On April 15, U.S. taxpayers will pay the last installment on their duty to government for 2003. The bill for federal, state, and local government totaled a staggering $3.3 trillion, of which one out of every seven dollars was in the form of “buy now, pay later” deficits, principally the federal one.
Federal spending accounted for two thirds of the tax bill, nearly all of which was levied on incomes in the form of personal, corporate, and social-insurance income taxes. The remaining third, funding state and local spending, was raised primarily by indirect property and sales taxes, plus fees.
It is difficult to put this scale of government in perspective, since Gross National Product (GNP) accounting obfuscates both the size and the proportion of government spending. Using National Income, government takes $38 out of every $100 of income. Even this is misleading, however, because income thus defined includes unproductive transfer payments for welfare and social insurance. Corrected for this, government consumes $45 out of every $100 of productive national income.
The average working family pays through government confiscation the equivalent of the income it retains, as if supporting an additional indolent family. Such submission to government confiscation can only be properly described as serfdom.
How did a country founded on a tax revolt and constituted on the premise of strictly limited central government degenerate to such a state of affairs? Originally, our government was dedicated to preserving freedom, responsibility, and property, while leaving the provision of welfare to families and communities. That government was replaced by a socialist one dedicated to philanthropic tyranny. Worse still, its mode of confiscation became intrusive direct taxation of individual incomes—a practice considered fit only for slaves and subject peoples since the days of early Greek civilization.
The road out of this swamp requires understanding how our government deviated from its foundations. The tax revolt that launched the revolution of the 13 colonies was the result not so much of the level of taxation as of the manner in which the taxes were levied and collected. Taxation without representation, exemplified by the Stamp Tax, was the catalyst, as opposed to tariffs (the outburst at the Boston Tea Party notwithstanding). Of equal or worse provocation was the high-handed and arbitrary method of enforcement employed by the British.
One of the principal reasons for replacing the Articles of Confederation with the Constitution of 1789 was an agreement on the rights of the federal government to levy taxes. The constitutional deliberations on taxation demonstrate how determined our forebears were to make government their servant—the opposite of the historical norm. Alexander Hamilton describes the nature of the taxation that is suitable for the new republic in Federalist 12 and 22, in which indirect taxes on consumption, in the form of tariffs and excises, are proposed for financing the federal government. Hamilton anticipates the “Laffer Curve” in observing that consumption taxes “contain in their own nature a security against excess. They prescribe their own limit which cannot be exceeded without the end proposed—that is, an extension of the revenue.” Ironically, in Federalist 46, James Madison scoffs at concerns that the “welfare clause” in the introduction to the proposed Constitution linking taxes to the general welfare “amounts to an unlimited commission to exercise every power which may be alleged to be necessary for the common defense or general welfare.” Time would show that he could not have been less prescient.
Before the Civil War, the U.S. government was financed by tariffs. During that period, rural states continually complained that they were being annexed to subsidize the protection of Northeastern industry through excessive tariffs; Charles Adams claims that, through the tariffs, the South paid three quarters of all federal taxes. Tariffs were reduced in 1846 and again in 1857, but they were raised once more in 1860 (precipitating the war). Nonetheless, before 1860, tariffs succeeded in paying for the entire operation of the federal government—plus the War of 1812, the Mexican War, the Louisiana Purchase, the purchase of Florida, and the Gadsden Purchase of New Mexico and Arizona.
The onset of the Civil War caused the escalation of expenditures beyond the federal government’s ability to fund the war through borrowing and the issuing of “greenbacks.” The solution adopted by Lincoln’s Republican Party was the unconstitutional federal taxation of personal incomes, corporate income, and inheritances, in addition to excises on manufactures, alcohol, and tobacco and the creation of the Internal Revenue Service in 1863. The personal income tax commenced at a top rate of five percent, which was increased to ten percent by the Tax Act of 1864. Total federal taxation rose from a pre-war two percent of National Income to an average of 15 percent during the Civil War.
These income taxes were discontinued in 1872, along with the bulk of excises on manufactures, but the “sin taxes” have continued until the present. During the Civil War and Reconstruction, income taxes never quite reached half of tax collections, but, just as the experience of England and France during the Napoleonic Wars had shown, income-tax collection had proved to be an awesome source of financing the growth and power of a centralized national government.
Over the course of Ulysses S. Grant’s two terms as President, the federal government and its revenues receded; as of 1876, federal revenues were less than five percent of GNP. This restraint continued until 1897; federal revenues were less than 2.5 percent of GNP on the eve of the Spanish-American War and were still sufficiently derived from tariffs and “sin taxes.”
Various populist efforts to reinstate income taxes in order to reduce tariffs drew little support until the Panic of 1893. Tariff revenues seriously declined at the same time that populists were clamoring for tariff reductions. In 1894, William Jennings Bryan succeeded in securing congressional passage of a two-percent tax on incomes of $4,000 or more, but this tax was declared unconstitutional by the Supreme Court in 1895.
In 1898, the United States declared war on Spain under Republican President William McKinley, launching the phenomenal growth of the federal government and the military that would accelerate throughout the 20th century. The war also launched the political career of Theodore Roosevelt, who, as President from 1900 to 1908, expanded both the Navy and the regulatory functions of government. Responding to the pressure for tariff relief in 1908, both William H. Taft, the Republican candidate for president, and Teddy Roosevelt, now the (quasi-Republican) Bull Moose Party candidate, backed the income tax.
The same arguments made during the Civil War—progressive income taxation as “social equity” for reining in wartime profits and meeting extraordinary financial demands during a national emergency—were now being used by Progressives as the prescription for “economic equity” for the country.
Over the course of the 19th century, American intellectuals traded the goals of the American Revolution for those of the French Revolution. Though the American way had provided unrivaled material success for all Americans—U.S. laborers were the highest paid in the world—the socialists claimed that they could provide an even better Utopia. Progressive taxation and government regulation would share the wealth and end depressions.
In Crisis and Leviathan, his classic chronicle of the growth of the federal government in the 20th century, Robert Higgs describes how income taxation, the Progressives’ beachhead for the adoption of the socialist agenda in the United States, was drafted in 1909 under the fumbling hands of the Republican and Democratic custodians of the Republic:
The conservative Republicans led by Senator Nelson Aldrich attempted to compromise with the Republican Insurgents by joining in passing a corporate income tax and the Sixteenth Amendment. With the Amendment in hand the Insurgents joined by the Democrats passed the personal income tax as well, with graduated rates up to 7 percent.
During this furious legislative process, a maximum personal tax rate of ten percent was proposed for inclusion in the 16th Amendment but was withdrawn on the assurance that no one would ever entertain such a rate. Nonetheless, by 1918, just five years after the ratification of the amendment, the maximum personal rate reached 77 percent under President Woodrow Wilson. The corporate “excess profits tax” had raised the maximum corporate rate to 33 percent. Nonetheless, Wilson proposed a further doubling of tax revenues, which finally led to a conservative reaction and a temporary crest in the collectivist tide.
Shortly after the moderate Republican administration of President Warren G. Harding, who entered office in 1921, the economy sank into a serious recession, and the wartime inflation collapsed. Treasury Secretary Andrew Mellon headed off the efforts of conservative Republicans in Congress to replace income taxes with an indirect tax (in the form of a national sales tax) by proposing income-tax cuts. By 1925, the top personal income-tax rate dropped to 25 percent, and the corporate rate declined to 11 percent; the inheritance tax was reduced to 20 percent by 1928. The boom of the Roaring Twenties was largely a consequence of this tax relief.
By the end of the 1920’s, excessive speculation and easy credit allowed by the Federal Reserve (reinstated in 1916 to prevent such excesses) caused a bubble that burst. The Fed overreacted and relentlessly drained the banking reserves, leading to a collapse of the banking system that turned the recession into a depression. The confiscatory taxation of President Franklin D. Roosevelt turned that into the Great Depression, which was ended only by the economic stimulus of last resort—World War II.
With the Depression widely proclaimed to be the result of the failure of capitalism, Roosevelt led the return to progressive taxation with a vengeance. In 1932, a top personal rate of 63 percent went into effect; as the economy finally started to stir in 1936, that rate was raised to 79 percent, and the economy relapsed once again. By the eve of World War II, the corporate income-tax rate had been raised to 79 percent; the inheritance-tax rate to a maximum of 52.5 percent.
To understand the total marginal effect of such rates on the inheritance of a dollar saved from a dividend, the cumulative effect must be tallied. In order to save a dollar and invest it, the taxpayer first has to pay personal income tax, then corporate tax on profit, then personal tax on the dividend, and, finally, inheritance tax; all told, to receive an inherited dividend of one dollar, eleven dollars of cumulative taxes must be paid.
During World War II, the personal income tax rose to a peak of 94 percent; the corporate income tax, to 40 percent. For the first time in U.S. history, middle-income citizens (not just the wealthy) became subject to the levies of the IRS. This caused a tax rebellion, which the IRS resolved by blackmail: Any taxpayer who would allow his income tax for 1943 to be withheld was forgiven his tax debt for 1942.
This level of taxation was perhaps understandable, given the state of total mobilization for a national emergency. Why, however, were personal income-tax rates left at wartime levels until 1963, and corporate rates until 1981? Now the war was against American taxpayers.
As the Mellon tax cuts in the 20’s revealed, lowered tax rates lead to accelerated economic activity. Perversely, the confiscatory taxation of income—which, whether superimposed on personal or corporate income, is punishment for producing economic value—continues. The Kennedy tax cuts of the early 60’s and the Reagan cuts of the 80’s also stimulated investment, productivity, and output and led to a similar broad distribution of prosperity.
The Kennedy tax cuts still left income-tax rates at lofty levels, with the maximum personal rate at 70 percent, the corporate rate at 48 percent, and inheritance at 58 percent. The Reagan tax cuts reduced maximum income-tax rates to 28 percent for individuals and 34 percent for corporations but retained a 60-percent rate on inheritances—rates still high enough to yield only 19 cents after cumulative taxes on an inherited dollar of dividend derived from investment.
A political tug-of-war on taxes has ensued since President Reagan’s cuts. President George H.W. Bush raised the maximum personal income-tax rate to 31 percent; President Bill Clinton, to 39.6 percent. President George W. Bush only reduced the maximum personal tax rate to 35 percent, but he has sizably reduced the composite marginal maximum rate for corporate income by lowering the personal rate on dividends and capital gains to a flat 15 percent, which substantially reduces “double taxation.”
The social-insurance taxes (FICA and Medicare) yield almost as much in federal revenue as the personal income tax does. Established by FDR, Social Security is a Ponzi scheme imported from European socialist democracies, which, instead of saving for the retirement of current taxpayers, uses current proceeds to pay the pensions of current retirees.
In 1937, taxpayers started paying for Social Security at a modest one percent of earned income matched by an additional one percent levied upon employers. Pensions commenced at the same time for workers who had never paid in a dime. Disability insurance was added in 1960; hospitalization insurance (the Medicare program of the Great Society), in 1970. The total contribution for federal social insurance is now 7.65 percent from both employee and employer (a total of 15.3 percent) on incomes up to $87,000; both employee and employer pay an additional 1.45 percent for Medicare (2.9 percent total) on all income over $87,000. Projections show that both programs will be insolvent at current rates of contribution and benefits within a decade, as the baby boomers retire.
The entire federal tax code is a legacy of the class warfare of the Progressive Era. Graduated income taxation has increased, despite lower maximum rates, since such innovations as the Alternative Minimum Tax, phaseouts of deductions and exemptions, and the Earned Income Tax credit (a subsidy for lower incomes) have been added. This has effected a significant increase over the past three decades in the share of income taxes paid by the top ten percent of incomes, which currently pay 65 percent of the personal income taxes collected by the IRS. The result has been a decrease in the after-tax-income share of the other 90 percent, through the reduction of saving for investment, which drives economic growth and prosperity. Redistribution intended to improve the well-being of lower-income Americans has worsened their status.
The socialist premise of confiscation is that the redistribution of wealth is necessary for social and economic justice. However, a study by Rector and Headerman of the Heritage Foundation shows that, while the U.S. Census Bureau estimates that the top quintile of U.S. incomes receives an average of 14 times the level that the bottom quintile receives, in reality, they receive only four times the level of the bottom quintile, after adjusting for workers per household, hours of work, fringe benefits, and transfer payments. The U.S. Treasury Office of Tax Analysis shows that six out of every seven Americans in the bottom quintile have moved to higher quintiles over the course of the subsequent ten years, and one out of seven have moved to the top quintile. The “economic injustice” that would justify the confiscatory progressive federal tax code is not evident. Furthermore, a 1997 Roper poll for Reader’s Digest found that Americans, regardless of income, education, ethnicity, sex, or ideological and political classifications, agreed that 25 percent is the highest rate at which any income should be subjected to tax.
Americans pay a sorry price for their utopian income-tax system. Progressive taxation is inefficient, intrusive, and inequitable by any reasonable standard. It has fostered social engineering at the expense of married families and the creation of an underclass, driven our capital overseas, and all but destroyed our manufacturing sector. Ironically, the most productive nation in the world has become increasingly uncompetitive in world markets, while U.S. workers’ wages continue a relative decline. As other nations increasingly favor the indirect taxation of commerce by value-added taxation—which is both border-adjustable and territorial—Americans cling to income taxation.
Continuing to play games with progressive tax rates (the recent Bush tax cuts are negated by increased federal spending) will not resolve the problem. Real federal tax reform requires more than lower income taxes. In fact, it requires the replacement of income taxes with some form of indirect tax on consumption, whether a value-added tax or a national sales tax (or both).
If the current tax system has any message to offer posterity, it is this: Taxing incomes is the means to everything revolting about government—namely, the unlimited power to confiscate, intrude upon, and regulate its subjects; to seek vainglory in foreign wars; and, ultimately, to destroy whatever stands in the way of those who govern.
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