America's Fiscal Constitution (30 page)

Dawes dramatized his push for efficiency at a second administration-wide budget meeting, in February 1922, attended again by the president, the cabinet, and all other senior federal officials. He illustrated the desired attention to detail by holding up an army broom and navy broom, which differed only by the army’s use of twine rather than the navy’s wire to wrap the bristles. He chastised the navy for ordering more of its wire-wrapped brooms even though the army had an inventory of 350,000 of its brooms.
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A well-run business, Dawes lectured, “would drive the guilty man out of his position in disgrace.”
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In the presence of the president and cabinet secretaries, Dawes then compared each department’s year-to-date spending with a pro-rata apportionment of its annual appropriations.

By the end of 1921 the Bureau submitted the first official presidential budget to Congress. That budget, for the fiscal year beginning on July 1, 1922, offers a clear snapshot of federal responsibilities and revenue sources at the time. Dawes balanced projected revenues of $3.9 billion with the same amount of outlays, including expenses of $975 million for interest and $387 million to reduce principal on the debt.
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Less than a sixth of the total represented spending on items other than debt reduction, interest, defense, veterans, and some wartime demobilization. Corporate and personal income taxes provided the bulk of federal revenue, which amounted
to almost 5 percent of national income in 1921.
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By 2012, when the nation had global military commitments, personal and corporate income taxes supporting the federal funds budget had grown to 8.9 percent of national income.
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Dawes earned a Nobel Prize for restructuring European debt after he left the Bureau of the Budget. His successor, Herbert Lord, served until 1930 and continued to manage “pay as you go” budget planning by convening biannual meetings with all senior officials in the executive branch. Sixteen of those meetings occurred from 1921 through the end of the Coolidge presidency in early 1929.

Federal budget accounting in the 1920s was straighforward. Budgets confined all spending, including planned debt reductions, to the limit set by estimated revenues. Congress treated annual debt reduction as a budgeted expense similar to defense, benefits for veterans, and interest. Federal officials did not claim a surplus until revenues exceeded a spending level that included a substantial annual amount of debt reduction. Secretary Gallatin had effectively employed a similar system 120 years earlier. Budget practices used in the 1920s would have made it difficult for the president and Congress in 2001 to claim that their budget reduced federal debt even though they allocated no revenue for that purpose.

By 1929 the federal government had retired $8.1 billion in debt, a third of the total a decade earlier.
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Annual appropriations accounted for three-quarters of that debt reduction, and additional surpluses paid down the rest. Even without the authority of the Budget Act of 1921, by the late 1920s the chief executive played a critical role in shaping federal budgets. The Constitution itself permitted Congress to ignore any budget submitted by a president, but the unwritten constitution evolved to include the White House as an active partner in the annual budget process.

In the 1920s most of the growth of the public sector occurred in state and local governments. Local governments financed sanitary water and wastewater treatment systems, the most radical effective public health reform in US history. Cities and states borrowed record amounts—with voter-approved bonds issues for specific purposes—to finance these improvements and others, such as new roads and hospitals. State and local debt grew from $4.5 billion in 1913 to $19.5 billion in 1932. By 1930, New York City’s net debt was $1.6 billion, far more than interest-bearing federal debt before World War I.
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Demands for efficiency rose alongside the cost of state and local services. Popular Democratic governor Al Smith of New York implemented management reforms and imposed fiscal discipline on a Republican legislature. With bipartisan support from business leaders, Smith obtained broad powers to manage the budget of the nation’s most populous state. He consolidated overlapping operations and cut income tax rates twice. New York permitted debt only for voter-approved bonds used for capital improvements that were accounted for apart from the state’s operating budget.

T
AX
R
EFORM

Treasury Secretary Andrew Mellon “agree[d] perfectly with those who wish to relieve the small taxpayer by getting the largest possible contribution from the people with large incomes.”
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One historian of the early income tax notes with wonder that while many Republicans had complained about the progressive income tax, “there was not, however, one serious utterance about repeal.”
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Mellon’s tax policies are instructive for those searching for lessons from budget history. Populists such as Senator Robert La Follette claimed that Mellon’s reforms favored wealthy citizens. In recent decades Mellon has been embraced by advocates of “supply side economics” who seek precedents for the debt-financed tax cuts in 1981, 2001, and 2003. Both perspectives distort the original intent and effect of Mellon’s policies.

The extraordinary tax increase adopted in 1919 ended within two years, after which tax rates fell back to the level imposed at the outset of the war. With the help of his twenty-nine-year-old assistant, S. Parker Gilbert, Mellon crafted a plan to increase federal revenues from corporations and Americans with the highest incomes while relieving millions of Americans in the lowest brackets from paying any income taxes at all. He strongly objected to debt-financed tax reduction.

In 1921 the top marginal personal income tax rate applied to 1 percent of Americans, most of whose taxable earnings came from interest and capital gains. Those taxpayers could avoid taxable income by investing in tax-exempt bonds or deferring the sale of investments for a gain. State and local bonds with interest exempt from taxation totaled at least $10 billion by 1924, a substantial amount in relation to all corporate bonds.
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Mellon
failed in his efforts to end the tax-exempt status of interest on state and local bonds.

Tax returns showed clearly that high income tax rates combined with tax avoidance served to reduce the total,
taxable
income of wealthy Americans. In 1916, when the highest income tax rate was 15 percent, Americans who reported taxable income in excess of $300,000 paid $81 million, almost half of all personal income tax revenue.
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By 1921, with the top rate at 73 percent, they reported about the same taxable income, but their share of the total taxable income had dropped to 10 percent.
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Between 1919 and 1921, the total tax revenue from the “surcharge,” the term used for tax rates applicable to higher brackets, dropped from $802 million to $411 million.
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Investors moved to tax-exempt bonds, deferred selling for capital gains, and retained income within corporations taxable at lower rates. High tax rates also contributed to tax evasion in an era in which many Americans routinely violated federal criminal laws against alcoholic beverages.

Congress acted slowly at first on Mellon’s recommendations concerning “scientific taxation.” In 1922 Congress increased corporate tax rates, reduced the maximum personal surcharge on high incomes to 50 percent above the base rate, and raised the personal exemption.
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Mellon’s arguments steadily gained converts. Congress cut tax rates and raised personal exemptions in 1924 and 1926, until the maximum personal tax rate fell to the level recommended by Mellon: 25 percent.
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As Mellon predicted, wealthy Americans shifted their investments to taxable bonds and dividends.
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By the late 1920s only corporations and the wealthiest 2 to 3 percent of Americans paid federal income taxes. The share of all federal taxes paid by the wealthiest Americans and corporations was immensely higher in the late 1920s, a supposed high-water mark of conservative power, than at any later time in the nation’s history.

After the adoption of Mellon’s tax program, some Democrats in Congress led by House Minority Leader John Nance Garner of Texas sought to lower corporate tax rates. With the backing of the US Chamber of Commerce, Garner proposed to cut the corporate tax rate from 13.5 percent to 11 percent. Along with the old Roosevelt Progressives still in Congress, Mellon fought Garner’s initiative on the grounds that it would reduce federal revenue and slow debt reduction, arguing that “as long as I am Secretary of the Treasury Department” he would “resist [any] undermining of
the principle” of balanced budgets.
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Throughout Mellon’s tenure, corporations paid far more income taxes than individuals; in 1926, for example, individuals paid $732 million out of total income tax revenues of $1.974 billion, with corporations accounting for the balance.
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In later decades Mellon’s policies would be invoked by Republican leaders, such as Congressman Jack Kemp, in support of debt-financed tax cuts. Yet Mellon himself flatly disagreed with the idea that new borrowings with reduced taxes were “preferable to higher taxes with reduced debts.” He said that “a moment’s reflection will convince anyone that prosperity cannot come from continued plunging into debt.”
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Mellon pressed only for tax rate reduction designed to promptly increase federal revenues as a share of national income. Those who cited Mellon’s policies in justification of tax reductions in 1981 and 2001 did so without evidence that tax revenues would promptly rise as a result of a tax cut.

The six years following both 1920 and 2000 offer some interesting contrasts, as they were the only six-year periods in the last century in which Republicans controlled both the White House and the House of Representatives. New Republican presidents pledged to pay down the debt. After 1920 the federal government retired debt, while after 2000 debt soared, even excluding war-related borrowing. From 1921 to 1926 Republican presidents frequently vetoed spending bills, something that did not occur from 2001 to 2006.

The cuts in the top personal income tax rate enacted in 1964 and 1986 offer a better parallel to the Mellon-era tax cuts. Mellon’s business experience led him to believe that the maximum personal tax rate that would avoid economic distortions was 31 percent.
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After passage of the Tax Reform Act of 1986, the top tax rate was 28 percent, though for many high-income taxpayers the effective tax rate was actually 33 percent, as deductions were phased out with income. This initiative, led by congressional Democrats with support from the Reagan White House, explicitly accepted another of Mellon’s arguments—that a lower maximum tax rate would lead to a less distorted or tax-driven economic decisions.

It is difficult to believe, as some do, that Mellon’s reductions in personal tax rates were responsible for the growth in national income from $73 billion in 1921 to $103 billion in 1929. Though lower taxes on investment income removed some perverse incentives, tax rates affecting 1 or 2 percent of the population had less impact on the economy than did
a reduction of over $8 billion in federal debt. Wealthy Americans paid more to the federal government by the end of the decade, and state and local spending and taxes increased. Steady annual economic growth in the 1920s is better explained by the impact of construction and technological innovation.

Similarly, Mellon’s liberal critics, including New Deal Democrats and historians such as Arthur Schlesinger, are incorrect to blame Mellon’s tax cuts for stock market speculation in the 1920s. Federal and state policies permitting high leverage on margin loans contributed more to the bubble that burst in 1929. Since interest on loans could be deducted, lower tax rates actually reduced incentives for the purchase of stock in margin accounts.

In the 1920s Congress and Mellon’s Treasury resolved an obscure issue that would have a profound effect on the federal tax system later in the century. Very few companies—with the notable exception of Sears, Roebuck and Company and the Eastman Kodak Company—made annual contributions to investment accounts held in trust for future pension obligations. They deducted those expenses in calculating taxable income. Tax accountants within the Treasury tried to treat income from pension trusts as if it belonged to a single wealthy person, but that made no sense because the ultimate beneficiaries were likely to have incomes lower than the standard exemption. Moreover, it was considered arbitrary and unfair to attempt to allocate taxable income to workers before they were entitled to receive it. Congress and the Treasury agreed to exempt employer pension contributions from personal income taxation. Future retirees would pay any taxes when they actually received a pension. That commonsense solution, later applied by analogy to noncash medical benefits, seemed fair and reasonable throughout the twentieth century.

Mellon abhorred tax loopholes. He helped close one that had long been used to avoid payment of estate or inheritance taxes. States relied on estate taxes to pay for essential services such as public education and roads. Florida, for the avowed purpose of attracting wealthy retirees from other states, banned all estate taxation. It seemed unfair that residents of other states could benefit from services paid for with inheritance taxes and then avoid those taxes by retiring to Florida. Mellon and Congress solved the problem by imposing a federal estate tax and agreeing to credit 80 percent of the federal tax to states that imposed their own estate taxation.