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Weird Tax Myths #2 -- Recessions, Depressions and Tax Policy

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Our prevailing mythology is that tax cuts help the economy.

They stimulate it. They promote growth. They create jobs.

The truth is that tax cuts cause crashes.

Tax hikes end depressions and recessions.

Those are the broad strokes.

They need some parameters and qualifications.

In modern times -- since the introduction of the income tax by constitutional amendment in 1913 -- there have been three basic types of recession.
  1. Post-war recessions come when war spending stops and the workforce swells with returning soldiers. We've had these after WWI, WWII, Korea, and Vietnam.
  2. Fiscal policy recessions come from cuts in government spending, as in 1937 and 1973 to balance the budget, or a hike in interest rates to tighten the money supply and control inflation, as in 1949, 1958, 1960, 1969, and 1980.
  3. Finally, there is the sequence of boom, bubble and crash. The first of these was in 1929. The collapse that followed was called the Great Depression. The others were 1990, 2001, and 2007, the one we're in now, starting to be called the Great Recession.
Except for 2001, these also included massive bank failures.

Economists, historians, and, as we move into the present, journalists and pundits, offer a mixed multitude of reasons for each of them.

But now that we've had four of them (including the crash of 2001), we can see a pattern.

The sequences of boom, bubble, and crash have, in each and every case, been preceded by a significant tax cut.

Coming out of World War One we had a top marginal tax rate over 70%.

From 1921-25 it was cut, in steps, down to 25%.

There was a boom, particularly in the fiscal sector.

The crash came in 1929.

When Ronald Reagan came into office in 1981, the top marginal rate was, once again, 70%.

Reagan started cutting in 1982, down to 50%, then to 38.5% in 1987, and 28% in 1988. There was a boom in the fiscal sector. In the mid-eighties the collapse began, and over 1,600 banks failed. There was a huge bailout.

It was followed by the recession of 1990.

Taxes went up slightly under George H.W. Bush, then again under Bill Clinton. The economy recovered.

However, in 1997, the Republican congress pushed Clinton into cutting the capital gains tax from 28% down to 20%. It was called The Taxpayer's Relief Act. It marks -- almost exactly -- the moment when the dot.com boom turned into the dot.com bubble.

It burst in 2000, and, along with the 9/11 attacks, there was another recession.

George W. Bush launched another round of tax cuts. The top rate went down to 35%. Capital gains rates were cut to 5%.

This was followed by the Bush boom.

There was huge growth in the fiscal sector, but "mysteriously," it was a jobless recovery. The boom was hollow. It was a bubble. It led to the Crash of 2007, with massive bank failures, followed by our current recession.

How does this type of recession -- boom, bubble, and crash -- end?

In 1932, Herbert Hoover raised taxes. He did it to balance the budget. In 1933 the economy changed direction and began moving upward.

In 1991, George H.W. Bush, disturbed by the huge deficits that followed Reagan's cuts, raised taxes. The economy subsequently turned around. When Clinton raised taxes again, the economy really took off, leading to the longest sustained period of growth in modern times. With some of the highest employment growth.

The 2,000 recession was followed by tax cuts. Not tax hikes.

A very strange think followed. There was great growth at the top. Corporate profits rose, there was a boom in real estate and in the fiscal sector generally.
But for normal people the recession never ended. There were no new private sector jobs. Median income went down. Manufacturing continued to decline.

The historical record suggests that this recession won't end until there is a tax increase.

Economies are complex. There are always a multitude of factors that effect booms and busts, growth and recessions. It is also a commonplace that correlation does not necessarily imply causality.

Nonetheless, if the same sequence takes place a multitude of times in different circumstances and the sequence takes place four out of five times -- tax cut, fiscal sector boom, bubble, crash, bank failures and recession or depression -- it makes a very good case for causality.

There is one significant tax cut that does not quite fit the model. In 1964 and 1965 the top marginal rate went down from 91% to 70%.

Tax cut enthusiasts always refer to them as the Kennedy tax cuts, but they took place under Lyndon Johnson. They also always cite them as a great stimulus to the economy.

In the short term, they had the same effect as the other tax cuts.

The Dow Jones had an upsurge and then a crash.

Over the next twenty years, it bounced around between 600 and a 1,000, a lot of fun for speculators, but as a measure of serious economic growth over the long term it is astonishingly flat.

The other standard measure of economic policy success is the increase, or lack thereof, in the Gross Domestic Product. Over the next two decades, there was only one year in which the rate of increase in the GDP matched the high tax periods that preceded them. Those rates go lower and lower with each tax cut.

Our public policy dialogue has little basis in fact or rationality.

Much of it, even in the academy, is bought and paid for. There is no interest group willing to pay foundations, endow universities, buy radio ads for commentators, who will advocate higher taxes.

But there's lots of money willing to invest in propaganda that calls for lower taxes and claim that they're good for the economy.

So you won't hear calls for higher taxes. You won't find politicians who dare to propose higher taxes.

If the Bush tax cuts are allowed to expire they will, hopefully, work as tax hikes. That will mark the beginning of a real recovery.

If they don't, and there are no other tax increases, expect lingering unemployment, lower wages, increased corporate profits, especially in the fiscal sector -- which we're already seeing -- a short term boom in the stock market, and another crash.