We often look at the American economy in two stages, pre- and post-1929, because the stock market crash of 1929, the subsequent catastrophe of the Great Depression, the devastation of World War II, and the Cold War that followed, had profound effects on the American psyche. We are not the same country we were in 1929, and nowhere is that more evident in how we view government and fund the federal budget.
Prior to 1929, Americans had an almost unbridled faith in free-market capitalism. The Crash of 1929 and the Great Depression shook that faith. In addition, prior to 1929, America was an isolationist country, reluctant to intervene in the domestic affairs of other countries (Latin America being the exception). World War II and the Cold War changed all that, and America's foreign policy today stands in stark contrast to that of the 1920s. Today, we look to the federal government to both serve the needs of ordinary people -- through Social Security, Unemployment Compensation, Medicare/Medicaid, Aid to Dependent Children, and so on -- rather than the elite few, as well as to intervene financially and militarily in all kinds of foreign affairs. This changed mindset has had a profound effect on the size of the federal budget. Federal government outlays today are five to eight times greater than they were in 1929, and total federal revenue has increased dramatically -- from 3.8% of GDP in 1929 to roughly 17% today.
Prior to WWII, the federal government's main source of income was federal excise taxes. That is certainly not the case today, as excise taxes have declined steadily since the 1930s. To fund its initiatives, the federal government has increasingly turned to income taxes. In 1934, personal income tax receipts were 14.2% of total federal revenue. Today they stand at about 47%. But by far it is payroll taxes that have played the major role in financing the increase of the federal budget. In the early 1930s, payroll taxes were virtually non existent. Today they are roughly 42% of total federal revenue. Payroll taxes have financed Social Security, disability, and Medicare, and have contributed some $3 trillion to the federal government's general fund as the Social Security Administration built up the OASDI and Medicare trust funds. Payroll taxes today nearly match individual income taxes as the primary source of federal revenue.
None of this should come as a surprise to you if you own a business; you pay both personal income and payroll taxes and feel the tax burden more than anyone else. As campaign season ramps up over the summer, there is undoubtedly going to be fierce debate over taxes and government spending. Keep in mind that the bulk of the federal budget now goes toward those "human resource" programs mentioned earlier, whether it is spent directly at the federal level or transferred to states and local jurisdictions to fund programs at those levels. With defense and virtually every other government program cut to the bone, a trend we've seen since 1980, there really is no other budget to cut except social service programs. Americans are quickly going to have to decide whether it wants to radically cut those programs or increase taxes. Believe it or not, today's income tax rates are strikingly low relative to rates over the past century, especially for high wage earners. For most of the century, including boom times, top bracket income tax rates were much higher than they are today. Also, periods of very low tax rates have been followed by periods with very high tax rates, and vice versa. History unfortunately suggests that tax rates will soon increase -- especially if cuts to the federal budget are not made. As you look to the future, be prepared to face those taxes both personally and professionally.