McGraw Hill Financial Inc (MHFI), Dow Jones Industrial Average: The Day the U.S. Lost its Luster

On this day in economic and business history…

The federal debt of the United States, which is commonly issued as Treasury notes, was downgraded by Standard & Poor’s, a unit of McGraw Hill Financial Inc (NYSE:MHFI), for the first time in history on Aug. 5, 2011 at the end of a tense legislative standoff over the debt ceiling. The ratings agency specifically pointed out “the gulf between the political parties” as part of its rationale. S&P also took issue with the last-minute debt-ceiling plan, which it felt fell short of “what … would be necessary to stabilize the government’s medium-term debt dynamics.” Treasuries were also assigned a negative outlook, indicating that S&P might issue another downgrade in the future if the U.S. were to continue dithering in its fiscal obligations.

The deal was widely criticized by high-ranking members of both political parties — who mostly seemed happy to point fingers at each other in advance of the 2012 election season — and by eagle-eyed analysts, who noted that S&P’s calculation significantly overestimated (by about $2 trillion) future deficits beyond Congressional Budget Office projections. Neither of the remaining “Big Three” ratings agencies followed S&P with their own downgrades, although both placed Treasuries on a negative outlook by the end of the year.

Because S&P snuck its downgrade in on a Friday afternoon following the close of trading, it took several days for the impact on American markets to be felt. The next trading day experienced a 5.5% decline in the Dow Jones Industrial Average , which brought total losses for the preceding two weeks to 15% and moved the Dow as close to four-digit territory as it had been in a year. However, fears proved fleeting, despite the apparent continuing inability of policymakers to actually make sensible policy regarding the debt ceiling. The Dow regained its footing and went on to add another 45% to its value over the next two years.

Time will tell whether that holds up. There might be another debt-ceiling crisis brewing for 2013 — particularly with Congress entering its summer recess without any plan in hand to deal with the anticipated exhaustion of the Treasury’s borrowing capacity before the end of the year. If that occurs, there may be more than one downgrade in store for U.S. debt.

Income taxes, beta mode
Early in the Civil War, the U.S. government under President Abraham Lincoln realized it would have a great deal of difficulty financing the war with the revenue-raising mechanisms then in place. Throughout the spring and early summer of 1861, the Lincoln administration worked to develop new avenues through which to finance the war. Finally, the government put together a Revenue Act, which Lincoln signed into law on Aug. 5, 1861.

The Revenue Act of 1861 introduced the first personal income taxes in American history. These taxes were to be collected at a rate of 3% on all annual income of more than $800 (equal to about $21,000 today) and at a rate of 5% on all annual income above $10,000 (more than $260,000 in present terms). There was no adequate enforcement mechanism built into the Revenue Act of 1861, and so it was replaced by an expanded Revenue Act of 1862. This upgraded tax-raising bill led to the creation of the Office of the Commissioner of Internal Revenue, predecessor to today’s Internal Revenue Service. It also reduced the minimum annual income subject to taxation to $600, which would be about $14,000 in present terms.