is referring to the 58% rate (really 56%) for 1922, and the 25% rate for 1925. Source.

So, now we know that he is comparing tax revenues in 1925 with tax revenues in 1922.

The top tax bracket was $200k in 1922, and was cut to $100k in 1925. So of course there was an enormous expansion in the number of people who belonged to the group of "high-income taxpayers".

It's not hard to imagine that the number of people earning $100k in 1925 could have been five times larger (or more) than the number of people earning $200k in 1922.

The author tries to imply that lower tax rates were the reason for the increase in revenues. I don't see any basis for that claim.

I would say that the author took some liberties, and didn't provide enough detail, as he shoehorned the data to fit his prose.

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#5) On May 25, 2013 at 9:40 AM, ETFsRule (99.94) wrote:

.

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#6) On May 26, 2013 at 1:04 PM, Melaschasm (58.81) wrote:

This is indeed an important yet overlooked area of economic study.  Most historical discussions begin with the Great Depression and ignore the decades prior.

I do need to correct one part of the OP.  During the 1930's tax rates were increased repeatedly, and spending was sometimes increased.  The Tea Party groups in the USA do not advocate increasing taxes.  Thus the Tea Party economic preferences can not be compared to the Great Depression, nor to austerity in Europe.  

Tea Parties want spending cuts, more spending cuts, and someday some tax cuts. 

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