A Tax Tutorial for an Indebted Nation
President Coolidge with his partner in tax policy, Treasury Secretary Andrew Mellon (Library of Congress)
By John W. Childs
This article appears in the Summer 2024 issue of the Coolidge Review. Request a free copy of a future print issue of the magazine.
It is too bad most American historians have such depressive mindsets—as illustrated by their insistence on devoting far more attention to the 1930s, a.k.a. the Great Depression, than to the 1920s, a.k.a. the Roaring Twenties. While much can be learned from each of these sharply contrasting decades, the 1930s is mostly about what not to do. The 1920s is the story of what to do—an owner’s manual on how to run an economically successful country.
We will leave the 1930s to the Prozac school of historians and focus on what America can learn from the successful federal policies of the 1920s, particularly the approach to taxation.
AUTOS, PLUMBING, ELECTRICITY
The Roaring Twenties are so named to convey the extraordinary, one might say transformative, economic growth that took place during that period. The car replaced the horse and buggy; indoor plumbing became the norm, not the exception—as did electricity in the home. The age of Gatsby was indeed great.
A driving force behind this economic growth was President Calvin Coolidge’s tax policy. At the outset of his administration, Coolidge and Treasury Secretary Andrew Mellon hypothesized that lowering marginal tax rates would stimulate economic growth sufficiently that total tax revenues, despite lower rates, would actually increase. History proved them right. And to think they did all this before Art Laffer was born.
But there is nothing random about this phenomenon. This pattern of economic growth following a tax rate reduction is as predictable as the sun rising in the east. Coolidge was simply the first president to demonstrate it.
It recurred after JFK’s tax cuts in the early 1960s, and even more so after Ronald Reagan’s cuts in the 1980s, when they lifted us out of the malaise. Most recently, President Donald Trump’s tax cuts, enacted in 2017, led to the boom that only COVID derailed.
Given the consistency of the historical record, it’s unclear why this model for tax policy isn’t universally recognized among economists. The inescapable arithmetic of this law of nature often seems obscured by political debate over fair share. And since fair share is in the eye of the beholder, or taxpayer, there is no right answer.
No one, except government, invests if the return doesn’t exceed the cost.
WHY LOWER TAXES WORK
So if we call this a law of nature, what are the explanatory and inevitable forces that make it work? Coolidge identified one of the key factors when he recognized the incentive factor in lower marginal rates. If you keep more of what you earn, you are likely to work more.
As Art Laffer likes to remind us, the more you tax something, the less you will get of it—and vice versa. By lowering marginal tax rates from 73 percent to 25 percent, Coolidge’s predecessor, Warren Harding, and Coolidge unleashed a tsunami of productive work. At 25 percent, tax revenues, along with all other boats, rose.
But work incentives alone fail to capture all the necessary ingredients of an economic boom. As most economists agree, economic growth requires investment.
Investments are made, whether by companies or individuals, to earn a return on the money invested. The key link of investment to tax policy is that return is calculated on an after-tax basis. Thus a lower tax rate will, as a matter of arithmetic certainty, increase the return on any given investment. Or put another way, a lower tax rate lowers the cost of capital.
The cost of capital is critical to economic activity—a.k.a. growth—because every investment made on an economic basis has an expected positive return. No one, except government, invests if the return doesn’t exceed the cost. Hence, the lower the cost of capital, the more investments will be made.
Plus, lowering marginal rates leaves more money in the hands of the investor. It’s fine to create incentives and lower the cost of capital, but it’s not sufficient. The would-be investor needs the money. Lower rates obviously leave him more with which to invest. From that investment comes tax revenues. Those revenues narrow debt and deficit. This virtuous cycle needs to be reestablished.
THE ROAD MAP
We said we would leave the 1930s to the economic nabobs of negativism, but let’s take one quick peek that proves our point. In the 1930s, FDR raised marginal tax rates to 79 percent. Who on earth would want to work or invest when three-quarters of the reward went to someone else?
No wonder the Depression continued until Hitler bailed us out. It isn’t just the arithmetic of an investment that was at play. The psychology of the would-be investor had to be deeply pessimistic, knowing that most of his efforts would be confiscated. High tax rates are a proven tranquilizer for the animal spirits that inform most booms.
Coolidge called overtaxation legalized larceny. There were always municipal bonds when tax rates became confiscatory. But there is no school of economists who think municipal bonds are an engine of healthy economic growth.
Incentive, cost of capital, greater availability of capital, and that sine qua non of growth investments, optimism, are all functions of lower tax rates. Coolidge figured it out, and his policies provide a brilliant road map for successful economic policy.
John W. Childs is the founder and chairman of J. W. Childs Associates, LP, a private equity and special situation investment firm. This article originally appeared in the New York Sun.