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Cutting tax rates can increase tax revenues

Yesterday I wrote about how the term ‘Trickle down economics’ was invented by its opponents. Specifically, by FDR’s speechwriter Samuel Rosenman who referred to

the philosophy that had prevailed in Washington since 1921, that the object of government was to provide prosperity for those who lived and worked at the top of the economic pyramid, in the belief that prosperity would trickle down to the bottom of the heap and benefit all.

As Thomas Sowell writes,

When Samuel Rosenman referred to what had been happening “since 1921,” he was referring to the series of tax rate reductions advocated by Secretary of the Treasury Andrew Mellon, and enacted into law by Congress during the decade of the 1920s.

What did Mellon do?

Mellon was a tax cutter. Among other things, he cut the top rate of income tax. In 1921, the tax rate on people making over $100,000 a year was 73%. By 1929, after a series of tax rate reductions, the rate was down to 24% on those making over $100,000.

Why did he do that?

Mellon noted that the number of top rate tax payers and the amount of tax they had paid had fallen as tax rates had risen.

Under the sharply rising tax rates during the Woodrow Wilson administration, to pay for the First World War, fewer and fewer people reported high taxable incomes, whether by putting their money into tax-exempt securities or by any of the other ways of rearranging their financial affairs to minimize their tax liability. Under these escalating wartime income tax rates, the number of people reporting taxable incomes of more than $300,000— a huge sum in the money of that era— declined from well over a thousand in 1916 to fewer than three hundred in 1921. The total amount of taxable income earned by people making over $300,000 declined by more than four-fifths during those years. Since these were years of generally rising incomes, as Mellon pointed out, there was no reason to believe that the wealthy were suddenly suffering drastic reductions in their own incomes, but considerable reason to believe that they were receiving tax-exempt incomes that did not have to be reported under existing laws at that time.

By the Treasury Department’s estimate, the money invested in tax exempt securities had nearly tripled in a decade. The total estimated value of these securities was almost three times the size of the federal government’s annual budget, and more than half as large as the national debt. In short, these were sums of money with great potential impact on the economy, depending on where they were invested.

Andrew Mellon pointed out that “the man of large income has tended more and more to invest his capital in such a way that the tax collector cannot reach it.” The value of tax-exempt securities, he said, “will be greatest in the case of the wealthiest taxpayer” and will be “relatively worthless” to a small investor, so that the cost of making up such tax losses by the government must fall on those other, non-wealthy taxpayers “who do not or cannot take refuge in tax-exempt securities.” Mellon called it an “almost grotesque” result to have “higher taxes on all the rest in order to make up the resulting deficiency in the revenues.”

Secretary Mellon repeatedly sought to get Congress to end tax exemptions for municipal bonds and other securities, pointing out the inefficiencies in the economy that such securities created. He also found it “repugnant” in a democracy that there should be “a class in the community which cannot be reached for tax purposes.” Secretary Mellon said: “It is incredible that a system of taxation which permits a man with an income of $1,000,000 a year to pay not one cent to the support of his Government should remain unaltered.”

Congress, however, refused to put an end to tax-exempt securities. They continued what Mellon called the “gesture of taxing the rich,” while in fact high tax rates on paper were “producing less and less revenue each year and at the same time discouraging industry and threatening the country’s future prosperity.” Unable to get Congress to end what he called “the evil of tax-exempt securities,” Secretary Mellon sought to reduce the incentives for investors to divert their money from productive investments in the economy to putting it into safe havens in these tax shelters. 

As Mellon put it,

Just as labor cannot be forced to work against its will, so it can be taken for granted that capital will not work unless the return is worth while. It will continue to retire into the shelter of tax-exempt bonds, which offer both security and immunity from the tax collector.

So what happened?

The results of Mellon’s tax rate cut were clear. Tax revenues rose.

In 1921, when the tax rate on people making over $100,000 a year was 73 percent, the federal government collected a little over $700 million in income taxes, of which 30 percent was paid by those making over $100,000. By 1929, after a series of tax rate reductions had cut the tax rate to 24 percent on those making over $100,000, the federal government collected more than a billion dollars in income taxes, of which 65 percent was collected from those making over $100,000.

Why the result?

Mellon’s theory had been correct. He had observed that the number of top rate tax payers and the amount of tax they had paid had fallen as tax rates had risen. He theorized that lowering tax rates would increase the number of top rate tax payers and the amount of tax they had paid. And his prediction was borne out.

There were 206 people who reported annual taxable incomes of one million dollars or more in 1916. But, as the tax rates rose, that number fell drastically, to just 21 people by 1921. Then, after a series of tax rate cuts during the 1920s, the number of individuals reporting taxable incomes of a million dollars or more rose again to 207 by 1925.

What does all this mean now?

Remember that decreasing tax rates on the rich had increased the tax revenues taken from them. Even so, Mellon’s policies were denounced as “a device to relieve multimillionaires at the expense of other tax payers,” and “a master effort of the special privilege mind,” to “tax the poor and relieve the rich”.

Little has changed. So-called ‘progressives’ and ‘liberals’ have to ask themselves the same question they had to ask themselves in the 1920s. Which situation do they prefer; one with high rates on the rich producing little revenue? Or one with lower rates on the rich producing more revenue?

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