Taxes Up, Stocks Up, What Can Go Wrong?

January 8, 2013

Bruce Bartlett is optimistic on the stock market, and higher tax rates. Writing in the NY Times, he points to the example of the Great Depression as a time when taxes went up dramatically while the stock market did quite well in a number of years:

For example, in 1932 Herbert Hoover enacted a large tax increase to stabilize federal finances devastated by the Great Depression, which began in 1929. Among other things, the 1932 tax increase raised the top federal income tax rate to 63 percent from 25 percent. But the Dow Jones industrial average increased sharply in 1933, rising 69 percent.

The Dow remained flat for the next several years and then took a sharp jump beginning in 1935. Intriguingly, 1935 just happens to be the year Franklin D. Roosevelt rammed a big tax increase on the rich through Congress. In his message to Congress on June 19, 1935, he emphasized that no wealthy person became wealthy alone, but only in cooperation with many others:

Wealth in the modern world does not come merely from individual effort; it results from a combination of individual effort and of the manifold uses to which the community puts that effort.

The top federal income tax rate rose to 79 percent beginning in 1936, from 63 percent. Yet the Dow was up 48 percent in 1935 and another 25 percent in 1936.

Bartlett points to this graph of the Dow Jones during FDR’s first term:

Does anyone need reminding that this was the Great Depression, and that 25 percent of the population couldn’t find work, much less invest in the stock market?

Further, only a minority of day traders and short term investors did well. The graph below shows that long term investors would have to wait 25 years – from 1930 to 1955 – for the stock market to recover. The stock market tanked between 1929 and 1932, during the Hoover administration’s failed attempts to close the deficit through tax increases. It tanked again in 1937 and early 1938 with the onset of another recession induced in part by FDR’s 1936 tax increase.

Bartlett concludes:

Clearly, there are times when a tax increase sets in motion positive economic forces, like deficit reduction or a more expansionary monetary policy by the Federal Reserve, that overwhelm whatever negative effects may result from higher taxes. The precise impact can only be determined by careful analysis unencumbered by dogmatic beliefs not anchored in empirical results.

But he never references any empirical results. In fact, most economists who look at this empirically find that taxes, particularly on corporate and personal income, reduce economic growth. Of 26 studies done over the last 30 years, only 3 find taxes have no measurable effect. On the stock market and the effect of taxes, less empirical research has been done, but one recent study by Marko Kalonovic at JP Morgan finds that corporate and personal income taxes are also associated with lower stock market returns.

Incidentally, the Dow is off about half a percent today.

Follow William McBride on Twitter @EconoWill

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