American Taxation

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Yet these results did not surprise Mellon. In a book he published in 1924, he explained it clearly: “It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the Government, and that more revenue may often be obtained by lower rates. There is an old saying that a railroad freight rate should be ‘what the traffic will bear’; that is, the highest rate at which the largest quantity of freight would move. The same rule applies to all private businesses. . . . The Government. . . can and should be run on business principles.”

The government ran large surpluses during most of the 1920s, but the ensuing Depression changed that completely. By 1931 the deficit was projected at $750 million just for the first quarter. President Hoover was reluctant to raise taxes under the circumstances, but economists in those pre-Keynesian days were nearly unanimous in their recommendations to do so. It is ironic that one of Andrew Mellon’s last acts as Secretary of the Treasury was to ask Congress to undo most of his work in the 1920s. The top marginal rate moved back to 55 percent, where it had been in 1922. The results of the tax increases for the economy as a whole were disastrous, and they assured Hoover’s defeat in the 1932 election.

Hoover’s successor, Franklin D. Roosevelt, moved cautiously regarding taxes during the first two years of his Presidency, but by the mid-thirties he was condemning “economic royalists,” and he proposed what soon was dubbed the “Wealth Tax.” It raised marginal rates on personal income back up to World War I levels and added a graduated corporate income tax of up to 40.5 percent. It also increased estate taxes.

The reaction of the rich was entirely predictable. As Andrew Mellon had predicted in 1924, they began to shelter income again. The result was a classic example of what biologists call coevolution. Taxpayers developed ever newer and better ways to shelter income in the interstices of the tax laws while Congress and the tax authorities tried to write new laws and regulations to prevent or govern (and, not infrequently, to allow and even encourage) each new wrinkle. The result was both the most complicated income tax code the world has ever seen and a great deal of income that goes entirely untaxed, today perhaps as much as a hundred billion a year in lost taxes.

In the early days of this process, some of the wrinkles were lulus. Sailing as a guest on a Vanderbilt yacht one day, Franklin Roosevelt was astonished to learn that many rich men were incorporating their yachts to escape taxation. A New York financier was overheard in a Paris bar proudly proclaiming, “My fortune is in the Bahamas and is going to stay there as long as that bastard is in the White House.” He was by no means the only one to take such action. And Congress, while retaining and even increasing very high marginal rates, began to write political favors into law, creating different categories of income, increasing the number and kinds of deductions, and adding provisions that are nearly meaningless to the uninitiated but that had the effect of saving companies and individuals millions in taxes.

By the time of World War II, the federal tax code was quickly spiraling into utter confusion. Of the 208 pages in the Revenue Act of 1942 (fifteen times the length of the original 1913 income tax act), no fewer than 162 dealt with closing or defining loopholes in earlier revenue acts. Seventy-eight percent of the act, in other words, dealt with the fiscal and economic consequences of earlier tax legislation.

THE REST OF THE ACT, ALMOST COINCIDENTALLY, CON- verted the income tax into a truly mass tax for the first time. With the advent of total war, it sharply raised taxes on the middle class, where the bulk of the income is found in this middle-class country. In the words of one tax historian, “it spread the income tax from the country club district down to the railroad tracks and then over to the other side of the tracks.”

After the war, rates were lowered on the smaller incomes, but very high marginal rates were retained on higher ones. By that time high marginal rates were liberal dogma, but the rich did not complain too loudly. In 1952, when a Republican President and a Republican Congress were elected for the first time since 1928, no attempt was even made to lower rates. There was a reason. The rich and their advisers had learned how to live with them and even flourish under them. For just as Mellon had explained, those with higher incomes were paying less of the total taxes under the status quo. Thus high marginal rates were effectively supported by liberals and the rich, just as Prohibition had been supported by preachers and bootleggers. Politics, as they say, makes strange bedfellows.