American Taxation

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This of course changed the nature of the federal tax system. In 1910 tariff and excise taxes had provided more than 90 percent of federal revenues. Today they provide well under 10 percent. In 1913 the income tax was a mere amendment to the tariff bill, a social-engineering device to force the rich to pay, in President Clinton’s favorite tax phrase, “their fair share.” By 1920 it dominated the federal tax structure, as it has ever since. Today only Social Security taxes, which are highly regressive payroll taxes, come close to providing as great a share of federal revenue.

With the federal government’s main source of revenue an income tax that featured highly progressive marginal rates, the whole basis of tax debate in this country shifted. When the tariff and excise taxes had been dominant, the debate, beyond the basic question of how much revenue should be raised, was between specific groups of producers and consumers and between regions of the country. Both textile workers and their employers, for instance, benefited from high tariffs on cotton cloth, while sharecroppers and their landlords benefited from low ones. With the income tax the debate was now between economic classes (as defined, of course, by the academy; 90 percent of all Americans define themselves as middle class).

To close the 1916 deficit, for instance, President Wilson wanted to lower the income tax’s personal exemption, which would have brought more families under the tax. The House voted instead to raise the normal rate from 1 percent to 2, affecting all the affluent equally but only the affluent. The Senate, where the strength of the progressives was concentrated, voted to increase the surtax on high incomes to 13 percent and eliminate the exemption on dividend income, placing the increased tax burden entirely on the very rich. It also added an estate tax on estates of over $50,000, an amount that limited that tax to the affluent. The Senate’s position prevailed.

This was social engineering pure and simple. Everyone agreed on the revenue needed, so it was only a question of what portions of society would pay it. Ever since, it has been an accepted tenet of American liberalism that tax increases should be effected by higher marginal rates on the rich.

IN 1920, THE LAST YEAR of the Democratic dominance that had made the income tax possible, 5.5 million returns were filed, from about 13 percent of the labor force. But while only 1 percent of those returns were for incomes of over $20,000, that group paid 70 percent of the income taxes. The rich, virtually untaxed as late as 1909, were, eleven years later, bearing the major burden of federal taxation. Like the barons of thirteenth-century England, they didn’t like it, and like the barons, they did something about it.

As David Houston, Wilson’s last Secretary of the Treasury, explained, “It seems idle to speculate in the abstract as to whether or not a progressive income tax schedule rising to rates in excess of seventy percent is justifiable. We are confronted with a condition, not a theory. The fact is that such rates cannot be successfully collected.” The reason, of course, was that the rich were quickly moving their assets in order to shelter their incomes into tax-exempt state and local bonds, for example, and into personal holding companies that were taxed at the much lower corporate rate.

The election of 1920 swept the Republicans back into power under the slogan of a return to normalcy, and there was no question that one aspect of normalcy was lower taxes. The new President, Warren Harding, appointed the banker Andrew Mellon, one of the richest men in the country, to be Secretary of the Treasury. Mellon would prove to be the most influential Treasury Secretary since Alexander Hamilton; the liberal senator George Norris joked that “three Presidents served under Mellon” during his twelve years in office. Mellon immediately set about lowering income tax rates.

CONGRESS WOULD LOWER TAX RATES THREE TIMES IN the early 1920s, until the top rate was down to 25 percent and many middle-class families were off the tax rolls altogether. This resulted in two interesting phenomena. The first was that revenue from the personal income tax did not fall; indeed, it rose from $690 million in 1921 to $711 million five years later.

Even more curious, the distribution of the tax burden became radically more progressive, not less. In 1921 those earning less than $10,000 had paid $155 million in taxes. In 1926 they paid only $33 million. Meanwhile the very rich, those earning more than $100,000, saw their portion of income taxes rise from 28 percent to 51 percent, paying $194 million in 1921 and $362 million in 1926.