Q&A Period
Jude Wanniski
October 10, 1997


Supply-Side University Economics Lesson #5

Memo To: Website students of SSU
From: Jude Wanniski
Re: Q&A Period

Michael Barkey sent a question that I privately answered. He responded this week with a series of questions generated by the first four lessons of the semester, several of which question my hypothesis of the 1929 Crash and the Smoot-Hawley Tariff Act. I’ll take them up one at a time.

National Living Standards and the Statistics of Production

Barkey: In a previous message I asked, "Why could one not read high marginal income tax rates, especially on the upper income brackets, as an inducement to higher growth and productivity?"  Then I discussed the evidence cited by demand-side scholars to support their contention that "the 70-92% top bracket during the high-growth ’50s and ’60s forced individuals [at the top] to work even harder [and manage their money investments with greater oversight] in order to achieve what they deemed an acceptable level of take home pay thus increasing [overall] productivity and generating higher levels of economic growth while allowing lower income individuals to retain a higher portion of their earnings for savings and consumption." You replied, "Economics should be about enabling people to work less and produce more. To make people work harder to produce at the same level is bad economics," and you then cite the last 30 years, with tax rates raised via inflation, to support the claim that higher tax rates resulted in real reductions in wages instead of advances in productivity and living standards. 

I agree with your reasoning whole-heartedly and, although I might dispute your contention that "national living standards have been in steady decline over this period" with data on consumption levels showing continuing increases across all income groups over that period despite inflation thanks to productivity gains, that is not important here. What is important is that we should be encouraging higher earnings and lower prices through greater productivity, both due to advances brought through encouraging traditional hard work and through innovations that save time, money, and sweat expended in the production of goods or through the provision of services.  My question involves which means best promotes greater productivity and growth, the supply-side model with its emphasis on low levels of taxation and regulation or the demand-side model with its emphasis on high levels of taxation on the wealthy and low levels on the poor.

Wanniski: The high tax rates of the 1950s and 1960s -- 91% on the top rate @$100,000 prior to 1964, 70% thereafter -- did not force people at these levels to work harder and manage their investments better in order to achieve a desired income level. The high rates forced citizens to persuade their politicians to open loopholes in the tax laws, which were called “tax shelters.” The government got very little revenue from these high levels, really a pittance. The economy did well enough because the money invested in the tax shelters did produce real goods and services -- housing, oil, farm output, and tax-free bonds. The 95% of the work force in low tax brackets was  channeling its investments into savings accounts and stocks, with a $100 tax deduction per person on dividends received. The semi-skilled worker of the period made $5000 a year. The skilled worker made $6000. The well-to-do professional -- doctor, dentist or lawyer -- commanded a princely $10,000 annually. So a $100 tax deduction was big money, $200 for a husband and wife filing jointly, especially since most women worked at home and earned no cash income. As your income rose above $10,000 annually, you would begin hitting more serious tax rates, which is why professionals at this cutoff point moved into tax shelters. Ronald Reagan wrote in his biography how discouraging it was as a movie actor, to face the 90% tax bracket after the first picture of the year. He said instead of making movies, the acting and production crews would become engrossed in how to protect their incomes with oilwell deals.

As the post-war economy grew under this perverse system, economic growth steadily slowed as the population each year edged into higher tax brackets. The political corruption we see now was only in its beginning stages. Eisenhower was elected in 1952 with a promise to cut tax rates, but reneged on that promise. In 1960, neither Nixon nor Kennedy promised tax cuts, but Kennedy promised to get the country moving again, and narrowly won. After his death, the top rate was cut to 70% from 91%. The economic boom of the mid-1960s reflected that change. Kennedy did not present it as a demand-side cut in tax rates, but explicitly made the argument that by cutting rates where they were high, production would increase and so would revenues. Upon the success of the tax cuts, which demand-side economists claimed for themselves, they (instead of arguing for deeper cuts to expand economic efficiency even more) pushed for a tax increase -- a 10% income-tax surtax -- to finance the Vietnam War. The great bear market on Wall Street began in 1966 as this idea began to take hold. It accelerated when Nixon in 1968 promised to end the Vietnam surtax, and won the election, only to quickly decide to defer the repeal. Instead Nixon accepted a 1969 increase in the capital gains tax and an increase in the marriage tax. When the economy moved toward recession, his demand-side economic advisors persuaded him to cut the link between the dollar and gold, to impose wage-and-price controls, and to levy a new tax on imports, aimed at Japan.

The question you pose, Student Barkey, compares apples and oranges, the difference being the great inflation that occurred after 1967. Prior to that year, most of the population enjoyed low or no tax rates on income. The economy prospered even though the well-to-do faced high tax rates, which they avoided through shelters. You disagree with my assertion that the economy has contracted since 1967 and say the disagreement is not important, but it is everything when you compare apples and oranges. It is inflation that has put most of the workforce into high tax brackets. The Reagan tax cuts lowered them at the top, where they were producing little revenue as a result of the shelters. You then offer a picture where things were much better when tax rates were nominally high than when they are nominally lower. Using the same apples/oranges, we would say that the economy would do much better than it is if we now raised the top rate to 70%, but increased the threshold tenfold, to $1 million, and at the same time dropped the marginal rate to 15% on incomes between $100,000 and $1 million. If we could do this with a 15% capital gains tax and a dollar fixed to gold, I have no doubt the economy would improve from the path it is now on. What you find in looking at the national income accounts is that consumption has increased each year, but you must then ask, “Who is consuming what?” An enormous proportion of the national income is going to government workers taking care of welfare cases and a prison population that keeps expanding. An enormous proportion of the economy goes to lawyers and accountants and the support system of the chaos industry, which helps people get through the day and the terror of Internal Revenue. Lawyers and accountants have to eat, don’t they?

Living standards have plummeted for the past 30 years because the economy has become   inefficient in producing the goods and services that people want to consume. Government statistics are not helpful. They automatically count all the work done to contend with the inefficiencies as part of national output. These are not only lawyers, accountants and government bureaucrats. They are also the tens of millions of women now being forced into the workforce in order to make family ends meet, who are now counted as “productive” when the same work they did as housewives was not counted as part of the GDP. As the inefficiencies in the framework of the economy are eliminated, we would expect this process to reverse. Even if it meant a net decline in official Gross National Product, clearly the national living standard would be raised.

Taxing the Top and Investment Capital

Barkey: The demand-side argument is that by taxing at a high rate those at the top, the owners of the means of production who have the greatest capacity to increase economic growth through productivity gains, and taxing the rest of the population, those with a high marginal propensity to consume who have the greatest capacity to increase demand throughout an economy at a low rate, a society creates an atmosphere that generates growth and productivity gains. The reasoning is two-fold. First, consumers who retain the fruits of their labor create opportunities for individuals to meet those demands whether that be through productivity advances in current industries to meet the added demand or through the creation of new industries to do so. Secondly, producers are forced to make exceptional advances through productivity gains in order to receive increasing returns on their investments. This does not necessarily entail "people work[ing] harder to produce at the same level" as you suggest, but perhaps a more informed utilization of available resources by management to do so. These two factors, it is argued, are complementary and meet the needs of the less well-off while pushing the economy to full employment and requiring productivity gains and continued growth for management and their investors to pocket greater returns.    

Wanniski: This is textbook theory that does not work in practice. This is why I presented the brief history above. If you apply your textbook theory in other economies at various points of time, you also do not find these demand-side policies producing economic growth. India, for example, has been following demand-side economic policies for the 50 years since independence, as a result of its leaders relying on graduates of the London School of Economics. High tax rates on the rich and no tax rates on the masses have produced only poverty for the nation, which can only grow by adding population. If China continues to expand as it has, while India remains in a demand-model, in other generation or so India will have a higher population than China. The main flaw in the model you present is in arguing that investment of surplus capital increases when the risks of failure increase. When the risks of failure increase, because government tax rates and regulations punish success, surplus capital either dries up or travels to other places where prospects of success are greater because the government is wiser.

Wealth-Making Beyond the Top 1%

Barkey: The supply-side argument is that by taxing those across the economic spectrum at a low or modest rate level and allowing them to retain the fruits of their labor, one encourages all to strive for productivity gains through traditional hard work, innovation, and, unlike under the high taxation demand-side model which focuses on boosting consumption, by encouraging greater investment in an effort to boost productivity. By eliminating stifling regulations and fighting inflation through a stable dollar pegged to gold, with low taxes (especially those on capital gains),  the wealth predominantly held by a small segment of the population will be invested at a higher rate than would otherwise occur because the atmosphere becomes ripe for investment returns and risk taking.  In the process, jobs are created and there is a downward pressure on prices which benefit the consumer and an upward pressure on wages thanks to productivity gains.

Wanniski: Not bad, but before we proceed with the question you pose on this premise, allow me a few quibbles. One is that we are not merely concerned with extracting investment from the small segment of the population that is wealthy. There is potential capital in most of the population that is trapped behind tax, monetary and regulatory barriers to production. If India exempted the top 1% of the population from all taxation and maintained the barriers for the 99%, the economy might improve, but only slightly. The surplus of time, energy and talent which constitutes potential capital is in the mass. The potential entrepreneurs who became the most productive are almost certainly in the mass, not the 1%. Bill Gates is now at the top of the heap, but when he was getting started, he was in the mass. If you had extremely high rates of income taxation on the top 1% but low rates on the 99%, the economy would look more like it did in the 1940s and 1950s.

Say’s Law and the Crash of ’29

Barkey: Working from this premise, and granting that it appears that the supply-side agenda seems to work better for an economy in good times, the question of viability becomes key.  Can underconsumption or overproduction destroy an economy as Keynes and Marx contend?  Lesson 4 takes issue with this.  It restates the explanation for why production is everything in an economy:  I produce to trade that which I produce for that which you produce and you produce to do the same.  Encouraging each of us to produce more high quality items for trade is then the focus of the supply-side policymaker. The demand-side policymaker might even affirm this proposition, at least if they’re not brain dead.  Where the two policymakers split is whether demand-side issues of consumption ever should come into the picture.  Granted, most Keynesians can only talk about consumption. Only demand can create supply, they say.  We agree that this is untrue, but what I am uncertain of is whether the economy can get in some trouble and need some demand-side priming or, perhaps, supply-side priming in an emergency. I do not accept this as a general role for the government in the economy, the last 40 years convince me of that, the only event I might is during a sustained downturn such as the Great Depression. [Your explanation in Lesson 4 on Say’s Law, and how it was validated, not undermined, by the Crash of ‘29] sounds good. It makes a lot of sense and would seem to resolve the major instance of where Say’s Law appears to have broken down and which shifted the economics profession to the cult of Keynes.  I have a couple of questions involving the evidence supporting your conclusion however.

The trade deficit of 1928 was only $1 billion. Why wouldn’t or, more accurately, why didn’t production efforts simply shift capital to domestic production that had previously been the market territory of the rest of the world in response to the tariff?  If your answer is that it reduced the number of producers that those in the U.S. could trade their products with, which it did, why is this not a repudiation of Say’s Law also?  In other words, since production at home should have kept the domestic economy going by doing what it had always been doing, producing, why would the economy not simply continue doing so and maybe ever start producing those things at home the tariffs exclude foreign producers from now providing?  Admittedly, long-term rates of economic expansion would be lower because there would be less producers to trade with and less competitive pressures on U.S. producers, but why the incredibly deep and lengthy slump, even after the repeal of the tariff in 1932?  Shouldn't the economy have recovered?

Wanniski: Excellent question, although you err in stating that the tariff was repealed in 1932. It was not. When Smoot-Hawley passed, the tariff wall caused goods destined for the rest of the world (ROW) to pile up on our side of the wall and goods from the ROW to pile up on the other side of the wall. This would mean only a recession, during the period when these surpluses were being liquidated and production redirected internally. The “Crash” only brought market capitalization down by one-third, the Dow tumbling to 230 from 380. In fact, Treasury Secretary Andrew Mellon, who was a holdover from the Harding and Coolidge administrations, advised that capital be liquidated and labor liquidated as soon as possible. (If it had been up to Mellon, there would have been no tariff act, or it would have been very narrowly drawn to affect only farm goods, which is all Hoover promised in the 1928 elections.) The problem was that first the error was compounded by foreign retaliation, which sent the Dow Jones average lower and lower. Then, it was multiplied as Hoover raised tax rates in order to balance the budget, as revenues had fallen sharply, principally because of the decline in tariff revenues. The U.S. economy spiraled and brought the world economy down with it. I covered this in some detail in Chapter VII of The Way the World Works, explaining why the Dow did not stop falling until it hit 41, in the summer of 1932. It really could use an entire book from this vantage point, which one of you may write some day. (One of our students informs me he is doing his doctoral thesis in Political Science on these issues.) By the way, Smoot-Hawley is still the basic tariff law of the United States, but it has been so riddled with loopholes during the past 60 years through bilateral agreements that only a few nations -- North Korea being one  -- do not get Most Favored Nation treatment.

To the point you make about Keynes and whether or not demand-side policies are ever correct I could answer that the summation of Keynesianism could easily be Always cut taxes in a depression and always cut spending in a boom. This formula flows from a demand framework, but it also works beautifully in a supply framework. Keynes himself believed a tax rate of 25% was about as high as you could go without inviting revenue loss. The problem with a demand model occurs when its practitioners urge a variation of the Keynesian model: Always raise spending in a depression and raise taxes in a boom. In the former case, government always tends to get smaller. In the latter, government tends to get bigger, which is what happened in the 20th century, because politicians of both parties have preferred larger government, no matter what they say in public.

Smoot-Hawley Revisited

Barkey: No one else had recognized the link of the Crash of ’29 to Smoot-Hawley and the newspapers you cite in TWTWW do not directly even hint at such a link.  Your conclusion is instead implied, as it must be.  Obviously for the link to have as great of an effect on the market as it did, a large number of investors would have to have acted on such a recognition.  Why didn’t their sentiments get registered in print anywhere?  This would seem to undercut your thesis.  I know that I would be whining to someone in a bar if I lost nearly everything because of some protectionist in Washington, and I know that I would be screaming at my local politician to fix it.  How do you reconcile the apparent lack of positive evidence for your thesis with its validity?

The economy was already slowing when the market crashed.  Employment and output began to decline in the summer of 1929, even before the stock market crashed in late October.  However, even after the crash, the business community was saying that little was wrong with the economy and that business conditions for 1930 looked good.  If the crash was a reply to the potential of a tariff, why would there be such positive sentiments held widely about the economy?  Even if people with great forethought remained quiet on pulling out of the stock market when the subcommittee stopped opposing the tariff, why would their sentiments turn positive in 1930 after the tariff had actually passed?  Have you done any new research on your Crash-Tariff linkage thesis or do you know of anyone else who has since the publication of TWTWW?  I would love to read it.  I’ll probably try to check it out myself.  I find it quite intriguing.

Wanniski: At the time of the Crash, economic theory fully supported the idea that the United States, as a creditor nation, could only be paid interest and principal by the ROW if we ran a trade deficit. For this reason, 1000 economists signed a letter to Herbert Hoover in the spring of 1930, urging him not to sign Smoot-Hawley. The idea that the broad financial markets would move up or down on any given day because of small information flows of a political nature was not yet conventional, though. It was obvious that when news of war would appear on the ticker there would be a turbulent readjustment This “efficient market” hypothesis did not take root until the 1960s and did not blossom until the 1970s, when I learned it from Art Laffer, who had picked it up at the University of Chicago where it had been developed. It was in knowing this argument that led me to assume that if I looked hard enough, I would find the cause of the Crash. I’d known that Smoot-Hawley was a contributing factor to the Depression, but not until I learned that Hoover signed it in 1930, not 1931, did I realize the key decisions could have been made by Congress in 1929, knowing each Congress begins in an odd-numbered year.

There of course would have to be people acting on the news for the market to move as it came across on the ticker, and of course bears are always looking for reasons to sell. When Smoot-Hawley passed the House in March, stocks swooned temporarily, without any comment on the connection between the two. There had to be people who knew conceptually why the market would have to fall with a higher tariff wall who would sell as the chances of the tariff passing would rise, or who at least would withdraw offers to buy. It does not take a great many people doing this to cause a dramatic sell-off. Prices do not fall because cash is withdrawn from the market, but because the market puts a lower value on the capital stock, which after all is a market entirely based on expectations. Think of a housing subdivision with units selling for $200,000, when news reaches the community that the subdivision is built on an environmentally dangerous plot of ground. Without one house changing hands, prices will crash. After my hypothesis was presented in October 1977, on the WSJournal editorial page, a reader subsequently advised me that in the biography of E.F. (Bud) Hutton, the founder of the Wall Street firm, the biographer notes that in 1929 Hutton, then a broker in Seattle, avoided the crash by selling out on news that the tariff act was making progress in Congress.

In 1979, without my knowledge, William Buckley of the National Review asked Alan Reynolds, then senior economist at First Chicago, to do a piece on why the market crashed in 1929. Reynolds decided to test my hypothesis himself, but used the Commercial and Financial Chronicle as his source. You can check your library for the NR that October, wherein Reynolds, who was then a protégé of Milton Friedman, affirms my hypothesis. I’ve simply not had the time it would take to do the work required to dig the story to its depths, as it would take years. Martin Anderson, who was Reagan’s chief White House economist and is now at the Hoover Institution at Stanford, a dozen years ago told me that the academic community silently accepts my thesis, but will not admit that a newspaperman discovered what academic professionals could not. “They are still trying to explain away the fact that Adam Smith did not have a Ph.D.,” he told me. These grumpy old academics only hurt their students by studiously ignoring the connection, which not only proves Say’s Law, but also the efficiency of the free market. John Kenneth Galbraith’s reigning hypothesis, that the Crash was an irrational puncturing of an irrational bubble, only perpetuates the idea that markets are inefficient and therefore have to be managed by governments.