Debt, Taxes and Politics: A Perspective on Federal Tax History

November 13th, 2012

by Doug Short

With the Bush tax cuts set to expire at the end of December, let's take a moment to reflect on the history of U.S. federal debt and personal taxation, the latter of which began in 1913.

The first chart is a snapshot of federal debt based on data from the U.S. Treasury and the 2013 Federal Budget issued by the Office of Management and Budget (OMB). The chart also shows the OMB six-year forecast through 2017.

As the chart clearly illustrates, the tax cuts in the early 1980s coincided with the beginning of an acceleration in real federal debt from a relatively consistent level over the previous three decades.

The next chart replaces real debt with the debt-to-GDP (Gross Domestic Product) ratio, which gives us a better idea of the true debt burden. Against the backdrop of U.S. history, the contours of the first two-thirds of the chart are easy to understand. Debt-to-GDP soared with the U.S. entry into World War I, as did the personal tax rates. After the war the ratio gradually dropped, this time against the backdrop of the "Roaring Twenties." The Crash of 1929 and Great Depression triggered a rise in the ratio to levels exceeding the peak in World War I. Logically enough, World War II brought about another rapid rise in Debt-to-GDP. War costs drove the ratio to a peak above 120% in 1946.

The ratio rapidly declined after WW II and bottomed out 28 years later in 1974, where it remained within a 3% range until 1982. Then, over a 14-year period the ratio more than doubled from 31.9% in 1981 to 67.1% in 1995. For the next six years the ratio improved, dropping to 56.5% in 2001. The ratio reversed again, this time in sync with several factors — the Tech Crash, 911, and wars in Afghanistan and Iraq. And then, of course, came a dramatic acceleration in the ratio triggered by the Financial Crisis and deepest market decline since the Great Depression.

Here is another view of the federal debt-to-GDP ratio, this time with major wars and the Great Depression highlighted. I've added markers to the debt ratio series to identify individual years. As we can readily see, only once in U.S. history, the WWII debt peak of 1945-46, have we had a higher Debt-to-GDP ratio than the current six-year forecast:

Debt and Taxes

There is a logic to the Debt-to-GDP ratio increases within the historical context of two World Wars and the Great Depression. Likewise, the steadily decreasing ratio over the next 35 years enabled the tax cuts in 1964. In contrast, the Economic Recovery Tax Act of 1981 was followed by an 18-year secular bull market that began the following year and, paradoxically enough, by a reversal in the direction of the Debt-to-GDP ratio. Correlation does not imply causation. Federal tax revenues did decrease fractionally in 1982 and by a more significant 6% in 1983. But the recession from July 1981 to November 1982 (culminating in 10.8% unemployment) was a key factor in the revenue slippage. There were other epic factors that played roles in the reversal — among them the gradual transition from manufacturing to a service-based economy, the dawn of the Age of Information, and a gradual relaxation of both private and public concern about debt.

The 2001 and 2003 tax cuts were originally set to expire at the end of 2010, but they were extended for two years and will now expire on December 31st.

Let's close with a snapshot of Debt-to-GDP and presidential politics:


Source for U.S. federal debt data: Budget of the United States Government. Table 7.1 presents the federal debt data since 1940 and includes six years of debt estimates. Treasury Direct is my source for the pre-1940 numbers.

Source for historic U.S. tax data: www.taxfoundation.org.

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