Nathan Lewis

In an economic decline, mediocre governments typically bounce back and forth between “stimulus” and “austerity.” They are the ketchup and mustard of bad recession policy.

“Stimulus” – favored by the left-leaning politicians – rarely amounts to more than a form of welfare spending. This is appreciated in hard times, but it tends to be extremely expensive and does little for the economy as a whole. Deficit worries increase. Then comes the “austerity,” often favored by conservative politicians.

“Austerity” usually means spending cuts and tax hikes. But, it does not take long before politicians, bureaucrats, public employees and corporate cronies all agree that they don’t actually want to cut spending. Usually, they take some unpleasant swipes at welfare programs and services – in other words, the only programs that actually do some good, and which are especially important in a recession. This also happens to be the only government expenditure that does not land in the pockets of politicians, bureaucrats, public employees and corporate cronies.

These spending cuts rarely amount to much, so the government relies more and more on tax hikes for their “austerity” plans. The results of the tax hikes are typically an even worse economy, and often no appreciable increase in tax revenue.

As the economy contracts further, demands on the government increase. “Austerity” becomes unpopular, and is postponed until some future date “after the economy recovers.” (The tax hikes remain, however.) If the government has not exceeded its debt carrying capacity, it lurches back toward “stimulus” and large deficits. Japan has been though this cycle probably a half-dozen times by now.

If the government can no longer credibly issue debt, the typical next step is a double helping of “austerity.” There is talk of huge spending cuts, which rarely materialize. What usually happens next is minor spending cuts and huge tax hikes. This often begins the final implosion, when businesses give up completely, and tax evasion soars as the government has lost all legitimacy. Default may follow soon after.

Britain’s government is near this point now. “Stimulus” is no longer tenable. Out come the tax hikes. The talk now is of raising the capital gains tax from 18% to 40%, and even 50% in some situations. This would be on top of an increase in the VAT to around 20% from 17.5%. It was 15% in 2009. In November 2008, Britain’s government raised the top income tax rate from 40% to 45%, and in 2009 it increased to 50%.

In his 1932 election campaign, Herbert Hoover boasted that more public works had been built in the four years of his administration than in the previous thirty. Federal spending ballooned from $2.9 billion in 1929 to $4.4 billion in 1931, a 52% increase. Part of this gusher of cash went to build the Hoover Dam on the Colorado River.

This spending binge, in the midst of recession, brought huge deficits. Hoover then tried to address the deficit with a huge tax hike. In 1932, the top income tax rate in the US rose from 25% to 63%. He also tried to implement a national sales tax, but this was defeated. This followed the infamous Smoot-Hawley Tariff of 1930, which put a 60% tariff on more than 3,200 products.

After 1933, the Roosevelt administration pursued much the same approach. By 1935, Federal expenditures had grown to $6.4 billion, and in 1940 they hit $9.5 billion – over three times the level in 1929. That year, the top personal income tax rate was 79%. President Roosevelt’s Treasury Secretary, Henry Morgenthau, described the results in May 1939:

“We have tried spending money. We are spending more than we have ever spent before and it does not work. …We have never made good on our promises… I say after eight years of this Administration we have just as much unemployment as when we started… And an enormous debt to boot.”

The cycle of “stimulus” and “austerity” eventually leads to more spending and higher taxes. It doesn’t work. So what’s the solution?

A better strategy is less spending and lower taxes.

In 1976, Britain was so hard up that it had to go to the IMF for a loan. Without this assistance, the government would have likely defaulted. The IMF insisted on its usual “austerity” plan, with spending reductions and higher taxes of course. In 1979, Margaret Thatcher became prime minister. Thatcher is remembered today for her sweeping reorganization of government, in which public employees, subsidies and state-run businesses were slashed or discarded. She crushed the influence of public unions in the face of widespread strikes.

Despite this, in the 1983 general elections, only 39% of union members voted for the opposing Labor Party. Thatcher was popular. Why? The other side of her strategy was tax cuts. She immediately moved to lower top income tax rates from 83% to 60%. By 1986, the top income tax rate was 40%, and the basic rate had fallen to 25%. Capital gains tax rates were reduced from 75% to 30%, and indexed to inflation. The corporate tax rate was reduced from 52% to 35%.

Ronald Reagan, in the US, had much the same strategy: tax cuts and spending cuts. During his presidency, the top US income tax rate fell from 70% to 28%. His attempts to reduce spending floundered in the Democrat-controlled Congress.

Ideally, spending reductions should focus on the waste, theft and graft – the politicians, bureaucrats, public employees and corporate cronies – not on the public services which are the government’s primary reason for existence. Britain still has its National Health system.

I find that these sorts of policies are accompanied by a certain change in mood. The political focus shifts from parasitic self-enrichment to one of national success and failure. If your initial premise is to find a way to strip-mine the populace for wealth, and then distribute your gains among your cronies, then tax hikes and spending increases are the natural conclusion. Politicians find the answers when they start to ask the questions. Thatcher studied conservative texts, and actually read Friedrich Hayek’s The Road to Serfdom from cover to cover.

You can sense this change in mood when the terms “stimulus” and “austerity” disappear from discussion. Politicians start to talk about “national greatness,” as Vladimir Putin did in 2000 when he introduced Russia’s amazing 13% flat income tax. In the explosive recovery that followed, the Russian government’s income tax revenues soared. In 2001, the first year of the new tax system, income tax revenues increased by an astonishing 46%! This had nothing to do with oil prices, which finished that year at $19.33 per barrel. In 2002, income tax revenues increased another 40%, and crude oil finished the year at $29.42. By 2007, income tax revenues were 624% higher than they were in 2000, and Russia was once again a major world power.

This can be a wonderful time for investors.

Sometimes, governments never pull out of their spiral of decline. During the 16th century, Spain was the wealthiest and most powerful state in Europe, with a world empire stretching from California and Peru in the west to the Philippines in the east – not to mention Portugal and most of Italy and the Netherlands. By the early 17th century, native Spaniards were fleeing to the Americas to escape crushing taxes.

In his wonderful book, For Good and Evil: the Impact of Taxes on the Course of Civilization, Charles Adams notes an observer in early 17th century Madrid who said:

“The galleons left on the 28th of last month; I am assured that in addition to the persons who sailed for business reasons, more than 6,000 Spaniards have passed over to America for the simple reason that they cannot live in Spain.”

Four hundred years later, Spain remains a nice place for a sunny vacation.

Nathan Lewis
for The Daily Reckoning

Nathan Lewis

Nathan Lewis was formerly the chief international economist of a leading economic forecasting firm. He now works for an asset management company based in New York. Lewis has written for the Financial Times, the Wall Street Journal Asia, the Japan Times, Pravda, and authored Gold: The Once and Future Money.

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