Unless action is taken soon, the United States is set to undergo one of the largest series of tax increases in the past half-century. The rapid rise in U.S. federal government spending over the past decade has been even more troubling. If the past century has taught us anything, it’s that high spending and high taxes are a recipe for economic disaster. Yet this is the course our newly re-elected president seems to favor, and it will leave him with a very tarnished legacy.
President Wilson’s second term provides the clearest evidence of how disastrous this path can be. From 1915 to 1921, the top marginal income tax rate was raised from 7 percent to 73 percent. Meanwhile, total government spending in the United States increased from around 8 percent of gross domestic product in 1915 to 30 percent of GDP by 1919. While that dropped a bit after the end of World War I, it still remained significantly higher than it had been before, at about 15 percent of GDP, by the end of Wilson’s second term. These figures include state spending, but the federal government was responsible for most of the increase.
Wilson’s massive government expansion helped lead to one of the most severe contractions in American history — the Depression of 1920-21. This is where things get interesting. There was a massive backlash against Wilson’s policies, resulting in the Republican landslide election of 1920. The Republicans responded to the crisis by dramatically lowering taxes and spending. U.S. government spending fell from 15 percent of GDP to 11 percent in a few short years. The top marginal income tax rate likewise fell from 73 percent to 25 percent.
Partly as a result of these reversals in policy, the United States had one of the greatest economic expansions in history. After factoring in inflation, America’s annualized real GDP growth was a paltry 1.0 percent during Wilson’s eight years in office. It then shot up to 4.4 percent from 1921 to 1929 after the policy reversals. It’s difficult to find a more authoritative rebuke of big-government policies than that.
Of course, we all know that 1929 brought poor fortunes. Largely as a result of flawed policies of the Federal Reserve Bank, we found ourselves in the midst of another contraction. In 1921, the crisis was solved by shrinking government, lowering taxes and reducing regulations. In 1929, however, President Hoover took the exact opposite approach. Instead of freeing up capital with lower tax rates and decreasing government spending, the Hoover administration dramatically increased the size of government in an attempt to “stimulate” the economy. This eventually was followed by a series of massive tax increases.
Government spending stood at about 11 percent of GDP at the beginning of Hoover’s single term in office. By the end of that term, it had doubled to 22 percent of GDP. In order to finance this large expansion in government, Hoover increased the top income tax rate from 25 percent to 63 percent. The result was a severe depression that only seemed to get worse as time went on. If the Great Depression seemed unique, it was. Every single other recession or depression since the Civil War had shifted to recovery within a few years. The Great Depression stood apart as the one that did not correct itself, and that was largely because of the massive interventions by the Hoover administration. We can see clear contrasts in the failures of Woodrow Wilson and Herbert Hoover versus the success of 1921 to 1929.
We are at another crossroads. Four years removed from the beginning of the current financial crisis, things haven’t improved much. Once you count “discouraged workers” who are excluded from official unemployment figures, our true unemployment rate is likely somewhere near 10 percent, even higher than it was when President Obama took office at the height of the recession. Real wage improvement has been stagnant, and new regulations such as Dodd-Frank and Obamacare have significantly harmed hiring.
If the president does not act, the top income tax rate is set to rise from 35 percent to 39.6 percent, while the top capital gains tax rate will increase from 15 percent to 23.8 percent. Perhaps most astonishing, the top dividend tax rate will jump from 15 percent to 43.8 percent. Meanwhile, federal government spending has skyrocketed from 18.1 percent of GDP in 2000 to approximately 25 percent of GDP today, with much of that increase attributed to the president.
Mr. Obama is faced with a choice. The question is, will he use reason and follow the examples of the 1921 Republicans, John F. Kennedy and Ronald Reagan, or will he repeat the same mistakes as Herbert Hoover and Woodrow Wilson? I hope for the former, but fear that the latter is inevitable.
Jake Huneycutt is an investment manager in Atlanta.