Slashing Taxes Is Good for What Ails Us

It worked for the French peasants in 1800. It worked for the Italians in the Great Depression. It's working for the Japanese right now.

Just a few months ago, when news of California's tax-slashing Jarvis-Gann initiative began to spread across the continent, it wasn't taken very seriously. And indeed, there seemed little reason why it should be: it strove, not to "put a limit" on California property taxes, not even to cut them back by a modest figure, but to slash them by an average of 65 percent! To the establishment who bitterly opposed it, Proposition 13 sounded at first like only a bad joke, but as it turned out, 65 percent was approximately the proportion of the voters that embraced it.

Since its passage in June, other states are quickly readying their own versions of tax reduction. On a national level, the Republican Party announced on July 6 that it would incorporate into its platform for the coming congressional elections a plank calling for a one-third reduction in the federal income tax, to be administered across-the-board. When Howard Jarvis, the coauthor of Proposition 13, came to Washington shortly after June's referendum, he was mobbed by congressmen who wanted to have their pictures taken while embracing him.

This is certainly a turnabout from the vicious scare campaign waged by the establishment in the weeks just preceding the election. Cutting taxes so deeply, they said, would cause a depression; some even claimed that businesses would flee California and that none would expand into the state. As the tax revolt spreads across the United States, a concerted effort on the part of government employees will surely be made to stop it. They will bring up these arguments, and more.

TAXES HAVE CONSEQUENCES John C. Calhoun, vice-president under Andrew Jackson, pointed out with dazzling clarity that however small the government might be, and however small might be the tax burden, the very existence of taxation itself creates two unequal and inherently conflicting classes in society: those who, on net, pay the taxes (the "tax payers") and those who, on net, live off the taxes (the "tax consumers"). It should be clear that, regardless of legal form, bureaucrats pay no taxes; they consume taxes. Additional beneficiaries of taxes are those in society subsidized by the government, be they armament manufacturers or common welfare recipients. Once a State has cemented a large group of both its members and its subsidized adherents to its cause, it can usually count on the apathy and ignorance of the remainder of the public—usually, but definitely not when the populace is continually buffeted by steep and increasing taxes. This is, fortunately, what is happening today.

Taxation always has a twofold effect: it distorts the allocation of resources in the society, so that consumers can no longer most efficiently satisfy their wants, and it severs the production of goods from their distribution. This is true of any sort of tax, be it sales tax, property tax, or income tax, either progressive or proportional in type.

The higher the tax is, the more the producers are crippled at the expense of non-producers. Hence, the higher the level of taxation, the lower will be both the level of production and the standard of living. It should be enlightening to turn to a series of case studies that demonstrate the above.

FRENCH TAX REVOLT: 1789 The French Revolution was caused, in large measure, by crushing taxes. By 1789, the year the Parisian mob sacked the Bastille, the French peasant was clearly being looted beyond the limits of his endurance. On 100 francs of income, he paid 53 to the State, 14 to the Church, and 14 to his seigneur, his lord of the manor. This adds up to 81 percent; he kept less than 20 percent for himself. Ten years after it began, Napoleon gained control of the revolution, and he was wise enough to reverse the situation. As a result of one of his first actions, by 1800 the same peasant paid nothing to the Church, nothing to his local lord, only a pittance to the State, and 25 percent to his commune and departement, his village and province. Thus, out of 100 francs of income, 70 remained in his own pocket.

Napoleon did this against the advice of all the "official" economists of his day; in fact, he refused even to talk to them. With sterling common sense he wrote to his brother Lucien on Christmas Day, 1799, that, "While an individual owner, with a personal interest in his property, is always wide awake, and brings his plans to fruition, communal interest is inherently sleepy and unproductive." Not surprisingly, the greatly lowered taxes unleashed the tremendous productive capabilities of the French people, and Napoleon was able to conquer most of continental Europe with that wealth behind him.

It was his actions against the free market that contributed to his eventual defeat, even setting aside the tremendous waste entailed in those wars. Unfortunately, Napoleon didn't realize that international trade benefits everyone, and when he put a comprehensive embargo on English goods, he invited the "disobedience" of his allies. Russia continued to trade with Britain—this was the cause of Napoleon's ill-fated Russian campaign, which gave him a defeat from which he never recovered. Further, while the emperor lowered taxes—and raised his popularity—at home, he taxed his conquered lands to the hilt. When those resources finally stopped producing, he turned back to the French and piled new taxes on them. This, in addition to the steady drain of French sons for war, was too much. He lost the support of his subjects even before Waterloo, in 1815.

THE PAX BRITANNICA At the close of the Napoleonic wars, Great Britain was the strongest nation on earth and ready to become the richest in history. But while this is apparent to us now, it didn't seem so at the time. For by war's end, Britain was reeling under a massive public debt of almost one billion pounds, an inflation unprecedented in her history, and a staggering tax-rate system. In 1820 the Edinburgh Review had this to say on how everyday life had been infiltrated by taxes: "The schoolboy whips his taxed top; the beardless youth rides his taxed horse, with a taxed bridle, on a taxed road; and the dying Englishman, pouring his medicine, which has paid [i.e., has been taxed] 7 percent, into a spoon that has paid 15 percent, flings himself upon his chintz bed, which has paid 22 percent, and expires into the arms of an apothecary, who has a license of 100 pounds for the privilege of putting him to death. His whole property is then immediately taxed from 2 to 10 percent. Besides the probate, large fees are demanded for burying him in the chancel. His virtues are handed down to posterity on taxed marble, and he will then be gathered to his fathers to be taxed no more."

Fortunately, the British Parliament acted. In the years immediately following the war, the income tax was abolished even though it had been responsible for a fifth of all revenues. Not surprisingly, between 1815 and 1851 there occurred the most rapid economic development of domestic resources in British economic history. By 1860 she was producing half the world's output of coal and manufactured goods. Britain had become not only the world's workshop but its banker and trader as well. Further, the problems that had loomed so large in 1815 evaporated. Prices tumbled and then continued to decline gently throughout the rest of the century. And the public debt, which had been growing for over a century, was gradually chiseled down, by 40 percent at the century's close. And such tariffs as the Corn Laws, which had for so long caused misery and even (in Ireland) starvation, were eliminated.

In the light of these policies it is no wonder that the 19th century belonged to Britain. The same, alas, cannot be said of the 20th. After the First World War British politicians did everything that their ancestors a century before did not do. Income taxes, which had been very nearly proportional, with everyone paying the same percentage, became progressive, and steep. There was no postwar economic expansion. In fact, Britain staggered through the 1920s in deep recession, if not, indeed, outright depression. By 1931 Britain had lost faith in the "free-market" principles she held responsible for her plight, went off gold, and reerected tariffs. England's economic history since then makes for sad reading.

AMERICA CUTS TAXES In the years just preceding World War I, the wartime Wilson administration had imposed high tax rates—an excess profits tax on business, a doubling of the normal corporate rate to 12 percent, and sharp increases in personal income tax rates, the tax which had only come into being three years before. The "old" 15 percent rate on incomes of $2 million and above gave way to a 77 percent rate on incomes above $1 million. The lowest bracket, 2 percent on $20,000, became a 6 percent rate on only $4,000. At war's end, the Democrats in power left these rates in force.

During the 1920 elections, Republican presidential candidate Warren Harding told the GOP convention, "I believe the tax burdens imposed for the war emergency must be revised to the needs of peace." He won the presidency by the greatest landslide then experienced. Harding kept his promise. The wartime excess profits tax was abolished, and Treasury Secretary Andrew Mellon pushed for a slashing of the top tax bracket from 77 percent to 25 percent. Congress was reluctant at first to take such bold action but acted in concert with him as it saw the beneficial effects on production of the gradual tax cuts. In 1922 the top rate was lowered to 56 percent, 46 percent in 1924, and finally to 25 percent in 1925. By 1929 the top tax rate was 24 percent, the lowest one was a bare three-eighths of one percent.

Consequently, the decade of the 1920s was among the most productive in American history—so much so that even the massive inflation being perpetrated by the government during those years did not have the effect of raising prices absolutely, although the credit expansion did raise prices relative to what they would have been otherwise. Prices would have dropped sharply over the decade because of this increased productivity, had it not been for the inflation. But regardless of whether consumer prices rose absolutely as well as relatively, the inflation caused the boom-bust cycle that was responsible for the Great Depression.

"IL MIRACOLO ITALIANO" The Great Depression was a world depression, but during the 1930s Italy suffered much less contraction than the other industrial nations. This good performance was watched by Hitler and Roosevelt, who—misunderstanding the cause of the success and attributing it to the corporate-state fascism where government and business joined together against laissez-faire—sought to incorporate these elements into their own economies.

The enchantment with Mussolini's corporatism was misplaced. He was not practicing what he preached. The true cause of the "Italian miracle" was his remarkably free-market policies—at least until 1935—while keeping the form of fascism. Soon after Mussolini attained power in 1922, he appointed Alberto de Stefani as finance minister. De Stefani quickly instituted a policy whereby public enterprise gave way to private initiative wherever possible. Public controls over production were abolished, and taxes were slashed. Added to this, a hard-money policy was instituted.

This program lasted throughout the '20s and early '30s. Not until late 1935 did Mussolini seriously begin chipping away at it, and when he raised taxes a year later to finance his invasion of Ethiopia, the economy soured. He imposed more taxes in October 1937, and his popular support plummeted with the economy.

INDIA BOOMS When Indira Gandhi suspended democratic rule and civil liberties three summers ago, the world was not prepared for the display of economic health that followed. Inflation dropped and the rupee rose on foreign exchange markets. Production increased dramatically. Some superficial observers believed that the dictatorship was actually good for India. But certainly, the censorship and numerous' prison terms by themselves would have insured revolution or at least guerrilla warfare.

Generally unnoticed and unreported in the West, however, were the policies of Gandhi's finance minister, C. Subramaniam, who used the suspension of Parliament to push through his pet scheme of lowering taxes. Not only was the 12 percent surtax removed, but the top rates were twice hacked at: They went from 85 percent to 77 percent and then to 66 percent in a matter of months. Other brackets were likewise adjusted. Whereas the 60 percent bracket was reached at $5,000 before, it was changed to $10,000. The wealth tax had been at 8 percent but was slashed to 2½ percent. The urban property wealth tax, which had ranged from 5 to 7 percent, was abolished entirely. Corporate tax rates were cut, and progressive taxes on investment and royalty income yielded to proportional rates.

These decrees had almost instant effects. Price inflation, which had been running at 30 percent annually, fell to 10 percent, and a real growth rate of 3 percent was registered in the following six months (the last half of 1975)—a period of contraction elsewhere in the world. Excess crops came in from the farms in a land where starvation is always just around the comer. Real growth registered a striking 10 percent rise during 1976, and during this year the consumer price index declined. Foreign reserves piled up at the rate of $150 million per month, even as India's bill for imported oil doubled.

Unfortunately for Mrs. Gandhi, she never realized that it was her finance minister's policies, and not her dictatorial actions, that had caused her upswing in popularity. Accordingly, instead of cutting taxes still further, she began new spending programs. This, added to such heavy-handed and authoritarian policies as her forced birth-control program, was enough to get her pitched out of office when she called elections in early 1977. Almost her entire cabinet was thrown out along with her (for they must stand for reelection, too, in India). Interestingly, Finance Minister Subramaniam was one of the few Congress Party members returned to his seat in Parliament.

A TALE OF TWO MIRACLES Germany found herself at war's end with almost unbelievably high tax rates, a legacy from the Nazi era. At an annual income of $600, a German paid fully 50 percent of it in taxes. The top bracket was a punishing 95 percent rate on incomes exceeding $15,000. On June 22, 1948, Finance Minister Ludwig Erhard announced cuts that pushed the "lowest" 50 percent rate up to $2,200 and the 95 percent rate to $63,000. Reforms continued, until by 1955, the 50 percent bracket had been pushed up to $42,000 and the top bracket to $250,000, with the top rate slashed to 63 percent. Still another tax reform took place in 1958. This one exempted the first $400 of income altogether, cut further in the middle brackets, and brought the top rate down to 53 percent.

During this time, the tax rate on dividend income had fallen from 65 percent to 15 percent. And to cap all this off, the mark was stabilized and kept scarce, and the wartime controls on production were swept away. All of these reforms, incidentally, took place against the wishes of the Keynesian American advisors sent to plague Erhard. He succeeded in circumventing them, however: he announced his abolition of economic controls on a quiet Sunday, when scarcely anyone was watching. The tremendous economic progress made by Germany since World War II speaks for the success of these moves.

Postwar Japan freed up her economy and productive capabilities by a different process, which still yielded the same result. Instead of actually lowering the tax rates, the tax code there was punctured with loopholes.

The occupying American forces, along with giving Japan a US-style constitution, gave Japan in 1947 a US-style progressive tax system. The 85 percent rate was reached at $14,000, with the result that the Japanese economy was, in the words of one commentator, "going nowhere fast." This should serve as a reminder that there is nothing inherently industrious about the Japanese people; when crippled by taxes, they, too, stop producing.

The American response to this economic stagnation was to send over in 1949 a team of professors who recommended an overhaul of the system that would have meant even higher taxes! The Japanese accepted the American plan but proceeded to exempt huge slabs of income from any taxation at all. So even though the top Japanese tax bite is 93 percent on income above $300,000, there are so many exemptions that this nominal rate almost never applies.

Instead of creating huge government bureaucracies to distribute social services, businesses themselves provide the services to their employees and are allowed to count these as business expenses. The first $40,000 of pension payments are tax free. Gift and estate taxes are high, but because the tax is levied on the heirs after an estate has been subdivided, only rarely is an estate taxed at the high rates. Wealthy Japanese need only adopt children to avoid paying the higher tax rates on estates that apply to non-children. Often these "children" are the grown sons of friends or "poor but promising" students.

Most remarkable of all, the Japanese have cut taxes on either personal or business income every single year since 1950, either outright or through loopholes. From 1950 to 1974, Japan cut tax rates by roughly 11 percent annually. Over these years the reductions usually have been made with the argument that they would encourage savings. They have done that, but they have also boosted production. Japan's Gross National Product has skyrocketed from $16 billion in 1952 to $300 billion in 1972, a 19-fold increase.

From even this brief summary, it should be clear that, far from the cry of the tax-consuming hordes against Proposition 13, cutting taxes will not cause a depression; it will rather cause living standards to spurt.

Fortunately, however, the tide is with those who want to cut taxes. But, paradoxical as it may at first appear, the greatest obstacle to true tax reform are those tax cutters whose ideas are currently influential.

In its July 3 issue, Newsweek magazine called Dr. Arthur Laffer of the USC School of Business Administration the "guru of the tax revolt." The "Laffer Curve" is an idea rapidly gaining currency both in Congress, where Republican Congressman Jack Kemp of New York is pushing it on the floor, and in the media, where Mr. Jude Wanniski of the Wall Street Journal is advocating it. Briefly, the Laffer Curve refers to the idea that taxes could be easily lowered—and give even more revenue to the government. Here's how the Lafferites think: production will be stifled at high levels of taxation. In fact, put taxes too high and production ceases. By traveling "down the curve" to lower taxes, production increases and there is more to tax. The trick is to find just that level of taxation at which the economy is producing at an optimal level while rendering the greatest possible revenue to government.

Our view, on the other hand, is that we have no interest in a plan that seeks as its objective to strengthen the State, that instrument of coercion and destruction. The historical experience clearly shows that reducing taxes is good for people. What it does to government revenues cannot give any fundamental support to the tax revolt.

Mr. Weber is a contributing editor to World Market Perspective, from which this article is adapted. Copyright 1978 by ERC Publishing Co., Box 91491, West Vancouver, BC, Canada V7V 3P2.