I. Introduction
Every major debate over tax policy in the United States since its origins has swept over a broad span of economic issues. Each of these debates has touched on all the central questions regarding the effect of taxation on the performance of the economy. Participants in the debates have asked: Will changes in tax policy encourage or discourage economic productivity? Will such changes promote economic expansion or perhaps cause unemployment? Will they dampen inflation or perhaps create inflationary pressures? What effect will changes in tax policy have on the distribution of income, wealth, or, more narrowly, the allocation of the tax burden among the members of society? What might the impact of these changes be on the distribution of economic power? Will they create a more just tax system, or contribute to a more just society? Will they do so at the cost of a less prosperous society? Or will they create more affluence at the cost of less justice? Discussions of such questions have been most intense during major national emergencies—the American Revolution, the Civil War, World War I, the Great Depression, and World War II. During each of these emergencies, passionate debates have yielded a new tax regime. This essay examines the debates and assesses how ideas about economic performance and tax justice have shaped their outcomes, especially the creation of new tax regimes.1
I have defined a tax regime as a tax system with its own characteristic tax base, rate structure, administration apparatus, and social purpose. For a survey of U.S. regimes, see W. Elliot Brownlee, Federal Taxation in America: A Short History (Cambridge and Washington, DC: Cambridge University Press and the Wilson Center Press, 2004).
II. The Founding Regime
The fundamental structure of the federal tax system emerged from the revolutionary crisis that extended through the formation of the U.S. Constitution. At its heart, the crisis was a constitutional struggle to define the basic ideas underlying the federal government: ideas of representation and consent, constitutionality and rights, and sovereignty.2
The most powerful interpretation of the American Revolution as an intellectual movement remains Bernard Bailyn, The Ideological Origins of the American Revolution (Cambridge, MA: Harvard University Press, 1967).
The treatment of taxation in the Constitution reflected, first and foremost, a trust in republican government. To the architects of the Constitution, taxpaying was one of the normal obligations of a citizenry bound together in a republic by ties of affection and respect. In trying to provide the new republic with robust taxing powers, the founders revealed that they embraced a classical republicanism, perhaps best described as “civic humanism,” that stressed communal responsibilities as well as private rights.3
On the meaning and long-run influence of civic humanism, see Dorothy Ross, “The Liberal Tradition Revisited and the Republican Tradition Addressed,” in John Higham and Paul K. Conkin, eds., New Directions in American Intellectual History (Baltimore, MD: Johns Hopkins University Press, 1979), 116–31.
Thus, the Constitution reflected the desire of Alexander Hamilton and its other architects to provide the new central government with far greater capacity to tax than had been possible under the Articles of Confederation. While the Confederation could only exhort the states to contribute voluntarily to the federal treasury, the Constitution gave the new government the fiscal authority that would reflect its sovereignty. Congress had the general power, in the words of Article I, Section 8, “to lay and collect taxes, duties, imposts, and excises.”
In The Federalist Papers, Hamilton explained how the new nation would have the means to acquire the economic resources it needed to fulfill its promise. He emphasized that, in peacetime, customs duties and excises would provide the bulk of the republic's revenues, and would do so in a fashion that was just. His arguments on behalf of the fairness of customs duties and excises, however, were complicated and conflicted. He identified various aspects of tariffs and excises as just, or at least as promoting justice, and one such aspect was the predictable, sustainable flow of revenues from these taxes. Without access to such a flow, Hamilton argued in The Federalist Papers, the federal government risked degeneration into a tyranny, subjecting “the people … to continual plunder,” as in “the Ottoman or Turkish empire.”4
Alexander Hamilton, The Federalist No. 30, in The Federalist (New York: The Modern Library, 1937), 183. At this point in The Federalist No. 30, Hamilton had not made it clear what taxes ought to replace requisitions of the Confederation, but in the pages that followed (183–84), Hamilton indicated that he was referring to both “external” taxes, like customs duties, and “internal” taxes, like excises.
Hamilton, The Federalist No. 12, 72–73.
This argument might seem to have been simply the invocation of the “benefit” theory of taxation that had originated with Thomas Hobbes. To Hobbes, taxation represented benefits received from “the commonwealth” (essentially for “defence”), and the best measure of those benefits was the value of consumption.6
Thomas Hobbes, Leviathan, with selected variants from the Latin edition of 1668, ed. Edwin Curley (Indianapolis: Hackett Publishing Company), 227–28.
On Hamilton's reading of Adam Smith, see Ron Chernow, Alexander Hamilton (New York: The Penguin Press, 2004), 347 and 376–77. On Smith as a civic humanist, see Donald Winch, Adam Smith's Politics: An Essay in Historiographic Revision (Cambridge: Cambridge University Press, 1978).
For the quotations from Smith, see his An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1937), 777 and 794.
Throughout Hamilton's discussion of taxation in The Federalist Papers, Hamilton wrestled with the “ability to pay” criterion. He acknowledged that consumers seemed likely to bear the burden of tariffs and excises, and advanced several arguments to offset this problem. First, he suggested that taxes on consumption might be the only practical way to tax personal property, and thus tax it according to “ability to pay.”9
Hamilton, The Federalist No. 12, 72 and 75.
Hamilton, The Federalist No. 35, 210–11.
Hamilton, The Federalist No. 21, 129.
Hamilton, The Federalist No. 12, 72. On Smith's criticisms of customs duties and excises on “the necessaries of life,” see, for example, Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 821–39.
In recognition of the conflict with Smith's “ability to pay” criterion, Hamilton fell back on a practical argument: the burden of consumption taxes in the new republic would be slight. He based this argument on four claims. First, he asserted that the desire of the government for revenues would help keep consumption taxes low, confining them to “proper and moderate bounds.” In other words, the need for revenue would form “a complete barrier against any material oppression of the citizens by taxes of this class”; the barrier was “a natural limitation of the power of imposing” such taxes.13
Hamilton, The Federalist No. 21, 130.
Hamilton, The Federalist No. 12, 72.
Ibid., 73. Under the Articles of Confederation, the individual states could levy their own export duties. Some states set tariffs relatively low to attract imports; others set them relatively high to protect local industries.
According to Hamilton's calculations, a trebling of American customs duties would establish a rate of 9 percent, contrasted with 15 percent in France and 20 percent in Britain. Hamilton, The Federalist No. 12, 75.
Hamilton recognized, however, that wartime could bring more demanding fiscal requirements. The disruption of trade might reduce customs revenues, and, in any case, the demand for tax revenues might be huge. It was “wars and rebellions,” the “two most mortal diseases of society,” that had “occasioned that enormous accumulation of debts with which several of the European nations are oppressed.”17
Hamilton, The Federalist No. 34, 206.
Under a capitation tax, every taxpayer paid exactly the same amount of tax. Poll taxes, or taxes that all voters had to pay, were the most common form of capitation taxes.
Hamilton, The Federalist No. 36, 223.
The third potential major source of wartime revenues was federal taxation of property ad valorem (according to its value). Such taxation of property was popular in the early republic. In an era when most wealth was in the form of real estate, the ad valorem tax on land offered the greatest potential for establishing a link between wealth and the responsibility to support government and public order. In addition, American republicans often saw such taxation as an attractive means of discouraging large, concentrated holdings of land. Hamilton, like Adam Smith, regarded taxation of land values as equitable and economically efficient. Thus, Hamilton wrote that after the settlement of the war debts of the states, “[a] small land-tax will answer the purpose of the States, and will be their most simple and most fit resource.”20
Ibid., 221. For suggestions as to the connections between a Massachusetts tax policy of “communalism,” which included high property taxes, and Federalist tax policies at the national level, see H. James Henderson, “Taxation and Political Culture: Massachusetts and Virginia, 1760–1800,” William and Mary Quarterly 47 (January 1990): 90–114.
Article I, Section 9 of the Constitution, however, severely limited the ability of the federal government to levy property taxes. It could tax property but only by allocating the property taxes among the states according to their relative populations, rather than the value of property in the states.21
Article I, Section 9 specified: “No capitation, or other direct tax shall be laid, unless in proportion to the census.” As legal disputes over the meaning of this language have demonstrated, the writers of the Constitution did not have in mind a clear definition of a “direct” tax. However, they definitely regarded at least property taxes and capitation taxes as direct taxes, and they thought of excises and tariffs as “indirect” taxes. (The founders may have regarded a “direct” tax as one levied directly on an individual and an “indirect” tax as one that individuals—consumers, in the case of an excise tax—would pay through intermediaries.) In framing Article I, Section 9, the founders were not thinking about income taxes. At the time of the writing of the Constitution there were no income taxes, strictly defined, anywhere in America. The political leaders of the new nation never discussed income taxes until 1799, when Great Britain, to finance the wars against Napoleon, adopted an income tax. The best scholarly exploration of the meaning of direct and indirect taxation to the founders remains Edwin R. A. Seligman, The Income Tax: A Study of the History, Theory, and Practice of Income Taxation at Home and Abroad, 2d ed. (New York: The Macmillan Company, 1914), 535–71.
Hamilton could live with the restriction of federal use of property taxation also because he recognized the administrative challenge of a federal property tax. He realized that obtaining a full and equitable assessment of property across the states of the new nation would be daunting. “In every country,” he wrote, “it is a herculean task to obtain a valuation of the land; in a country imperfectly settled and progressive in improvement, the difficulties are increased almost to impracticability.” Further, he did not think there was any way to measure, in a more general way, the “wealth of nations.” Consequently, he saw “no general or stationary rule by which the ability of a state to pay taxes can be determined.” In turn, he wrote, “the attempt … to regulate the contributions of the members of a confederacy by any such rule, cannot fail to be productive of glaring inequality and extreme oppression.” Using population as the basis to distribute property taxes would reduce the risk of arbitrary assessments, and would have the advantages of “simplicity and certainty.”22
Hamilton, The Federalist No. 21, 129–30.
Regardless of the reasons for including Article I, Section 9 in the Constitution, the provision had powerful implications for the long run. It had the practical effect of reserving for state and local governments the taxes that had the greatest potential for redistributing wealth. Allowing the federal government to impose a property tax would have enhanced, at least in principle, the power of the federal government to shape the distribution of income and wealth. With the advantage of hindsight, we know, for example, that it would have opened the door a century later to enacting at the national level the radical program of Henry George, who wanted to replace all taxes with a “single tax” on the site value of land.23
In his best-selling Progress and Poverty (1880), Henry George advocated shifting all taxation to a property tax on the monopoly profits embedded in the price of land (i.e., the true economic rent of land). He referred to these embedded profits as the “unearned increment,” or site value, resulting from the location of a piece of land rather than its use. (In George's analysis, the price, or total value, of land equaled the sum of its site value and its use value.) See Henry George, Progress and Poverty (London: J.M. Dent and Sons, 1976). Article I, Section 9 of the Constitution meant that the federal government would have had to allocate a tax on site value to the states according to their shares of population, rather than their shares of total site value. Consequently, Henry George and his disciples had to pursue their “single-tax” reform at the state and local levels, rather than at the national level.
As the first secretary of the Treasury (1789–1795) of the new republic, Hamilton led in creating a peacetime tax regime based on customs duties and excises. In its first two sessions, the Congress adopted tariffs over a broad range of goods. It also adopted internal taxation in the form of an excise tax on distilled spirits.24
Hamilton regarded the excise tax on distilled spirits as consistent with his desire to keep excise taxes “within a narrow compass.” It was also consistent with his view, expressed in The Federalist No. 12, that diminishing the consumption of “ardent spirits … would be equally favorable to the agriculture, to the economy, to the morals, and to the health of the society.” There was, he wrote, “perhaps, nothing so much a subject of national extravagance as these spirits.” Hamilton, The Federalist No. 12, 72 and 75.
Alexander Hamilton, “Report on Manufactures,” quoted in Jacob E. Cooke, ed., The Reports of Alexander Hamilton (New York: Harper and Row, 1964), 140. As Ron Chernow has recently pointed out, Hamilton carefully modulated his tax program. He wanted tariffs to be “moderate in scale, temporary in nature, and repealed as soon as possible.” Chernow, Alexander Hamilton, 377.
Hamilton's tariff adjustments were too cautious to provide much protection, but otherwise the new tariff system worked much as Hamilton had predicted. The tariffs produced buoyant revenue in periods of expanding foreign trade, which began as early as the 1790s (when American merchants profited handsomely from the Napoleonic Wars), and these tariffs did not seem to impede trade significantly. Economic growth, which began to increase in a significant and sustained way during the 1820s, meant continuing increases in the per capita demand for imported goods and, in turn, increases in tariff revenues per capita. The flow of most ocean commerce through a few major ports, and a low level of smuggling, provided the setting for well-administered tariffs.
The most heated controversies over Hamilton's tax program concerned excise taxes rather than tariffs. The excise taxes on whiskey touched off the Whiskey Rebellion of 1794. Washington had to raise 15,000 troops to discourage the Pennsylvania farmers who had protested.26
See Thomas P. Slaughter, The Whiskey Rebellion: Frontier Epilogue to the American Revolution (New York: Oxford University Press, 1986).
Hamilton's economic policies led to a fiscally strong federal government, just as he had planned. The revenue system not only serviced the nation's debt; it proved adequate for almost all the other needs of the new federal government. It used indirect taxes to finance an undeclared naval war with France in the late 1790s and Jefferson's war against the Barbary “pirates.”27
A shift of American foreign policy by Federalist presidents George Washington and John Adams in a pro-British direction led to French seizures of American merchant ships and retaliation by American privateers and naval forces in 1798. The Convention of 1800 ended the hostilities. Federalist foreign policy also included bribing the Barbary States of North Africa not to raid American shipping in the Mediterranean. In 1801, President Thomas Jefferson abandoned the payments and engaged in a war with Tripoli (one of the Barbary States) which lasted until 1805.
Hamilton's revenue system held until the Civil War. In the undeclared naval war with France and the War of 1812, just as Hamilton had expected, the national government expanded excise taxation and levied property taxes (allocated among the states according to population, as the Constitution required). The only significant departure from Hamilton's program came during the 1820s with a dramatic expansion of protectionism—raising tariff rates far beyond those that Hamilton had proposed. The wave of protectionism was halted in the early 1830s, however, and was then reversed decisively in 1846, when Congress passed the Walker Tariff. This tariff legislation paralleled Britain's repeal of the Corn Laws in the same year, and it seemed to herald the adoption of free trade throughout the Anglo-American world. Nonetheless, customs revenues remained substantial because international trade thrived. In fact, the revenues were sufficiently ample to finance the Mexican War, which began in the same year that Congress adopted the Walker Tariff.
On the eve of the Civil War, the federal tax system seemed stable. It could fund future wars of territorial or imperial expansion—so long as those wars were not substantially larger in scope than the Mexican War and did not disrupt the federal government's ability to raise revenue through international trade. And, so long as Americans believed that local and state governments based their systems of property taxation on the principle of “ability to pay,” the federal government would not have to consider reducing its reliance on regressive taxation of consumption.
III. The Civil War Regime and Its Challengers
One of those rebellions that Hamilton feared might seriously disrupt the fiscal system of the early republic erupted in 1861. While the American Civil War did not significantly diminish customs duties, its scale and capital intensity demanded a program of emergency taxation that was unprecedented in scope. The Republicans introduced a tax system composed primarily of high tariffs and excise taxes. During and after the war, their system of consumption taxation became the financial centerpiece for the Republicans' ambitious new program of nation-building and national economic policy.
Two new long-term components of federal taxation emerged during the Civil War (1861–1865). The first component was a system of high tariffs. Over the course of the war, tariffs had risen dramatically, to almost half the total value of all dutiable imports. The highest rates were imposed on manufactured goods—particularly metals and metal products, including iron and steel, cotton textiles, and certain woolen goods. On many manufactured items, the rate of taxation reached 100 percent. By 1872, tariff duties dominated federal revenues; except in a few years of severe depression and during the financing of the Spanish-American War, they would do so until 1911. Until the Underwood-Simmons Tariff Act of 1913 significantly reduced the Civil War rates, the ratio between tariff duties and the value of dutiable goods rarely dropped below 40 percent.
The second new long-term component of federal taxation was a system of excise taxes on alcohol and tobacco products. There was nothing new about excise taxation of alcohol and tobacco, but the new, permanent taxes were much higher than any enacted before the Civil War. Buoyant, price-inelastic demand for alcohol and tobacco products meant that taxes on them yielded substantial revenues, even after the federal government increased the tax rates. In the years before World War I, revenues from levies on alcohol and tobacco always produced at least one-third of all federal tax revenues, and by the mid-1890s they averaged close to one-half. During the period from 1911 to 1913, alcohol and tobacco taxes produced even more revenue than did the tariffs.
These new long-term components made the nation's tax system significantly more regressive, and potentially much more unpopular than the low tariffs of the early republic. During the Civil War, to compensate for damage that these taxes might do to the Republican Party and the war effort, Republicans looked for supplementary taxation that bore a closer relationship to the criterion of “ability to pay” than did the tariffs and excises. They imitated the way in which British Liberals had relieved property taxes during the Crimean War and adopted a modest tax on the net incomes of individuals. The new tax significantly increased the taxes on the wealthy, and in 1865 accounted for about 21 percent of federal tax revenues (versus about 50 percent for excise taxes, and 29 percent for tariffs). Nonetheless, Republicans generally viewed the income tax as purely an emergency measure and phased it out between 1867 and 1872.
After the war, Republicans emphasized the way in which the new fiscal system offset the regressivity of consumption taxes by funding programs or providing regulation that benefited a wide swath of the citizenry. Northern Republicans prized subsidies for agriculture, education, public works, and an increasingly generous pension system. Many workers believed that the tariffs protected them from lower-wage labor in Europe, Latin America, and Asia. Many manufacturers welcomed the protection they believed the tariffs afforded them against foreign competitors, and they praised the tendency of a favorable trade balance with Europe to reduce the cost of capital in America. Small manufacturers were most supportive, but large manufacturers, even those who had little to fear from foreign competition, joined them. During the 1880s and 1890s, some large manufacturers were especially enthusiastic about the high-tariff system because it allowed them to build national marketing organizations, free of worries about short-term disruptions caused by European competitors. Even many bankers and members of the financial community, who were more appreciative of the benefits of free trade, liked the way in which substantial taxes on consumption forced increases in the nation's rate of saving and facilitated the repayment of the wartime debt. By using consumption taxes to finance the war debt and interest payments, the Republican leadership transferred significant amounts of capital from consumers to holders of federal debt (Europeans as well as Americans), who tended to be wealthier than the average consumer and more likely to invest.28
The aspect of the Civil War program that most stimulated productivity and economic growth may well have been the system of debt retirement and interest payments. This system accounted for as much as half of the rise of the shares of national economic product devoted to capital formation between the 1850s and the 1870s. See Jeffrey G. Williamson, “Watersheds and Turning Points: Conjectures on the Long-Term Impact of Civil War Financing,” Journal of Economic History 34 (September 1974): 636–61.
During the Civil War, the federal government had gone off the gold standard, placing the Union on a fiduciary standard, or one founded on public confidence in the currency itself. This happened in 1862, when the federal government discontinued its offer to convert greenbacks, printed to help finance the war, into gold.
This Civil War tax system of consumption taxation remained in place, quite intact, until World War I. However, well before the war, critics of the system succeeded in moving it to the center stage of political drama. Previously, issues of tax justice had been salient largely during periods of war that required federal experiments with direct taxation. Now, they became significant in peacetime politics.
One issue was simply the regressivity of the tariff system. The Democratic Party emphasized this issue and made it part of an appeal to roll back tariffs. Doing so, Democrats argued, would apply the criterion of “ability to pay” and reduce the tax burden on American consumers.
A second issue was the way in which the tariff fueled the programs that Republicans had created, particularly during the years of the Civil War and Reconstruction, when they usually controlled all branches of the federal government. Reducing tariffs, Democrats argued, would not only make the tax system fairer, it would make the entire fabric of government more virtuous—and economically efficient. Reducing tariffs would, in their view, undermine the public corruption, special privilege, and monopoly power that they saw as the consequences of Republican power. Thus, the critique of the tariff became part of a more general attack on special privilege, monopoly power, and public corruption—an attack that drew on the ideals of the American Revolution. Important support for this criticism came from the radical idealism of Henry George. While he and his followers primarily sought to reform state and local taxes, their goal of breaking the influence of monopoly power led them to become critics of protective tariffs.30
See note 23 above. On the career and influence of George, see Charles A. Barker, Henry George (New York: Oxford University Press, 1955), and W. Elliot Brownlee, “Progress and Poverty: One Hundred Years Later,” National Tax Association Proceedings (1979): 228–32.
During the 1880s, and especially during the depression of 1893–97, these two ideas for creating a more virtuous system of public finance became the foundation of proposals not only to eliminate protective tariffs but also to adopt a progressive income tax. That tax increasingly won support from Democrats, largely from the West and South, and from supporters of Henry George and his single-tax reform, who viewed income taxation as a step in the right direction for tax reform. Most of the Democratic and single-tax advocates of the progressive income tax wanted to shrink government and consequently proposed the tax only as a limited tax, one that would only partially replace tariff revenues.
These advocates of income taxation wanted primarily to reallocate fiscal burdens according to “ability to pay.” During the 1890s, unemployment increased and personal income declined. Deflation increased the real value of debts and interest payments, wiping out net incomes and bankrupting many farms and other small businesses. Moreover, incomes fell more rapidly than tax burdens. On the one hand, these trends increased popular pressure to reduce consumption taxation. On the other hand, they reduced any threat of an income tax to the incomes of ordinary working people. Consequently, the “ability to pay” criterion, already firmly grounded in republican ideology, became even more appealing.
Increasingly, the Democratic and single-tax advocates of income taxation sought another goal: restoration of a virtuous republic free of concentrations of economic power. They wanted to go beyond removing the protections to big business that the tariff, which they sometimes called “the mother of trusts,” provided. And they wanted to do more than simply adjust tax burdens to make them easier for common people to bear. They wanted, as well, to use taxes to attack monopoly power. Aggressively taxing the largest incomes and corporate profits, they argued, would reduce the maldistribution of wealth and power that was responsible for the evils of industrialization. Income taxation that attacked monopoly would be not only just but economically efficient, stimulating economic growth by fostering opportunities for small businesses. On one level, the enthusiasm for antimonopoly taxation reflected a revival of the benefit theory of taxation. On another, it reflected the long-standing American struggle to limit the role of special privilege within a republic. The specific impetus for the antimonopoly campaign was the proliferation in the 1880s and 1890s of corporations that were technologically advanced, vertically integrated, geographically vast, bureaucratically complex, and sometimes monopolistic in their practices. Thus, support for a radical, progressive income tax had far more to do with the search for tax relief, social justice, and economic opportunity than with the quest for an elastic source of revenue. Until World War II, this search would play a major role in shaping the income tax.
In 1893, depression conditions enabled Democrats to take control of both houses of Congress. The next year, with the critical support of the surging Populist movement, they enacted an income tax as part of the Wilson-Gorman Tariff.31
President Grover Cleveland refused to sign the Wilson-Gorman Tariff, which included the income tax. Cleveland had supported modest taxation of investment income, but he objected to what he regarded as Wilson-Gorman's excessively high tariffs on raw materials. Under the provisions of Article I, Section 7 of the Constitution, the bill automatically became law.
John Stuart Mill, Principles of Political Economy (London: Longmans, Green and Co., 1886), 484.
For the quotation by John Sharp Williams, see Richard J. Joseph, The Origins of the American Income Tax: The Revenue Act of 1894 and Its Aftermath (Syracuse, NY: Syracuse University Press, 2004), 91–92. Joseph has provided the best general discussion we have of the congressional debates and what he calls “the rationales” for and against the 1894 tax legislation. See ibid., 89–104.
The Republican leaders, reinforced by some northeastern Democrats, did succeed in limiting the progressivity of the new tax. Congress reproduced many of the technical features of the Civil War income tax and set a somewhat lower rate on incomes and profits (2 percent). But Congress also introduced several changes that reflected rising popular enthusiasm for taxing the rich. For example, Congress applied the 2 percent tax to the income of business corporations. This tax embodied the assumption that the federal government ought to tax corporations according to a “benefit” theory of taxation as well as the principle of ability to pay. Americans had begun to regard corporate taxation as an especially important vehicle for both taxing the rich and assaulting special privilege.
The 1894 tax was short-lived. In 1895 the Supreme Court, in Pollock v. Farmers' Loan and Trust Co., declared that the income tax of the Wilson-Gorman Tariff was unconstitutional.34
Pollock v. Farmers' Loan and Trust Co. (Rehearing), 158 U.S. 601, 15 S.Ct. 673, L.Ed. 1108 (1895).
During the next fifteen years, however, support for income taxation grew, winning support even among Republicans, and in the urban Northeast. There, both Republican and Democratic leaders found that the tax had begun to appeal to their constituents as a means of making up for the failure of property taxation to reach intangible personal property such as stocks and bonds. The economist Richard T. Ely captured the essence of the new reform program at the state level: “Some way must be contrived to make owners of … new kinds of property, who include most of our wealthiest citizens, pay their fair share of taxes.” His solution was for states to adopt the income tax, “the fairest tax ever devised.”35
Richard T. Ely, Taxation in American States and Cities (New York: Thomas Y. Crowell, 1888), 140 and 288.
Edwin R. A. Seligman, “The Income Tax,” Political Science Quarterly (1894): 610.
Presidents Theodore Roosevelt (1901–1909) and William Howard Taft (1909–1913) both recognized the growing support for progressive income taxation and made vague gestures on behalf of its adoption. By 1909, there were enough insurgent Republicans in Congress who supported a graduated income tax to force action. Congress enacted a modest corporate income tax, described as “a special excise tax,” and submitted the Sixteenth Amendment, which legalized a federal income tax, to the states for ratification.
Ratification prevailed in 1913, in large part because of two other sets of campaigns, both of which redirected interest in income taxation toward economic restructuring. One set consisted of efforts to enact the “single tax” of Henry George. Beginning in 1909, soap magnate Joseph Fels, who had converted to George's faith, began to finance state and local campaigns for the tax. Although the campaigns won no significant electoral victories except in Oregon in 1910, they awakened the interest of the urban middle class in using the income tax to attack concentrated holdings of real estate.37
On Joseph Fels's campaigns, see Arthur P. Dudden, Joseph Fels and the Single-Tax Movement (Philadelphia: Temple University Press, 1971), 199–245; and Arthur N. Young, The Single Tax Movement in the United States (Princeton, NJ: Princeton University Press, 1916), 163–83.
In 1913, bipartisan support for income taxation was broad, and the Democrats controlled Congress. Nonetheless, the income-tax measure they enacted was only modest. This was so largely because the nation's political leaders were unsure of how much redistribution they wanted the new tax instrument to accomplish. President Woodrow Wilson, for example, wanted a progressive rate structure, but he urged caution on Furnifold M. Simmons, chair of the Senate Finance Committee. “Individual judgments will naturally differ,” Wilson wrote, “with regard to the burden it is fair to lay upon incomes which run above the usual levels.”38
Woodrow Wilson to Furnifold M. Simmons, September 4, 1913, in Arthur S. Link, ed., The Papers of Woodrow Wilson, vol. 28 (Princeton, NJ: Princeton University Press, 1978), 254.
Consequently, the Underwood-Simmons Tariff Act of 1913, which reestablished the income tax, was less progressive and less ambitious in its revenue goals than the Civil War legislation or even the legislation of 1894. In the first several years of the income tax, only about 2 percent of American households paid taxes. Meanwhile, the tariff and the taxation of tobacco and alcohol remained the most productive sources of revenue. The tariff, in fact, became even more productive because the 1913 reduction of tariff rates by the Wilson administration stimulated trade and increased revenues. If it had not been for World War I mobilization, the major consequence of the passage of the income tax in 1913 might have been the protection of the regime of consumption taxation inherited from the Civil War, and that regime might well have lasted another generation or more.
IV. The Wartime Wilsonian Regime
The United States did, however, intervene in World War I, in 1917. To do so amid the disruption of international trade meant that the United States, for the first time since the War of 1812, had to abandon its reliance on customs duties. Moreover, the huge scale of the financial requirements of the American war effort meant that the federal government had to find new taxes that did far more than just replace customs revenues. What were the options potentially available to the administration of Woodrow Wilson?
First, there was a set of consumption tax alternatives. In the realm of internal sales taxation, the only measures with which the federal government had recent experience were taxes on spirits and tobacco. To be sure, the resulting revenues were significant. In 1914, taxes on spirits, “fermented liquors,” and tobacco produced over $300 million in revenue. In that year, these revenues exceeded tariff revenues, were more than four times as large as revenues from the income tax, and accounted for nearly one-half of all the nation's tax revenues. Transforming the systems for assessing and collecting “sin taxes” into a system for imposing general taxes on consumption, however, was virtually impossible, particularly because of the brief period of time (roughly a year and a half) the United States was at war. The assessment and collection of a general sales tax, assessed at the point of final transaction, would have required intervention in millions of transactions. The Treasury had no way to identify and monitor the hundreds of thousands of businesses that participated in such transactions. Consequently, no one within the federal government ever seriously considered a general consumption tax.
The second set of alternatives included ways of expanding income taxation that were progressive but collected large revenues from middle- and low-income Americans. Such taxes would have set personal exemptions at low levels and would have levied high rates on wages and salaries. During World War I, advocates of these “mass-based” income taxes had to face the reality that the federal government lacked the capacity to administer them. In levying such taxes, the Bureau of Internal Revenue would have had to face the facts, which the 1910 census revealed, that approximately one-third of American workers were employed as farmers, either as owner-operators of farms or as agricultural laborers, and at least another third owned or worked in small, usually unincorporated, nonfarm businesses. During World War I, the federal government did not know who these people were, and had no means of readily discovering their identities. Even more daunting would have been determining and analyzing their wages, salaries, rents, gross incomes, and capital gains, to say nothing of mobilizing an army of auditors and collectors.
The federal government learned the identities and earnings of a significant number of Americans only after it developed an administrative apparatus for the Social Security system, which was enacted in 1935. With Social Security's mechanisms in place for the collection of taxes at the source, the federal government was then able to introduce the mass-based taxation of incomes during World War II. Could such a system have been created during the first two decades of the century? Perhaps, but certainly not in time to finance the war effort, even if the war had dragged on into 1919. President Franklin D. Roosevelt signed the Social Security legislation into law in August of 1935, but it was over two years before the federal government could process employer reports of wages paid. Even then, the federal government did not identify the many Americans, such as farmers and other self-employed individuals, who were outside the system. By the late 1930s, the administrative capacity of the federal government had grown considerably beyond what it had been in 1917, as had that of the corporations that were part of the system for collecting Social Security taxes. It would have taken the federal government far longer than two years to create a comparable administrative apparatus in 1917. Even more time would have been necessary to adapt that infrastructure to tax assessment and collection. Mass-based income taxation was simply not a realistic option in 1917. No one in the Treasury seriously entertained its enactment, and the war did not go on long enough to initiate serious consideration.39
On the early administrative problems of Social Security, see Arthur J. Altmeyer, The Formative Years of Social Security: A Chronicle of Social Security Legislation and Administration, 1934–1954 (Madison: University of Wisconsin Press, 1968), 43–98.
There was in place, however, a set of taxes that already identified most middle-class Americans, and assessed significant portions of their wealth-holdings. This third set of alternatives consisted of the various property taxes that were technically the responsibility of the states of the Union. Many members of the Wilson administration (including Wilson himself) and the House of Representatives found the single-tax ideas of Henry George appealing and wanted the federal government to take a hard look at property taxation as a means of war finance. Another possibility under consideration within the Treasury was adapting state and local systems of property taxation to help in assessing income taxes. Here, Britain's experience with its income tax was of interest. As historian Martin Daunton has written recently, “collection and assessment of the income tax” in Britain “were based on the existing machinery of the land and assessed taxes, which passed responsibility to the taxpaying class.”40
Martin Daunton, Trusting Leviathan: The Politics of Taxation in Britain, 1799–1914 (Cambridge: Cambridge University Press, 2001), 188. The “assessed taxes” were special taxes directed at “signs of conspicuous wealth and display such as male servants, windows, carriages, and pleasure horses” (ibid., 33–34).
The impossibility of developing mass-based systems of consumption, income, or property taxation meant that the federal government had to focus its wartime tax initiatives on the available targets of opportunity—the incomes of wealthy individuals and corporations. While mass-based income or consumption taxation would have required dramatically new administrative arrangements, taxing the rich allowed the Treasury and the Congress to conscript the information systems of corporations into the armies of tax assessment. In addition, in doing so, the federal government could take advantage of the experience of other nations.
Most compelling was the British experience. Experts within the federal government studied, in particular, how the British during the war had abandoned their earlier practice of treating “companies merely as withholding agents who forwarded tax to the Inland Revenue, rather than taxable entities in their own right,” as Daunton has put the matter.41
Ibid., 211.
I. J. Talbert, Head of Law Division, Commissioner of Internal Revenue, to George R. Cooksey, Assistant Secretary of the Treasury, August 8, 1917, Papers of William Gibbs McAdoo, Library of Congress.
Excess-profits taxation, which the Wilson administration enacted in the Revenue Act of 1916 as a preparedness measure and then expanded after the United States entered World War I, accounted for about two-thirds of all federal tax revenues during the war. Under the Revenue Act of 1918, the progressive rates of excess-profits taxation ranged from 30 to 65 percent on profits above a “normal” rate of return. Most of the remaining revenue came from a highly progressive income tax on the wealthiest individuals. In 1918, the wealthiest 1 percent of households paid marginal tax rates that ranged from 15 to 77 percent. The effective rates of taxation of the incomes of the wealthiest households averaged 15 percent. This was perhaps low by the standards of the late twentieth century, but the 15 percent level represented a major increase from the 3 percent level that prevailed before the war, in 1916. Moreover, this 15 percent did not include whatever additional taxes wealthy individuals paid through the taxation of corporate incomes.43
W. Elliot Brownlee, “Historical Perspective on U.S. Tax Policy Toward the Rich,” in Joel B. Slemrod, ed., Does Atlas Shrug? The Economic Consequences of Taxing the Rich (New York and Cambridge, MA: Russell Sage Foundation and Harvard University Press, 2000), 44–45.
With the excess-profits tax and a highly progressive income tax on the wealthy, the Wilson administration was the first to discover the revenue potential of taxing the rich. The numbers clearly showed where the money was. In 1918, only about 15 percent of American households had to pay personal income taxes, and the tax payments of the wealthiest 1 percent of American households accounted for about 80 percent of the revenues from the personal income tax. One might reasonably describe this as “soak-the-rich” taxation. In other words, the Wilson administration discovered that a highly progressive income tax has great value as a tool for building the state—above and beyond whatever capability it might also have for redistributing the cost of government, regulating the scale of business, or demonstrating the commitment of the government to social justice. The revenue capacity of “soak-the-rich” is especially apparent during periods when the concentration of incomes increases at the top, and also during periods when inflation pushes taxpayers into higher tax brackets (“bracket-creep”).
If the Republicans had been in a position to manage the financing of the war, what kind of tax system might they have put in place? If we take Republican criticism of the Wilson administration seriously, in the first place they would have raised less tax revenue and borrowed more heavily. In the second place, they would have also taxed the wealthy and corporations heavily, and at progressive rates. There was no other feasible option. In the third place, however, they would have followed the preference of most professional economists, as well as the most politically active business leaders, including significant supporters of the Wilson administration, for the adoption of the British model of excess-profits taxation. Economist Edwin R. A. Seligman, for example, urged the adoption of the British standard of taxing profits that exceeded prewar levels, arguing: “[E]xcessive taxes on industry will disarrange business, damp enthusiasm, and restrict the spirit of enterprise at the very time when the opposite was [sic] needed.” He added that a fiscal policy “predicated primarily on principles of social reform will be likely to lose the war.” He had launched his career in the public sphere by challenging the single-tax ideas of Henry George, and he correctly regarded the Treasury's approach to excess-profits taxation as based on the same kind of assumptions about the nature of profits that George and his followers had made in their effort to socialize economic rent.44
Edwin R. A. Seligman, “Our Fiscal Policy,” in Financial Mobilization for War, Papers Presented at a Joint Conference of the Western Economic Society and the City Club of Chicago, June 21 and 22, 1917 (Chicago: privately printed, 1917), 10 and 12. Seligman and experts in the Wilson administration agreed that businesses could not pass on the excess-profits taxes to consumers or others in the economy. While the Wilson administration experts thought the tax would penalize monopoly power and promote competition, Seligman believed it would drive up the cost of capital, impeding investment and undermining business confidence.
In short, in order to raise significant tax revenues, the federal government had to rely heavily on taxation of corporations. Even under a Republican regime, the transformation of the federal tax system during World War I would have been the most dramatic in the history of the republic. The Wilson administration made the wartime break even sharper, however, by consistently rejecting alternatives that were tested by experience, easier to administer, and more favorable to the interests of powerful forces within the business community, including Wilson's own business supporters. Instead, the Wilson administration and the Congress consistently chose radical forms of anticorporate taxation. They sought to use the wartime crisis as a means of advancing the cause of economic democracy.
The Wilson administration failed, however, to sustain the most radical of its fiscal reforms. In fact, these reforms contributed to its political downfall. During the congressional elections of 1918, in reaction to the administration's proposal to roughly double wartime tax revenues, the investment banking community and the leaders of the Republican Party launched a successful assault. They blamed the wartime tax program for causing serious inflation and pointed to the problem of “bracket-creep.” The outcome was clear: the capture of both houses of Congress by the Republicans in the 1918 elections.
The political backlash from wartime inflation continued to damage the Democrats, and the cause of progressive taxation, even after the electoral defeats of 1918. Many Americans continued to blame increases in cost of living, which continued well into 1920, on wartime taxes. Some also blamed the tax program for damaging business and business confidence, thereby causing the depression of 1920–21. Wealthy individuals and corporations took advantage of this analysis of economic performance, and the postwar political weakness of the Wilson administration, to win popular support in 1921 for repealing the excess-profits tax and reducing the top marginal rate of the individual income tax to 58 percent.
The progressive income tax itself survived, however. It did so in part because of the enormous revenue capacity of the tax, but also because Woodrow Wilson, through his handling of wartime finance, had reinforced and enhanced Americans' belief in the justice of taxing according to ability to pay. In deference to the power of this ideal, and to protect the important new source of revenue, Andrew Mellon, the secretary of the Treasury from 1921 to 1932, cast his support behind preservation of the progressive income tax, and thus the progressive income tax survived the Republican program of returning to “normalcy.”45
At the same time, however, Mellon led in reducing the top marginal rate on the rich in 1926 and in 1928, bringing it down to 25 percent. One of his objectives in so doing was to reduce avoidance and evasion of the income tax by the wealthy.
V. The Regimes of Depression, War, and Franklin Roosevelt
The next two national emergencies, the Great Depression and World War II, ended Republican “normalcy.” These back-to-back crises of social order and national survival both created huge demands for taxation that would produce new revenues, redistribute social power, and reallocate the tax burden according to the criterion of “ability to pay.” In response, the New Deal and wartime mobilization of President Franklin D. Roosevelt produced three great tax initiatives.
The first initiative echoed the approach of the wartime Wilson administration to income taxation. On this front, Roosevelt initially moved slowly, partly because he feared a conservative counterattack of the kind that had defeated the Wilson administration. Worrisome too was the possibility that Roosevelt might worsen the economic depression by undermining business confidence and investment. Finally, however, in 1935, the growing “Thunder on the Left,” particularly Huey Long's “Share Our Wealth” movement, pushed Roosevelt into action. He first proposed a tax program that included a graduated tax on corporations and an increase in the maximum income-tax rate on individuals. In a message to Congress, he explained that accumulations of wealth meant “real and undesirable concentration of control in relatively few individuals over the employment and welfare of many, many others.” He went on: “Whether it be wealth achieved through the cooperation of the entire community or riches gained by speculation—in either case the ownership of such wealth or riches represents a great public interest and a great ability to pay.” Later that year, he explained to a newspaper publisher that his purpose was “not to destroy wealth, but to create a broader range of opportunity, to restrain the growth of unwholesome and sterile accumulations and to lay the burdens of Government where they can best be carried.” Thus, he justified his tax-reform program in terms of both its inherent equity and its ability to liberate the energies of individuals and small corporations, thereby advancing recovery. There was no trade-off, Roosevelt believed, between growth and progressiveness.46
For the Roosevelt quotations, see Arthur M. Schlesinger, Jr., The Age of Roosevelt: The Politics of Upheaval (Boston: Houghton Mifflin, 1960), 328; and Walter K. Lambert, “New Deal Revenue Acts: The Politics of Taxation” (Ph.D. dissertation, University of Texas, Austin, 1970), 259–60.
Congress gave Roosevelt most of what he wanted, including his 1936 proposal of an undistributed profits tax—a graduated tax on the profits that corporations did not distribute to their stockholders. Roosevelt believed that the measure would fight the concentration of corporate power. He and his Treasury advisers were convinced that the largest corporations had the power to retain shares of surpluses greater than those retained by small companies. The surpluses, they were certain, gave large corporations an unfair competitive advantage by reducing the need to borrow new capital. The tax, they believed, would create opportunities for smaller corporations and provide a powerful incentive for corporations to distribute their profits to their shareholders. New opportunities and spending would, in turn, stimulate economic recovery.
More than any other New Deal measure, this tax aroused fear and hostility on the part of large corporations. They correctly viewed the tax as a threat to their control over capital and their latitude for financial planning. Despite Roosevelt's hope that the measure would stimulate recovery, the tax may well have contributed significantly to the exceptionally low level of private investment during the 1930s, and even, by depressing business expectations, to the severity of the recession of 1937–38. Antimonopolist New Dealers like Harold Ickes went so far as to charge that capitalists had conspired and gone “on strike” in response to New Deal taxes.47
Both Kenneth D. Roose and Joseph A. Schumpeter stressed the role of the tax in the recession of 1937–38. See Roose, The Economics of Recession and Revival: An Interpretation of 1937–38 (New Haven, CT: Yale University Press, 1954), 10–12 and 209–16; and Schumpeter, Business Cycles (New York: McGraw-Hill, 1939), 1038–40. On the conspiracy charges, see Mark Leff, The Limits of Symbolic Reform: The New Deal and Taxation (Cambridge: Cambridge University Press, 1984), 212–13. On the intellectual sources of the undistributed profits tax, see Michael Bernstein, The Great Depression: Delayed Recovery and Economic Change in America, 1929–1939 (Cambridge: Cambridge University Press, 1987), 190–92.
The second Roosevelt tax initiative was the establishment in 1935 of payroll taxes to finance the new Social Security system. These taxes were regressive. The incongruity between this initiative and Roosevelt's reforms of income taxation might suggest that he was little more than a cynical manipulator of the powerful symbolism of taxation. But he conceived of Social Security as an insurance system. In his mind, taxpayers received the benefits for which they had paid. Roosevelt's concept was shared by much of the American public, and it lent the payroll tax a popularity that enabled it to win a narrow victory in 1935. In addition, the benefit formula of even the initial Social Security program had a progressive dimension. In 1939, Roosevelt and Congress firmly established a progressive benefit formula and introduced pay-as-you-go financing.48
This tax measure may also have impeded recovery from the Great Depression by offsetting the demand-side stimulus of fiscal policy. On the limitations of the New Deal's fiscal policy, see E. Cary Brown, “Fiscal Policy in the ‘Thirties’: A Reappraisal,” American Economic Review 46 (December 1956): 857–79; and Herbert Stein, The Fiscal Revolution in America (Chicago: University of Chicago Press, 1969), 39–168.
The third great initiative came during World War II. Because of the creation of the information-gathering capability of the Social Security system, and the continued expansion of corporate employment, the federal government had more options available than in World War I. In particular, mass-based income and/or consumption taxes were now administratively feasible.49
By mid-1940, the Bureau of Old-Age Benefits had processed more than 312 million individual wage reports forwarded by the Bureau of Internal Revenue and had posted over 99 percent of them to more than 50 million individual employee accounts. Altmeyer, The Formative Years of Social Security, 86–87.
As in World War I, the commitment of a Democratic president to economic democracy shaped the choice of options. Roosevelt resisted conventional consumption taxation as too regressive, although, at one point in negotiations with Congress, he proposed a progressive tax on “spendings.” More serious were Roosevelt's proposals of various Wilsonian taxes on excess corporate profits. However, he lacked broad support for these taxes from Democrats in Congress. Many worried that such a tax program would weaken the financial ability of corporations to cope with the depression they thought would more than likely follow the war. Federal Reserve Chairman Marriner Eccles and Vice President Henry Wallace shared this concern and consequently supported a sales-taxation approach to war finance. In response, Secretary of the Treasury Henry Morgenthau Jr. complained that his opponents had forgotten about the “people in the lower one-third.” In the face of defections of many Democrats, like Wallace, who had once supported anticorporate taxation, Morgenthau declared: “I can get all my New Dealers in the bathtub now.”50
John Morton Blum, From the Morgenthau Diaries: Years of War, 1941–1945 (Boston: Houghton Mifflin, 1967), 35.
Roosevelt abandoned the World War I method of determining excess profits, thus ending twenty-five years of Democratic initiatives in using income taxation to attack monopoly power. But Roosevelt succeeded in defeating consumption taxation and advancing instead a highly progressive income tax. By the end of World War II, the marginal rate of taxation on personal income had risen to 94 percent (on dollars earned over $200,000), higher than at any other time in the history of American income taxation. In 1944, the effective rate on the rich reached an all-time high of nearly 60 percent, or almost four times the highest level achieved during World War I. The rates were high enough so that, even with the broad base of taxation, in 1945 the richest 1 percent of households produced 32 percent of the revenue yield of the personal income tax.51
See Brownlee, “Historical Perspective on U.S. Tax Policy,” 60; and Bureau of Internal Revenue, U.S. Department of the Treasury, Statistics of Income for 1945, Part I (Washington, DC: Government Printing Office, 1951), 71.
Roosevelt and Congress agreed not only on highly progressive rates but also on an exceptionally broad base for the reformed income tax. As Americans prepared for entry into World War II, President Franklin Roosevelt and the congressional leadership assumed that mobilization would be on an even greater scale than during World War I and that the inflationary pressures would be correspondingly more severe. As a consequence, the nation's leadership quickly reached a bipartisan consensus favoring an income tax that would reach deep into the American middle class. This broad base of taxpayers would finance an even larger portion of the costs of the war than they had done in World War I. At the same time, the high taxes would discourage consumers from bidding up prices in competition with the government. Under the new tax system, the number of individual taxpayers grew from 3.9 million in 1939 to 42.6 million in 1945, and federal income-tax collections over the period leaped from $2.2 billion to $35.1 billion. By the end of the war, nearly 90 percent of the members of the labor force submitted income-tax returns, and about 60 percent of the labor force paid income taxes. In 1944 and 1945, individual income taxes accounted for roughly 40 percent of federal revenues, whereas corporate income taxes provided about one-third—only half their share during World War I. And current tax revenues paid for approximately half of the costs of the war. Mass taxation had returned as a central element of federal taxation.
Mass taxation succeeded partly because of the popularity of the war effort. It was not as important as during World War I to leverage popular support and sacrifice for the war by enacting a highly redistributional tax system. More than in World War I, Americans concluded that their nation's security was at stake and that victory required both personal sacrifice through taxation and indulgence of the profits that helped fuel the war machine. Nonetheless, the high progressivity of the income tax was important, as well as the popularity of the war. Middle-class Americans accepted the income taxes they now paid in part because the overall rate structure of the tax system was highly progressive, providing a financial sacrifice to match the sacrifice made by fighting men and women.
VI. Survival and Reform of the World War II Regime
In contrast with Wilson's tax program of World War I, Roosevelt's wartime tax regime survived the war's aftermath essentially intact and remains essentially intact in the first decade of the twenty-first century. On an important level, this was a consequence of a general agreement of the two major political parties on the need to maintain a large federal government and to keep the World War II revenue system as the means of financing it. For the first time since the early nineteenth century, the two political parties agreed on the essential elements of the nation's fiscal policy.
Having agreed on the need for big government, the two parties also agreed on the attractiveness of the revenue capability of the World War II system. Of particular political value was the fact that the new tax regime was generally able to fund the expansion of both domestic and foreign programs without requiring any legislated tax increases, thus avoiding the unpleasant task of picking losers. This was so because both economic growth and long-term inflation, working through the expansion of the tax base, provided an elastic source of new revenues. In fact, that elasticity enabled the federal government to make periodic, substantial tax cuts.
The convergence on tax policy involved restraint by Republicans in seeking consumption taxation, and an acceptance by them of greater taxation of large incomes than they had found palatable before World War II. Conversion to a tax system based on consumption, or on a hybrid of income and consumption, would have been administratively feasible. But Republican leaders recognized the political appeal of “ability to pay” and did not seriously entertain such a conversion until the 1990s. For their part, Democrats largely abandoned taxation as an instrument to mobilize class interests. Most dramatically, they abandoned the antimonopoly rhetoric of World War I and the New Deal and adopted instead a more benign view of corporate power.
Republican and Democratic leaders also agreed that there were two major problems with high marginal rates of taxation, and, at least through the Reagan era, they often lent bipartisan support to tax-rate reform. The first problem was that the rates created economic disincentives for wealthy Americans to save and invest, and to work. The Kennedy-Johnson tax cuts in 1964 began the work of reducing the high marginal rates, and then the Reagan tax reforms (both the Economic Recovery Act of 1981 and the Tax Reform Act of 1986) continued the reductions, bringing the top rate down to roughly 36 percent.52
The impact that cutting the top marginal rates has had on productivity is an open issue. Economic analysis finds daunting the long-run world, where all significant variables, including capital stocks, change simultaneously. However, accelerations in productivity have often followed marked reductions in the taxes on the richest Americans. For example, the productivity surges during the 1920s, the late 1950s and early 1960s, and the late 1990s each followed reductions in taxes on the rich during the 1920s, the post–World War II years, and the 1980s.
The second problem was that the high marginal rates tended to undermine the goal of broadening the economic base for taxation. They created incentives for taxpayers to seek lucrative loopholes in the form of special deductions and exemptions. The loopholes in turn created economic distortions by favoring one form of income over another, made the tax code mind-numbingly complex, and weakened the public's faith in the fairness of the income tax. The most comprehensive and successful effort to close loopholes was the Tax Reform Act of 1986. In a concerted effort to promote this measure, President Ronald Reagan invoked the search for tax equity, defined as horizontal equity—equal treatment for taxpayers in similar economic circumstances. Reagan declared that he was seeking to “free us from the grip of special interests.” There would be, he said, “one group of losers in our tax plan—those individuals and corporations who are not paying their fair share, or for that matter, any share.”53
Ronald Reagan, “Address by the President to the Nation,” May 28, 1985, folder Tax Reform (5), OA 17746, Beryl Sprinkel Files, Ronald Reagan Library.
None of the Republican or Democratic reforms, however, challenged the fundamental progressiveness of the rate structure. In 1986, for example, the Reagan administration coupled rate reductions at the top with significant cuts for low-income Americans. At the end of the Reagan administration, the tax code, even including Social Security taxes, was more progressive than it had been when Reagan took office.
After 1986, bipartisan agreement on tax reform broke down. Both Republicans and Democrats abandoned any interest in ridding the tax code of “tax expenditures.” In fact, each party developed a list of new tax loopholes and enacted many of them into law. On the one hand, President George H. W. Bush revived the idea of preferential taxation of capital gains. On the other hand, President Bill Clinton returned to a “soak-the-rich” policy and in 1993 led in significantly raising rates on the wealthiest Americans. Meanwhile, he plumped for numerous tax preferences for middle-class Americans. The tax cuts of President George W. Bush further increased the complexity of the tax code. At the same time, he and congressional Republicans undertook what seemed to be an incremental program to transform the progressive income tax into a system of regressive consumption taxation. If the program succeeds, the federal government will have broken away sharply from traditional definitions of “ability to pay” and returned to a pattern of fiscal development that the great national crises disrupted.
VII. Conclusion
Without the crises that the nation has faced since the founding of the republic, needs for national security and the services of a welfare state would still have led the federal government to grow substantially. It might even have grown to roughly the same size that it had reached by the middle of the twentieth century. Without the crises, however, the path of growth probably would have been smoother, and the development of the federal tax system more incremental. Periodic demands for new revenues would have been less intense, and calls for social justice through the tax system—through both redistribution and economic reform—would have been less pressing. New tax regimes might have emerged, but they would have appeared gradually rather than springing full-blown out of national emergencies. Moreover, all these new regimes might have relied on consumption taxation, rather than shifting to income taxation, and kept tax rates flat. In other words, the federal government might have emphasized the flat-rate taxation of consumption down to the present day. If the federal government adopts a flat-tax, consumption-tax regime in the early twenty-first century, perhaps we should view the shift as a return to the path the nation had taken before the disruptive series of crises that began with the Civil War and ended with World War II. If the federal government retains the progressive income tax, we should conclude that the canon of “ability to pay” has retained much of its historic power in the United States.
