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April 19, 2012
News Analysis: Should Taxes Promote Fairness or Growth?
Joseph J. Thorndike

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The following article is adapted from remarks delivered April 10 at the George W. Bush Institute's conference on "Tax Policies for 4% Growth." Thorndike is a fellow of the institute's 4% Project.

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When it comes to tax policy, revenue is the main thing, but it's not the only thing. Politicians can argue long and hard about how much money the federal government needs, but they can also work up quite a sweat over how best to raise it. That second debate can actually be more vicious than the first, especially when framed as a trade-off between growth and fairness.

Not everyone accepts the existence of the trade-off. Pro-growth partisans generally see it as a nonissue, with growth dissolving questions of distributional equity. Rising tides, expanding pies -- pick your metaphor -- but the essential point remains: Growth makes everyone better off.

Some fans of fairness also reject the notion of a trade-off. They say that progressive redistribution of wealth and income is actually the key to long-term growth. Prosperity broadly shared is the only prosperity that lasts.

Other fairness champions view tax policy as a zero-sum game, in which pro-growth cuts for a lucky few are paid for with higher taxes on the rest of us. In its most pessimistic form, that argument rests on the assumption that growth will be too modest to resolve distributional concerns. Rather than hoping for a new and bigger pie, we need to focus on how to slice the one we have.

More upbeat iterations of the fairness argument simply reject the notion that growth -- however spectacular -- can ever make equity irrelevant. No amount of shared prosperity can paper over the essential injustice of rampant inequality.

Contemporary debates over tax policy reflect all those disparate views. But arguments over fairness and growth are hardly new. Indeed, they have animated debates over federal tax policy since the early days of American nationhood. Several decades in the middle of the 20th century were especially vital. Between 1930 and 1960, the champions of equity and growth struggled to define the appropriate focus of federal tax policy. And both sides won.

1930s: Fairness Over Growth

For much of the 1930s, federal tax policy reflected a dismal set of assumptions about the nation's economic future. While most political leaders and policy experts believed the Great Depression was a temporary phenomenon, a substantial cohort of "stagnationist" economists were less hopeful about the future. Often associated with Harvard economist and early Keynesian Alvin Hansen, the stagnationists believed that the U.S. economy was "maturing." The high-growth years of our national adolescence were over, done in by the closing of the frontier, a steady decline in birthrates, and the limited prospects for technological innovation. Rather than fighting those inexorable trends, lawmakers should try to cope with them. The United States needed to live within its economic limits, according to the stagnationists.

For tax policy, stagnationist thinking implied a new focus on fairness. If the economy wasn't going to grow (at least not much), then taxes should be used to redistribute existing wealth. Moreover, to the extent that a larger government was necessary to cope with slow economic growth, the cost of that government should be more equitably distributed.

A weaker version of stagnationism -- one that held out at least some hope for continued growth -- focused on the dangers of oversaving. According to that line of thinking, growth depended on more consumption, not more investment. Consequently, tax policy should be designed to increase aggregate demand rather than aggregate supply. Higher taxes on the rich were good, because they took money from people inclined to save and gave it to a government inclined to spend. Similarly, taxes on corporate income, including a new levy on undistributed corporate profits, would force companies to disgorge idle capital and get it to shareholders (who would presumably be more inclined to spend it).

Broadly speaking, New Deal tax policies reflected those stagnationist theories about the economy, as well as proto-Keynesian notions of demand management. But even some New Deal economists were worried about the heavy emphasis on progressive tax increases. Even assuming that oversaving was a problem, undersaving (and underinvestment) could still slow recovery from the Depression. Such concerns did not bring an end to the progressive thrust of New Deal tax reform (although electoral reverses in the late 1930s forced the Roosevelt administration to backtrack on its more ambitious reforms, like the undistributed profits tax). But they did reflect a diversity of opinion, even among liberals, about the proper focus of federal tax policy.

1940s: Fighting Inflation

World War II brought an end to stagnationist thinking about the U.S. economy. As historian Robert Collins wrote in More: The Politics of Economic Growth in Postwar America, "The coming of World War II resolved the ambivalence of the Depression era, tipping the balance decisively away from the economics of scarcity and toward economic expansion."

But if the war demonstrated the nation's enormous potential for economic growth, it also underscored the dangers of unchecked inflation. In the late 1930s, economists speculated on the use of activist fiscal policy to manage aggregate demand, with a keen eye on tax reform that would increase it. The war shifted attention to limiting demand, at least on the consumer side of the economy. Lawmakers expanded the income tax dramatically, asking millions of middle-income Americans to pay a tax long confined to the nation's economic elite. Only a mass tax could be used to effectively manage aggregate demand, according to most economists.

Fairness, however, remained a central concern of policymakers, and the wartime tax regime included a healthy dose of New Deal-style progressivity. Lawmakers might have chosen to regulate demand with regressive levies, like a national sales tax. But President Franklin Roosevelt's continuing commitment to progressive reform led them to abandon that option. Moreover, Roosevelt also insisted on a dramatic increase in tax rates for the rich, because he was determined to ensure that the overall tax system appeared fair to all its new taxpayers. Ultimately, the wartime tax regime blended new versions of demand management with more traditional Democratic notions of fiscal justice.

By 1943, as lawmakers began to consider the end of the war, they were overwhelmed by worries. They worried about inflation, given pent-up consumer demand from the war years. But they also worried about resurgent depression, as war production slowed and government spending necessarily fell from its stratospheric levels.

Ultimately, worries about recession won out. Americans were tired of heavy wartime taxes, and lawmakers responded with a series of tax cuts. Historian Dennis J. Ventry Jr. has said, "Postwar tax programs -- conservative and liberal, Republican and Democratic -- emphasized economic growth through tax reduction." Led by pro-growth liberals like Leon Keyserling of the newly created Council of Economic Advisers, policymakers in both parties emphasized the politics of prosperity.

But President Truman, after an initial willingness to tolerate expansionist cuts, soon dug in his heels. He was never wholly -- or even largely -- a convert to the gospel of growth. "Truman's own frugal instincts -- he loved poring over budgets and was happiest when they balanced -- kept him from fully embracing a growth framework as the solution to all problems," said Collins. Truman continued to worry about inflation, and he soon refused to cooperate with a Republican-led drive for further tax reduction. Not only did tax cuts threaten price stability, but they also threatened to undermine vital notions of economic fairness, he said.

1950s: Uneasy Growth

The 1950s represent a paradox of sorts: a Republican era marked by robust growth and high tax rates. In fact, that paradox is more apparent than real. For starters, growth was not quite what it's been cracked up to be: about 2.9 percent over President Eisenhower's term, with a significant recession in 1958. Moreover, rates were not quite as high as they might appear either, at least from a casual glance at bracket tables. To be sure, the top marginal rate on individual income remained over 90 percent through Eisenhower's presidency. But effective rates on the very rich dropped substantially from the wartime high of nearly 60 percent to less than 40 percent in the late 1940s and just 32 percent in the 1950s (according to estimates by economic historian W. Elliot Brownlee).

Still, the 1950s remain a puzzle. After 1952, the nation had a new Republican president, but it retained key elements of the Democratic tax regime enacted under Roosevelt and Truman. Of course, Eisenhower had to cope with Democratic majorities in Congress, and that provides part of the explanation.

But the key factor was Eisenhower himself. While fully enthusiastic about growth, he was even more worried about inflation. Like Truman, he believed that price stability was the key to growth, even if that meant heavy taxation. "I believe that economic growth in the long run cannot be soundly brought about except with stability in your price structure," he said in 1959.

Many Republicans rejected that conservative view, arguing that faster growth was possible. Eisenhower actually had to beat back a move from within his party to cut taxes early in his first term. Eisenhower was sympathetic, but he considered fighting inflation his first responsibility.

Democrats, meanwhile, were generally happy to cooperate. While occasionally pushing for tax cuts targeting low- and middle-income Americans, they were happy to retain high rates on the rich. Eisenhower's blanket resistance to tax reduction seemed a reasonable compromise, serving Democratic notions of tax justice (at least at the top of the income scale) as well as Eisenhower's anti-inflation agenda.

By the end of Eisenhower's second term, the struggle between growth and fairness was still alive and well, sustained by the president's fiscal rectitude and Democrats' fondness for high marginal rates. But it was an uneasy compromise and one not endorsed by most economists. Over the course of the 1950s, tax experts had continued to argue that marginal rates were too high. And after the recession of 1958, they had substantial (if hardly conclusive) evidence to support their case.

The triumph of pro-growth tax policy, however, would not come under a Republican president -- or at least not the kind of Republican president holding office in the 1950s. Instead, it would be the project of a new Democratic president and the liberal economists who advised him. While pro-growth policies would soon make a permanent home in the GOP, their initial appearance was a Democratic achievement.