How Lowering Taxes on the Rich Can Raise Revenue: Amity Shlaes

Feb. 2 (Bloomberg) — Tax the rich. Forever. And not just in election years. The general assumption is that rate increases will be the new norm. The main reason for this is said to be democracy itself.

We have reached the point where just about half of all taxpayers, the lower-earning households, pay almost no income tax. Voters have no reason to endorse a tax cut that's not for them. The group that pays high rates represents an electoral minority.

In other words, America has passed its tipping point on taxes. In fact, we are officially tipped.

There's something un-civic and creepy about this status. Everybody should pay some tax, just as everybody should vote. As recent history shows, an untaxed majority is unlikely to reduce taxes on the taxed minority. In the 1970s and '80s, rate cuts were possible only because inflation pushed many lower-earning taxpayers into higher brackets. Then these lower earners endorsed cuts. Politicians prevented a repeat of that by indexing brackets.

Look further back, and you'll find there is a case of the majority helping the minority: the model of the 1920s.

In 1917, the tax schedule was highly progressive, topping out at 66 percent of income. But the income-tax schedule only commenced with earners who made over $2,000 a year. That amount was double the wage for the unskilled, and well above what skilled workers made.

Rising Top Rate

So how did the rich get their cut? Not easily. A 1918 tax law in the Woodrow Wilson administration actually tipped some more, pushing the top rate on the wealthy up further, to 77 percent from that 66 percent.

But gradually tax authorities, and with them many politicians, came to see that the high rates weren't necessarily productive for the Treasury or the economy. The spread between the yield of earnings subject to the top income-tax rate and earnings from tax-free municipal bonds was so attractive that estates poured their cash into the bonds; by 1923, almost $4 in $10 of estates was invested in municipal bonds, compared with less than $1 in 1917. Millionaires went on "capital strike," as the newspapers called it. Revenue to Washington generally came in below forecasts.

The waste disgusted President Warren Harding's Treasury secretary, Andrew Mellon, who treated the U.S. government as just another business to manage. Mellon posited that lower income-tax rates might bring in more revenue, just as lower freight taxes sometimes created more trains. He found support first from Harding and then, especially, from President Calvin Coolidge. Mellon and Coolidge plotted an elaborate propaganda campaign for lower rates. In the tax lexicon of the day, they wanted to reduce not merely the "normal" (base) rate, but also the surtax schedule that sat atop it.

Such a plan took chutzpah. Mellon was one of the wealthiest men in the nation, almost a parody of a plutocrat. Yet now he was publishing articles and even a leather-bound book on the merits of lower rates from which fortunes like his would benefit. Mellon even titled his anti-tax book, "Taxation: The People's Business," at a time when "the people" paid no income tax at all.

This made the Treasury secretary the perfect target for Western progressives, such as Senator James Couzens of Michigan or "Fighting Bob" La Follette of Wisconsin.

The first effort to cut top rates misfired dramatically when Congress opted to emphasize cuts for lower earners more. Victory for Mellon and Coolidge came only in the fourth tax cut of the period, in 1926, when they managed to get the top rate, even for plutocrats, down to 25 percent from 46 percent.

Buying Municipal Bonds

Why did Mellon, Harding and Coolidge succeed? First, the administrations' tenacious publicity work revealed the extent of the cash flowing into municipal bonds, which turned out to disgust the average citizen, as well. Second, federal revenue increased after each rate cut. Third, Harding, Mellon and Coolidge slashed the budget, year after year. The budget reductions built confidence that tax cuts could be permanent.

The prosperity resulting from the small government policy also did its part. Under Coolidge, the U.S. economy grew at an average rate of more than 4 percent a year. Unemployment stayed at less than 6 percent — often, less than 4 percent. Wages rose slightly in real terms, and automobile prices dropped.

That yield spread between munis and other kinds of bonds narrowed, in tandem with the tax reduction. The tax distribution tables showed that by decade's end the very wealthiest were paying a greater share of income taxes than they had before.

The outcome surprised many, even the administration's own people. A secretary of Coolidge's wrote after the 1926 cut that "it was greeted with joy by his opponent because it was felt that here was an issue between the rich and poor where popular feeling could be but one way."

That the entire experiment has been forgotten matters less than that it happened. Look back far enough and there's the evidence: Even a tipped nation can untip.

(Amity Shlaes is a Bloomberg View columnist and the director of the Four Percent Growth Project at the Bush Institute. The opinions expressed are her own.)

© Copyright 2012 Bloomberg

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To book Amity Shlaes for a speaking engagement, contact Jamie Brickhouse at the Red Brick Agency, 646.281.9041.
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