December 16, 2006 10:14 pm
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By Dr. Richard LaNear
Globe columnist
In the summer of 1984, I had the pleasure of testifying at the tax system hearings held by the U.S. Treasury Department and conducted at different locations across the United States. These hearings were chaired by then-Deputy Assistant Treasury Secretary Charles McLure, of whom great credit should be given for guiding the tax system through the last major reform in 1986.
All testimony (with one exception) given at the hearing I attended, concluded that the present tax system was a mess! The one exception was testimony from a lawyer who teaches tax law at the University of Alabama. He felt the present system was fine — draw your own conclusions.
My testimony, in brief, was that marginal tax rates were too high and that the tax base was too narrow. And after a long and arduous political struggle, the tax reform act of 1986 brought the lowest top rate on individual income seen in more than 50 years, 28 percent! What I had considered a political impossibility had become a reality.
For many years, I have been studying the issue of what kind of tax system is conducive to a capitalistic economy. And since an economic system based on capitalism implies “incentive” as the basic motivating force, it is imperative that “marginal” tax rates not climb to high levels, since this would negate the incentive to earn more income, or would lead to a situation whereby these individuals who were being taxed at high rates, seek avoidance via tax shelters, tax exemptions or tax deductions.
I have also observed the continued gradual decline for societal compliance with the tax system caused by the following factors:
1) Complexity — The tax code has become a Byzantine system requiring an army of professional help to interpret it. Wouldn’t this nation be better served if we could direct more attention and resources into the production of goods and services rather than tax shelters? Societies tend to stop obeying laws they don’t understand.
2) Fairness — Even though the actual number of wealthy individuals who pay no federal income tax is small, people lose faith in a system that has loopholes that allow this to happen (even on a limited scale). For example, more than 200 wealthy individuals paid no federal income tax in 1982 primarily because they were given “credits” against foreign income tax paid.
Were they not U.S. citizens enjoying the freedom and right to private property that the greatest democracy in history has provided? When hard-working citizens of any society see other citizens (usually wealthier than they) not paying any tax, they tend to become skeptical of the whole system.
Have we not forgotten the lesson taught by the French Revolution? Complete exemption of tax was enjoyed by the nobility, while the working and middle classes were heavily taxed. The wise government ministers, Colbert and Vauban, both advised the implementation of a flat 10 percent on all citizenry, but the “Sun King” would not listen — the story ends with another “Louis” losing his head.
It is imperative that we instill a feeling in every member of our society of a sense of duty to pay some tax. Do we want to emulate Italy or France where not paying any tax has become a national pastime?
But before examining the federal tax code since the revolutionary reform of 1986 (and the subsequent ill-advised tax increase of 1990), let us take a quick perusal at the evolution of our tax code.
From 1776 to the Civil War, the primary means of raising federal revenues were via tariffs on foreign goods and excise taxes of “sinful” consumption i.e., whiskey, and tobacco. Keep in mind these were “consumption” taxes and “income” was not taxed — also remember that the only major expenditure by the federal government was for national defense.
The first national income tax levied was initiated in 1862 to finance the Civil War (keep in mind that the U.S. then only included the “North”). The “South” irresponsibly decided to finance the war by printing money, with disastrous results.
This 1862 decision to initiate an income tax was very controversial and was finally upheld in the Supreme Court as being constitutional. In the post Civil War era, the political posturing by the “Populists” (personified by William Jennings Bryan) and later the “Progressives” (Woodrow Wilson), to “soak the rich,” culminated in 1894 with a congressional compromise to impose a “flat” 2 percent income tax on all wage earners.
But this act was declared unconstitutional by a “conservative” Republican-dominated Supreme Court. As we are probably about to see in the “abortion” debate, the “constitutionality” of an issue depends on the current makeup of the Supreme Court.
This issue was finally, permanently resolved with the 16th Amendment to the Constitution in 1913 that allowed for an income tax. The Republican resistance against an income tax was greatly weakened by Teddy Roosevelt’s party-splitting “Bull Moose” coalition, which almost ensured Wilson’s election in 1912. The first rates levied in 1913 were
on a “progressive” scale of 1 percent to 7 percent (my, for the good ol’ days).
The conservative Republicans’ biggest fear in their fight against an
income tax was that once it was put in place, the top rate would climb inexorably toward 100 percent. Their prescience was proven right when the top rate went from 7 percent to 77 percent in 1917!
Of course, this was a “war-time” situation and people will tolerate a high rate of taxation in periods of national distress. In the 1920s, the top rate dropped to 24 percent at the return of Republicans to the White House and peace to the world.
This massive tax cut ushered in an era of economic growth (the 1920s), not seen since the post Civil War-era of “railroad development,” fostered by heavy foreign investment in the United States. Another “lesson of history,” illustrating that “foreign” investment is good for the recipient nation, not bad!
Of course, the offset to a “surplus” in foreign investment is a trade “deficit” which, contrary to the negative view presented by the media and the “Congressional Protectionists,” is the necessary status quo for strong nations that attract a lot of foreign investment.
Then, in one of the most ill-advised congressional decisions in this nation’s history (and abetted by President Hoover’s disdain for a veto), the top rate was raised from 24 percent to 79 percent in 1932. It defies logic how a major tax increase in perilous economic times can be justified.
The biggest federal tax decreases in the 20th century occurred in the early ’20s, early ’60s, early to mid ’ 80s, and the Bush tax cuts of 2001-2002 — all three tax cuts were followed by periods of vigorous economic expansion.
Does this not seem to be more than just circumstantial? Does not “common sense” imply that people work harder, produce more and buy more when they are left with more of their income?
The wartime 1940s brought a marginal top rate of 94 percent and even until the early 1960s, the top rate was 90 percent — what an incentive to work harder, when the government takes 90 cents of every dollar! The top rate then incrementally fell to 70 percent in the late 1970s, just before the 1980 election of Ronald Reagan, who campaigned on the premise of lower income tax rates. By the end of Reagan’s second term, the top rate had fallen from 70 percent to 28 percent (a rate not seen since the 20s). The nation then entered into the longest peace-time expansion in this nation’s history (1982-1990).
The next major tax decrease occurred between 2001 and 2003 as President Bush delivered the best-timed tax cut in recent memory and helped bring us out of the 2001 recession (starting with the “Tech Wreck” of 2000), the 911 attack and rising oil prices. The top rate dropped from 39.6 percent to 35 percent, where it now stands until the tax cut expires in 2010.
Dr. Richard LaNear is the J.R. Kuhn Distinguished Professor of Finance at Missouri Southern State University.
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