Disconnection, Income Tax and the Booming 20s

Disconnected from reality?

People may be astonished at this notion, but it took 124 years of American history for the second-handers in politics and society to get their hands, permanently, on income tax. The ratification of the 16th Amendment constituted the first permanent federal income tax in American history. Just to think that prior to 1913, only 2% of the US population owed federal taxes. From 1914 to 1920 the federal revenue coming from income taxes rose from about 10% to 70%, largely to fund the US efforts in WWI. After this uncharacteristic influx of taxes and the economic recession of 1920-21, the US politicians had a tough time maintaining these high income tax rates. At this time, treasury secretary Andrew Mellon, a Pittsburgh entrepreneur, proposed a principle of supply-side economics to dramatically reduce the tax rates to levels of the pre-WWI era. He argued that high surtax rates led to a misallocation of capital, reduced tax collections, and hindered productive economic activity. By reducing taxes on wealthy individuals, who during periods of high tax-rates took extensive steps to avoid federal income taxes (i.e. through tax-exempt securities), Mellon's policy had tremendous impact by diverting capital from tax-exempt practices to investment within the private industry. This promoted extensive growth in the economy and significantly increased the overall average of real wages. Odd enough, and something for the "spread the wealth" leftist ideology to think about, the increase in money supply for all individuals meant the tax burden shifted from the lower-income group toward the upper-income group. Also, the government still received the same amount of money as they did during the significant tax increase years, because of the overwhelming wealth produced in the booming economy.


At the first sign of a troubled economy, a recession no different than seen in 1920-21, Hoover and his congressional supporters implemented a policy to drastically increase the tax burden. By 1935 the tax rate, under FDR, rose to 79% on the upper income individuals and the economy still proved to stagnate. It was not until the significant drop in the tax rate on upper-income families, post WWII, that the US began seeing the type of economy that promotes wealth and productivity. 

Are we to wait this long? The reinstatement of the high tax rate on the upper echelon will only serve to cripple the economy and in effect increase the effective tax burden on the lower-income families. While it would seem that the hike in the percentage of tax increases would serve to induce "equality" so-to-speak, it will only cause a decline in real wages and effectively limit the productive expansion of industry. 

[Main Ideas from the Article "Federal Personal Income Tax Policy in the 1920s" Author(s): Gene Smiley and Richard H. Keehn; Source: The Journal of Economic History, Vol. 5, 1995]