No Room for Policy Blunders of the Past
Posted by Todd Davidson on Monday, July 9, 2012

The correlation between high taxes and noteworthy economic growth between 1947 and 1979 has caused many to conclude High Taxes = Economic Growth.  Such a correlation fails to account for the different circumstances of the era.  Namely, after the Second World War nearly all foreign competitors were destroyed, the US government alleviated burdensome WWII taxes and rationing and the era saw the implementation of numerous cost saving innovations.  The circumstances of yesteryear no longer apply and we must realize we cannot afford the high taxes of the past.

Economic growth boils down to one equation: Revenues – Costs.  Put simply increased revenues or decreased costs drive economic growth. While taxes and regulations were incredibly costly during the post-war era a multitude of circumstances both raised revenues and lowered costs for producers.  

Foreign countries had been demolished

The late Princeton Economics Professor William H Branson:

At the end of World War II the United States was by far the dominant industrial economy in the world. With industrial capacity largely destroyed in Europe and Japan, the United States produced more than 60 percent of the world's output of manufactures in the late 1940s. As a result, the United States was a net exporter of manufactured goods of all kinds; historically the United States was a net importer of consumer goods, but in 1947 there was a net export surplus of $1 billion in that category.  

The late 1940s were unique in that America companies had somewhat of a monopoly on worldwide production.  This offered a nice boost to revenues.

Government actually shrank following the Second World War

Although government was big from 1950s to 1970s, it was much smaller relative to the 1930s and 1940s, as described by economics professors Jason Taylor and Richard Vedder:

[The US] Government canceled war contracts, and its spending fell from $84 billion in 1945 to under $30 billion in 1946. By 1947, the government was paying back its massive wartime debts by running a budget surplus of close to 6 percent of GDP. The military released around 10 million Americans back into civilian life. Most economic controls were lifted, and all were gone less than a year after V-J Day. 

As Professor Burton Folsom points out taxes were lowered from New Deal and WWII highs:

Income tax rates were cut across the board. FDR's top marginal rate, 94% on all income over $200,000, was cut to 86.45%. The lowest rate was cut to 19% from 23%, and with a change in the amount of income exempt from taxation an estimated 12 million Americans were eliminated from the tax rolls entirely.  Corporate tax rates were trimmed and FDR's "excess profits" tax was repealed, which meant that top marginal corporate tax rates effectively went to 38% from 90% after 1945.

The downsizing of government freed up resources, reduced onerous taxation and eliminated burdensome rationing; significantly lowering costs for producers and consumers.

1948-73 was a “Golden Age” of Innovation

The increased prevalence of affordable electricity augmented manufacturing output by powering mechanized labor.  Productivity on the farm began its exponential trend, thanks to the internal combustion engine.  The internal combustion engine also brought on faster, cheaper travel which reduced the cost of shipping and enabled Americans to travel farther to work; expanding their pool of potential jobs.  The advent of containerized shipping dramatically reduced the cost of transporting goods across the ocean while the interstate highway system provided efficient routes for those containers to reach their destinations.  The result of these and many other cost saving innovations was a “Golden Age” of productivity that boosted economic growth.

(For the charts I thank Stephen Moore, Julian L. Simon, and Pf. David Beckworth.)

As shown in the fourth chart, gains in productivity slowed after 1977.  Tyler Cowen, George Mason University Economics Professor, argues in his book The Great Stagnation; that we’ve ate all the low hanging fruit and innovation is now much harder.  Rather innocently, we’re not innovating as much because we’ve advanced so much already.

Perhaps an example will be more intuitive; going from no refrigerator to a refrigerator in every home was a significant decrease in the cost of food and a substantial increase in our standard of living.  While now  it makes my life only slightly better to have a larger refrigerator that makes ice in cubed or crushed form – some cost reduction but not nearly as much.

My how times have changed

Fortunately, the rest of the developed world is not in a rebuilding state after massive destruction.  And now, thanks to the internal combustion engine and containerized shipping, foreign producers can feed American consumers rather cheaply – great for consumers but inconvenient for American producers’ revenues.  Producers can no longer absorb the high taxes they were forced to pay in the past.

We don’t have the luxury of mitigating our policy blunders with the high innovation rate seen in the post-war era. As Cowen succinctly articulates, the very high background rate of innovation enabled marginal tax rates which would not prove workable today.

We obviously need taxes to finance our infrastructure, education, security and other government services – all necessary for a prosperous economy – however we should understand that the circumstances of the post-war era are no longer with us.  Government, much like American producers, must deliver services at the lowest possible cost.  Designing tax policy without this consideration will only slow economic growth.