Paul Krugman - the Nobel prize winner, the Keynesian economist, the face of big government economics, and the face of centralized planning and monetary inflation - has written an article in the NY Times that has gotten quite a bit of attention. He points out that the 1950's were a prosperous time in America, yet the higher marginal tax rate was at 91%. He is wondering what all the fuss is about right now with tax rates. He almost implies that we can just go back to 91% marginal tax rates and everything will be great.
This is an interesting point and I think it is important and deserves a libertarian response. He is actually correct that the 1950's were a relatively prosperous time considering the high tax rates. So how can this be explained by free market economists?
This is why economics is so hard. It is because there are so many variables. We don't live in a vacuum where we can keep everything the same and just experiment with different tax rates.
But it is ironic that Krugman, champion of government spending, is citing the 1950's as a prosperous time. Because aside from the tax rates, the 1950's looks like a free market paradise compared to what we have now. There was no Medicare or Medicaid. There was no EPA. There was no Americans with Disabilities Act. It was also a relatively peaceful time in America, with the exception of the Korean War wrapping up in 1953, which did not consume anywhere near the resources that were used in World War 2 or in today's wars.
The list of things could go on, but I think there is one hard statistic in general that can be pointed to that makes Krugman look bad here. It is government spending. The 1950's is actually strong evidence that total government spending and monetary policy are more important factors to the economy than tax rates. If you look at federal spending for the 1950's, it was a fraction of what it is now. Total federal spending never exceeded $100 billion annually for every year in the 50's. It was only $42.6 billion in 1951. Adjusted for inflation, total federal spending was only about one-fifth of what it is today.
Even as a percentage of GDP, it was lower than 20% in all years except one (1953), whereas it is now about 24% or 25%. And because spending was relatively low in the 50's, the deficits were relatively low. And because the deficits were relatively low, monetary inflation from the Fed was relatively low.
So while marginal tax rates on high income earners were extremely high, there was still relative prosperity because of the lower government spending and the stable money. While the high tax rates were discouraging to entrepreneurs and workers, the relatively tight money policies were a great incentive. Businessmen could plan and could count on the dollar maintaining its purchasing power. It was an incentive to save. As a result, there was not a giant misallocation of resources as we see today. While there were downturns in the economy, there was not a severe boom and bust cycle like we see today.
So Krugman was right that the 1950's were prosperous during a time of high marginal tax rates. But if you look at the rest of the picture, it is actually a case against Krugman's big government/ big spending theories. If government spending and monetary inflation are kept under control, then you can have prosperity even with confiscatory tax rates. This should be a lesson to Tea Party conservatives that they should focus more on government spending and less on taxation.