Obama's Tax Planning Needs New View of New Deal

Nov. 12 (Bloomberg) — President-elect Barack Obama is using the New Deal as his model for how to deal with economic crisis. He might want to distinguish between what worked and what didn't.

One reason the Depression lasted until World War II, as Paul Krugman argued this week in the New York Times, is that the New Dealers sabotaged their own plan.

With one hand the New Dealers gave, spending to stimulate the economy. In fact, they put through the same kinds of infrastructure projects that Obama and congressional Democrats are considering today.

With the other hand the New Dealers took away, by raising tax rates — just as the new president and Congress are likely to do in 2009.

Especially damaging to the prospects of recovery were the heavy levies of the second half of the 1930s, which, as Krugman points out, were key in "precipitating an economic relapse that drove unemployment back into the double digits." President Franklin D. Roosevelt specialized in persecuting the rich via taxes, telling the upper class, point blank, that they had "met their master."

For more on the tax-recovery connection, it's useful to turn to the just-published "The End of Prosperity: How Higher Taxes Will Doom the Economy — If We Let It Happen" (Threshold Editions, 352 pages, $27), by three proud Reaganauts: Art Laffer, Stephen Moore and Peter Tanous. The text shows in detail how taxes helped calibrate boom and bust from the 1920s on.

While the book cites the tax increases of Roosevelt and Herbert Hoover, it adds the most value in its insight into other eras.

Dismal Line

The authors spend some time on the dismal line that is the Dow Jones Industrial Average from 1960 to 1982.

A hopeful upward jolt in the first half of the 1960s accompanied the income-tax cuts of Presidents John F. Kennedy and Lyndon Johnson. Then, within a year or so of Johnson's announcement of his Great Society, the Dow flattened and began to head south. A steep drop followed LBJ's income-tax surcharge of 1968.

The nominal drop of roughly 20 percent between the mid-1960s and early 1980s –- from 995 in February 1966 to an abysmal 627 in September 1974 to 816 in August 1982 — was bad enough. But the authors point out that the real drop in equities was more like 70 percent, if you reckon it all in 1999 dollars.

The Clinton years also offer a tax story. President Bill Clinton raised taxes, of course, but not back to pre-Ronald Reagan levels. His late 1990s capital-gains rate cut, enacted with the Republican Congress, helped make the decade sizzle.

Other Countries

So did the Republican victory in the 1994 mid-term elections. After hanging between 3,000 and 4,000 for a year, the Dow took off after that election and swelled to 8,000 by 1997.

Laffer, Moore and Tanous chart the correlation between tax cuts and growth in other countries as well. In Ireland, unemployment began to drop following cuts in the personal income tax. It rose again before falling dramatically as the Irish government cut capital-gains taxes and then corporate taxes.

It's worth noting that Ireland was enduring Depression-level rates of unemployment — 16 percent to 17 percent — at the outset of its tax experiment and managed to get down to the five-percent range even as the nation found its way to a budget surplus.

So what might an ideal American reform look like?

It would include a lower capital gains rate, to be sure. This should be a no-brainer, since capital gains revenue seems especially responsive to rate cuts. (It also is responsive to the mere prospect of rate hikes. How much in capital gains are Americans realizing now to avoid a possible increase next year?) The current slump is a great argument for Obama to give up his campaign-trail suggestion that he would increase the capital-gains rate to as high as 28 percent.

Another Dream

Dream on, you might say. I will, and I'll add another improbable idea for Democrats: It is time to begin taxing –- if only by a few dollars — the millions of lower earners who pay no tax or get money back. This largely symbolic step would allow citizens to reestablish their connection with the federal government.

Obama has a far better chance of pulling this off than any Republican would. He might package such a tax into a larger work program of community service.

It would be valuable as a form of insurance against overreaching government. In the 1970s and 1980s –- the time of the last tax revolution –- more citizens paid taxes, so more people appreciated the Reagan rate cuts.

Time to Choose

Today, America looks more like the 1930s: a small huddle of the wealthy shoulder an ever-greater share of the tax bill. In 2005, the top 1 percent of earners paid about 40 percent of the taxes. Those earners are so few that there is little political downside to targeting them. But the economic downside is huge.

What about the hoped-for recovery of 2009? The planned tax increases would diminish the effect of those billions for infrastructure, just as tax increases undermined the Public Works Administration or the Works Project Administration in the 1930s. What Laffer, Moore and Tanous are saying is that the Democratic Party will now have to decide which is more important: its eagerness to trash the Bush-Reagan tax legacy, or its eagerness for recovery.

Gazing at Messrs. Paul Volcker, Robert Rubin, Tim Geithner, Austan Goolsbee et al. –- the talented Obama economic team -– you can't preclude that the new administration will, in the end, scuttle some of its destructive tax increases. The rest of us just have to help them figure out a graceful way to do so.

(Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations and author of "The Forgotten Man: A New History of the Great Depression," is a Bloomberg News columnist. The opinions expressed are her own.)

© Copyright 2008 Bloomberg

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