Jude Wanniski: Taxes and a Two-Santa Theory

In 1976, Jude Wanniski was an editorial writer for the Wall Street Journal who had lately learned about supply-side economics from Robert Mundell and Arthur Laffer. Wanniski had already started work on his book, “The Way the World Works,” that would be published by Basic Books in 1978. Among the books that heavily influenced his thinking was Herb Stein’s “Fiscal Revolution in America,” a magnificent history of fiscal policy in America published by the University of Chicago Press in 1969. Jude once told me that the first time he ever heard about the idea that tax rate reduction might raise revenue was from reading Stein’s book, in its discussion of Republicans’ tax cuts of the 1920s.

The following article reflects an early effort by Wanniski to create a narrative history of fiscal policy similar to Stein’s, but which emphasized tax policy. (Stein had been more concerned with the spread of Keynesian economic theories.) I am reproducing it here because Jude’s article was profoundly influential among Republicans in Congress in the late 1970s. The copy I have is a reprint Jack Kemp made to hand out to those interested in knowing what supply-side economics was all about. Unfortunately, Jude’s essay has long been inaccessible because the newspaper in which it appeared folded in 1977 and has never been made available in any online newspaper databases to my knowledge. (The National Observe was sort of a weekly news magazine in newspaper format that was published by Dow Jones on presses that would otherwise be idle on the day neither the Wall Street Journal or Barron’s was being printed.)

Because of the historical importance of Wanniski’s article–echoes of which can still be heard in Republican tax cut rhetoric–I am making it available to a wider audience. I retyped it myself from a rather grainy copy. I’ve done my best to reproduce it exactly as it was printed. Bruce Bartlett

National Observer
March 6, 1976

Taxes and a Two-Santa Theory
By Jude Wanniski

The only thing wrong with the U.S. economy is the failure of the Republican Party to play Santa Claus. The only thing wrong with President Ford is that he is still too much a Hoover Republican when what the country needs is a Coolidge Republican.

These statements, seemingly absurd, follow naturally from the Two-Santa Claus Theory of the political economy. Simply stated, the Two Santa Claus Theory is this: For the U.S. economy to be healthy and growing, there must be a division of labor between Democrats and Republicans; each must be a different kind of Santa Claus.

The Democrats, the party of income redistribution, are best suited for the role of Spending Santa Claus. The Republicans, traditionally the party of income growth, should be the Santa Claus of Tax Reduction. It has been the failure of the GOP to stick to this traditional role that has caused much of the nation’s economic misery. Only the shrewdness of the Democrats, who have kindly agreed to play both Santa Clauses during critical periods, has saved the nation from even greater misery.

It isn’t that Republicans don’t enjoy cutting taxes. They love it. But there is something in the Republican chemistry that causes the GOP to become hypnotized by the prospect of an imbalanced budget. Static analysis tells them taxes can’t be cut or inflation will result. They either argue for a tax hike to dampen inflation when the economy is in a boom or demand spending cuts to balance the budget when the economy is in recession.

An Earlier Heyday

Either way, of course, they embrace the role of Scrooge, playing into the hands of the Democrats, who know the first rule of successful politics is Never Shoot Santa Claus. The political tension in the market place of ideas must be between tax reduction and spending increases, and as long as Republicans have insisted on balanced budgets, their influence as a party has shriveled, and budgets have been imbalanced.

They were not always so dumb. The GOP’s heyday was in the 1920s, when, acting on the advice of Treasury Secretary Andrew Mellon—who served Presidents Harding, Coolidge, and Hoover—the Republicans cut tax rates no less than five times. Mellon, the embodiment of the Republican Santa Claus, argued that a cut in tax rates would provide business an incentive to expand, increase prosperity, expand the tax base, and thereby provide more revenues to the Government than would have accrued without a tax cut.

Mellon pointed out that the 65 per cent surtax on excess profits, enacted by the Democrats to finance World War I, had yielded $2.5 billion in 1918, but, in driving the economy into a recession, brought in only $335 million in 1921. He asserted that high taxes are self-defeating. Experience proved him exactly correct.

The Roaring Twenties

In 1921, over the screams of congressional liberals, he pushed through a cut in the personal income surtax in the highest brackets, to 50 per cent from the 65 per cent maximum, and an elimination of the excess-profits tax. The economy leaped out of recession, tax revenues poured into the Treasury, and by 1924 Mellon was ready for another cut, this time driving the surtax maximum to 40 per cent and putting a 40 per cent lid on inheritance taxes. The Twenties Roared.

“Any man of energy and initiative in this country can get what he wants out of life,” Mellon asserted. “But when that initiative is crippled by legislation or by a tax system which denies him the right to receive a reasonable share of his earnings, then he will no longer exert himself, and the country will be deprived of the energy on which its continued greatness depends.”

Mellon didn’t fool around. As national productivity galloped ahead, consumer prices fell, employment expanded, and revenue increased. Coolidge staked the 1924 election on Mellon’s proposal to cut the surtax to 25 per cent and the inheritance tax to a top of 25 per cent, with an 80 per cent credit against state inheritance levies.

A Coolidge Landslide

The New York Times, which in those days preferred income growth to income distribution, editorialized: “Languid critics may say there is nothing inspiring in humdrum projects to enforce Government economy and lighten the burdens of taxation. But they can say this only if they lack the imagination to perceive what Mr. Mellon actually means. It would lighten the demands upon millions of purses hard to fill. It would not only do away with oppressive taxes. It would lower the cost of living. It would release capital for productive industry and enterprise of all kinds. This would result in fuller employment of labor, multiplication of goods in common consumption, and probably bring about a period of great and legitimate expansion of industry and commerce never surpassed in the United States.”

Coolidge was elected in a landslide, and the Congress that swept in with him had to be restrained by Mellon from cutting tax rates deeper than he had proposed. The next four years were as glorious as the Times had forecast. The low tax rates not only produced an enormous expansion of the economy, with real per capita income increases approaching 4 per cent a year, but they also produced sufficient revenue to pay off almost a third of the national debt, slicing it back to $17 billion by 1928. In eight years American productivity—output per man-hour—increased by 30 per cent.

During those glorious years, Secretary of Commerce Herbert Hoover had nothing much to do but co-ordinate disaster-relief projects, winning national acclaim for his kind heart and compassion. Hoover and Mellon were not mutual admirers, and after Hoover’s 1928 election Mellon stayed on at Treasury only because Hoover could not fire a national Republican hero. But it was broadcast that Treasury Undersecretary Ogden Mills, a Hoover man appointed without consulting Mellon, would call the shots.

Shaky World Economy

Seven months after Hoover took office the stock market crashed, not the result of fiscal policy, but of economic contraction in Europe and a rapid unwinding of most of the stock-market loans that had been built on the excessive monetary policies of the Federal Reserve. Hoover turned away from Mellon, who had advised: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate,” meaning the Government should keep hands off and let prices fall to a new equilibrium that would provide a sound foundation for recovery.

“Secretary Mellon was not hard-hearted,” Hoover wrote in his memoirs. “In fact he was generous and sympathetic with all suffering. He felt there would be less suffering if his course were pursued. The real trouble with him was that he insisted that this was just an ordinary boom-slump.…”

Hoover did everything he could think of to slow liquidation. He got businessmen to pledge to hold on to uneconomic labor and to sustain un economic wage rates. He tried to prop up farm prices. He argued for expansion of Federal Reserve credit. And he signed the Hawley-Smoot Tariff Act to protect American labor, thereby causing a further contraction of the world economy.”

Balancing the Budget

But these measures only delayed liquidation and were probably offset to a degree by a 1 per cent cut in the corporate tax rate in 1930. By March 1931 the New York Times could suggest that the economy seemed to have gotten over the worst of the recession and recover lay ahead. But through the summer, another outburst of trade wars in Europe caused further global economic contractions, and in September Great Britain went off the gold standard, adding currency warfare to the equation.

On the heels of Britain’s decision, Hoover decided that the $2 billion in revenues lost during the recession had to be recovered so the budget could be balanced. He boosted taxes on “luxuries and nonessentials,” raised the inheritance tax to 45 per cent from 23 per cent, raised the income tax to 45 per cent from 23 per cent, and imposed a 15 per cent corporate tax rate. The Republican Congress enacted these measures in the summer of 1932 going into the teeth of the Presidential elections, banks failing left and right, and the stock market reeling.

Franklin Roosevelt, the prototype of the Democratic Spending Santa Claus, was elected. But instead of just boosting Federal spending, pump priming as it was called, Roosevelt boosted tax rates too. In four years he pushed the rate beyond where they had been in 1920, putting the highest marginal tax rate to 92 per cent. The Roosevelt prescription was “tax and tax, spend and spend, elect and elect.” The idea, perfectly suited to a Santa Claus who prefers income redistribution to growth, was to tax money away from the well-to-do, because they were not spending it fast enough, and spend it for them.

Congress Cuts Taxes

Not only didn’t conditions improve, but the big tax hike of 1936 inspired the recession of 1937, the recession within the Depression , and altogether the Roosevelt policies kept the Depression going for eight years. The drag of Roosevelt’s tax policies became so obvious that in May 1938, over FDR’s protests, Republicans and Southern Democrats in Congress forced repeal of the 1936 tax on “undistributed profits” and cut the corporate tax rate. The recession officially bottomed out the following month.

To this day, the two main economic theories that attempt to explain the Great Depression ignore or underestimate the impact of the steady increase in tax rates. The Keynesians either argue that Roosevelt did not tax or spend enough or simply that he did not spend enough. The monetarists, led by Milton Friedman, believe everything would have been wonderful if the Federal Reserve in 1930 and 1931 had printed a lot of money.

Keynesians like to argue that spending. Pure and simple, brought prosperity during World War II. But the U.S. economy revived first because the European powers liquidated wealth to wage war, spending that wealth on U.S. exports of munitions and materiel. Second, the United States financed its own effort chiefly through bond sales, not steep tax-rate increases. Most important, the “tax” on business through bureaucratic red tape and regulation that also flourished under the New Deal was ended as businessmen came to Washington to run the war-mobilization effort. In addition, industry could write off against taxes all war-related capital expansion; national survival made it necessary for the Government to permit producers to keep a reasonable share of their earnings.

Recovery Under Truman

After V-J Day in 1945, the Democratic liberals made a pitch to keep the high nominal tax rates up to pre-war levels, along with an end to tax write-offs, of course. Liberals warned that unemployment would go to 10 million unless the Government taxed and spent on social desirables. But taxes were cut sharply. President Truman wisely liquidated war contracts on the word of the contractors instead of harassing them with tax audits. And recovery ensued.

As in Mellon’s day, the lower tax rates produced expanded revenues, and the Republicans, led by Sen. Robert A. Taft of Ohio, demanded another tax cut. The Keynesian economists, who by this time dominated both the academic community and Washington policy makers, predicted a worsening of inflation if the Taft tax cut of $5 billion were enacted. It was enacted in 1948, over Truman’s veto, and inflation came to a halt. The Keynesians to this day have explanations of why the tax cut should have produced a rampant inflation.

The Korean War upset Republican plans to cut taxes again in 1950, but in the tradition of Herbert Hoover, Dwight Eisenhower shot Santa Claus in January 1953. As in 1931, the GOP forgot Mellon’s advice and sought to balance the budget, hoping to end the deficits of the Korean War years. The Republican chairman of the House Ways and Means Committee, Daniel Reed, introduced H.R. 1, a general tax-reduction bill, but Eisenhower’s economic advisers argued that it would be fiscally irresponsible, and Ike asked Reed to withdraw the bill. In the 1958 recession , Eisenhower again stoically rejected calls for a tax cut by members of his won party.

Economic Role Reversal

As a result, there were eight years of Eisenhower economic stagnation. In 1953, as in 1931, the GOP brain trust insisted the tax cut would mean a deficit. The deficit would have to be financed with Treasury bond sales. And these sales would “crowd out” private borrowers from the capital market. In 1974 Treasury Secretary Simon made the same arguments in inveighing against tax cuts.

Ignoring these kinds of arguments, Presidents Kennedy and Johnson got the economy moving again by slashing taxes $20 billion between 1962 and 1965, doing the job the GOP Santa Claus should have done.

But as business expanded and the tax base grew, the Democrats spent the increased revenues that poured into the Treasury. The Great Society programs of 1965 through 1968 were financed by these tax cuts. So was the increased spending for the Vietnam War. The Democrats realized that the Republicans would never call for a tax cut unless the Federal budget were in surplus, so they engineered their spending programs in a way that would guarantee spending would always outrun revenues.

Republicans Play Scrooge

The typical Great Society legislation that passed in 1965 and 1966 called for spending a few dollars the first year, $1 million or so the second year, and $1 billion in the third. The Democrats were spending anticipated revenues. Throughout the period, Republicans continued to play Scrooge, carping against increased spending without ever offering the obvious alternative to tax reduction. Even with a Republican back in the White House in 1969, it was the Democrats who pushed tax reduction in the face of continuing deficits. In 1969 and in 1971, tax cuts were put through over Republican budget concerns. After both, the economy expanded and revenue increased.

In learning how to play both Santa Clauses, the Democratic majorities in Congress grow larger and larger. They can alternate between increased spending and occasional tax cuts and take credit at the polls for both. The economy suffers, though, because the Democrats do not fulfill both roles with equal zest. They spend with exuberance and cut tax rates only when in doing so they can redistribute income from the middle and upper incomes to the less affluent. Americans, discouraged by ever-increasing tax rates, work less and invest less, devoting more time to leisure and a higher portion of their income to current consumption. Because middle- and upper-income Americans are the most productive (an engineer produces more than a ditch digger), taxing them the most has the effect of reducing economic output.

Tax Cuts—Timidity

Until President Ford in January 1975 timidly proposed a tax cut of sorts (three-quarters of his $16 billion package was a rebate on 1974 taxes, not incentives for new production), the Republicans had gone 22 years without proposing the kind of reduction President Eisenhower rejected in 1953 upon the advice of his Hooverlike advisers.

Both President Ford and Ronald Reagan are inching toward the Mellon approach. Still, they each insist in one way or another that tax reduction be bound to spending cuts. This is an improvement on the straightforward demand that the Spending Santa be shot. But as the Two-Santa Claus Theory holds that the Republicans should concentrate on tax-rate reduction. As they succeed in expanding incentives to produce, they will move the economy back to full employment and thereby reduce social pressures for public spending. Just as an increase in Government spending inevitably means taxes must be raised, a cut in tax rates—by expanding the private sector—will diminish the relative size of the public sector.

All the United States needs now to prosper is a Coolidge in the White House, a Mellon at Treasury, and GOP tax-cutting St. Nick.

——

Jude Wanniski, a former National Observer Staff Writer, is now on The Wall Street Journal.