The Origin Of The Rust Belt – Part 1

In our new book Taxes Have Consequences: An Income Tax History of the United States, my co-authors Arthur Laffer, Jeanne Sinquefield, and I devote two chapters to the states and their imposition of new types of taxes, particularly income taxes, in the twentieth century. The first big wave came in the 1930s, as states tried to bail out localities that had caused rampant housing foreclosure through their stiff property taxes in the early Great Depression. The second big wave of state income tax impositions was in the fifteen years after 1960. From 1961-76, ten states that did not have one added an income tax.

These ten states jump out on a map. You look at them and a thought quickly comes to mind: that’s the Rust Belt! Here were the states that added an income tax over the fifteen years after 1960: New Jersey, Pennsylvania, Ohio, West Virginia, Michigan, Indiana, and Illinois, plus Nebraska, Maine, and Rhode Island. The first seven on this list—the line running from New Jersey through Illinois—is coextensive with what today we call the Rust Belt.

In the 1960s, steel mills were still added to and improved in Pennsylvania—the state-of-the-art furnaces at the United States Steel Duquesne Works outside Pittsburgh for example. In 1963, the company built its fancy Dorothy 6 iron blast furnace and followed up with buying the latest equipment into which to feed that iron to make steel. In the 1960s, U.S. Steel’s capex showed it was making a commitment to stick around to make product and money.

In 1971, Pennsylvania added an income tax, while permitting municipalities to tack one on themselves in addition if they wanted to. Today, Pennsylvania has an income tax of 3.07 percent and the city of Pittsburgh a 3 percent wage tax. That’s over 6 percent of normal income sailing off to the authorities for working Pittsburghers.

How such things undermine capital commitments and the location of industry, especially over the long term, is a woefully neglected and misunderstood topic in modern American economic and social history. The kind of capital allocation the steel company made in the 1960s takes a long while to make a fully positive return. Incremental profits each year pay down the investment. Depreciation allowances against taxes also take years to become full—and these took even longer in the 1970s, because the depreciation schedules were unindexed for inflation.

Massive capital purchases paying out over the long term comes through interaction with productive labor, and then marketing and sales. In 1971, as Pennsylvania started its income tax, labor got upwards of 6 percent more expensive. For workers to stay whole, they had to get an additional 6 percent (actually more because of progressive federal tax rates) in wages from the company.

U.S. Steel made huge capital investments in the 1960s that needed probably decades to pay out. The labor needed to make that happen got more expensive thanks to state action. The company’s accountants weighed the new wage requirements against the deductibility of wages from the corporate tax (of 48 percent) and stared at something like a 4 percent permanent increase in labor costs. All thanks to the new state income tax.

In certain businesses, 4 percent can be a profit margin—in particular when expensive capital assets recently purchased have to be paid off. In groceries a margin might be half that. There are businesses with astronomical profit margins (Apple Computer for example), and such companies can locate themselves in a place with a high cost structure, such as California, and still make a beautiful dollar.

Dinging U.S. Steel with another 4 percent in 1971 shortly after it had laid out big capital money—the implication for real profit margins, and business planning, of this sort of development makes one shudder. Such a new cost will prompt a company to squeeze as much productivity out of the recent capital investment, made before the new income tax, with little in the way of capital upkeep let alone further improvement (and hiring). Then as soon as the investment pays out, best to scrap whole endeavor, pursued originally in a lower tax environment, and sell off what one can piecemeal.

United States Steel razed the Duquesne Works in the 1980s.

In the following series of columns, I shall offer vignettes and stories about how and why the future Rust Belt states opted for an income tax in these years, 1961-76. Education was the stalking horse. Faked out by the ending baby boom, states in the 1960s and 1970s said they needed ever more money for schools. The people who took notice were corporate accountants. It took ten or fifteen years, but after that duration once companies could escape the new income tax states with a semblance of return on their investment from the pre-income tax days, they got out.