The study is by Ellen R. McGrattan and is titled “Capital Taxation During the U.S. Great Depression” (pdf). McGrattan works as a Monetary Advisor for the Minneapolis Federal Reserve Bank. For those of you not familiar with the ideological leanings of the various Federal Reserve Banks, let me assure you that the Minneapolis Fed is not a hot-bed of free-market, anti-tax, tea-party thinking. So, let’s read McGrattan’s finding in her own words (citations removed):
Although there is no general agreement on the primary causes of the U.S. Great Depression—the sharp economic contraction in the early 1930s and the subsequent slow recovery—many do agree that fiscal policy played only a minor role. This conventional view is based on both empirical and theoretical analyses of the period. Although federal government spending notably increased during the 1930s, the data show that as a share of gross domestic product (GDP), it did not increase enough to have had a large impact. At the same time, income tax rates increased sharply, but taxes were filed by few households and paid by even fewer. Feeding estimates of spending and tax rates into a standard neoclassical growth model, Cole and Ohanian confirm that the impact of fiscal policy during the 1930s was too small to matter.
Here, I challenge that conventional view. My challenge is based on an examination of all types of taxation during the 1930s. As is standard, Cole and Ohanian and others limit their attention to taxes on wages and business profits. I look as well at taxes on capital stock, property, sales, excess profits, undistributed profits, and dividends. When these overlooked taxes are incorporated into the neoclassical framework, the model predicts patterns in aggregate data that are much closer to those in U.S. data than previous studies have found. A crucial factor for the model predictions is the tax treatment of capital income. If tax rates on undistributed and distributed profits (i.e., dividends) are equated, then the impact of taxation is found to be small. If they are not assumed to be equal and are set at levels observed in the 1930s, then the impact of taxation is found to be large.
Perhaps surprisingly, given that capital taxation plays a central role in my analysis, a key policy change in the decade is the increase in tax rates on individual incomes. But individual incomes include corporate dividends. Although few households paid income taxes in the 1930s, those who did earned almost all of the income distributed by corporations and unincorporated businesses. Thus, increasing the tax rate on dividends would naturally have had a significant effect on economic activity.
Besides including overlooked taxes, I extend the neoclassical growth model to allow for both tangible and intangible business investment. I do this because the U.S. tax code allows businesses to reduce taxable income by expensing intangible investments like advertising expenditures, research and development (R&D), and labor devoted to building up businesses. I assume that part of intangible investment is financed by owners of capital and is expensed from corporate profits rather than capitalized. The remainder is financed by unincorporated business owners who are paid less than their marginal value product with the expectation of realizing future profits or capital gains. Making the distinction between tangible and intangible capital explicit in the model allows it to better capture the actual effect of taxes.
And it does. My model predicts that higher taxes during the 1930s led to a dramatic decline in tangible investment, similar to that observed in the United States, with the primary cause being the rise of the effective tax rate on dividends. The pattern of investment is a steep decline in the early part of the decade, followed by some recovery and another steep decline in 1937. The primary cause of the second decline is the introduction of the undistributed profits tax. Overall, the model predicts 1929–1933 declines in GDP and hours worked that account, respectively, for 41 and 48 percent of the actual declines. These are improvements over the Cole and Ohanian model predictions—four times larger for GDP and three times larger for hours. The model also predicts correctly that equity values should have fallen by about 30 percent over the decade.
My model’s quantitative results, especially for the early 1930s, do depend somewhat on how household expectations about future income tax rates are modeled, but sensitivity analysis shows that the main results are not overturned as I vary assumptions about expectations. The period was rife with institutional uncertainty. Major changes in the U.S. tax code were not enacted until the Revenue Act of 1932. However, as early as February 1930, President Herbert Hoover warned that large tax increases would follow if Congress enacted its proposed spending projects. Theoretically, anticipated tax increases on future distributions lead to immediate increases in current distributions and immediate declines in business investments and equity values. Regardless of the uncertainty, since tax rate increases are large, the effects on economic activity are too.