September 2009

How Do We Solve a Revenue Problem and Create Economic Prosperity?

The Answer is Tax Cuts

By John Hendrickson

In early August the Associated Press reported that “the recession is starving the government of tax revenue, just as the President and Congress are piling a major expansion of health care and other programs on the nation’s plate and struggling to find money to pay the tab.”[1] The federal budget is already over $3 trillion and a national debt of at least $11 trillion and a current deficit of close to $2 trillion has resulted in substantial concern for future tax and spending policies. The Associated Press also reported that “tax receipts are on pace to drop 18 percent this year, the biggest single-year decline since the Great Depression…individual income tax receipts are down 22 percent from a year ago. Corporate income taxes are down 57 percent.”[2] The report paints a pessimistic fiscal future for the United States.

The solution to the problem of declining revenues is to follow a policy of tax cuts and reducing government spending. In 1920 the nation was in the midst of an economic depression with double digit unemployment (11.7%) and declining business activity. Ohio Senator Warren G. Harding won a large electoral victory in the 1920 presidential election and came into office with an economic policy that was directed at reducing expenditures and cutting taxes to solve the economic crisis. The key element to the Harding economic program was Andrew Mellon, who served as Secretary of the Treasury. His economic policies would earn him the title of the greatest Treasury Secretary since Alexander Hamilton.

Mellon argued that tax policy must follow three principles:

 It must produce sufficient revenue for the Government; it must lessen, so far as possible, the burden of taxation on those least able to bear it; and it must also remove those influences which might retard the continued and steady development of business and industry on which, in the last analysis, so much of our prosperity depends.[3]

Mellon also understood that cutting taxes does not necessarily mean a loss of revenue for the federal treasury. “The history of taxation shows that taxes which are inherently excessive are not paid, noted Mellon.”[4] In regard to high tax rates Mellon wrote:

The high rates inevitably put pressure upon the taxpayer to withdraw his capital from productive business and invest it in tax-exempt securities or find other lawful methods of avoiding the realization of taxable income. The result is that the sources of taxation are drying up; wealth is failing to carry its share of the tax burden; and capital is being diverted into channels which yield neither revenue to the Government nor profit to the people.[5]

President Harding and Secretary Mellon not only faced double digit unemployment, but also high tax rates that were left over from the Great War (World War I). In fact the highest income tax rate was 73 percent under President Woodrow Wilson’s administration. Both Harding and Mellon understood that the way to bring about economic recovery and encourage business activity was to focus on reducing government spending and cutting taxes.

The Administration had to fight temptations and pressures from Congress to pass new entitlement and spending programs such as a veteran’s bonus bill. Historian Jim Powell has noted that in the Harding administration “federal spending was cut from $6.3 billion in 1920 to $5 billion in 1921 and $3.2 billion in 1922.”[6] An additional concern for Harding and Mellon was to pay off the national debt.

The idea of tax cuts fit into this economic policy blueprint. “It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the Government, and that more revenue may often be obtained by lower rates,” wrote Mellon.[7] Mellon expanded on his theory when he wrote:

On the other hand, a decrease of taxes causes an inspiration to trade and commerce which increases the prosperity of the country so that the revenues of the Government, even on a lower basis of tax, are increased. Taxation can be reduced to a point apparently in excess of the estimated surplus, because by the cumulative effect of such reduction, expenses remaining the same, a greater revenue is obtained. High taxation, even if levied upon an economic basis, affects the prosperity of the country, because in its ultimate analysis the burden of all taxes rests only in part upon the individual or property taxed.[8]

The Mellon tax-reform plan was pushed by both President Harding and President Coolidge. Economist Veronique de Rugy discussed the impact of the Mellon tax cuts when she wrote:

After five years of very high tax rates, rates were cut sharply under the Revenue Acts of 1921, 1924, and 1926. The combined top marginal normal and surtax rate fell from 73 percent to 58 percent in 1922, and then to 50 percent in 1923 (income over $200,000). In 1924, the top tax rate fell to 46 percent (income over $500,000). The top rate was just 25 percent (income over $100,000) from 1925 to 1928, and then fell to 24 percent in 1929.[9]

The result of the Mellon tax plan, along with the commitment by Presidents Harding and Coolidge to slash federal spending resulted in the economic expansion of the 1920s, more famously referred to as Coolidge prosperity. In fact, the Depression of 1920 was over by 1923 and unemployment was reduced to about two percent and the prosperity created an expansion of entrepreneurship. The Coolidge administration also had budget surpluses and worked on reducing the national debt.

The economic policies of Mellon serve as an economic blueprint that is rooted in not only a successful policy, but also based upon the principles of the American founding. Mellon was a successful businessman and investor, but he was also a student of history and political economy. Mellon learned from the political and economic principles of Alexander Hamilton.

Throughout the 20th century administrations, most notably those of President John F. Kennedy and President Ronald Reagan, followed a policy of tax cuts to stimulate the economy in times of downturn. Mellon’s thesis has proved to be correct. In following Hamilton, Mellon wrote: “A corollary of Hamilton’s policy of keeping the Government’s expenditures within its income is the further policy of keeping the revenues not too greatly in excess of expenditures.”[10]

Tax cuts are effective, but tax cuts are most effective when they are combined with reducing government spending. “In the case of Government, therefore, every new expenditure must be paid out of new borrowings,” noted Mellon.[11] This means that Congress and the President should be very prudent in enacting new policies and entitlements which will further strain the federal treasury. The proposed health-care reform plan, for example, would cost an additional $1 trillion and entitlement programs such as Social Security and Medicare are forecasted to go bankrupt, which will result in entitlement spending consuming a majority of the budget.

Mellon has offered an approach not only to reverse declining revenues, but also reduce government spending and follow a prudent course of action in enacting new policies. This approach must be utilized in order to bring about economic recovery and prosperity.

John Hendrickson is a Research Analyst at Public Interest Institute.

The views expressed herein are those of the author and not necessarily those of Public Interest Institute or Tax Education Foundation.  They are brought to you in the interest of a better-informed citizenry.

[1] Stephen Ohlemacher, “Federal tax revenues plummeting,” Associated Press, August 3, 2009.

[2] Ibid.

[3] Andrew W. Mellon, Taxation: The People’s Business, Macmillan Company, New York, 1924, p. 9.

[4] Ibid., p. 13.

[5] Ibid.

[6] Jim Powell, “Not-So-Great Depression,” National Review Online, January 7, 2009.

[7] Mellon, p. 16.

[8] Ibid., p. 20-21.

[9] Veronique de Rugy, Tax Rates and Tax Revenue: The Mellon Income Tax Cuts of the 1920s, Tax & Budget Bulletin, No. 13, February 2003, CATO Institute, 2003.

[10] Mellon, p. 51.

[11] Ibid., p. 53.