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CHARLOTTESVILLE--Recent deliberations on the "fiscal cliff" make one thing very clear: Too many lawmakers have become wedded to too many myths about tax policy and economic history. To ensure that the current policy struggle doesn't deflect us from a return to widespread prosperity and full employment, we should look clearly at the record and puncture these myths forcefully. There are at least two key lessons:
Tax increases can much more readily stimulate a capitalist economy than tax cuts. While the effects of both are dependent upon how budgets are adjusted in their wake, for a stimulus, increases must only be spent; tax cuts must be coupled with additional deficit spending of equal magnitude. Put another way, to have any stimulus effect
If, instead, we insist on maintaining the prevailing posture (no change in the existing deficit, surplus, or balance), and offset tax cuts with budget cuts, we will depress economic activity. It does matter, of course, how these tax cuts are focused, for if wealthier citizens receive the largest share (in the absence of companion deficit spending), the economy-depressing effect is that much more profound.
And since the payroll tax is the only federal tax of significant enough size to become the object of a major cut focused on the not-so-wealthy, there is really very little opportunity to do anything with fiscally neutral federal tax cuts than depress economic activity in a significant way. Even more remarkable than our blindness to this phenomenon on the federal level--where deficit spending is a readily available tool--is our lunatic embrace of state level tax cuts as stimulus, where deficits are much more circumscribed--legally and politically.
While we are fortunate, therefore, to have had additional deficit spending alongside every recent federal tax cut--the real stimulus here--repeated application of this combination has also diminished the dollar-for-dollar power of fiscal policy and deficit spending. As Keynes explained it in 1936, the power of deficit spending stems from the way it augments the general power of wise monetary policy and progressive fiscal policy. It becomes a necessary force, in special circumstances, only when interest rates are kept too high and fiscal policy is insufficiently progressive.
BANG FOR OUR BUCK
This explains why the tax increases of 1942, 1990, and 1993 helped to lift the American economy and why the notable tax cuts of the 1920s--the only major federal reductions in the modern era not accompanied by equal or greater deficit spending--contributed greatly to one 13-month recession (1926-27), and to the onset and awful persistence of the Great Depression.
It also explains why we have gotten less bang for our deficit buck in recent decades. The general theory Keynes underscored remains simple and instructive: A low monetary threshold for investment and a progressive fiscal policy to re-seed the demand on which new investment always depends. Astoundingly, the applicable tax and fiscal policy effects rely on principles we learned long before Keynes; Adam Smith highlighted them in Book Five of the "Wealth of Nations" and Alexander Hamilton urged them in Federalist No. 36.
For reasons related to the effects cited above, capitalism depends upon progressive taxation, and this is dependent upon the nation's entire tax structure. The golden age of American capitalism, for example, was built largely on the effects of three key tax policy changes: the 1910s to 1960s adoption of moderately progressive state income taxes, the decreased dependence on archaic and regressive local taxes that accompanied this state-level trend, and the World War II-era adoption of the first broad and progressive federal income tax.
The reversal of all three of these changes--in modest ways since the 1960s, and in much less modest ways in recent years--helps to explain much of our current predicament. Recognition
Unless we lessen again the regressive character of state and local taxes (currently accounting for approximately half of the nation's fiscal weight), or lessen our dependence upon them by increasing federal aid to states, our federal tax structure must be at least as progressive as it was in the 1960s, after which we began this Great Reversal.
While other related myths abound--shaping our tendency to equate fewer tax brackets and flatter rates with simplicity, for example, or to tax blindly with regressive proxies in the name of "balance"--those deflecting us from progressive taxation, in general, are likely the most debilitating we possess, making a return to widely shared capitalist prosperity well near impossible.
David Shreve is an economist and former professor of economic history at the University of Virginia.