March 21, 2003


Tax Hike Won’t Cure California State Deficit

By Veronique de Rugy

Governor Gray Davis wants to hike sales and income taxes $8.3 billion to help close California’s $35 billion budget deficit. In addition, Davis wants to add $1.10 in taxes to each pack of cigarettes, and raise assorted fees. He is also calling for minor program cuts compared to the spending frenzy of the last four years, during which time the state budget ballooned nearly 40 percent.

The push for tax increases over spending cuts is a lose-lose idea that follows in the policy-footsteps of Presidents Hoover and Roosevelt. In the 1930s, they pursued tax increases based on the mistaken idea that a balanced budget would help the economy. Yet the high tax rates they approved hurt the economy, and made the deficit higher, not lower. Higher taxes were a bad idea then, and higher California taxes are bad idea now.

After the 1929 market crash, a sharp monetary contraction pushed the economy into the Great Depression. Overnight, everyone forgot how effective the large tax cuts implemented by Treasury Secretary Andrew Mellon were in restoring economic growth and how, in turn, deficits had disappeared. Obsessed about deficits, Hoover had raised individual tax rates at all income levels-the top rate rose from 25 percent to 63 percent. Following Hoover, Roosevelt signed into law a series of tax increases. At the bottom end, personal exemptions were reduced and an earned income credit was eliminated. At the top end, the highest marginal rate was increased to 79 percent in 1936.

  Between 1930 and 1940, the corporate income tax rate was doubled from 12 percent to 24 percent and an “excess profits” tax was added on top. In addition, Roosevelt imposed an excise tax on dividends, a capital stock tax, liquor taxes, and he increased estate taxes. Finally, the Social Security payroll tax was imposed with a 2 percent rate starting in 1937.

Interestingly, while the federal budget was balanced throughout the 1920s, the tax increases of the 1930s coincided with increasingly large deficits. On the campaign trail in 1932, Roosevelt noted: “For over two years our federal government has experienced unprecedented deficits, in spite of increased taxes.” Yet, much like Gov. Davis today, Roosevelt decided to increase taxes more. He found out that a tripling of tax revenues did not balance the budget because the deficit soared from $2.2 billion in 1932 to $2.9 billion in 1940.

A key problem in trying to balance the budget with tax increases is that higher taxes fuel more spending. As Milton Friedman has said,  “Raise taxes by enough to eliminate the existing deficit and spending will go up to restore the tolerable deficit.”

Another reason why tax hikes don’t balance the budget is because the hikes contract the tax base by reducing economic growth and spurring greater tax avoidance. As a result, the government gains only a fraction of the revenues it hopes to receive.

And the 1930s tax return data for high-income individuals reveals a lot. For instance, as the marginal tax rate on those earning over $100,000 was hiked from 25 to at least 62 percent, the share of overall taxes paid by that group fell from 50 to 27 percent. That happened, in part, because taxes went up at all income levels. But those high rates at the top end stifled the economy and sparked tax avoidance and, thus, suppressed tax revenues. Here again, the analogy is clear: Californians can expect a continued exodus of high income and economically productive citizens for more tax-friendly states such as Arizona, and tax receipts will continue to fall.

Roosevelt’s ideological devotion to soaking the rich, blinded him to the economic reality unfolding around him. He claimed that increasing the tax paid by individuals in the higher brackets was “the American thing to do.” Yet that and other anti-growth policies killed incentives for work, investment and entrepreneurship. As a result, while the U.S. unemployment rate fell during the tax-cutting 1920s, it soared to 25.2 percent in 1933, and remained high through 1940, at 14.6 percent.

The tax increases of the 1930s coincided with large deficits and economic stagnation. While high taxes should not be blamed for all the problems of the Great Depression - monetary and trade policy mistakes also deserve some blame-it should be clear that raising taxes to balance a budget is like drinking a six-pack to cure a hangover. As the California Senate grapples with the state’s budget deficit and mediocre economic growth, it should look to the tax cuts of the 1920s for inspiration rather than the failed “budget balancing with high taxes” approach of the 1930s.

Veronique de Rugy is a fiscal policy analyst with the Cato Institute,

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