Understanding Fiscal Policy During the Great Depression

My little spat with with Rauchway regarding unemployment during the Great Depression draws in Paul Krugman.  Krugman doesn’t respond to any of my arguments but he does give us the old line that fiscal policy didn’t fail during the Great Depression it wasn’t tried.

Now, you might say that the incomplete recovery shows that “pump-priming”, Keynesian fiscal policy doesn’t work. Except that the New Deal didn’t pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump. Here’s the Cary Brown estimates, from Brad DeLong…Net stimulus of around 3 percent of GDP – not much, when you’ve got a 42 percent output gap.

Now there is actually a lot of truth to this but the way in which Krugman, Rauchway, DeLong and others present this point is esoteric and likely to mislead even many economists.  What Krugman seems to be saying is that the government didn’t spend enough during the thirties (Rauchway, who also cites Cary Brown, says directly "there was never enough spending to achieve the desired effect.")  Yet federal spending during this time increased tremendously.  So what is really going on?  The answer is actually quite simple.

During the Great Depression federal expenditures increased tremendously but so did taxes.  Thus, the reason spending was not stimulative was not that spending wasn’t tried it’s that taxes were also raised to prohibitive levels.  But don’t take my word for it.  Read Cary Brown (JSTOR) whom Krugman, Rauchway, DeLong all cite but none of whom quote at length.  Here is Brown:   

The primary failure of fiscal policy to be expansive in this period is attributable to the sharp increases in tax structures enacted at all levels of government.  Total government purchases of goods and services expanded virtually every year, with federal expansion especially marked in 1933 and 1934.  [But] the federal Revenue Act of 1932 virtually doubled full employment tax yields…

…the highly deflationary impact of this tax law has not been fully appreciated…The Revenue Act of 1932 pushed up rates virtually across the board, but notably on the lower and middle income groups….Personal income tax exemptions were slashed, the normal-tax as well as surtax rates were sharply raised, and the earned-income credit equal to 25 percent of taxes on low income was repealed.  Less drastic changes were made in the corporate income tax, but its rate was raised slightly and a $3000 exemption eliminated.  Estates tax rates were pushed up, exemptions sharply reduced, and a gift tax was provided.  Congress toyed with a manufacturers’ sales tax, but finally rejected it in favor of a broad new list of excise taxes and substantially higher rates for old ones….

The Revenue Act of 1932 was followed by many further tax increases (e.g. Brown notes "…social security taxes began in 1937 to exert a pronounced effect…") many of them, under pressure from the Huey Long wing, designed to "Share our Wealth." Here is a graph of the highest marginal income tax rate which went from 25% to 79% between 1929 and 1940 and here is a graph of the lowest marginal income tax rate which (from a low base) increased by a factor of 10.  (Hat tip to Carpe Diem).

Thus, an accurate portrayal of fiscal policy during the Great Depression – entirely consistent with Krugman – is that we had much greater spending, much greater taxes and not much economic stimulus.  And if supporters of the New Deal argue that fiscal policy was only "modestly expansionary" then it’s quite reasonable to think that once we take into account the supply side effect of taxes and the increase in regime uncertainty then the net effect might even have been contractionary. 


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