Causes of the transformation of the US fiscal system in the 1930s

Martín Gonzalez-Eiras, Dirk Niepelt

11 October 2016

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Wallis (2000) and others have pointed out that the US fiscal system underwent a radical transformation around the time of the Great Depression and the New Deal (see Figure 1). In the early 1930s, the US federal government accounted for about a third of total government revenues; virtually no grants from the federal to state governments or from state to local governments were present. Within a few years, this arrangement had changed dramatically. The revenue share collected by the federal government doubled, and intergovernmental grants, which had been introduced to fund major New Deal programmes, emerged into a central source of revenue for state and local governments.

Figure 1. Government revenues and grants

Notes: Federal relative to total government revenues (solid), and federal grants relative to state and local revenues (dots). Sources: Wallis (2000) for years 1902, 1913, 1922, 1927; NIPA tables for subsequent years.

An even more dramatic transformation occurred with respect to the tax base (see Figure 2). The income tax share of federal revenues increased from 27.5% in 1934 to 83.7% in 1945, and the share of tax units who paid income tax increased with similar rapidity, from only 7.2% in 1933, to 25.7% in 1940, and 84.6% in 1945.

Figure 2. Tax base

Notes: Number of tax returns relative to number of tax units (dots), and federal income tax (including OASDI) relative to total revenue (solid). Sources: Piketty and Saez (2003: Table A0), and Office of Management and Budget, Fiscal Year 2016, Historical Tables, Table 2.2.

Existing theories require rather strong assumptions to rationalise these drastic changes. For example, Wallis (2000) suggests that the increase in federal relative to state and local receipts might reflect a reduction of the cost of taxation for the federal government. Indeed, the introduction of Social Security payroll taxes might have given federal authorities an information advantage that could in turn have led to lower costs for it to raise income taxes. But an argument along those lines has difficulties explaining why the drastic changes were not undone later in time. After all, rapid advances in information technology throughout the second half of the 20th century render it unlikely that an information advantage for federal authorities could have persisted over decades.

Similarly, an explanation based on traditional fiscal federalism motives appears to have problems explaining the facts. Such an explanation would emphasise positive externalities of government outlays that call for spending by the federal government. And it would have to argue that these externalities permanently increased around the time of the Great Depression. But the major technological innovations that could have transformed production and thus, the benefits of public investment in that period (in particular, electric light and the internal combustion engine) had already occurred at the end of the 19th century (Gordon 2012). By the time of the Great Depression, most of the infrastructure investments based on these innovations were already undertaken, at least in urban areas.1 The shifts in the fiscal landscape thus should have been observed earlier. Moreover, even if spending externalities had increased around that time, federal spending should have spiked rather than permanently increased since the higher externalities would have triggered a federal public investment boom followed by more moderate maintenance spending. This is not what we see in the data.

In a recent paper, we propose a theory of tax centralisation and intergovernmental grants in politico-economic equilibrium that provides a potentially simpler explanation (Gonzalez-Eiras and Niepelt 2016). The theory resonates with Wallis’ (2000) notion of taxation-cost differences across layers of government. It motivates such differences within a micro-founded general equilibrium model that blends politics and macroeconomics.

We consider an economy where a central government and many local governments may tax labour income. Taxation slows down capital accumulation and thus has general equilibrium effects – it drives up interest rates and lowers future wages, which reduces the tax base in the subsequent period. Policymakers and voters at the federal level rationally internalise these general equilibrium effects to the extent that they are of relevance for current voters. (Voters do not internalise the welfare consequences for yet unborn cohorts.) In contrast, policymakers and voters at the regional level rationally do not perceive general equilibrium effects of their decisions, since regions are small relative to the nation and markets are not segmented. As a consequence, the net cost of a federal tax hike as perceived by a voter participating in national elections differs from the net cost of a regional tax hike as perceived in local elections.

Against this background, we pursue the questions of which level of government taxes more or less, why intergovernmental grants exist, and why they have risen in prominence. Our preferred specification features complementarities in the production of public services between government spending at the federal and regional level such that regional spending is essential. While the federal government cannot affect the provision of public services by itself, it may employ federal grants to increase regional spending, and thus indirectly affect public services. And since the general equilibrium effects described earlier render tax revenue at the federal level ‘cheap’,  it also is in the interest of the federal government to do just that. In equilibrium, the degree of centralisation of both taxes and spending is determinate and as a consequence, the size of intergovernmental grants is uniquely determined as well. These results hold independently of whether grants are of the uniform or the matching type.

Our theory rationalises the centralisation of tax revenue and the emergence of grants as the equilibrium response to the Sixteenth Constitutional Amendment (enacted in 1913) that introduced the possibility for the federal government to tax income.2 We argue that in an environment where voters at the regional level were indifferent between (and thus, used) various revenue channels, voters in nationwide elections perceived the newly available federal labour income taxes to have a cost advantage. As a consequence, revenue collection was not only centralised but income taxation gained prominence as a source of revenue, as documented above.

In addition to offering an explanation for the US experience in the 1930s, the theory can be used to forecast federal and regional taxes and government spending as well as intergovernmental grants. Figures 3 to 5 illustrate that the model is able to capture the trends in government spending, taxation, and grants. 

Figure 3. Total spending

Notes: NIPA data (circles) and model predictions (dots).

Figure 4. Regional revenues

Notes: NIPA data (circles) and model predictions (dots).

Figure 5. Federal grants

Notes: NIPA data (circles) and model predictions (dots).

Predicted grants increase to approximately 5.5% of GDP by 2060. In a counterfactual analysis, we find that if general equilibrium effects of taxation were not internalised at the federal level, federal taxes would have been six percentage points lower in the year 2000, regional taxes four percentage points higher, and intergovernmental grants would have been absent.

References

Gonzalez-Eiras, M and D Niepelt (2016) “Fiscal federalism, taxation and grants”, CEPR Discussion Paper No. 11482.

Gordon, R J (2012) “Is US economic growth over? Faltering innovation confronts the six headwinds”, NBER, Working paper 18315.

Piketty, T and E Saez (2003) “Income inequality in the United States, 1913—1998”, Quarterly Journal of Economics, 118(1): 1-39.

Wallis, J J (2000) “American government finance in the long run: 1790 to 1990”, Journal of Economic Perspectives, 14(1): 61-82.

Wallis, J J and W E Oates (1998) “The impact of the New Deal on American federalism”, in M D Bordo, C Goldin and E N White (eds) The defining moment: The Great Depression and the American economy in the Twentieth century, University of Chicago Press, chapter 5: 155-180.

Endnotes

[1] By 1952 almost all US farms had electricity, and by 1970 the main network of interstate highways was in place, see Gordon (2012).

[2] The adjustment did not occur immediately after the ratification of the Sixteenth Amendment. Presumably, non-modeled political or administrative hurdles had to be overcome. Wallis and Oates (1998) discuss that the federal government ran large deficits during the 1930s; this is consistent with the fact that the rise of grants started before tax revenues were centralised.

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Topics:  Economic history Politics and economics Taxation

Tags:  Great Depression, New Deal, US, taxation, fiscal system, intergovernmental grants, general equilibrium model, government revenue

Associate Professor, University of Copenhagen

Director, Study Center Gerzensee; Professor, University of Bern

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