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December 4, 2008
FDR's Unlikely Prescription: Tax Hikes for Recovery
Joseph J. Thorndike

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Joseph J. Thorndike is a contributing editor with Tax Analysts. E-mail: jthorndi@tax.org.


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In this corner, Amity Shlaes, senior fellow at the Council of Foreign Relations, Bloomberg columnist, and conservative slayer of liberal dragons. To her left, Paul Krugman, Nobel Prize winner, New York Times columnist, and spiritual leader of the Ancient and Hermetic Order of the Shrill (no kidding -- do a Google search).

In recent weeks, Shlaes and Krugman have squared off on a key question: Did the New Deal work? In a series of articles and blog posts, they've traded insults and analysis. For my money, Krugman has gotten the better of the exchange, successfully defending Franklin Delano Roosevelt from charges that he prolonged the Great Depression with a decade of incoherent and often misguided policy improvisation.

But are Shlaes and Krugman asking the right question? It's certainly relevant, given the prospect of a New Deal do-over in the Obama administration. But a myopic focus on the bottom line -- New Deal: success or failure? -- can obscure other important questions. And get in the way of useful lessons.

Who You Callin' Stupid?

Consider fiscal policy, a leading count in most indictments of the New Deal. In retrospect, we know that Roosevelt never fully embraced the Keynesian prescription for ending the Depression. He spent too little and taxed too much. But taking FDR to task for that mistake is a cheap shot. Hindsight makes it easy to identify errors, but it's much harder -- and more important -- to explain them.

The interesting question is not whether the New Deal made effective use of expansionary fiscal policy (a debate which, in any case, has been largely settled), but why it didn't. In particular, why did Roosevelt undermine the stimulatory effect of New Deal spending by raising taxes -- not once, but three times? Was he some sort of moron?

It was FDR's historiographical misfortune to begin his experiment with pump priming at the time that John Maynard Keynes was arguing for countercyclical fiscal policy. The coincidence of those events has made Roosevelt look like a dolt, at least to future generations.

But he looked a lot less foolish to his contemporaries. The Keynesian prescription for ending the Depression was hardly dominant when Roosevelt came to the White House in 1933. Keynes didn't actually publish his grand manifesto, The General Theory of Employment, Interest and Money, until 1936. And while many early New Dealers had a nodding acquaintance with Keynesian ideas, few had embraced them.

But indicting Roosevelt for that failure -- so obvious in retrospect -- is a cheap shot. We might just as well complain that doctors weren't treating infections with penicillin after it was invented in 1928 (it didn't come into widespread use until the 1940s). In politics, as in medicine, it takes time to translate theory into practice.

That being said, Roosevelt's tax policy is still open to legitimate criticism. While there weren't many full-fledged Keynesians in 1933, there was a variety of proto-Keynesians -- policymakers who believed in the value of stimulatory spending, even if they couldn't stomach the kind of wholesale, debt-financed fiscal orgy that Keynes considered vital. Those officials knew that tax hikes could undermine the expansionary effect of new spending.

Political Expedience

So why did Roosevelt and other policymakers support new taxes? For three reasons: one moral, one political, and one theoretical.

As I noted in an article several weeks ago, taxation was a key moral issue for most New Dealers. They believed that rich people were getting away with murder and shirking their fiscal responsibilities through aggressive tax avoidance. That was bad enough when times were good, but in the face of widespread suffering, it was especially repugnant. As a result, New Deal tax laws were designed to raise both statutory and effective rates on the rich.

The political explanation for New Deal tax hikes hinged on the notion of "soundness," a vague but powerful criteria for assessing fiscal policy. Almost everyone in Washington considered unchecked deficits a threat to prosperity. Raising spending without also raising taxes would impair confidence in the government and its stewardship of the economy. This in turn would impede recovery and perhaps even plunge the nation further into the economic abyss.

Even if Roosevelt didn't take this threat too seriously -- and there is reason to think that he never lost much sleep over it -- he understood that gestures in the direction of fiscal orthodoxy were expedient. Consequently, he began his presidency with a splashy effort to cut federal spending known as the Economy Act. "Too often in recent history," he told Congress less than a week after his inauguration, "liberal governments have been wrecked on the rocks of loose fiscal policy." The New Deal, he promised, would not make the same mistake.

Strange words for a man about to engage on an epic spending spree. But Roosevelt understood that Congress and the business community needed reassurance. If he was to dodge the charge of being a spendthrift, then a flurry of budget cutting was vital. As economist Herbert Stein later observed of these early efforts at economy: "However muddled they seemed and may actually have been at the time, in retrospect they look like a brilliant strategy to make possible inflationary or, as we might now say, expansionary action."

Roosevelt's spending cuts probably didn't slow recovery too much because new spending quickly overwhelmed them. But his tax hikes were another story. By almost any measure, New Deal taxes undermined the stimulatory effect of New Deal spending.

Yet they grew out of the same political soil as the Economy Act. As Randolph Paul, who served Roosevelt as an unofficial adviser on tax policy during the 1930s and as a senior Treasury official in the 1940s, later observed: "The climate of opinion of the day sanctioned deficits for relief, but only in combination with tax increases."

Tax Hikes for Recovery

So much for the moral and political explanations. What about the theoretical case for raising taxes in a depression?

Here we see the reemergence of Lord Keynes (who actually didn't become a lord until 1942, but why quibble). Keynesian ideas had begun to filter into the Roosevelt administration by 1934, when Treasury Secretary Henry Morgenthau recruited some of the nation's best and brightest economists to advise him on tax policy. Those economists were not, by any reasonable measure, Keynesians -- at least not yet. Most were convinced that tax increases were an essential component of the recovery program, if only to satisfy soundness concerns. As one of their leaders, Roy Blakey, advised Morgenthau in a key memo:


    Too heavy and, especially, ill-advised taxes may be deflationary, may check recovery, and may deflect the purpose of all economic effort, including that of the Government. On the other hand, inadequate taxation and too much borrowing would be inflationary, injurious to Government credit, and equally or more destructive of recovery than heavy taxation. The history of the past has shown that Governments -- as well as private individuals -- have usually been prone to borrow too much and unwilling to support their current expenditures and especially their credit by adequate taxes.

Blakey insisted, however, that when it came to tax hikes, not all were created equal. Absorbing Keynes's insight on the relative propensity to consume of different economic groups, he argued that income taxes aimed at the rich were less likely to slow recovery than consumption taxes aimed at the poor. "A properly designed and administered income tax is peculiarly in harmony with the ideals and aims of the present administration," he wrote. "It offsets the regressiveness of most other Federal and State taxes, which fall all too heavily on 'the forgotten man.' It does not cut down the purchasing power of those with small incomes, including those on relief, as do sales taxes and tariffs, which raise commodity prices."

Randolph Paul made a similar argument when looking back on the New Deal in 1954. Keynes understood that the desire of the individual to save might rise faster than the desire of business to invest, Paul wrote:


    From this followed the desirability of progressive tax policy which imposed a heavier burden upon high bracket incomes that are largely saved than upon low bracket incomes that are largely spent. A tax system of this type would counteract tendencies towards a disproportionately fast rise in saving and promote tendencies to enlarge consumption in step with the rise in productive capacity.

Those arguments provided intellectual cover to New Dealers who wanted to raise taxes on the rich (even if Roosevelt and his advisers were driven principally by moral and political concerns). Taxes on the rich could be raised, as they were in the Revenue Act of 1935, without doing grievous harm to the economy.

Indeed, some taxes might even speed recovery. That, at least, was the argument New Dealers used in 1936 to defend the undistributed profits tax (UPT). The Keynesian case for raising rates on personal income never made its way to the political arena in 1935; it was an internal, rather than an external, argument for progressive reform. Which is just as well, because Keynes himself never endorsed soak-the-rich tax reform in the midst of a depression.

But the next year, New Deal tax officials used the Keynesian insight on progressive taxation to help sell a sweeping overhaul of corporate income taxation. Corporate managers, they argued, were shielding rich shareholders from their legitimate tax burden by retaining profits rather than paying dividends. A new tax on undistributed profits would force companies to disgorge this money by imposing a graduated penalty on retained earnings, with the penalty calibrated to the percentage of profits retained. Such a tax would strike a blow for tax fairness and close a loophole exploited by the lucky few.

At the same time, the UPT would free money trapped in corporate coffers and move it to the pockets of people who might actually spend it. If corporations obstinately refused to pay larger dividends, then the government could use the resulting increase in tax revenue for the same stimulatory effect. Treasury experts made this Keynesian case in 1937:


    There are good grounds for believing that there exists in this country a considerable stream of uninvested savings which prevent a full absorption of the potential products of industry. Aside from its equitable advantages, therefore, the tendency of the undistributed profits tax to prevent over-saving by the higher income groups may be considered to be a desirable contribution.

Critics of the UPT -- and they were legion -- considered it a disaster. The tax, they insisted, destroyed confidence and dried up investment capital.

That argument carried the day in the late 1930s; the UPT disappeared just a few years after its enactment. But in the decades since, the levy has fared a bit better. In retrospect, it seems unwieldy and more than a little overambitious. But one thing it doesn't seem is foolish. The tax grew out of a real problem and represented an honest effort to solve it.

The same can be said of other New Deal tax reforms. To be sure, they were counterproductive -- as everyone now agrees, the Depression-wracked economy needed tax cuts, not tax hikes.

But that's a modern assessment removed from the political and economic context of the 1930s. While a few contemporaries counseled Roosevelt to avoid tax hikes, most supported them. The only ones who didn't, by and large, were Republicans, and they opposed the entire New Deal project without offering constructive alternatives. If Roosevelt failed to take their warnings seriously, he should be at least partially forgiven.

The New Deal tax hikes were not some sort of horrible mistake or a colossal error in judgment by people who should have known better. They were a product of their time and a response to political and economic dynamics that seemed real to those living through them.

And before they get too haughty about FDR's mistakes, modern critics might consider that some of those silly old political dynamics are still with us. As the Obama administration stands poised to champion a mammoth fiscal stimulus, the president-elect still finds it necessary to reach for the mantle of fiscal responsibility.

"To make the investments we need," President-elect Barack Obama said when announcing his new economic team, "we'll have to scour our federal budget, line by line, and make meaningful cuts and sacrifices as well."

Now that sounds familiar.