Income Tax & Fed Created In 1913, Phil Mickelson Shrugs In 2013?

Phil Michelson

Don’t quite recall what happened in 1913? The Philadelphia Athletics’ World Series win that year didn’t make its mark? How about this, as I wrote in my book Econoclasts:

For all one hears about, say, 1914, 1929, 1945, 1968, 1989, and 2001, 1913 may well be the most important year in modern American—if not modern world—history. In 1913, the last three major reforms of the Progressive era were enacted: the direct election of senators; the federal income tax…; and the Federal Reserve System of central banking. Today, the direct election of senators is a footnote to history. The income tax and the Federal Reserve, however, have rather shaped life as we have known it in the century since 1913.

We always hear about how the President/Congress/the Fed chairman “runs” the economy. Experts intone about “fiscal policy” and “monetary policy,” when not the “fiscal-monetary policy mix.” Experts couldn’t do this before the momentous year of 1913, because the governmental institutions that make possible fiscal and monetary policy didn’t yet exist. It made for a thin market in experts.

Fiscal policy refers to the ability of the government to increase and decrease taxes and spending in order to achieve some general economic result. In the classic “Keynesian” formulation, cuts in taxes and increases in spending on the part of the government can transform a recession in the economy as a whole into a boom.

It might be suggested that the income-tax power conferred in 1913 was not necessary for the federal government to conduct fiscal policy, in that spending was enshrined in the Constitution of 1789. And there were other tax powers, above all the tariff.

But as long experience in the hundred some years prior to 1913 had shown, tariff rates often could not be raised without heavy losses in receipts: what is known as the Laffer-curve effect. As the great political historian Phil Magness has shown, by 1913 it was clear that any increase in tariff rates would result in less revenue to the government, in that foreigners would stop shipping goods for sale in the United States if the markup got too high. And this is when taxes had to cover total federal expenditures less than 3% of GDP.

So a new device, an income tax was necessary to actualize fiscal policy. Yet income-tax rates would soon be discovered to have an effective upper limit of their own. Take them up too high, say to 77%, where the top rate stood as early as 1918, and receipts to the government will top out and sink. It really was no different from the tariff. People will stop earning money—at least that kind of money that has to be reported on a tax return—if rates get punishing. Just the other day, the golfer Phil Mickelson provided an illustration of this effect in his own case.

Here is where the Fed comes in. If the tax system loses its ability to rake in revenue, and thus deprives the government of the resources it needs to conduct fiscal policy through spending, the Fed can buy government bonds to cover the extra.

It’s funny that the income tax and the Fed were created in the same year. You would think, in theory, that the income tax would prove sufficient to enable federal spending. But since Atlas does in fact shrug, an insurance policy was necessary. The Fed would be there to finance whatever spending even the most exacting taxes can’t pay for.

Not that all of this was totally discernible at the time, in the political hurly-burly of 1913, that last blessed year before the world-crisis of 1914. As these institutions, the income tax and the Fed, matured as “the new kids on the block” (to borrow a phrase used in this context by Robert A. Mundell in his Nobel Prize lecture of 1999), it became apparent that this was the clever game that could be played. Taxes could finance spending up to a maximum point, and then the Fed could finance even more.

“Fiscal policy” and “monetary policy” are therefore misnomers. The whole thing is fiscal policy. Sure enough, government spending rocketed up above the 2%-of-GDP-standard that had held for a century and a quarter before 1913, going up ten-fold in World War I, then sinking back to the norm in the prosperous 1920s, and then using the opportunity of the 1930s to stage a leap up to 10%, then 15% in the 1950s, 20% in the 1970s, and now about 25% in the 2010s.

These days, sure enough, we have witnessed (just two weeks ago!) the efforts of the Congress and the President to max out on tax increases to cover big spending. While it will all prove insufficient, there stands the Fed with its most helpful posture of “Quantitative Easing.”

In March we shall hit the anniversary of the income tax, in December that of the Fed. They will be occasions to talk about the strangely lower growth performance of the last hundred years compared to the earlier century and a quarter, and about vastly greater incidents of vicissitudes, including Great Depressions, Great Recessions, and Great Inflations that proved new to the historical experience.

N.B., a paper I wrote for the Laffer Center for Supply-Side Economics on the phenomenon discussed in this column may be found here.

Books mentioned in this essay may be found in The Imaginative Conservative Bookstore. Originally published at Forbes.com the essay is reprinted here with gracious permission of Brian Domitrovic.