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Paying for World War

Paying for World War. American Taxes and Debt during World War I and II Supplemental Lecture for Chapter 2. Organization of Lecture. Discuss whether Taxes or Borrowing is the better method to finance war. Look at how taxes were used to finance World War I and World War II.

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Paying for World War

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  1. Paying for World War American Taxes and Debt during World War I and II Supplemental Lecture for Chapter 2

  2. Organization of Lecture • Discuss whether Taxes or Borrowing is the better method to finance war. • Look at how taxes were used to finance World War I and World War II. • Look at how borrowing was used to finance World War I and World War II. • Explore if Debt from World War II has been repaid? • Conclusion

  3. I. The Great Debate: Taxes or Borrowing?

  4. Taxes v. Borrowing • Major debate in war economics • Focuses on basic question: Since war is fought currently, should it be paid for currently? • Four criteria for judging which financing method is better? • Fairness • Avoidance of wartime inflation • Disruption of industry production incentives • Impact on postwar economy

  5. Taxes v. Borrowing • Fairness • Basis for judging: To what extent does method place disproportionate burden on a part of society? • Taxes • Current civilians pay for the war • Borrowing • Postpones payment. • However, when debt redeemed at later time, it will be partially paid for members of armed forces who also fought in the war (doubles the burden of war on soldiers). • Edge goes to Taxes

  6. Taxes v. Borrowing • Avoidance of wartime inflation • Basis for judging: To what extent does method divert purchasing power away from private sector? (don’t want the government and households to compete over scarce resources) • Taxes • Reduce disposable income • Compel households to place a part of existing income in savings. • Borrowing • Leads households to believe they are already saving (since purchasing a bond is considered a form of saving for households) • Consequently, household is likely not to save any portion of the rest of its income. • Edge goes to Taxes again

  7. Taxes v. Borrowing • Production Incentives • Basis for judging: To what extent does method compel a household to work more? • Taxes • Make households feel poorer. • Borrowing • The purchase of bonds makes a household feel richer. • Does not take income from businesses who need funds to reinvest in capital. • Edge goes to borrowing

  8. Taxes v. Borrowing • Postwar Effects • Basis for judging: To what extent does method continue to impact the economy after the war? • Taxes: • Can be lowered after the war • Borrowing: • Can create debt overhang that could provoke the government to impose an inflation tax. • Edge goes to taxes

  9. Limits to Taxation • Despite the apparent superiority of taxes over borrowing, there are limits to the ability of a government to tax during war: • Political limit: Taxes can make war unpopular • Psychological limit: Only so much burden a household is willing to bear. • Economic Limit: Most important because patriotism can not override it.

  10. Economic Limits to Taxation • There are two economic limits. • First Limit: Diminishing returns to patriotism motive. • Appealing to people’s patriotism as a motivation to work will only go so far. • People need financial incentives to work long hours at tedious task. • Taxes can remove this incentive.

  11. Economic Limits to Taxation • Second Limit: Uniform tax increases have limits because income growth is highly asymmetric during wartime: • Income grows for firms in defense related industries • Income stagnates or declines for non-defense related industries.

  12. II. Tax Financing the Budgetary Costs of World War I and II

  13. Taxes During World War I • See page 21 of text • Taxes paid for 30% of the war’s total cost • Income tax begun in anticipation of possible European War. • Intended initially to be tax on rich, expanded when war began

  14. Brackets widened during war Rates rose during war Source: Tax Brackets and Rates from United States Internal Revenue Service. Table A.--U.S. Individual Income Tax: Personal Exemptions and Lowest and Highest Bracket. Tax Rates, and Tax Base for Regular Tax, Tax Years 1913-2003. Available on-line at http://www.irs.gov/pub/irs-soi/03inta.xls. Consumer Price Levels from Minneapolis Federal Reserve Bank. Available at http://minneapolisfed.org/Research/data/us/calc/index.cfm

  15. Taxes During World War II • Paid for 47% of the cost Rockoff, Hugh. In Harrison, Mark. The Economics of World War II. 1998. p. 108 • Started Tax withholding (taking taxes out of every paycheck, rather than once a year) • Done to give people an incentive to file taxes! • A Treasury Department official testified in early 1943 (U.S. House Hearings 1943: 2): “Up until 1941 we never received as many as 8,000,000 individual income-tax returns in a year. In 1941 that number increased to 15,000,000; in 1942 it increased to 16,000,000. This year we expect 35,000,000 taxable individual income-tax returns.” Source: Twight, Charlotte. “Evolution of Federal Income Tax Withholding: The Machinery of Institutional Change.” Cato Journal. Winter 1995. p. 370.

  16. Brackets widened during war Rates rose during war Source: Tax Brackets and Rates from United States Internal Revenue Service. Table A.--U.S. Individual Income Tax: Personal Exemptions and Lowest and Highest Bracket. Tax Rates, and Tax Base for Regular Tax, Tax Years 1913-2003. Available on-line at http://www.irs.gov/pub/irs-soi/03inta.xls. Consumer Price Levels from Minneapolis Federal Reserve Bank. Available at http://minneapolisfed.org/Research/data/us/calc/index.cfm

  17. Taxes During World War II • Impact of tax withholding, raising tax rates, and expanding brackets: • Increased federal receipts from $8.7 billion in 1941 to $45.2 billion in 1945. • Federal taxes as a share of GDP grew from 7.6 percent in 1941 to 20.4 percent in 1945. • Increase in the number of income taxpayers from 4 million in 1939 to 43 million in 1945. • Source: United States Department of the Treasury. “History of the U.S. Tax System.” Available at: http://www.treas.gov/education/fact-sheets/taxes/ustax.shtml

  18. III. Debt Financing the Budgetary Costs of World War I and II

  19. Debt Financing of WW I • 58 percent of war’s budgetary cost financed through debt issuance. • Debt issued primarily over a series of four “Liberty Bond” loans and two “Victory Bond” loans.

  20. The Liberty and Victory Loans Source of Data: Rockoff, Hugh. “When It’s Over, Over there: The U.S. Economy In World War I.” NBER Working Paper 10850. 2004. Table 6.

  21. Funds obtained through Borrowing • Bonds Offered (Billions of 1917 $) • First Liberty Loan: $2 • Second Liberty Loan: $3 • Third Liberty Loan: $3 • Fourth Liberty Loan: $6 • Total Victory Loan: $4.5 Source: Rockoff, Hugh. “When It’s Over, Over there: The U.S. Economy In World War I.” NBER Working Paper 10850. 2004.

  22. Debt Financing of WW I • More limited debt financing obtained through $4.12 “War Certificates” and $0.25 “Savings Stamps” (figures in 1917 dollars). • However, these only accounted for approximately 3.5% to 4% of the total debt issuance.

  23. Patriotism = Affordable Debt • Despite the large quantities of Liberty bonds issued by the government, Yields on Liberty Bonds remained low because public demand stayed high (thanks to bond rallies and celebrity endorsements).

  24. Patriotism = Affordable Debt • Hugh Rockoff (2004) points out that the interest rate on Municipal Bonds was higher than Liberty Bonds, indicating that the public was eager to purchase them.

  25. Debt financing of WW II • War budgetary cost was $288 billion in current dollars. • $156 billion of bonds issued (54.2% of total cost). • Sources: Nofi, Al. Statistical Summary: America’s Major Wars. The United States Civil War Center. Louisiana State University. Available on-line at www.cwc.lsu.edu/cwc/other/stats/warcost.htm and Murphy, Henry. National Debt In War and Transition. McGraw-Hill: New York. 1950. Table 8. p. 154

  26. When was the debt Issued and when did it mature? • Seven War Loans and 1 Victory Loan from 1942 through 1945.

  27. When The Debt Was Issued and When It was to Mature Source of Data: Murphy, Henry. National Debt In War and Transition. McGraw-Hill: New York. 1950. pp. 134, 139, 146 – 152.

  28. Debt Issued with Each War Loan (Billions of Current US $) Source of Data: Murphy, Henry. National Debt In War and Transition. McGraw-Hill: New York. 1950. Table 9. p. 155

  29. IV. Have we Paid off World War II?

  30. Have we Paid off World War II? • Question difficult to answer because, as the next figure shows, government debt has continually risen since 1950s, thereby making it difficult to identify just WWII debt.

  31. Maturing Debt • Technically, World War II should have been completely paid off from 1968 through 1972 (when longest term bonds matured). • However, was debt rolled over?

  32. Does it matter if WWII has been paid off? • Probably Not • Inflation has diminished the real value of the debt. • Economy has grown, so burden of debt has diminished.

  33. Inflation • Interest Rate on Longest Term bonds was 2.5 percent. • Average Inflation rate from 1945 through 1972 was 3.189 percent. • Plug into Real Interest Rate Equation: ireal = inominal + po • Real Interest rate is – 0.689 percent • Source of Inflation data: Federal Reserve Bank of Minneapolis, Consumer Price Index, 1913 – 2005. Available at http://minneapolisfed.org/Research/data/us/calc/index.cfm

  34. Inflation

  35. V. Conclusion

  36. Main Points • Many methods to finance a war • For major wars, taxes are better than borrowing (within limits). • WWI and WWII employed both taxes and borrowing. • Many features of the current U.S. tax system are a product of the two world wars. • Even if U.S. still has debt acquired from WWII, it doesn’t appear to be a major concern.

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