THE ECONOMIC IMPACT OF TAX CHANGES, 1920-1939.

• Author: Reynolds, Alan

Estimates of the elasticity of taxable income (ETI) investigate how high-income taxpayers faced with changes in marginal tax rates respond in ways that reduce expected revenue from higher tax rates, or raise more than expected from lower tax rates. Diamond and Saez (2011) pioneered the use of a statistical formula, which Saez developed, to convert an ETI estimate into a revenue-maximizing ("socially optimal") top tax rate. For the United States, they found that the optimal top rate was about 73 percent when combining the marginal tax rates on income, payrolls, and sales at the federal, state, and local levels. A related paper by Piketty, Saez, and Stantcheva (2014) concluded that, at the highest income levels, the ETI was so small that comparable top tax rates as high as 83 percent could maximize short-term revenues, supposedly without suppressing long-term economic growth. Such studies could be viewed as part of a larger effort to minimize any efficiency costs of distortive taxation while maximizing assumed revenue gains and redistributive benefits.

A previous article in this journal, "Optimal Tax Rates: A Review and Critique" (Reynolds 2019), analyzed such U.S. postwar ETI estimates that were being misconstrued as recommendations for a 73-83 percent optimal top tax rate for the federal income tax alone. I surveyed evidence and arguments suggesting that even if top tax rates designed to maximize short-term revenue might be "socially optimal" in some sense, such high marginal rates would not prove to be economically optimal in terms of the incentive effects on sources of longer-term expansion of the economy and the tax base. As Goolsbee (1999: 38) rightly emphasized, "The fact that efficiency costs rise with the square of the tax rate is likely to make the optimal rate well below the revenue maximizing rate."

The early paper by Goolsbee included estimates of the ETI in the 1920s and 1930s. Together with another paper about the ETI during those years, by Romer and Romer (2014), the prewar studies came to nearly the same conclusion as their postwar counterparts did--namely, that hypothetical top tax rates of 74-83 percent could have maximized federal tax revenues during the Great Depression. Unlike Diamond and Saez (2011), however, the prewar studies excluded state and local taxes (which were much larger than federal taxes) and major new federal taxes on payrolls and sales added in 1932-37.

Romer and Romer (2014: 269) use an average of ETI estimates for federal income tax changes from 1918 to 1941 to conclude that "our estimated elasticity of 0.21 implies an optimal top marginal rate of 74 percent" (2014: 269). Yet their estimated elasticity is twice that high for 1932 (0.42) when the top marginal rate was raised from 25 percent to 63 percent. And their elasticity coefficients for major tax changes in 1934-38, they acknowledge, "cannot be estimated with any useful degree of precision" (2014: 266).

Goolsbee (1999: 36) compares 1931 and 1935 to judge how high-income taxpayers responded to much higher tax rates in 1932 (and higher still in 1934). He concludes the ETI at high incomes was so low that "if there were only one rate in the tax code, the revenue maximizing tax rate given the [low] elasticity estimated ... [would be] 83 percent using the using 1931 to 1935 data."

When discussing a smaller 1936 rate increase, confined to incomes above $50,000, Goolsbee concludes: "Technically, the revenue-maximizing [single tax] rate would be at the maximum of 100 percent using 1934-38 data, since the elasticity was negative" (ibid). A study of postwar data by Piketty, Saez, and Stantcheva (2014: 252) likewise theorized that "the optimal top tax rate ... actually goes to 100 percent if the real supply-side elasticity is very small." My review of that paper (Reynolds 2019: 250-54) found their estimated ETI and Pareto parameters to be far below consensus estimates for high incomes and inapplicable to untested tax rates of 83-100 percent. This review of similar prewar studies also finds their ETI estimates implausibly low and the alleged revenue-maximizing tax rates of 74-83 percent too high.

Romer and Romer (2014) are incorrect in claiming that tax responsiveness was low in the 1920s and 1930s, and Goolsbee is incorrect in making that same claim about just the 1930s. Their erroneous low response estimates lead them to conclude that high tax rates are a good thing. This study finds, instead, that high income taxpayers were very responsive to lower marginal tax rates in the 1920s and higher marginal tax rates in the 1930s.

I find that large reductions in marginal tax rates on incomes above $50,000 in the 1920s were always matched by large increases in the amount of high income reported and taxed. Large increases in marginal tax rates on incomes above $50,000 in the 1930s were almost always matched by large reductions in the amount of high income reported and taxed, with a brief exception connected with the 1937-38 recession, which is investigated in detail.

The Folly of Raising Taxes in a Deep Depression

An earlier generation of economists found that raising tax rates on incomes, profits, and sales in the 1930s was inexcusably destructive. In 1956, MIT economist E. Cary Brown pointed to the "highly deflationary impact" of the Revenue Act of 1932, which pushed up rates virtually across the board, but notably on the lower-and middle-income groups. The scope of the act was clearly the equivalent of major wartime enactments. Personal income tax exemptions were slashed, the normal-tax as well as surtax rates were sharply raised, and the earned-income credit equal to 25 per cent of taxes on low incomes was repealed [Brown 1956: 868-69],

In 1958, Arthur Burns wrote:

If prosperity is to flourish, people must have confidence in their own economic future and that of their country. This basic truth was temporarily lost sight of during the 1930's.... In the five years from 1932 to 1936, unemployment ... at its highest was 13 million or 25 percent of the labor force. The existence of such vast unemployment did not, however, deter the federal government from imposing new tax burdens.... The new taxes encroached on the spending power of both consumers and business firms at a time when production and employment were seriously depressed. Worse still, they spread fear that the tax system was becoming an instrument for redistributing incomes, if not for punishing success [Burns 1958: 27-28],

In 1966, Herbert Stein referred to President Hoover's 1932 policies as "the desperate folly of raising taxes in a deep recession" (Stein 1966: 223). In contrast, Romer and Romer (2014) viewed their ETI estimates for 1932-38 as evidence that enormous tax increases in those years had no visible adverse effects on the Depression. To demonstrate the supposedly negligible impact of much higher income and excise taxes in 1932, they enumerate a few upbeat statistics about short-term business conditions. Meanwhile, Cole and Ohanian (1999) and Mulligan (2002) have been even more vocal in asserting that federal income and excise tax increases during 1932-36 share no responsibility for the depressing performance of the economy (and income tax receipts) from 1930 to 1940. The final sections of this article question the "taxes don't matter" arguments and evidence of Romer and Romer, Cole and Ohanian, and Mulligan. Before doing so, however, we must first begin with a scenic detour of some new graphical evidence suggesting that most ETI estimates in Romer and Romer, and Goolsbee, are implausibly low, particularly for higher tax rates in 1932 and 1936.

A Graphical Illustration of Elasticity of Taxable Income, 1920-1939

Figure 1 illustrates yearly connections between (1) changes in the average of all marginal tax rates applied to annual incomes above $50,000, and (2) the amount of net income, in billions of dollars, reported at incomes above $50,000. Taxable incomes of high-income taxpayers have grown rapidly when their marginal tax rates were low, and were flat or falling when their marginal tax rates were high. The only apparent exception was 1936-37 when taxable earnings above $50,000 briefly reached the equally unimpressive lows of 1922-23.

Romer and Romer (2014: 248, 252) define "high income" as the top 0.05 percent of income earners, which comprise "about 25,000 returns per year." Taxpayers in that group and the incomes required to be included don't remain constant from year to year. Indeed, "net income cutoffs for being in this group ranged from $25,400 in 1933 to $75,100 in 1928" (2014: 248). Consequently, defining high income as a percentage of income makes it a moving target for studying taxpayer response. Romer and Romer (2014) allocate marginal tax rates according to incomes on tax returns. But an income of $25,400 in 1933 faced only a 21 percent marginal rate in 1933--one-third of the top tax rate of 63 percent that year and even lower than the 23 percent marginal tax on $75,100 in 1928. Thus, we are unlikely to find a meaningful estimate of how high-income taxpayers react to high marginal tax rates by measuring how they reacted to marginal tax rates as low as 21 percent.

Figure 1 defines high income in a simpler way that is more transparently linked to tax rate schedules--namely, as net (taxable) income above $50,000--which, in 1935, included 10,680 tax returns and made up the top 0.33 percent of taxpayers (Tax Policy Center 2019b). That threshold combines the two highest of Goolsbee's three high-income groups. It matches the definition of affluence in FDR's 1936 tax law, which raised tax rates only on those earning over $50,000. Net income figures above $50,000 are added up from tax returns (SOI Tax Stats Archive). The graph is confined to 1920-39 to minimize possible distortions for 1918-19 caused by WWI and for 1940-41 by rearmament, though including those years would not make a great difference except for 1941.

The recession from January...