Another Great Depression may well be on its way due to the global recession resultant from the coronavirus. We spoke with the father of Supply-Side economics, Dr. Arthur Laffer, who shared his perspective regarding the Great Depression that began in 1929, as well as the true cause of global depressions.

 

(Interviewer: Hanako Cho)

 

— In our previous interview, we featured your interview regarding the 1970s recession. As of today, the coronavirus recession is worsening the economy and suggesting the possibility of another Great Depression. What are your thoughts on the Great Depression that began in 1929?

Laffer: Before I get into that, let me tell you about the history of the United States starting in 1913.

The 1920s in the U.S. was in a period called the ‘Roaring 20s’ in which the U.S. economy boomed. There’s a reason why this was a period of prosperity.

In 1913, when the income tax was put into place, the highest federal income tax rate was seven percent. That was it. Six years later, by 1919, they had raised that highest tax rate from 7 percent to 73 percent. Isn’t that amazing? It was a very bad economy from 1913 to 1919; that was during World War I, which was used as an excuse to raise taxes.

The presidential election of 1920 was really a referendum on Democratic President Woodrow Wilson’s higher tax rates.

The Democratic presidential candidate, handpicked by Wilson, was an Ohio governor named James Cox. Cox picked his good friend, a man named Franklin Delano Roosevelt, to be his vice-presidential running mate. The Republican candidates were Warren Harding for president and Calvin Coolidge for vice president.

Cox and Roosevelt argued that they wanted to keep tax rates high to pay back the wartime debt that was incurred fighting WWI. Harding and Coolidge ran a slogan of a ‘return to normalcy,’ which meant cutting tax rates back to where they had been prior to WWI. I think Harding and Coolidge won the election by the largest percentage ever. They took office in 1921.

Things were good, but they phased in their tax cuts. This was the same thing that Kennedy and Reagan did, just repeating the same mistake over and over again. They cut the highest tax rate in the U.S. from 73 percent to ultimately 25 percent. One year, it was 24 percent. If you know the tax rates next year are going to be lower than they are this year, what do you do? You postpone your income to the next year, thereby causing a very sharp downturn in the U.S. economy from 1920 to 1922.

All of a sudden, final tax cuts came in 1923 and the economy grew like had never been seen. This was during the period called the Roaring 20s. Output, employment and the stock market soared. There was real employment growth. American was in prosperity, which was unprecedented in our entire history as a country.

One last point is that no other country did a tax cut during WWI. Countries including England, France and Germany didn’t do it, so they experienced a depression in the 1920s. The U.S. was the only western economy that had prosperity and a boom.

 

President Hoover Advocates Higher Taxes

Laffer: U.S. Secretary of the Treasury Andrew Mellon proposed tax cuts in the Harding-Coolidge administration. There was one person who disliked Mellon’s policy: Secretary of the Commerce Herbert Hoover.

Hoover had argued throughout the late 1920s that we needed to put a tariff on imported products of agriculture. Hoover ran for president in 1928 to replace Coolidge, and he was elected in a landslide. Coolidge and Harding had done such a wonderful job at running the country in the stock market boom, but Hoover still wanted to have his tariff bill on agricultural products. The one industry that did not do well during the Roaring 20s was agriculture because we imported all of these products.

He took office and pressure started to lobby for his bill in 1929. All of these congressmen started putting in various tariffs and protection measures for their constituents in their political districts. As a result, Senator Reed Smoot and Representative Willis Hawley cobbled together a tariff bill that was the biggest tax increase on traded products in the history of the U.S.: the Smoot-Hawley Tariff.

It was obvious that this bill would raise taxes to an unprecedented rate, but the bill passed the House and the Senate. In October 1929 the stock market collapsed in anticipation of the bill being signed. The bill was passed in 1929 but Hoover waited and didn’t sign it until June of 1930.

There was a huge collapse in the stock market upon signing the bill, and the economy took a deeper downturn until 1932.

 

Turning to a Tax Increase During the Great Depression

Laffer: By 1932, the economy was in the deepest decline ever, so what did Hoover do? He and the Republicans decided, just like the Abe government in Japan decided, that the solution to their problem would be to raise taxes.

In 1932, they passed a tax bill that raised the highest marginal income tax rate from 25 percent to 63 percent. They raised corporate taxes and inheritance taxes. They even put in a gift tax that had not existed. They raised all sorts of taxes in 1931, and all of those taxes took effect on January 1, 1932. When the economy hit January 1, 1932, the bottom fell out of the economy, all caused by tax increases. Hoover of course lost the election to Democratic President Franklin D. Roosevelt (FDR).

 

FDR Signs “Wealth Tax” Quickly After Inauguration

Laffer: In March 1933 after winning a landslide election victory, FDR declared something called a Bank Holiday. It’s something that’s very unusual in America.

Let me go through the four things he did. Four things. First, he closed all the banks and prohibited all banks from buying or selling foreign currencies. Second, banks no longer were allowed to buy or sell gold coins. If you wanted to withdraw money from a bank, you couldn’t take it out in gold; you had to take it out in paper currency. Third, the federal government made it illegal for American citizens and institutions to own gold or silver. They confiscated all the gold and silver. There were criminal penalties unless you turned in all your gold and silver into the federal government by the end of April 1933. The Roosevelt administration gave you $20.67 per ounce of gold at that April conversion, if you had over $100 worth of gold. This is why all of the gold today is held in Fort Knox because they confiscated all the gold and silver, and buried it in a newly constructed fort, Fort Knox, in Kentucky. After they confiscated all the gold and silver, the Roosevelt administration sets the gold price to be $35 per ounce. The profit from a delta of $15 per ounce became government revenue.

This “wealth tax” was the size of 10 percent of GDP at the time. This measure devalued the dollar by approximately 40 percent, which not only hurt those whose gold was confiscated, but also those who were saving the U.S. dollar.

Fourth, all gold clauses for public and private contracts were annulled and replaced with currency clauses. Gold clauses mean that a contract will be valued by the price of gold 10 years from now when converted. You could no longer guarantee something in terms of gold in the contract.

These measures were essentially wealth taxes on all Americans. It’s a legal thief, and that’s what Roosevelt did: they stole their properties.

In his second presidential term, Roosevelt raised the highest marginal income tax from 63 percent in 1937 to 79 percent. He raised the inheritance tax rate to 70 percent. He also raised the gift tax rate to over 50 percent. He put on a corporate tax and a windfall profits tax on corporations. – I think it was 27% add-on windfall profits tax on them and businesses were not allowed to retain earnings because of that. I think the highest tax raise was from 1931 from 25 percent to 94 percent during World War II.

In 1935, Roosevelt passed the social security law for the U.S. which gave retirees federal social security in exchange for a payroll tax. This social security payroll tax that was passed in 1937 was one percent on both employers and employees. They also passed a tax of two percent in 1938 and another for three percent in 1939. By the time they got to 1937, the effect was so devastating on the U.S. economy that they postponed the tax increase of 1938 and 1939 for later years.

 

Tax Festival by States

— Besides federal taxes, you’re also conducting research around state taxes.

Laffer: During the Great Depression, a number of states adopted personal income taxes, corporate income taxes and sales taxes. In 1932, the federal government’s taxes were smaller in total magnitude than the state or local taxes. In fact, federal taxes in 1932 were about 20 percent of total taxes in the U.S. The federal government was only a small share of total taxation, which means that the state governments were also at fault for the Great Depression.

As of 1928, only 13 states had corporate taxes in place; by 1939, 33 states had corporate taxes. In other words, 20 out of 48 states adopted a corporate tax during that 11-year period, which were the darkest years of the U.S. Great Depression. There were also 13 instances where state governments increased the corporate tax rate.

Next is sales tax. This may be a surprise to you, but there were no sales taxes in the U.S. in 1928. The first state to introduce a state sales tax was Mississippi in 1930. By 1939, 22 out of 48 states had adopted sales taxes. Everyone was raising every tax they could find. Even after adopting sales taxes so late in history, there were still six states that increased their sales tax rates during that period.

Now let me go over personal income taxes. In 1928, only 13 out of 48 states had personal income taxes. By 1939, however, 19 additional states introduced them and there were 32 states with personal income taxes. Not only did they introduce personal income taxes, 27 states’ personal income taxes were also increased during that period. Some of those tax rates went on to be pretty high.

A number of states adopted corporate taxes, personal income taxes and sales taxes in 1933, so it is only natural for GDP growth rate to fall drastically in 1933. It’s surprising that tax increases in this many states were implemented during the recession.

 

Taxpayer’s Revolt

Laffer: Americans weren’t just quietly observing and accepting the tax hike during the 1930s. In the ‘30s, there were revolts led by taxpayers in every state and county.

As protests went on, taxpayers demanded that they were willing to give up public services in return for not paying the cost of government. The tax revolt of the 1970s and 1980s in the U.S. didn’t compare to the size of the tax revolt in the 1930s. The ‘30s was essentially a tax festival.

If you tax people who work, and pay people who don’t work, what do you think will happen?

— We are going to have more people not working.

Laffer: Exactly. They already taxed people who worked during the Great Depression. And you wonder why we had the longest, deepest depression in U.S. history. And I don’t understand why fellow economists don’t look at this.

 

No Depression Without Taxation

— Do you think that we could’ve prevented a serious Great Depression if the Hoover-Roosevelt administration didn’t propose a tax increase?

Laffer: I’m sure it would not have occurred. If we had not done the Smoot-Hawley Tariff nor the tax increases, I believe we would have continued the prosperity of the 1920s. We would have become Hong Kong or Switzerland, and we would’ve become one of these universally prosperous countries for years and years. We can’t go back and run an experiment, but I believe very strongly that it is true.

— That is a very important lesson we have to learn from the Great Depression, but it seems like we haven’t learned from our past.

Laffer: That’s because the commonly believed cause of the Great Depression is not true.

Keynes himself argued that the problem with the Great Depression was an under-consumption and that the animal spirits had not been satisfied; people got so rich during the 1920s, and at the end of the 1920s, the rich had so much money that they didn’t invest enough. His theory is that by not investing enough in the economy, that led to a market crash and ultimately the Great Depression.

Others have attributed the Great Depression to the Federal Reserve Board (FRB) tightening too many monetary policies. Milton Friedman and Anna Schwartz explains this in “A Monetary History of the United States” that was published in 1963. Charles Kindleberger and former Chairman of the Federal Reserve, Ben Bernanke, have attributed the Great Depression to these ideas.

Strangely enough, neither Keynes, Friedman nor Kindleberger reference tax rates at all. They don’t discuss the effect of tax rates on the economy.

If this lesson is not learned, depending on the outcome of the presidential election, the U.S. economy may collapse further.

 

Tax Cuts Took Place After the War

Laffer: Some things have been learned from the Great Depression. The high tax rates of over 90 percent lost favor after WWII. From 1946 on to the Reagan administration, we have been cutting tax rates pretty drastically. The U.S. economy from 1946 was an economy of slowly but surely reducing taxes, reducing barriers to economic activity and reducing regulations. The highest marginal income tax rate in 1946 was 91 percent in the U.S., but today, it’s 37 percent. Even though we cut it down to 28 percent with Reagan, that’s still a big reduction from 91 percent. Corporate tax rates were at 53 percent, but they are down to 21 percent. In 1976, Nevada was the only state in the U.S. that didn’t have a state death tax, but today, I think there are 33 states that have gotten rid of their state death taxes. In 1957, only two states were right-to-work states, which didn’t have forced unions, but there are 31 states today which have right-to-work laws.

We used to have laws in the U.S. that manufacturers could require stores that sold their products to sell them at a fixed price. There was no price competition. There was no Walmart or Costco. None of these discount stores existed. It used to be that you couldn’t sell alcohol and have stores open on Sunday, a religious day.

We’ve moved back three or four years, but then we moved forward again. It’s really wonderful that we’ve gotten tax cuts and deregulations.

 

Difference in Tax Policies is Not a Matter of Political Parties

Laffer: It has not only been Republicans cutting taxes. John F. Kennedy was a great tax cutter. Take Jerry Brown’s flat tax proposal when he ran for president in 1992; he was a liberal Democrat.

In 1919, President Wilson said in his State of the Union address that there is a point in which high rates of income and profits taxes remove the incentive to new business activities and produce higher unemployment.

Although the highest marginal income tax rate during WWI was above 70 percent, this is not only destructive for government revenue, but it has already passed the point of productivity. As a result, the highest marginal income tax rate fell from 73 percent to 25 percent.

Decades before the Laffer Curve was presented, the Democratic administration at the time had a good understanding that higher taxes will affect productivity and interfere with American citizens’ incentives.