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November 20, 2008
New Deal Taxes: Four Things Everyone Should Know
Joseph J. Thorndike

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Four Things That Everyone Should Know About New Deal Taxation

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


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"Suddenly, everything old is New Deal again," according to Paul Krugman. And he's right: As darkness descends on the U.S. economy, almost everyone is reaching for Roosevelt. Newspapers are replete with Depression speculation, and pundits are pondering the prospects of a second New Deal.

But much of today's New Deal nostalgia is deeply ahistorical. Liberals have engaged in more than a little romantic recollection, while conservatives have waged a dubious rearguard action to discredit New Deal achievements.

So let's set the record straight on at least one key element of the New Deal: taxation. Here are four things that everyone should know about New Deal taxes.

1. The New Deal made liberal use of conservative taxes. Some of the most important elements of the New Deal tax regime were engineered by Herbert Hoover. Congress passed the Revenue Act of 1932 five months before Franklin Roosevelt won his bid for the White House. But key elements of the law -- including an array of regressive consumption taxes -- remained a cornerstone of federal finance throughout the 1930s.

The 1932 act imposed the largest peacetime tax increase in American history. Congress expected it to raise roughly $1.1 billion in new revenue, much of it from the rich. Lawmakers raised income tax rates across the board, with the top marginal rate jumping from 25 percent to 63 percent; overall effective rates on the richest 1 percent doubled, according to economic historian Elliot Brownlee. Meanwhile, estate tax rates also climbed sharply, while the exemption was cut by half.

For all its progressive features, Hoover's revenue swan song -- which passed with strong support from the Democratic majority in Congress -- also included an array of regressive excise taxes. The law created new levies (including taxes on gasoline and electricity), while raising rates for old ones. As a group, most of these consumption taxes fell squarely on the shoulders of Roosevelt's famous Forgotten Man. Yet once in office, the new president did nothing to reduce them. Indeed, excise taxes provided anywhere from a third to half of federal revenue throughout the 1930s.

2. Most New Dealers were not Keynesians -- at least not initially and not when it came to taxes. Why did Roosevelt tolerate regressive taxation? Because he needed the money. The president -- and most of his economic advisers -- believed that unchecked borrowing posed a threat to recovery. While English economist John Maynard Keynes was urging the president to embrace an aggressive program of debt-financed spending, many New Dealers clung to more orthodox notions of public finance.

Keynesians were a rare breed in the early 1930s. (Indeed, the word "Keynesian" didn't enter popular usage until 1938, when countercyclical fiscal policy began to attract a broader following.) Most policymakers believed that government spending could help spur recovery, but few endorsed wholesale fiscal intervention. "Despite enormous, if not profligate spending, the New Deal has never achieved the volume or kind of pump-priming expenditure which Keynes insists is necessary to start private enterprise going," The Washington Post observed in 1934.

Keynes himself said as much in a December 1933 letter to FDR. "The set-back which American recovery experienced this autumn was the predictable consequence of the failure of your administration to organise any material increase in new Loan expenditure during your first six months of office," he scolded the president. "The position six months hence will entirely depend on whether you have been laying the foundations for larger expenditures in the near future."

Pump priming did accelerate toward the middle of the 1930s, but it was never adequate to the task. As economist E. Cary Brown later concluded, stimulatory fiscal policy failed to end the Depression, "not because it did not work, but because it was not tried."

Spending never had a chance to spur recovery because taxes kept going up. Both parties worshiped at the altar of fiscal responsibility. In 1932 they had competed to see who could inflict more pain on the American taxpayer, with Democratic leaders even sponsoring a manufacturers' sales tax (ultimately defeated by a rank-and-file rebellion). With revenue in a free fall, policymakers across the political spectrum felt compelled to raise taxes.

FDR, for his part, remained deeply conflicted when it came to fiscal stimulus. On one hand, he was genuinely committed to the notion that budgets should be balanced -- someday, at least. His close friend and Treasury secretary, Henry Morgenthau, was even more averse to red ink. But Roosevelt also wanted to spend. So he embraced regressive elements of the 1932 tax act, convinced that consumption tax revenue was indispensable. Later he championed a series of additional tax hikes in 1935, 1936, and 1937.

Most New Deal economists -- at least those working in the Treasury Department -- shared Roosevelt's orthodox inclinations. They worried about unchecked borrowing, even when it was used to finance expansionary spending. "The situation calls for more than merely drifting with the tide of expenditure on the assumption that no grave problems would be presented by a large increase in the present Federal debt," they warned in a key 1934 report.

Treasury economists remained deeply suspicious of countercyclical tax policy. "Talk of more ambitious attempts to use the Federal revenue system as a regulatory mechanism has been heard," they noted with some disdain. "The tax system, so the argument runs, may be employed to eliminate business cycles or at least to lessen their severity, by penalizing 'over-saving' and encouraging consumption, by checking speculation, by favoring certain geographical or social classes at the expense of others, by encouraging business initiative, by discouraging 'unwise' business expansion, and so on."

All of which struck these sober minds as more than a little dangerous. "The use of taxes for other than revenue purposes is not necessarily an evil," they concluded, "but in all such cases great care should be taken to consider all possible effects, some of which may be undesirable and contrary to the ultimate goal originally contemplated."

Eventually, most New Deal economists hopped aboard the Keynesian Express. But it would take the better part of a decade. In the meantime, they were more than willing to contemplate substantial tax hikes -- at least on some people.

3. New Dealers believed that heavy taxes on the rich were a moral imperative. Roosevelt was a vigorous champion of progressive tax reform, especially when it came to raising taxes on the rich. Since 1934, Treasury economists had repeatedly urged the president to lower taxes on the poor; they wanted to expand the income tax and use resulting revenue to pay for excise tax repeal. But the president cast his lot with a different group of advisers: Treasury lawyers more interested in soaking the rich than saving the poor.

FDR embraced this approach in 1935, driven by a keen instinct for political opportunism. The New Deal faced a challenge from the left, particularly in the colorful person of Sen. Huey Long. The Louisiana populist was making headlines with his tax plans to share the wealth, and Roosevelt was determined to steal his thunder.

But FDR was also motivated by moral outrage over tax avoidance. He considered taxpaying a pillar of citizenship, a civic responsibility that transcended narrow questions of legality. But in 1935, Treasury lawyers gave Roosevelt detailed evidence that rich Americans were successfully avoiding much of their ostensible tax burden.

This was hardly news, but Roosevelt used it to justify a series of dramatic soak-the-rich measures. Some, like the Revenue Act of 1935, were designed simply to raise statutory rates. Others, like the Revenue Act of 1937, tried to close egregious loopholes. And one, the Revenue Act of 1936, imposed a new tax on undistributed corporate profits, which supporters believed would curb tax avoidance among wealthy shareholders.

As a group, the New Deal revenue acts of the mid-1930s substantially boosted the tax burden on rich Americans. According to Brownlee, the income tax changes alone raised the effective rate on the top 1 percent from 6.8 percent in 1932 to 15.7 percent in 1937.

Some New Deal critics have questioned whether such changes were meaningful. High taxes on the rich didn't really compensate for regressive taxes on the poor. They were, in the words of historian Mark Leff, largely symbolic.

Leff is right: New Deal tax reform was largely symbolic (although it felt real enough for those facing higher tax burdens). But symbols can be important. Sometimes they even change the world.

4. To understand New Deal taxation, we have to understand World War II taxation. The New Deal experiment with soak-the-rich taxation ended with a whimper. In 1938, business leaders, Republicans, and conservative Democrats united to destroy the undistributed profits tax, Roosevelt's most ambitious but least durable tax innovation. For a moment, it looked as though progressive taxation had reached its high-water mark.

In fact, the tide was still coming. World War II changed the politics of taxation forever -- or at least for the next 50 years or so. Driven by staggering revenue needs, lawmakers in both parties agreed to raise taxes on everyone: rich, poor, and -- especially -- the middle class. Treasury economists got the broad-based income tax they'd been seeking since 1934; the number of people paying the levy increased sevenfold in just a few years. But New Deal lawyers got their high rates on the rich, too. The top marginal rate for individual income tax payers reached 94 percent in 1944, and effective rates on the top 1 percent reached nearly 60 percent the same year.

After the war, effective rates dropped substantially. But the income tax retained both its breadth and its steep nominal rate structure. What changed was the focus on loopholes. High rates made loopholes valuable, and lawmakers in both parties tacitly embraced them. As long as rates stayed high, members of Congress could do a brisk business selling tax preferences. Narrow ones could be marketed to well-heeled contributors. Broader ones could be used to assuage the worries of middle-class voters. It was a good deal for everyone - - at least for a while.

Lessons From History?

Are there lessons to be gleaned from the history of New Deal taxation? Today's pundits seem to think so, and they're probably right. But the lessons may not be the ones they expect.

Lesson #1: Progressive taxation can be its own worst enemy. Roosevelt's support for a steep nominal rate structure eventually undermined the apparent fairness of the tax system. The bipartisan tax consensus that followed World War II proved unstable. Tax preferences drew scrutiny from influential lawmakers, and voters began to suspect that some taxpayers were getting a better deal than others. By the mid-1970s, confidence in the fairness of the tax system had eroded. By the 1990s, it had all but vanished. If proposals to scrap the income tax, including its progressive rate structure, ever succeed, a good share of the blame will belong to FDR.

Steep rates may have advanced the cause of progressive tax reform in the 1930s; they almost certainly ensured that wartime taxes were more broadly progressive than they otherwise would have been. But the Roosevelt rates had a pernicious effect in the out years. Sustainable taxation is moderate taxation -- something New Deal economists understood -- but New Deal lawyers did not.

Lesson #2: Sometimes regressive taxation can be an element of progressive reform. Roosevelt's tolerance for excise taxation was almost certainly unwise; by almost any calculation, the 1932 revenue act slowed recovery at the worst possible moment. But Roosevelt understood that regressive taxes had a role to play. In the early years of the New Deal, he accepted them as a fiscal necessity. Later he chose them deliberately to finance the New Deal's most important innovation: Social Security.

That being said, Roosevelt also managed to poison the well against other forms of consumption taxation -- forms that might have financed an even more ambitious welfare state. His vigorous opposition to a general sales tax made it hard for the United States to consider other forms of broad-based consumption taxation (like a VAT), even while the rest of the world was discovering their utility.

Lesson #3: If you want progressive tax reform, talk a lot about tax avoidance. FDR sometimes frankly made the case for the redistribution of wealth (although he usually framed it as an attempt to thwart the concentration of wealth -- a subtle but crucial difference). More often, however, he focused instead on the evils of tax avoidance. Americans respond well to the suggestion that everyone should pay their fair share. Demonstrate that some people are not, and voters will rally to your cause.