FDR’s Tax Increase Scared Him Off Hiring 87,000 IRS Agents

One of the delicious errors in Thomas Piketty’s Capital in the 21^st Century is this assertion: “Roosevelt came to power in 1933 [and] immediately decided on a sharp increase in the top income tax rate, which had decreased to 25 percent….The top rate rose to 63 percent in 1933.”

Actually the top rate had increased not decreased to 25 percent, in 1930 from 24 percent in 1929. But that’s a minor point. When Roosevelt took office in March 1933, the top income tax rate had stood at 63 percent for the previous fourteen months. It was already in effect for the first taxes due date of the FDR presidency, March 15, 1933. The sharp increase, from 25 to 63 percent, had been done during FDR’s predecessor Herbert Hoover’s administration, and not in 1933 but 1932.

For one more whopper, FDR “immediately” decided not “on,” but against, a sharp increase in the top income tax rate on becoming president in 1933. He did not dare rase the top tax rate in 1933, 1934, or 1935. His feet would stay cold on this matter until 1936.

Capital in the 21^st Century is a mess. But you already knew that.

What we may not know—unless Taxes Have Consequences replaces the Piketty book on the nightstand—is that when FDR finally mustered the courage to raise the top tax rate, the result was a ludicrous backfire.

FDR in a huff forced the Revenue Act of 1935 on Congress after the Supreme Court invalidated the better part of the New Deal. Congress obliged, and an income tax increase became effective on January 1, 1936. It took the top rate from 63 to 79 percent.

What happened to revenues from the top group became the stuff of great Congressional curiosity the next year, 1937, when the taxes were due and the economy was plunging into the “little Great Depression” of 1937-38 featuring 18 percent unemployment. The tax revenues never showed up. Treasury secretary Henry Morgenthau had a theory why:

“The fees of the tax lawyer exceed by thousands of percent the pay of his opponent employed by the Government. In this manner the most resourceful brains of the legal world are engaged actively in trying to avoid taxes for their clients. Among these are men who received their early training from the Government, and who use the skill they acquired in that service against younger men who take their paces. The Government then becomes a training school for many of its top opponents.”

Morgenthau was explaining that raising a tax rate at the top raises the incentive of the person to whom it applies to avoid it, legally. The beautiful way was to make the best IRS agents an offer they couldn’t refuse (10X their salary). Want to hire more agents to collect on a tax increase? That means more of the best of them to be picked off by the moneyed for tax-avoidance purposes. The talented tenth of the revenue bureau sailed off to private tax-defense practice every year. All the more reason to keep the total number of tax agents low.

Roosevelt was not so thick as to propose hiring more agents to fill the “tax gap” that materialized after his 79 percent rate. Instead as war came, he tried patriotic appeals. It was moral to pay what the tax rate code implied you should pay, and so on. This sort of worked during Wolrd War II, but not at all before or after.

Thomas Piketty wants to dream that the FDR recovery of 1933-35 happened while the New Dealer raised income tax rates. What really happened is that FDR first held tight on raising income tax rates. Then when he did act, the rich sloughed off the new higher tax rates like a piece of cake while the economy tumbled back into a Hoover-like Depression. 87,000 new IRS agents today means about 8,700 new (and well-compensated) members of the tax bar badly defeating the remaining 78,300 lessers still on the job searching for money for the government. The easier solution is to cut rates, indeed at the top, and deplete the relevance of the tax bar.