How wartime inflation affected tax progressivity and redistribution

Posted by Sara Torregrosa Hetland on 27 November 2019

Debate:  The Economics of the Second World War: Eighty Years On

Sara Torregrosa (Lund University) and Oriol Sabaté (Lund University)

War has been considered “a great leveller” of economic disparities, and specifically World War II, which left a long-lasting legacy of lower inequality in many Western countries (Scheidel, 2017). This pattern, widely documented in the literature, has been attributed to the destruction of capital (Piketty, 2014), as well as the demand for labor, social preferences, economic regulation, and progressive taxation (Scheve and Stasavage, 2016).

As Walter Scheidel mentions in his recent column, the two wars led to remarkable income tax reforms in several countries, as well as heavier wealth taxation of individuals and corporations. There were similar outcomes in some countries that remained neutral, like Sweden.

Progressive taxes not only soared during the wars, but remained important afterwards for the finance of modern welfare states. Income taxes changed from narrow levies on affluent families to contributions paid by ordinary citizens. What was a “class tax” became a “mass tax” (Steinmo, 2003).

Wartime taxation was heavily influenced not only by regulatory changes, but also by high levels of inflation. Inflation lowered the real levels of exempted tax thresholds, deductions, and bracket limits. This changed the incidence and progressivity of the tax system. The inflation mechanism has been mentioned in earlier literature (Broadberry and Howlett, 2005), but not quantified. How much of the growth in income taxes during the World Wars was due to inflation? How did this process affect tax progressivity and redistribution?

We try to answer these questions in a recent paper. We analyze the income taxes of Sweden, the United Kingdom and the United States during the World Wars, comparing the actual operation of the tax with alternative counterfactual scenarios of lower or no inflation (here, we concentrate on our first counterfactual, defined by the level of inflation over the five pre-war years). The exercise is based on disaggregating the original tabulated tax data (following Blanchet et al., 2017), and imputing income tax payments to the synthetic observations according to the regulations in place.

Our calculations show that inflation was a powerful mechanism for the downward extension of the tax. By the end of World War II, nearly 1.4 million US taxpayers started paying the tax for no other reason than nominal increases in their incomes (see Table 1). The same can be said of more than 3.6 million in the United Kingdom (here, however, the period of analysis ends three years later because of data availability). In the paper we also show estimates for World War I, which are in all cases higher (because inflation was higher).  

Table 1 Additional taxpayers brought in by inflation

Source: Torregrosa and Sabaté (2019).
Notes: these calculations refer to taxpayers who would not have paid the tax if pre-war inflation had persisted.

Because of these new “inflation taxpayers”, and of old taxpayers being pushed into higher tax brackets, inflation was responsible for 30% of the income tax revenue in Sweden and the United States in 1946, and nearly 50% in the United Kingdom in 1949. If we consider total tax revenue as a reference, this additional “inflation revenue” represented around 15% in the United States and the United Kingdom, and nearly 10% in Sweden.

Table 2 Additional income tax revenue brought in by inflation

Source: Torregrosa and Sabaté (2019).
Notes: these calculations refer to additional income tax revenue, which would not have been paid if pre-war inflation had persisted. It corresponds both to new taxpayers and to increased taxation of 'old' taxpayers.

Inflation also made income taxes less progressive, given that the increases in tax burden were relatively more intense at the bottom of the income distribution than at the top. During the Second World War, this regressive effect was especially strong in the United Kingdom. Figure 1 shows the extent to which low and middle incomes became subject to higher average effective tax rates by the end of the war due to inflation. 

Figure 1 Average effective tax rates under different inflation scenarios at the end of WWII

Source: Torregrosa and Sabaté (2019).

Despite this, the impact on redistribution was positive in all three countries. In general, tax redistribution is positively related to both progressivity and tax size. Inflation reduced progressivity, but increased tax size. The effect of greater tax size outweighed the reduction in progressivity. For example, the income tax caused a reduction in the Gini index of 5.1 points in the United States in 1946, while without wartime inflation the reduction would have been only 4.7 points. 

Our work shows that inflation helped to shape income taxes during the World Wars. Wartime inflation brought new taxpayers and incomes into the tax, and its effect persisted into peacetime. Even if income taxes lost progressivity with their downward extension to the lower and middle classes, inflation helped them to become the strong redistributive mechanisms that we have known in the post-war era. Inflation was, hence, one of the important channels through which wartime taxes contributed to the “levelling” of incomes in the first half of the twentieth century. We leave for future research to investigate whether these effects were well understood by policymakers at the time, and to what extent inflation was consciously overlooked to raise taxation through the back door.

References

Blanchet, T., Fournier, J., and Piketty, T. (2017): Generalized Pareto Curves: Theory and Applications. WID.world Working Paper Series 2017/3.

Broadberry, S., and Howlett, P. (2005): 'The United Kingdom during World War I: business as usual?', in S. Broadberry and M. Harrison (eds.) The Economics of World War I, New York: Cambridge University Press, pp. 206-234.

Piketty, T. (2014), Capital in the twenty-first century, Cambridge US: Harvard University Press.

Scheidel, W. (2017): The great leveler: Violence and the history of inequality from the Stone Age to the twenty-first century, Princeton: Princeton University Press.

Scheve, K, and Stasavage, D. (2016): Taxing the rich: A history of fiscal fairness in the US and Europe. Princeton: Princeton University Press.

Steinmo, S. (2003): 'The evolution of policy ideas: tax policy in the 20th century', British Journal of Politics and International Relations, 5 (2): pp: 206–236.

Torregrosa, S. and Sabaté, O. (2019): 'Income tax progressivity and inflation during the two World Wars'. STANCE working paper 2019:1.