01/16/2014 05:39 pm ET | Updated Mar 18, 2014

How Did We Reduce World War II Debt?

There is a productive way to pay down the federal and consumer debt loads, instead of the austerity policies currently in vogue both here and in Europe (i.e., cut taxes and government spending), thus freeing more capital to grow the U.S. economy. It means implementing policies that will increase average household incomes; and tax revenues in the case of governments. We know this works because it happened after World War II with its record 120 percent of GDP debt load that was reduced to as low as 31.7 percent in 1974.

But it has climbed back to 100 percent of GDP today (including $5 trillion owed to the social security trust fund) for a variety of reasons; including spending for the 2 Wars on Terror + an extensive domestic security apparatus that wasn't paid for, regressive tax policies, the decline in household incomes, and the Great Recession itself.


Graph: Trading Economics

The last 4 years of Clinton's presidency also gave us 4 federal budget surpluses. This was because of a slightly higher maximum federal income tax rate while capping government spending, mainly because of the post-cold war drop in military spending during the longest growth cycle (10 years) in U.S. history.

The fallacy is to believe that it can't happen today. Because, the story goes, only the immediate post-WWII society had lots of savings so that Eisenhower's sky-high maximum income tax rate of 92 percent didn't harm private spending and investment. That is why we could afford to fund a new freeway system and travel to the moon, goes the narrative.

But there is as much wealth saved today. Only it has become very concentrated. Those with the wealth today--such as the top 1 percent--also have very high savings rates. According to research from American Express Publishing and Harrison Group, the savings rate of the wealthiest 1 percent soared to 37 percent in the second quarter 2013. That's up from 34 percent in the second quarter of 2012--and more than three times their savings rate in 2007. And it contrasts with the current 4.2 percent personal savings rate for all consumers.

Studies in fact show that increasing the maximum tax rate to as high as the 80 percent wouldn't harm consumption, the main driver of domestic economic growth. Today, the richest 1 percent of Americans pay a top federal rate of 29 percent, according to Emmanuel Saez, an economist at the University of California, Berkeley. That's because almost a third of their income derives from capital gains and dividends -- which are now taxed at around 20 percent rate -- while the rest is ordinary income taxed at a top marginal rate of 39 percent.

Today, people earning over $200,000 a year capture more than a third of national income. In fact, three decades of tax cuts may have gilded the pockets of the rich, but they didn't provide much economic juice, says one study. Among developed nations, incomes per person grew no faster in countries like the United States and Britain that slashed their top tax rates than in countries like Spain, Germany or Denmark, which did not.

There is even evidence that higher tax rates encourage growth. For instance, reducing inequality through higher tax rates on the wealthy may promote wealth creation. What's the mechanism? Bowles and Jayadev claim to have identified one element of it: inequality leads to conflict and tensions, and society has to waste resources dealing with those conflicts and tensions.

The people at the top have to spend a lot of time and energy keeping the lower classes obedient and productive. So-called "guard labor" is one such waste. Some estimates say that 1 in 4 Americans is employed to keep fellow citizens in line and protect private wealth. This waste includes corporate IT monitoring, CCTV at work, and mobilizing police forces to protect property.


Graph: Center For American Progress

The above chart shows that there is no correlation between cuts in U.S. top tax rates and average annual real GDP-per-capita growth since the 1970s. And, countries that made large cuts in top tax rates such as the United Kingdom or the United States have not grown significantly faster than countries that did not, such as Germany or Denmark.

How to increase household incomes is more difficult, as many right-to-work states have limited both collective bargaining and union membership for middle class workers that have prevented their incomes from even keeping up with inflation. But there are movements to increase the minimum wage, as well as strengthen collective bargaining laws for better wages and benefits. The ongoing economic recovery and increasing employment will also boost both taxes and incomes.

So there are many good reasons to support policies that increase tax revenues and household incomes, and no longer valid reasons for austerity policies that actually increase deficits, and continue to depress household incomes.

Harlan Green © 2013