Why Higher Deficits Don't Mean Higher Income Tax Rates

Per one’s request, my latest quarterly letter to Peridot Capital clients included a section on the current macro-economic outlook for the United States. The question they wanted me to address had to do with possible hyperinflation resulting from ever-increasing budget deficits at the federal level. As with any question like that, I try to completely ignore everything I have heard and instead rely on what the numbers tell me to form an opinion. Numbers don’t lie, people do.

The latest set of numbers I have looked at are very interesting and so I thought they were worth sharing. The consensus viewpoint today is that higher budget deficits will ultimately lead to higher income taxes on Americans, which is likely to hurt the economy over the intermediate to longer term. Interestingly, historical data does not necessarily support his hypothesis. Let me explain.

Despite current political debates, which are more often than not rooted in falsehoods, the United States actually saw its level of federal debt peak in 1945, after World War II. Back then, the federal debt to GDP ratio (the popular measure that computes total debt relative to the size of the economy that must support it) reached more than 120%.

Even after a huge increase over the last decade, currently the ratio is around 80%. As a result, our federal debt could rise 50% from here and it would only match the prior 1945 peak.

Given all of that, the first question I wanted to answer was “how high did income tax levels go after World War II to repay all of the debt we built up paying for the war?” After all, the debt-to-GDP ratio collapsed from 120% all the way down to below 40% before President Reagan spent all that money in the early 1980’s. Surely tax rates went up to repay that debt, right?

The reality is that the top marginal income tax rate went down considerably over that 35 year period and even if Congress maintains the top rate at 39.6% (up from 35% under President Bush), the rate will still be near historic lows since the income tax was first instituted nearly 100 years ago.

Below is the actual data in graphical form. All I did was plot the top marginal income tax bracket along with the federal debt-to-GDP ratio. This makes it easy to see what was happening with tax rates as debt levels were both rising and falling over the last 70 years.

As you can see from the data, tax rates did not go up even as debt was paid off dramatically. As a result, it appears to be a flawed assumption that increased federal borrowing automatically means we will have to pay higher taxes in the future. Political junkies won’t like what this data shows, but again, numbers don’t lie.

Comments

[The Geoffster:]

I think JFK proved that lower tax rates and higher tax revenues were not mutually exclusive. Too bad his democrat brethren haven't followed suit but they're too busy waging class war and playing Robin Hood.

Aug 20 09:23 AM

[whidbey:]

Rotten analysis.

The truth is tax rates v. debt levels are not well related until one looks at inflation and life styles concurrently. They do matter.

The capacity of an economy to pay its debts is never in question if one inflates heavily (as will/must happen), tax rates not withstanding. What you did not say is what happens to consumers capacity to maintain life style.

The comparison with WWII is never apt since no one wants to use a near sinking as the bench mark of seamanship. I hope your clients look at your work and walk.

Dealing is the rote numbers is a pitiful way to write an analysis.

Aug 20 09:27 AM

[Jiang Nan:]

I would also take a look at Tax as percentage of GDP over the years before commenting further.

Higher tax rate does not necessarily means higher tax burden since there may be means of avoiding paying the full amount.

Aug 20 09:31 AM

[traden4alpha:]

Interesting premise, but I draw the exact opposite conclusion from the graph. The graph shows that an >70% tax rate enabled repayment of the debt and that tax rates less than 70% led to growing debt. Ergo, the tax rate will return to >70% to help repay the debt.

Of course the larger issue is that the top marginal rate tells very little of the full story of tax burden and debt repayment in four areas. First, tax burdens are a function of many other tax law issues such as bracket definitions, deduction rules (and phaseouts for high income households), AMT, and other non-income tax income taxes (e.g. FICA). For example uncapping FICA will boost the top rate by 6.2% or 12.4% (depending on whose pocket one thinks the money comes from). Second, the underlying economy play a huge role -- boom times (e.g., the 1950s baby boom and the 1990s dotcom boom) create growing tax revenues (and declining spending on poverty reduction) without increasing tax rates. Third, the required top tax rate is a function of all other tax rates -- for example, higher tax rates on the middle class would allow unchanged or lower top rates on the rich (and vice versa). Fourth, the level government spending is just as important as the level of taxation in supporting repayment of debt. A lean government can repay the debt without high tax rates.

The point is that repaying the debt requires higher tax revenues (or cutting government spending). The money has to come from somewhere. Higher tax revenues means either: 1) higher rates (or fewer deductions) on some or all citizens; 2) boosting the economy so that everyone moves to a higher tax bracket and pays more taxes. Personally, I suspect (and fear) that option 1 is much more likely.

Aug 20 09:37 AM

[TradingHelp...:]

"current political debates, which are more often than not rooted in falsehoods".

It's OK, you can say politicians lie. That's what they do - allegedly.

Aug 20 10:15 AM

[Larry House:]

Did anyone hear candidate Obama say that he wanted higher taxes on wealthy Americans if he became President Obama? Aren't higher taxes already being talked about? I think one needs to look at current events rather than history to project what is happening now.

Aug 20 10:46 AM

[Neil459:]

Another example of journalistic misconduct in order to support a political view. Printing two graphs and drawing a conclusion without showing any cause and effect relationship is just pure lying.

Some of the issues are noted above, but there is (1) also the issue of boomers coming into the workplace and (2) the fact that the debt was incurred in return for real products and work, not waste and political paybacks. With the current government spending I seem to be missing the posters where housewife's are working in manufacturing plants because there are no other employees that can be hired. You know where people that have never worked are now working. So many differences between now and then that Chad Brand should just go to work for Obama and spread the word, true or not.

Aug 20 11:19 AM

[chap08:]

The historical comparison just doesn't wash. Today is nothing like the end of WW II e.g. how does consumer indebtedness compare? How successful was the post-war US economy? How successful will it be in the next few years? What are our projected deficits and how do these compare with our post-war federal budgets?

Higher tax rates are an inevitable part of the solution to the deficit. As are inflation, savage cuts driven by budget crises and a possible debt restructuring, on terms dictated by our creditors.

Aug 20 11:34 AM

[Vox Rationalis:]

The top marginal tax rate, by itself, offers very little to the discussion; for the same reason that the U.S. corporate tax rate is fairly meaningless: the exemptions and deductions and other nuggets in the tax code have to be included in any analysis. So, while the U.S. corporate tax rate is higher than almost any other developed country, the effective tax rate - the rate actually paid - is much less.

In this case, the overall average tax rate would be far more meaningful.

Aug 20 12:14 PM

[Vox Rationalis:]

On Aug 20 09:23 AM The Geoffster wrote:

> I think JFK proved that lower tax rates and higher tax revenues were
> not mutually exclusive. Too bad his democrat brethren haven't followed
> suit but they're too busy waging class war and playing Robin Hood.

Lowering a rate from 90% to 70% is a far cry from cutting one from 39% to 35%. The potential effects aren't even comparable.

Aug 20 12:19 PM

[pre-boomer:]

For the 20+ years after the war the US economy was very heavy in manufacturing - we were producing hard assets that were sold both here and around the would (exports) ! Can't say the same for today - we seem to be producing problems ( mortgage backed securities ) and selling them around the would !

Aug 20 12:22 PM

[conceptwizard:]

Its not all about the debt for the tax increase debate, its the interest on the debt that will rise from the current 8%, the shortfalls on social security and medicare, falling tax reciepts and the ongoing cost of war. These all combined will have a great effect on Government revenues and will leave them no option than to increase taxes.

Aug 20 01:06 PM

[Dieter Hohe...:]

Terrible analysis. The higher taxes resulting from higher government spending don't necessarily manifest themselves as higher marginal rates (or fewer "loopholes"). The higher cost of borrowing and paucity of available credit mean higher unemployment and lower productivity. A caving dollar from monetizing debt tends to produce higher inflation than otherwise would occur. The earlier part of the chart occurred when we were a creditor nation and didn't need to monetize debt in order to address hyperspending. Deflation from lack of available credit and low money velocity causes the ultimate tax for millions.... no jobs! The graph overlay of debt and marginal rates is inconclusive at best, and over most of the relevant time period demontrates a correlation between lower debt ratios and lower marginal rates.

Aug 20 02:25 PM

[Jimbo:]

I endorse almost all the previous comments. Allow me to add another idea: looking out into the future, we have absolutely enormous "unfunded liabilities". Everyone reading this knows we have Medicare, Medicaid,Social Security,existing and projected federal debt not to mention all those Federal Reserve Notes laying in foreign vaults. The only way we can resolve this debt is taxes, inflation, or most likely, both.

Aug 21 10:29 AM

[snakyjake:]

We don't need higher taxes today because we are able to fund our spending via debt, not taxes. If this continues, no need for higher taxes. And let's not forget how low those Treasury interest rates are right now...it's cheap money. If/when interest rates go up....higher taxes might appear better than the interest payments.

Another form of "taxes" is inflation. The Treasury can simply print money, and not have to raise taxes. I believe this is how the Vietnam War was financed.

And with WW2, I believe a portion of the financing was with war bonds (a volunteer tax), government price controls, and the government confiscating raw materials from the private sector, plus the US was profiting from the European war and giving us the industrialization boost.

Aug 21 01:28 PM

[User 393155:]

Agreed

On Aug 20 09:37 AM traden4alpha wrote:

> I draw the exact opposite conclusion from the graph.
> The graph shows that an >70% tax rate enabled repayment
> of the debt and that tax rates less than 70% led to growing debt.
> Ergo, the tax rate will return to >70% to help repay the debt.<br/>
>
> Of course the larger issue is that the top marginal rate tells very
> little of the full story

Aug 22 02:31 PM

[Suncatcher:]

I am pretty sure most of the posters here have a better view of this then the author. I will only add the following:
Comparing the current geopolitical/ financial world to post WW2 would require you bomb out most of the industrialized world. And taxation has crept into every nook and cranny of what we do. Comparing income tax is misleading, unless you weight it with every other tax as well.

Aug 29 02:23 AM

[Alfredo Mar...:]

This article is incredibly stupid.

Have you ever looked at the tax rates during WWII?

The top marginal rates were 94%, and the rate stayed at above 90% for 15 years afterwards! The debt nearly sank the US, that's why in addition to incredibly high tax rates, average citizens were CONSTANTLY told to buy war bonds.

It took Democrat JFK to lower marginal tax rates, and surprise, federal revenues went up dramatically.

All debt has to either be paid or inflated away. The fact that our debt has reached where we were in WW2 when our entire nation's economy and manufacturing was converted into a war effort is incredibly troubling; and that's not even taking in consideration the coming tsunami of baby-boomer entitlements.

Oct 04 01:38 PM