HOW A NATION BORN OUT OF A TAX REVOLT has—and especially hasn’t—solved the problems of taxing its citizens
Today the American goose flock, 260 million strong, is hissing furiously over the nation’s federal tax system, and it is not hard to see why. The United States Internal Revenue Code takes up six inches of shelf space in two fat volumes. But that is not the half of it. Federal tax regulations, the Talmud, if you will, to the Torah of the tax code, takes up an additional foot of shelf space in eight volumes. Thousands of accountants and lawyers devote entire careers just to small portions of this behemoth, and no one could possibly know its entirety, not even the Internal Revenue Service. Indeed, it is estimated that one-third of the inquiries made to the IRS’s own 800 help line are answered incorrectly.
Every year the IRS sends out more than eight billion pages of forms and instructions (requiring, at least according to one authority, 293,760 trees to make the paper). Even modest incomes can require an astonishing number of pages of tax forms to report. My own—believe me, modest—income needed sixteen pages for the federal return for 1994, another seven for the state. A friend who comes from a wealthy family and has his own considerable business had a personal return this year that ran to more than four hundred pages.
Meanwhile, corporations have it far worse. Chrysler’s 1991 return, for instance, was a stack of paper six feet high, prepared by fifty-five accountants who worked on nothing else that year. The company is perpetually audited by at least nine IRS agents. Chrysler’s chief tax counsel estimates that it will be ten years before all current matters in dispute between Chrysler and the Internal Revenue Service are settled. And they will be settled, essentially, by negotiation. There simply are no cut-and-dried, right-orwrong answers to the thousands of questions that are raised in a return that has tens of thousands of calculations that are required by a law that has hundreds of thousands of provisions, exemptions, provisos, interpretations, and internal contradictions.
The cost of all this is staggering. Although the IRS spends only about seventy cents for each hundred dollars it collects in taxes, the burden lies principally on tax filers and their employers, who act as unpaid tax gatherers in addition to having to file their own returns. A 1985 IRS-commissioned study estimated that individuals and businesses needed 5.4 billion man-hours to complete and file returns. Had these man-hours been fully compensated, they would have cost $159 billion, or 24.4 percent of the income tax revenues received by the government that year.
To put it all another way, the means by which the federal government raises revenue violates every single principle of sound taxation developed over the more than five thousand years in which taxes have been collected. These principles are no great mystery. Adam Smith listed four of them in the Wealth of Nations more than two hundred years ago. “I. The subjects of every state ought to contribute towards the support of the government . . . in proportion to the revenue which they respectively enjoy under the protection of the state. . . . II. The tax which each individual is bound to pay ought to be certain, and not arbitrary. . . . III. Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it. . . . IV. Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state.” Today, in a heavily taxed, highly industrialized, completely integrated cash economy that Smith never imagined, we might add another: “V. Taxes should distort as little as possible the underlying economy that generates the wealth to pay them.”
How did a country born out of a tax revolt and still the most tax-aversive major power on earth get into this situation? Simple. You take constitutional language that none of the Founding Fathers apparently really understood, a very conservative Supreme Court in the 1890s, an increasing public demand that the rich pay income taxes, and a very gifted lawyer who happened to be President of the United States. You mix them all together, and the result is two completely separate income tax systems, one corporate, one personal, that were never integrated or even designed to work smoothly together.
Then, no sooner are the two systems in place than two world wars and a Great Depression utterly transform the revenue needs of the federal government and raise taxes to levels inconceivable a few decades earlier. These levels provide powerful incentives for tax avoidance, and other gifted lawyers (and gifted accountants) play one tax system off against the other for the benefit of their clients, while the IRS tries to keep up, using ever more complicated regulation.
And, of course, in Congress it has been politics as usual. One squeaking wheel—or, in this case, hissing goose—after another has been paid attention to politically with favorable changes in the tax code, while more and more money has been funneled to interest groups via “tax expenditures—deductions and credits for favored activities. Meanwhile, the general interest in an equitable, comprehensible tax system has been ignored.
How do we get out of this mess? For this student of the system, the answer to that question is also simple, at least to state, if not politically to achieve: We have to abandon the very idea of tax reform and design a whole new system from the ground up. There is no reforming a system that never made sense to start with.
This year it appears that the process is under way. In the 1992 presidential campaign only the former California governor Jerry Brown advocated fundamental change of the tax system. This year every major candidate for President has put forth or endorsed a plan for exactly that. Thus it is increasingly likely that a serious debate on taxes will be a major feature of this year’s final campaign, and the results of that debate could be turned into law in the next Congress.
The result, if done properly, would be not only a lot of happier geese but a flood of additional golden eggs from the American economy once it is freed from a misbegotten tax system that has become a disgrace to democracy and capitalism alike.
In ancient Egypt landholders had to pay 20 percent of their normal crops, plus 20 percent of all other household production, to the government. Even if crops were way down, however, the taxes remained the same. Tax inspections were frequent, and those deemed to be cheating, it is safe to assume, did not fare well. On the other hand, tax inspectors who were found to have abused their power had their noses and ears cut off, a practice many a survivor of a modern tax audit would be happy to see revived.
In the early days of Rome, the state relied as much as possible on tribute from conquered provinces and arbitrary direct taxes (taxes laid directly on individuals), such as forced loans and requisitions, which are demands by the state for particular goods and services. Requisitions, among the most arbitrary, capricious, and regressive of all taxes, would not disappear until modern times. As recently as 1791 the Third Amendment to the U.S. Constitution restricted the last common form of requisition, the billeting of soldiers in private houses.
One of Rome’s earliest indirect taxes (taxes laid on economic activities, such as manufacturing and selling, rather than on individuals) was a 5 percent tax on the value of manumitted slaves, imposed in 357 B.C. By the end of the empire, Rome had created virtually all the taxes known today, on land, income, sales, imports, inheritances, and capital, among others. The ever-increasing tax burden and evasion of it by those in a position to do so were no small factors in the final collapse of Roman power.
With the end of the Roman Empire in the West came the end of most taxes there, largely replaced by feudal obligations that were not altogether dissimilar to the Egyptian system of three thousand years earlier. It was only after kings had once again begun to mint coins in quantity sufficient to provide an adequate money supply, after the year 1000, that feudal obligations slowly began to transmute into monetary obligations, or, in other words, into taxes.
The people upon whom the burden of these new taxes fell, naturally, did not like it. They never do. In England, for instance, the king was expected to operate the government with the income from the crown lands, except under extraordinary circumstances. When a weak and inept king tried to impose new taxes on the nobility anyway, the result, in 1215, was Magna Carta, and King John was forced to swear that “no scutage or aid may be levied . . . without [the nobility’s] consent. . . .”
Magna Carta was the start of a long struggle between the crown and what would by the end of the thirteenth century develop into Parliament, a struggle that is at the very center of British constitutional history and thus of our own. In 1649 that struggle cost Charles I his head, and in 1688 his son, James II, his throne. The following year the new sovereigns, William and Mary, gave their assent to the Bill of Rights, which, among much else, specified again that no new taxes could be laid on the people without the consent of their representatives in Parliament.
But for all the blood spilled over taxes in its long history, Britain in fact was the most lightly taxed major nation in Europe, because the English Channel freed the country from the vast expense of a large standing army. More lightly taxed still were the inhabitants of the new American colonies. Many colonial officials served without pay, as did the colonial militias. What taxes there were were principally of four kinds.
The Southern colonies also favored import and export duties as a means of raising revenues.
In New England, however, the property tax was dominant from the beginning, and it soon became the primary revenue source in the middle colonies as well. In the beginning it was often assessed on all forms of property. Today it is largely restricted to real estate and remains the main source of revenue for most local governments.
There is little mystery regarding this geographical divergence in favored taxes. In the South the dominance of large property owners over local governments made the property tax politically difficult, while New England was characterized by small property owners, with often limited means, and a large and soon wealthy merchant class. The New England merchants, already active on a global scale, naturally opposed customs duties. Thus, from the earliest days, American taxation was like all taxation: The burden of it has tended to fall lightest on those with the most political power, and wealth, of course, easily translates into political power.
Greatly helped by low taxation, more and more wealth was being generated by the American economy by the middle of the eighteenth century, and this naturally attracted the attention of the cash-strapped mother country. The Seven Years’ War, fought from 1756 to 1763, was hugely successful for the British Empire but, like all wars, was also hugely expensive. The government in London wanted North America, where much of the war had been fought, to help pay the bill.
The British political class, steeped in mercantilism, saw colonies as existing for the benefit of the mother country and therefore ripe for plucking by taxation. The American colonists increasingly saw them as existing for the sake of their own citizens, and these were represented not in the Parliament at Westminster but in their colonial legislatures.
When the British government sought to impose taxes on the American colonies, in flat contradiction, as the Americans saw it, of the British Bill of Rights, the resulting hissing was immediate and ferocious. Today it would be called a political firestorm, and it soon forced the repeal of the taxes. Although the British government continued to insist on its right to tax the colonies, it sought to meet the colonists’ demands halfway and raise revenues by other, less objectionable means. In an atmosphere of increasing political strain, however, they all failed and, indeed, made matters steadily worse. The result was revolution.
The financial demands of the American Revolution simply could not he met by the primitive colonial tax system in place, and all manner of expedients were required to prosecute the war successfully. The result was that in 1783 the United States was free but a fiscal basket case.
The Articles of Confederation, the first American constitution, did not help matters. The states, jealous of their new sovereignty, resisted transferring meaningful power to the central government. Most important, the Articles of Confederation did not grant the new federal government the power to tax. Instead the federal government had to assess the states for the money it needed to operate—but had no means to force the states to pay up. Many were late or simply didn’t pay at all.
The fiscal chaos continued until it finally forced the drafting of a whole new constitution, which gave Congress the power “to lay and collect Taxes, Duties, Imposts and Excises”—a very broad mandate. But it required that these be uniform throughout the United States, in order to prevent several states from ganging up on one or two rich ones, the same reason it forbade duties on the exports of any state.
To protect the interests of the less wealthy, the Constitution required that all revenue measures originate in the House of Representatives, elected by the people, rather than in the Senate, whose members were then elected by state legislators, who were in turn overwhelmingly men from the top of society. But to protect those men of wealth, it required that “no Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census. . . .” At the Constitutional Convention Rufus King of Massachusetts wanted to know the precise definition of “direct taxation.” James Madison reported in his notes that “No one answered.” It was a silence that would have no small consequences a hundred years later.
Congress immediately set about devising a federal tax system. On July 4, 1789, it passed the first Tariff Act, and import duties ,would usually provide the bulk of the federal government’s revenues until the First World War (although the proceeds from the sale of public land in the West, not a tax at all, increasingly contributed to the government’s revenues as the frontier pushed westward). But at first tariffs were not enough. To gain more revenue, Congress passed excise taxes on carriages, distilled spirits, sugar, salt, and other items. The tax on carriages was clearly a soak-the-rich measure (only the rich, after all, could afford carriages), but a very modest one.
Liquor, sugar, and salt were taxed simply because they were three of the relatively few commodities then manufactured on an industrial scale and thus amenable to efficient tax collection.
The federal government quickly ran into a serious problem with the so-called whiskey tax. In most areas of the country, liquor distillers were too few in number to protest the new tax effectively, and in any event they could easily pass it along to their customers in higher prices. But the small farmers in Western areas were blocked from Eastern markets by the Appalachian Mountains. They had to convert their grain to whiskey to make it valuable enough to bear the cost of transportation across the mountains. A 25 percent excise tax was economically disastrous for them, and they flared into rebellion, the first direct challenge to the authority of the new federal government. The rebellion was quickly and easily suppressed, and the two rebels who were convicted of treason were pardoned by President Washington. But the point was made that the new federal government could, and would, enforce its writ.
A number of these taxes were reimposed during the War of 1812, but they were again repealed soon after the war ended. Until the Civil War the federal government would, in most years, run a large surplus, thanks to steeply increased tariffs.
In the first days of the new federal government, the Secretary of the Treasury, Alexander Hamilton, had hoped to accomplish two things with the tariff: First, of course, he wanted to establish a revenue stream that would fund both the operations of the government and the debts acquired in the Revolution, and second, he wanted to protect American industry until it was efficient enough to compete on even terms with the established industrial firms of Europe, especially Britain. This latter intent is a classic example of the second purpose of taxation, one that developed only in modern times: an effort to affect the workings of the national economy rather than to raise revenue—in other words, taxation for the purpose of economic engineering.
Far more often, economic engineering requires a benevolent—not to mention objective—despot to succeed. Any time it happens to benefit a particular segment of the population, the way tariffs protect manufacturers, that segment will always work hard to maintain its benefit long after the original purpose of the tax has been served. In the push and shove of democratic politics, meanwhile, economic engineering has also, of course, often served as a splendid refuge for scoundrels, providing cover for political favors to the rich and powerful.
Congress at first ignored Hamilton’s call for protective tariffs because there were few industries to protect and they had little political influence. The people who would have to pay the tariffs—the American population at large—loomed far larger in Congress’s political consciousness. That situation changed radically after the War of 1812. The British blockade during the war and laws such as the Embargo and Non-Intercourse acts that preceded it spurred a large jump in American manufacturing, much of it concentrated in New England. The traditional New England opposition to tariffs began to fade as the new American industries pushed for ones high enough to protect them from renewed foreign competition.
The South, ever more dependent on the export of cotton and the import of manufactured goods from both the North and Europe, fiercely resisted these increased tariffs, but with only limited success. The one passed in 1828—called, with typical Southern genius for political phrasemaking, the Tariff of Abominations—led directly to the nullification crisis of 1832, which threatened the Union itself. Tariffs were lowered in settling that dispute, and were lowered as well in 1857, but they remained far higher than revenue needs normally required. The tariff, then nearly synonymous with federal taxes, was a prime cause of the Civil War.
At the end of 1860 the federal government was spending money at the rate of about $173,000 a day. Three months later the War Department alone was spending $1 million a day. By the end of that year it was up to $1.5 million. A conflict unprecedented in scale in Western, let alone American, history, the Civil War placed wholly unprecedented demands upon the financial resources of the United States and the federal tax system.
Much of the cost of the war for the North was thrown off onto the future by the borrowing of nearly $3 billion from American citizens, many of modest means, in the world’s first bond drives. About $450 million was raised by the printing of greenbacks, legal tender not backed by gold. About $750 million was raised by taxation.
The act establishing the Bureau of Internal Revenue also moved to tax nearly everything. Excise taxes were slapped on most commodities; stamp taxes on licenses and legal documents. The gross receipts of railroads, ferries, steamboats, and toll bridges were taxed. Advertisements were taxed. The tariff was sharply raised.
Also imposed was a tax on all income “whether derived from any kind of property, rents, interest, dividends, salaries, or from any trade, employment or vocation carried on in the United States or elsewhere, or from any other source whatever.”
The act exempted the first $600 in income, and income between $600 and $10,000—a very comfortable sum indeed at the time—was taxed at 3 percent. Income over $10,000 was taxed at 5 percent. Taxes had to be raised sharply again in 1864, so the top rate on income was doubled to 10 percent, while taxes on liquor reached two dollars a gallon, no small sum when it would have sold for about twenty cents a gallon untaxed. But resistance to the heavy taxes—and high taxes’ inevitable handmaiden, evasion—were not widespread during the war. One of the natural principles of taxation, it turns out, is that the people will willingly pay very high taxes during wartime.
Peacetime is another matter altogether. Immediately after the war the cry for repeal of the wartime taxes became insistent. With military expenses quickly dropping, the problem, basically, was what taxes to cut. American industrialists, who had prospered mightily thanks to wartime demand and wartime high tariffs, naturally did not want the tariff cut. Because the Civil War had broken the political power of the South, the center of opposition to the tariff, they got their way. The tariff was kept at rates far above the government’s need for revenue as the North industrialized at a furious pace in the last three decades of the nineteenth century and became the greatest—and most efficient—industrial power on earth.
Of course, no matter how large, efficient, and mature these industries became, they continued to demand protection and, thanks to their wealth and political power, get it. As Professor William Graham Sumner of Yale explained as early as 1885, “. . . the longer they live, the bigger babies they are.” It was only after the bitter dispute between Andrew Carnegie and Henry Clay Frick had caused the astonishing profits of the privately held—and highly protected—Carnegie Steel Company to become public knowledge, in 1899, that the political coalition behind high tariffs began to crack.
Hard as they fought to maintain high tariffs, the industrializing states fought equally hard to diminish the wartime income tax and then to abolish it. In 1867 rates were cut to a uniform 5 percent on incomes over $1,000. In 1870 they were reduced again, and in 1872 they were allowed to expire altogether.
Before the Civil War there had been little pressure for a federal income tax in this country, although by the start of the war six states had implemented such taxes. But once a federal income tax was in place, it quickly acquired advocates, as political programs always do. These advocates pushed the idea relentlessly, and they had some compelling arguments.
The indirect taxes, such as excises and tariffs, by which the government was funded are inherently regressive. That is to say they fall harder on the poor than the rich because they are based on consumption, and the poor necessarily consume far more of their income than the rich do.
As for the claim by the wealthier states that they paid a disproportionate share—New York State alone paid onethird of the Civil War income taxes—Oliver Morton, Republican of Indiana, had a simple answer: “I should be very willing to exchange with New York and agree that we would take her incomes and pay her taxes. . . . They have to pay the income tax simply because the large incomes are there.”
But as usual with taxes, it was political power, not equity, that prevailed. Representatives of seven Northeastern states plus California, which collectively had paid 70 percent of the income tax, voted 61 to 14 not to renew the tax. Meanwhile fifteen mostly Southern and Western states, which had paid only 11 percent of the tax, voted 69 to 5 in favor. Support for the income tax, in other words, was inversely correlated with its local impact. Politicians will always try to live up to the dictum usually credited to former Sen. Russell Long of Louisiana: “Don’t tax you and don’t tax me. Tax the man behind the tree.”
But perhaps the decisive reason not to renew the Civil War income tax was that it was simply not needed for revenue. The traditional federal taxes more than covered federal expenses once the war was over and it was politically impossible to lower them. The argument to continue to utilize an income tax, then, was basically an argument for social engineering, using taxes to affect the distribution of wealth, not to raise revenue. This is the third purpose of taxation and one that developed only in the late nineteenth century. It would flower greatly in the twentieth.
Like taxation for purposes of economic engineering, taxation for social engineering is intellectually valid in theory. Indeed, there is little doubt that imposing an income tax and using the revenues to reduce excise taxes would have had both socially and economically beneficial results in the late nineteenth century. But taxation for social engineering suffers from exactly the same problem as that for economic engineering: Once in place it is very hard to remove, even when circumstances and political perceptions change.
The nineteenth century was the golden age of social engineers, as the left—a term that did not enter the American political vocabulary until the twentieth century—rose in importance with the development of the labor movement in the East and the Populist and Granger movements in the West and South. One of the world’s earliest and most influential leftists was, of course, Karl Marx, who was the first to advocate a steeply progressive income tax, in The Communist Manifesto , to break the power of the bourgeoisie.
Henry George, who would later be elected to Congress, advocated a single tax on the value of land. Felix Adler, the founder of the Ethical Culture movement, called for a 100 percent tax rate on incomes above the amount needed “to supply all the comforts and true refinements of life.” One can only wonder how that amount was supposed to be objectively determined. None of these schemes had the slightest chance of being put into practice in the nineteenth century. But many would come to haunt the twentieth, despite vastly changed social and economic circumstances.
Killed in the 1870s, the income tax did not make much headway in the prosperous 1880s, when the federal government was running up surpluses so large they bordered on the embarrassing. But the panic of 1893 revived the movement. With a Democrat, Grover Cleveland, in the White House and Democratic majorities in both the House and the Senate, the chances for a renewed income tax grew suddenly bright.
In the House a classic debate ensued between Bourke Cochran, Democrat of New York, and William Jennings Bryan, Democrat of Nebraska. Cochran, whose home state would bear the biggest burden by far of this tax, argued that it wasn’t necessary. He thought that the tariff reductions contained in the same bill would result in higher revenues from that tax (a supply-side argument nearly a century before the term even entered the language). Furthermore he thought that by imposing a tax only on the rich, Congress would deprive the rest of the country of the privilege of supporting the cost of government.
Bryan, ever the soul of eloquence, if seldom of economic logic, pounced at once. “Why, sir,” he orated, “the gentleman from New York said that the poor are opposed to this because they do not want to be deprived of participation in it, and that taxation instead of being a sign of servitude is a badge of freedom. If taxation is a badge of freedom, let me assure my friend that the poor people of this country are covered all over with the insignia of freedom. . . . The gentleman says he opposed the tax in the interest of the poor! Oh, sirs, is it not enough to betray the cause of the poor—must it be done with a kiss? Would it not be fairer for the gentleman to fling his burnished lance full in the face of the toiler, and not plead for the great fortunes of this country under the cover of a poor man’s name?”
Much of Cochran’s argument was of course tendentious twaddle that richly deserved its fate at Bryan’s oratorical hands. But Bryan’s in turn was a pure form of the class-warfare rhetoric that would bedevil and cloud the politics of taxation right up to the present day. It worked then to achieve the immediate objective, as it has frequently since, and the tariff bill passed both houses. Cleveland, who was well to the right of his party in economic matters, could not bring himself to sign it, but he allowed the bill to become law without his signature.
The opponents of the income tax, however, were not finished yet. They quickly brought a suit alleging that it violated the constitutional ban that forbade direct taxes unless they were apportioned among the states on the basis of population, something obviously impossible with an income tax. The following year a deeply conservative Supreme Court agreed with this argument—by the barest possible majority—and the income tax was dead for nearly two decades.
The Democrats continued to advocate an income tax, but the Republicans remained the dominant party through the post-Civil War era. It was only a split within the Republican party that finally allowed the modern tax system to come into being. The party had long been firmly in the hands of the Eastern industrialists, but a progressive wing began building as political consciousness spread down the social scale. In the first years of the twentieth century, the Republican President Theodore Roosevelt moved sharply in the direction of these progressives.
In 1906 he even advocated a tax on inheritances, with the social-engineering purpose of preventing the “transmission in their entirety of those fortunes swollen beyond all healthy limits.” Mainstream Republicans were, to put it mildly, aghast. But there was no real threat to the taxation status quo until the panic of 1907 and the short-lived depression that followed it caused government revenues from the tariff to decline sharply.
Democratic Sen. Joseph W. Bailey of Texas introduced an income tax amendment and gained support from some influential Western Republican senators, including William E. Borah of Idaho. Leading the forces against change was Sen. Nelson W. Aldrich of Rhode Island, a self-made multimillionaire whose daughter was married to John D. Rockefeller, Jr.
Aldrich managed to salvage the principle of a high tariff, but the Republicans were now hopelessly fractured on the income tax issue. Aldrich looked to the new President, William Howard Taft, to save the day. Taft was far more conservative than Roosevelt, and he revered the Supreme Court (he would be Chief Justice of the United States for most of the 1920s). The idea of legislation’s directly defying a constitutional ruling of the Court horrified Taft. If the Court yielded, he thought, its position as arbiter of the Constitution would be gravely compromised. If it did not, it would be setting itself against the two popularly elected branches of government, and a messy showdown would likely ensue.
Taft came up with an elegant solution to the immediate political problem. He suggested avoiding a confrontation with the Court by proposing a constitutional amendment to permit a personal income tax. Then, to satisfy the mounting political demand for an immediate tax on the incomes of the rich, Taft called for a 2 percent tax on the profits of corporations. Since at that time stockholding was almost entirely confined to the very affluent, a tax on corporate profits was for all intents and purposes a tax on the income of the rich.
Needless to say, the corporate tax was challenged, but in 1911 the Supreme Court ruled unanimously that it was not a direct tax upon income that would have to be proportioned among the states, but an indirect tax, measured by income, on the privilege of doing business as a corporation. In other words, it was an excise tax, not an income tax at all. One can hardly help admiring the legal artistry of Taft’s deft end run around an inconvenient phrase in the Constitution, but his corporate income tax would prove as persistent and pernicious as Hamilton’s protective tariff.
Meanwhile the proposed Sixteenth Amendment to the Constitution passed the Senate by a vote of 77 to O and the House by 318 to 14, with 55 abstentions, a remarkably high number on so grave a matter as a constitutional amendment. Doubtless many who had voted for it or abstained counted on the difficulty of gaining the agreement of the needed threefourths of the state legislatures. They were severely disappointed, however, and the amendment was declared adopted on February 3, 1913.
By that time the split within the Republican ranks had torn the party completely apart, with Roosevelt and the Progressives forming their own party, under the banner of the bull moose. As a result the White House fell into the hands of a Democrat for the first time in twenty years, and the split gave Woodrow Wilson solid majorities in both houses of Congress.
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.
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.
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.
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.
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.
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.
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.
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.
An especially popular way to deal with high marginal rates at the time was with allowable deductions, for a deduction from taxable income is obviously worth more the higher the marginal rate. In the 1950s, when the top rate was 91 percent, what was nominally a 5 percent interest rate was, thanks to the deductibility of interest payments, a .45 percent interest rate for the rich man, while Uncle Sam picked up the other 4.55 percent.
John F. Kennedy understood this, and because he was a Democrat, he was able to do something about it. In 1964 the top marginal rate was lowered from 91 percent to 70, and many aspects of the tax law designed to offset those high rates were eliminated. Just as had happened in the 1920s, tax revenues before long increased, and the rich began to pay a larger percentage of total taxes collected. In the first year of the new rates, those in the highest bracket declared more taxable income and paid more taxes than they would have had to do under the old law.
In the 1970s another disadvantage to trying to achieve progressivity with high marginal rates became manifest. The wracking inflation of that decade pushed people into higher and higher brackets, forcing those living principally on wages (who have few tax shelters) to pay high and higher taxes while not receiving, in real terms, a higher income.
But by this time the federal budget’s spending machine was gaining momentum, and many politicians were losing touch with the real world beyond Washington. In the late seventies Rep. Jack Kemp and Sen. William Roth, both Republicans, proposed slashing marginal tax rates for everyone while, once again, plugging loopholes. Democrats derided the proposal. When Ronald Reagan embraced it, President Jimmy Carter started calling it the “Reagan-Kemp-Roth” tax proposal, hoping to tar his opponent with the brush of “tax cuts for the rich.” Jimmy Carter became the first elected President to be defeated for re-election since Herbert Hoover.
Reagan cut taxes the first year he was in office, lowering rates to a high of 50 percent and again slashing deductions. As before, the government’s total tax receipts increased, and the percentage paid by those in the higher income range sharply increased. In 1986, working with the Democratic representative Dan Rostenkowski, chairman of the tax-writing House Ways and Means Committee, Reagan slashed rates again, this time to only two brackets, 15 and 28 percent, while eliminating most remaining open-ended deductions. It was the greatest reform of the federal tax system since the introduction of the income tax itself and, as before, produced higher revenues and higher tax payments by the rich. In 1981 those with the top one percent of incomes paid 17.9 percent of personal income taxes. In 1990 they paid 25.6 percent, an increase in their portion of 43 percent. Meanwhile federal tax revenues rose by more than 24 percent in real terms during the 1980s.
But the Washington spending machine was now out of control. With massive new spending programs out of the question because of the deficit, tax credits for worthwhile causes multiplied. This kept the spending out of the federal budget by hiding it in tax law. Tax credits, by reducing taxes owed rather than taxable income, at least were of some value to individuals. But it is still hard to justify a $480 income tax credit for child care for someone with a milliondollar income. And some tax credits for corporations, such as the one for ethanol additives to fuel, are cash cows, as that one is for Archer-Daniels-Midland, the giant grain company that lobbied furiously for it.
Amid low inflation in the 1980s, the deficit exploded, and the new President, George Bush, caved in to the Democratic majorities in Congress and broke his pledge of “no new taxes.” He, too, was decisively defeated for re-election. In 1993 his successor again raised marginal rates and created five brackets where only two had existed seven years earlier. But he had to do it without any Republican help in Congress, and his bill carried in the House by a single vote only when several Democratic legislators were promised virtually anything to go along. The following year many of those Democrats were defeated for re-election and the Clinton Presidency was nearly crippled as a result of the Republican landslide that wiped out the House’s Democratic majority for the first time in forty years.
So what is next? One might hope, given the fate of Presidents Carter, Bush, and Clinton, that the nation has heard the last of Karl Marx’s prescription for dealing with the inequities of the European economy of the 1840s. Even as early as the Wilson administration, which put the income tax in place, it was known that in a country with democratic politics and a capitalist economy, high marginal rates are counterproductive at best and perverse at worst. They simply do not achieve their purpose in the real world. Yet some current proposals would do no more than simplify the present system, leaving it open to sliding back into higher rates and more loopholes, as it did in 1990 and 1993.
A national sales tax would not be hidden, but being a consumption tax (the VAT is too), it would not tax much of the incomes of the very rich and thus would be inherently regressive. It has the very same drawback as the nineteenthcentury tax system of tariffs and excises, violating Smith’s first principle.
What’s left is the flat tax, which taxes every dime earned above a personal exemption, allowing no deductions, credits, or other complications whatever. Furthermore, it integrates the corporate and personal income tax systems, thus taxing all income but taxing it only once, while preventing the rich from using the interaction of the two systems for their own advantage. Because there are no complications, both individuals and companies alike can theoretically fill out their income taxes on the back of a postcard. And because there are no deductions, politicians cannot hide social and economic engineering or political favors in the tax code, where they don’t belong. History clearly shows that deductions and credits are to politicians what cocktails are to alcoholics: It is a lot easier for them to refuse the first than the second.
There are two main criticisms of the flat tax. The first is that it is, well, flat. There is no progressivity. But that is not actually true. The marginal rate—the tax on the next dollar of income earned—is indeed flat. But it should be; otherwise the rich man is more discouraged than the poor man from earning that dollar. The government cannot tax a dollar that has not been earned. What is not flat is the effective tax rate, the amount of total income that is taken in taxes.
To illustrate simply, assume a $10,000 personal exemption and a 20 percent tax rate on all income above that amount. Under those conditions a family of four would have a zero percent effective tax rate at an income of $40,000, but a 4 percent rate at $50,000. At $100,000 the rate is 12 percent, and at $1,000,000 it is 19.2 percent. Thus, with a flat tax, you know that however much you are paying, the guy down the block who is making more money is paying not only more taxes but a higher percentage of his income in taxes for the privilege of living in this country. Today you only know that he probably has a better tax accountant.
The other criticism is that the flat tax would hit the middle class harder than it would the rich, compared with the present system. But this is true only if one compares the flat tax with today’s personal income tax. It must be compared with both the personal and the corporate income taxes to get a true picture.
Corporations, after all, are only wealth-making machines created for the benefit of their stockholders, not separate economic entities, as the left has often portrayed them for a hundred years. As William Howard Taft understood in the first decade of this century, to tax a corporation is to tax its stockholders. And the flat tax would tax them much as it taxes individuals. In other words, no deductions beyond the direct cost of doing business.
Although this is only a personal opinion, I believe that the flat tax would move massive amounts of money out of tax shelters and unproductive assets and into fully taxed income-producing activities, while freeing billions of manhours for useful labor. The effect on the economy as a whole would be vastly positive.
And it would finally achieve what this country has so long sought. It would, for the first time, force the rich to pay their fair share.