Manipulation through tax policy is getting more popular with lawmakers all the time. They love to say, if you do X, you can keep your money. If you do anything else, you cannot. President Clinton says just that when he proposes tax relief consisting of deductions for only certain kinds of spending, say, buying a home or paying college tuition.
That is Big Brother in its subtle mode. Since people have become more skeptical about big government, it has been harder for politicians to launch big spending programs. So they have turned to another way of accomplishing their ends: manipulation through the tax code. Instead of openly subsidizing college tuition, President Clinton calls instead for a tax deduction or credit. He can achieve the same effect without a spending program. It is true that a deduction is not the same thing as a cash subsidy. But manipulation of behavior occurs in both cases. Better to abolish the income tax and let people make their own decisions with their own money.
Politicians like these gimmicks at election time, and voters may thrill to talk about “tax relief.” But tax relief through deductions is very precarious. It is a way for the government to let you keep a little cash without conceding that it is your money. Tax deductions can be taken away (though some, like the mortgage-interest deduction, are harder to take than others). The courts, naturally, do not see tax deductions as a return of stolen property to the taxpayers. “An income tax deduction is a matter of legislative grace,” the U.S. Supreme Court said in 1943.21 In other words, all income belongs to the state. If it allows you to use some of it for purposes it chooses, be grateful. But don’t think it is yours as a matter of right. That is where the Sixteenth Amendment to the U.S. Constitution has delivered us.
To repeat, it is not exemptions from income taxation that need to be abolished but income taxation itself.
The Burden of Uncertainty
A fluid tax code is a bad thing. No one can say what will be in the code from year to year. Sometimes the changes are even retroactive. As noted earlier, the tax code was changed more than one hundred times in the 1980s alone. The “simplification” of the 1986 Tax Reform Act amended two thousand sections. One hundred new forms were introduced.22 The changes continued in the 1990s with President Bush’s and President Clinton’s tax-rate increases. A tax exemption people count on one year can be gone the next. Who can confidently make long-term plans when a tax amendment next year or in ten years could drastically change conditions and reduce the anticipated return? This is not to say that long-term planning does not occur in the U.S. economy. But since the uncertainty of the tax code is a way of life, investment and other planning is surely less ambitious than it would be without the income tax. It would be naive to think that the ever-present threat of amendment does not affect how entrepreneurs act. Economists Alan Auerbach and James Hines have said that “in the uncertain business of planning for U.S. corporate investment, one of the few reliable forecasts one can make is that the tax law will change before any new investment outlives its usefulness.”23
James Payne asked an accountant who specializes in small corporations how the tax code affects planning. The accountant replied, “Oh you can’t plan. There is no way you can plan. You don’t know what the tax law’s going to be this year, let alone next. And they make things retroactive.”24
Payne wished to quantify the full cost of tax uncertainty, but he found it impossible, since uncertainty is subjective. The closest he could come was an estimate of the cost that uncertainty about tax rates creates for work and savings decisions. Analyst Jonathan Skinner, using the period 1929–1975, estimated that “the annual loss of uncertain taxation, expressed as a proportion of 1985 U.S. national income, is $12 billion.”25 Payne suspects that is an underestimate because it accounted for changes in rates only and because the period looked at had fewer changes than subsequent periods. But the point is made: uncertainty about the tax code takes its toll on the capacity of the U.S. economy to create prosperity.
The cost of uncertainty is but one aspect of what Payne calls the burden of the tax system, which comes on top of the burden of the tax itself. Let’s look now at other costs the system imposes on the American people. Payne catalogues and conservatively estimates the (1985) costs for individuals and businesses this way:
Compliance: $159.4 billion (computed on 5.424 billion hours plus the amount spent on paid preparers used by individuals)
Enforcement costs (audits, litigation, forced collections): $12.9 billion
Disincentives to production: $155.3 billion
Disincentives from tax uncertainty: $12 billion
Evasion and avoidance: $19.3 billion
Government operations: $4 billion
That totals $362.9 billion. Payne emphasizes that the various costs are hard to quantify and that those numbers are underestimates. He doesn’t even try to attach numbers to the emotional, moral, and cultural burden of the tax system.
Small Business and the Self-Employed
The special burden of the tax system on small business and the self-employed should be emphasized. Large companies, of course, can afford the accounting and legal services that are required to grapple with the difficult and ever-changing tax code. Small-business owners and the self-employed often cannot. The record keeping, form filing, and need to be informed about the tax laws surely discourage a significant number of people from venturing into independent entrepreneurship. The system hampers the entrepreneurs who proceed anyway. That burden represents a loss to everyone, because small business is a major source of innovative products and services that raise our living standards. It is also a major source of jobs. Anything that stunts the development of small business is bad for our economic well-being. Imagine the additional prosperity the American people would enjoy if the income tax were lifted off the shoulders of small business.
The self-employed have another burden to carry: IRS animosity. It seems that the agency doesn’t like people who work for themselves; taxes are easier to collect from people who have employers to do withholding. “The IRS has long striven to minimize the number of self-employed,” writes James Bovard.26 As a result of its efforts, thousands of small businesses have been damaged or disrupted in the health care and high-technology industries. The IRS has done that by classifying contractors as employees and penalizing companies that buy their services for not withholding taxes.27
The Growth of Government
The income tax opened the gates to the growth of the federal government. It is hard to imagine today’s federal government supporting itself by excise taxes and tariffs, which were relied on before the income tax became a tax for ordinary people in World War II. Indeed, when the income tax became fashionable among America’s intellectuals, they argued that the modern state requires access to new sources of revenue in order to do things that government did not have to do before. What they had in mind, of course, was the welfare state, which they had observed in Bismarck’s Germany, and an activist foreign policy, under which the U.S. government would guarantee “American interests” all around the world. Those are expensive items. The source of revenue with the biggest potential pay-off was the new fortunes being made by industrialists, particularly in the northeastern United States. (See chapter 5.) That wealth looked like a huge ripe plum ready for picking. Since most people were not making those fortunes, there was little public opposition.
The income tax was not a big revenue producer at first because it hit only a small percentage of Americans. But thanks to two world wars, the tax became a revenue gusher. The individual income tax raised $420 million, or about 14 percent of all federal receipts, in 1934. In those days the budget was $6.5 billion (unadjusted dollars). In 1942, America’s first full year in World War II, the tax brought in $3.3 billion, or 22 percent of receipts. In 1944 the take came to $19.7 billion — 44 percent of total receipts.
That demonstrated to the policymakers that the individual income tax was a bonanza indeed (as was the corporation income tax). The war ended in 1945, but the amount raised by the inc
ome tax never fell back by any significant amount. In 1951, the tax was raising more than it raised at its wartime height in 1944. It has been up and up ever since, with only a few minor exceptions. In fiscal year 1997, the tax was expected to raise $645 billion, or 43 percent — the biggest single source — of total federal receipts in a budget of more than $1.6 trillion.
We have understated the amount the government extracts, because we left out the payroll taxes that finance Social Security and Medicare, and the corporation income tax. All of these reduce incomes to some extent. When you add those revenues to the personal income tax, the total comes to $1.3 trillion for fiscal year 1997.
To put this all in perspective, the federal government, thanks to the Sixteenth Amendment and the income taxes it permits, has perpetrated the biggest hold-up in the history of the world. We have all paid the price in lost prosperity.
In the next chapter, we will see how the income tax came to the land of the free.
Notes
1 James L. Payne, Costly Returns: The Burdens of the U.S. Tax System (San Francisco: ICS Press, 1993). This is apparently the only book that attempts a full accounting of the burdens of taxation in the United States.
2 Ibid., p. 9.
3 Murray N. Rothbard, Power and Market: Government and the Economy (Kansas City, Mo.: Sheed Andrews and McMeel, 1977), pp. 86–88.
4 Jean-Baptiste Say, A Treatise on Political Economy (1803; New York: Augustus M. Kelley, 1971), p. 416.
5 Quoted in Murray N. Rothbard, Classical Economics: An Austrian Perspective on the History of Economic Thought, vol. 2 (Brookfield, Vt.: Edward Elgar Publishing Co., 1995), p. 42.
6 Ibid., p. 41.
7 Rothbard, Power and Market, p. 98. Italics in original.
8 Quoted in Rothbard, Classical Economics, p. 42.
9 Say, p. 147.
10 However, Say did not oppose all taxation, and even supported a progressive income tax.
11 The numbers, which come from the Internal Revenue Service, are reported in Chris R. Edwards, “Who Pays Federal Income Taxes?” Special Report no. 42, November 1994, Tax Foundation. The 1994 numbers are at the foundation’s website, www.taxfoundation.org/prtopincome.html.
12 It should be acknowledged that, in theory, a progressive rate structure with low rates could be less damaging than a high flat rate.
13 Stephen Moore and John Silvia, “The ABCs of the Capital Gains Tax,” Cato Institute Policy Analysis no. 242, October 4, 1995. See also Martin L. Gross, “Capital Gains Tax: You Lose; Washington Wins — All the Time” in The Tax Racket: Government Extortion from A to Z (New York: Ballantine Books, 1995), pp. 52–58.
14 “Who Earns Capital Gains, and Who Pays Capital Gains Taxes?” at the Tax Foundation website: www.taxfoundation.org/prcapgains.html.
15 This is drawn from Roy E. Cordato and Sheldon Richman, “A Tax Deduction for Education,” The Freeman, June 1994, pp. 303–5.
16 Stephen Entin, “Tax Biases Against Saving and Investment and How to Fix Them,” in National Commission on Economic Growth and Tax Reform, Unleashing America’s Potential (New York: St. Martin’s Griffin, 1996), p. 69. Also see Laurence J. Kotlikoff, “The Economic Impact of Replacing Federal Income Taxes with a Sales Tax,” Cato Policy Analysis no. 193, April 15, 1993.
17 Rothbard concludes that even explicit consumption taxes must also tax savings implicitly because savings is motivated by future consumption. Power and Market, pp. 108–11.
18 Ibid., p. 119–20. Congress, in its typically flawed way, tried to balance the disincentives by letting people create Individual Retirement Accounts. Deposits up to an arbitrary limit were tax-deferred until withdrawal at age 55 or later. Congress later added more restrictions, then reduced them.
19 See John C. Goodman and Gerald L. Musgrave, Patient Power: Solving America’s Health Care Crisis (Washington, D.C.: Cato Institute, 1992).
20 See, for example, James Bovard, “Archer Daniels Midland: A Case Study in Corporate Welfare,” Cato Institute Policy Analysis, no. 241, September 26, 1995.
21 Quoted in James Bovard, Lost Rights: The Destruction of American Liberty (New York: St. Martin’s Griffin, 1995), p. 291.
22 Daniel J. Pilla, “Why You Can’t Trust the IRS,” Cato Institute Policy Analysis no. 222, April 15, 1995, at www.cato.org.
23 Quoted in Payne, p. 96.
24 Ibid., p. 97.
25 Quoted in ibid., p. 98.
26 Bovard, Lost Rights, p. 260. For details see pp. 259–65.
27 See, for example, Jon Christensen, “Self-Employed under Fire by the IRS,” Wall Street Journal Interactive Edition, June 6, 1996 (http://interactive.wsj.com) (editorial page).
5
How We Got the Income Tax
In 1913 the Congress of the United States passed the income tax that has been with us ever since. That tax was enacted after the states ratified the Sixteenth Amendment to the U.S. Constitution:
The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
The tax enabled the federal government to amass unprecedented power over the lives and economic activities of the American people. It enabled the government to participate in global affairs and enter wars that would have been unthinkable without such a tax. In sum, it helped create the Leviathan that so many of the Founding Fathers feared might someday come to America and that plagues us to this day.
How did it happen? Why did a nation founded on the premise of minimum government and maximum individual freedom succumb to the political malady so characteristic of Europe, which the Founders had struggled so heroically to be free of?
It didn’t happen overnight. The intellectual change in America that led to adoption of the income tax was a slow process working through many media. The process was fueled by several sources: populists envious of the wealth held by others, “Progressive” politicians seeking to consolidate power and to expand the functions of government, court intellectuals who foresaw the professional opportunities that big government would provide, and businessmen who understood that a well-funded, muscular state — not laissez faire — was the route to guaranteed success.
The first proposal for an income tax (and an inheritance tax) came during the War of 1812 against Britain. By 1814 the government had run up an unprecedented debt of $100 million. Most revenues were raised by customs duties on foreign products. Although they were doubled in 1812, they actually brought in less revenue because trade dropped off. By 1815 excise taxes had been imposed on domestic goods and commodities and taxes were put on houses, slaves, and land. All the new taxes were removed after the war, but a high protective tariff was passed in 1816 to retire the debt.1
The Civil War
The American people barely escaped an income tax during the war against Britain. They were not so lucky in the war between the states. The Civil War provided the rationale for Congress to pass six successive income-tax bills, setting a precedent that would dog the American people until the tax became a permanent fixture. The war of course was expensive — costing an average of $1.75 million a day.2 Moreover, the South was no longer sending tariff revenues to Lincoln’s government. To finance the Union effort, the Congress issued bonds and notes, doubled the tariff, sold public lands, imposed license fees, and increased old and created new excise taxes. None of this was enough.
In 1861 House Ways and Means Chairman Thaddeus Stevens, Republican of Pennsylvania, introduced a tax on land in each state “with each state’s share to be apportioned by population.”3 The South and West objected because they felt they had already been stung by earlier tariffs on such basic things as tea, coffee, and sugar. Stevens countered by reducing the direct land tax and adding a tax on wealth and income. In July the House passed a 3 percent tax on all incomes over $600 a year. At the same time the Senate added to a tariff bill a 5 percent tax on all incomes over $1,000 a year. The conference committee compromised with a 3
percent tax on incomes over $600 ($10,500 in 1995 dollars). This was net income, with deductions to be specified by the Treasury. There was also to be a 1.5 percent tax on interest from government securities. The tax was due June 30, 1862, against 1861 incomes.
No money was ever raised by the income tax of 1862 because a second tax passed before the first could take effect. In 1862 the war’s demand on resources was immense, and bond sales were massive. In March the House passed a new revenue bill that included a tax similar to the first, but with a $600 exemption ($10,500 in 1995 dollars). The Senate made the rate progressive: 3 percent on incomes of $600 to $10,000; 5 percent on $10,000 to $50,000; and 7.5 percent over $50,000. Deductions were allowed for other taxes and for all profits or income “derived from … any articles manufactured, upon which specific, stamp, or ad valorem duties shall have been directly assessed or paid.…” This would have exempted most business income, but the provision was not used and a year later it was stricken.4
The conference committee compromised by eliminating the 7.5 percent rate. But it included a modest inheritance tax. The bill was signed by Lincoln on July 1, 1862, and it took effect a month later. It was to expire in 1866. By the time of passage the Union debt was $505 million.5
There were two interesting sidelights to the law. First, it included withholding of the tax on federal salaries and on interest and dividends, foreshadowing introduction of the withholding tax for everyone during World War II. Second, a year after the law was enacted, an amendment was passed allowing for a deduction for rent paid for dwellings.6
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