American Taxation

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First, once the personal income tax finally became a reality, it should have been merged with the corporate tax, which had been intended as a stopgap measure to get at the incomes of the rich immediately. But it was not, and because the taxes on corporate income and personal income have never been integrated, many perverse—and entirely unintended—forms of economic engineering have resulted. The most important, perhaps, is that the interest paid by corporations on bonds comes out of pretax income but that dividends on stocks are paid out of after-tax income and then taxed again as personal income when received by the stockholder. Under current tax rates, dividend income can be taxed as high as 60.7 percent, while interest income is never taxed higher than 39.6 percent. This is both an immense incentive to finance by debt rather than equity and an immense disincentive to entrepreneurship. It makes no economic sense whatever.

The lack of coordination between the laws of personal and corporate income also has provided nearly endless opportunities for the lawyers, accountants, and advisers of the affluent (about half a million people now earn their living doing this) to find ways to shift income between corporate and personal in order to postpone taxes, pay the lowest ones possible, or avoid them altogether. Politicians as well have found the two tax systems a very convenient arrangement for quietly handing out political favors to the rich.

BUT THE PERSONAL INCOME TAX HAD MANY FLAWS OF ITS own. Although very simple in retrospect—it was only fourteen pages long—it already contained the seeds of vast complexity. There was an exemption for income below $3,000, thus allowing the tax to reach into the upper middle class, but there was also a marital deduction of $1,000. At those rates 99 percent of the 1913 American population was still exempt. A “normal rate” of 1 percent was charged on income above $3,000, but above $20,000 in taxable income, rates began to rise until they reached 7 percent on incomes over $500,000.

To counterbalance these rates, however, there were many exclusions. The interest on state and local bonds was not taxed. Gifts and inheritances were exempt. So were the proceeds of life insurance policies, giving the life insurance lobby the honor of being the first of countless thousands to extract a favorable income tax proviso from Congress.

There were numerous deductions as well. Business expenses, naturally, were excluded. But so were other taxes, interest paid on all debts, uninsured casualty losses, bad debts, depreciation of property, and dividends on stock (up to $20,000).

One aspect of the 1913 income tax, however, was better than what we have had since. It was what is known in tax jargon as “deduction at source.” Wages, interest, and dividends subject to the tax were subject to withholding, and any excess taxes collected were refunded at the end of the tax year. In 1916, unfortunately, this system was replaced with “information at source,” with companies and banks only informing the government of wages, dividends, and interest paid.

Wages were again subject to withholding during World War II and remain so, of course, but other forms of income were not. The result has been a clerical nightmare for the IRS, which today receives more than a billion Form 1099s a year reporting income paid, which it has to match up with well over a hundred million Form 1040s reporting income received. The temptation of and opportunities for—and, doubtless, the incidence of—evasion are vast.

In the beginning, however, the income tax caused hardly a ripple. Only 357,598 Form 1040s (as they were called even then) were filed in 1914. Slightly less than a year after the modern personal income tax had been introduced, however, World War I began, and the twentieth century began with it. Although the war caused an immediate and continuing jump in American exports, principally war matériel to the Allied powers, imports dived, and the revenues from the tariff along with them. By 1916 the government, facing sharply increased naval expenditures as well as falling revenues, projected a deficit of $177 million.

REAGAN’S 1986 rate cut and simplification was the greatest reform since the income tax was introduced.

The government soon turned to the income tax to plug the gap, because it had one powerful advantage over indirect taxes: It could produce increased revenue very quickly. As the clouds of war darkened during the Wilson administration, it turned to the income tax more and more. When the country actually declared war, the exemption on income taxes was dropped from $3,000 to $1,000 ($2,000 for married couples) thus embracing much of the middle class just as the Civil War income tax had. The normal tax rate was doubled to 4 percent, and surtaxes ranged all the way up to 50 percent. They would reach 77 percent by war’s end. Federal revenues soared from $800 million in 1916 to $3.7 billion in 1918.