The ABC’s of U.S. Tax Policy: An Historical Perspective

Sep
8
2008

Amata Miller, IHM, 1990

revised by Catherine Pinkerton, CSJ, 1997

From the days of George Washington to that of the present Administration, taxes have been a subject of national controversy. In his farewell address to Congress in 1796, our first President put the issue starkly before the legislators of the heavily indebted new nation: “It is essential [to bear in mind]…that toward the payment of debts there must be revenue; that to have revenue there must be taxes; that no taxes can be devised which are not more or less inconvenient and unpleasant.”

When read in the light of the nation’s current political, economic and social situation, Washington’s directive about tax policy is both enlightening and challenging. The first President spoke of taxes as the vehicle for the nation’s debt relief. Today, he would necessarily speak of taxes as financing the multiple services which citizens expect from government at every level, services which they could not provide for themselves because they require excessive cost and complex infrastructures.

In the heat of tax debate rhetoric, the larger economic, political and social contexts are often obscured. Few citizens have the opportunity to study the structure of the federal budget, how revenues are generated, how they are dispersed to various segments of the public or what citizens actually receive from government in return for paying taxes.

More importantly, the nation’s current tax system must be evaluated not only according to the citizens’ expectations of government’s responsibilities toward them, but also in the context of complex interrelated factors which characterize this historical moment:.

•  efforts by Congress to balance the budget by 2002 and questions about who should bear the burden;
•  the rising cost of entitlement programs and the aging of the population;
•  the widening disparities between wealth and poverty, in income distribution and job opportunities;
•  efforts to diminish the role of the federal government and devolve greater responsibility to the states and local governments;
•  a trend toward privatization and corporatization of many government functions; and
•  the ongoing globalization of the economy which raises questions about who controls the economy of any nation-state.

During the congressional budget debates and presidential campaign in 1996, politicians played upon the electorate’s distaste for taxes. Promises of tax relief and restructuring of the income tax system were touted for political gain while candidates failed to truthfully address the need to deal with the current global economic reality and its effects on the domestic economy. Further, the changes which candidates advanced for the restructuring of the tax system were not progressive in nature and would adversely affect millions of middle- and low-income people.

The nation lacks the quality of leadership which George Washington exercised, leadership which forthrightly defines federal budget priorities in the light of current fiscal, economic and social realities. In working toward fair tax policies, elected leaders must start from the premise that taxes are not a negative force in the nation’s fiscal life, but rather a vehicle through which government and citizens democratically exercise responsibility for the common good. The following historical examination will uncover the deep roots of our present tax dilemma, with an emphasis in Section II on the debate between progressive and flat tax advocates.

I. HISTORICAL ROOTS OF OUR PRESENT DILEMMA
As George Washington’s words imply, Americans have resisted taxation from the start. The colonists’ cry, “No taxation without representation,” reveals that tax issues were (and are) ultimately questions of power: How large should government be? Who will control it? How can the payment of the nation’s bills be shared fairly among its citizenry?

The tensions inherent in these questions have shaped the nation’s pattern of taxation and spending from its beginning. The story is a colorful one, bearing the stamp of some of the giants of our history, including Henry Clay, William Jennings Bryan, Andrew Mellon and Franklin Delano Roosevelt.

A Consensus For Balanced Budgets
The tax system of a nation is rooted in its basic values. Political scientists Carolyn Webber and Aaron Wildavsky contend that U.S. decisions about taxing and spending were shaped by a shared commitment to limited government and balanced budgets until the presidency of Franklin Delano Roosevelt. The American dedication to balanced budgets had held political and emotional power because it was buttressed by a vision of fearful consequences for ignoring it: inflation, unemployment, public immorality, private corruption. Politicians utilized these themes in ensuing tax struggles.

From Tariffs to Income Taxes
Tariffs on imported raw materials and manufactured goods were the nation’s first major taxes, enacted on the fourth of July, 1789. Until the Civil War, tariffs raised enough to pay the bills of the relatively small federal government. Through the early 1800s, regional differences in the burden of tariffs divided the nation. Henry Clay described eloquently the oppression of Southerners under protectionist policies which benefitted Northern industrialists and bankers. Historians argue that this tax controversy was a root cause of the Civil War. In 1862 President Lincoln called for a temporary, emergency income tax—the nation’s first. But it only lasted until 1872.

“Robber Barons” and Populist Pressure for Income Taxes
The prosperity of the 1890s, together with the ostentatious accumulation of wealth by the “robber barons,” generated populist pressure for income taxes—in the name of greater equality.

In 1892, William Jennings Bryan convinced Congress to levy a 2% tax on personal incomes over $4,000. It was challenged in court, however, before taking effect. Then, as now, business interests opposed an income tax as confiscatory, anti-growth and unfair to the rich.

From Unconstitutionality to the 16th Amendment
Siding with business, the Supreme Court ruled in 1895 that an income tax violated the Constitution’s prohibition against direct taxation. Populists campaigned for personal income and estate taxes based on “ability to pay.” As an alternative, President William Howard Taft proposed a corporate profits tax. And, in a period of anti-business sentiment, even conservative Republicans supported it. Thus, the corporate income tax first became part of the U.S. tax code.

Taft also suggested a constitutional amendment to overrule the Supreme Court prohibition. Diverse groups united to pass the 16th Amendment in 1913. Populists wanted equality; progressives wanted a more active government; business wanted predictability.

Immediately, a federal tax on income from all sources was enacted-a flat 1% rate on incomes of more than $3,000 for individuals ($4,000 for married couples). Also, a surtax of 6% was levied on the highest-income earners.

Average annual personal income in 1913 was $621, so only 2% of the population paid any income tax between 1913 and 1915. The law provided exemptions and deductions to insure fairness and provide incentives to work, save and invest.

World War I Means More Taxes
War again mandated higher taxes. In 1918, lowered exemption levels increased the number of income tax payers, and tax rates rose to a maximum of 77%. Still, the income tax was not a tax on the masses. More than 70% of income tax revenues between 1917 and 1919 came from 1% of the taxpayers—those with annual incomes of more than $20,000.

Even after the War, the enduring commitment to balanced budgets overruled partisan preferences. All agreed to reduce high wartime rates—but controversy inevitably arose over whose rates should be cut.

“Ability to Pay” Takes on New Meaning
The prosperity of the 1920s multiplied Treasury revenues, and the two political parties began to compete over how to cut rates and write in tax preferences for special interests. With each of five revisions during the decade, the tax code became more complex. In keeping with the long-cherished ethic, Treasury Secretary Andrew Mellon staunchly supported a balanced budget and fought to make up the revenues lost by the changes.

Mellon defined “ability to pay” to mean: Those with property and savings could finance the needs of government more easily than those who rely on earnings. Thus he argued for taxing investment income at higher rates than earned income, and for providing earned income tax credits to balance the benefits among rich and poor. By the end of the 1920s, the division of revenue sources among different levels of government—which persists today—had emerged. Cities specialized in property taxes, states in sales and excise taxes, and the federal government in income taxes.

The Depression Changes Everything
Past experience was no guide for tax policy during the Depression years. As revenues fell, tax rates were again increased, worsening the downward spiral.

President Franklin D. Roosevelt focused on those with high incomes. He proposed loophole-closing measures, and lashed out against “economic royalists”—wealthy citizens who were avoiding taxes. Meanwhile, support was growing for a larger central government which could be a positive force to keep business in check and to reduce inequalities among states.

Payroll taxes were levied on employers and employees to finance the social insurance programs for unemployment compensation and Social Security. Federal government bureaus multiplied to provide services to the millions impoverished by the Depression failure of the market economy. Thus ended the shared commitment to limited federal government with low spending and low taxing—a bargain kept because groups with diverse political values held balancing the budget as the ultimate norm of fiscal policy.

World War II
World War II revenue needs once again dictated very high rates on the wealthy. It also led to a withholding tax on earnings, the step which effectively converted the income tax into a mass tax for the first time.

“Great Society” and Retreat
The “Great Society” programs of the 1960s increased federal spending to equalize opportunity. Congress appropriated funds for diverse social programs: Head Start and job training programs, Medicaid and nutrition, housing subsidies and community development.

During the 1970s and 1980s, the nation retreated from its “Great Society” goals. Consequently, our tax system’s progressivity declined. Several tax code revisions shifted the burdens from corporate to individual taxes, and from wealthy to middle-class taxpayers. High corporate taxes were perceived as detrimental to the increasingly global economy.

The 1981 Reagan tax breaks were spurred by the “supply-side” economic theory that cutting taxes and abolishing regulations on industry would spur investment in the private sector and produce wealth, thus generating more revenue without raising taxes. The 1981 Economic Recovery Act, which encompassed this theory, also lowered the top rate on capital gains and lowered profits on the sale of investments from 28 to 20 percent. These tax changes disproportionately favored the rich, whose tax rates fell while their incomes rose.

In the same year, economists Robert Hall and Alvin Rabuska of the Hoover Institution supported a return to the “flat tax”, hoping to spur savings and investment and simplify tax filing. California Governor Jerry Brown, in his bid for election, advanced a flat tax and, in 1982, Rep. Leon Panetta (D-CA), later President Clinton’s White House Chief of Staff, introduced the Income Tax Simplification Act, a proposal for a 19% flat tax with almost no deductions, credits or exclusions.

In 1986, a comprehensive overhaul of the code (The 1986 Tax Reform Act) reduced the number of tax brackets to three, lowering the top rate from 50% to 28%. Many of the loopholes which had enabled wealthy individuals and large companies to escape taxation were eliminated. An alternative minimum tax was also levied on individual and corporate income that escaped taxation through remaining loopholes.

Intended to bring more progressivity into the system, the 1986 tax act was short-lived. New loopholes were found and, in an effort to make up for the lost revenues, the top rate was raised to 31 percent in 1990. Contrary to popular myth, federal taxes for most Americans rose during the 1980s. Nine out of ten U.S. families saw increases in their federal tax burden.

In 1993, the Clinton Administration, in an effort to address the deficit and bring further progressivity to the system, increased the top tax rate from 31% to 36% for couples with taxable incomes of $140,000-$250,000 and to 39.6% for those of more than $250,000.

In the following year Republicans, having taken the majority of seats in Congress for the first time in 40 years, again expressed interest in the flat tax as a vehicle for budget balancing. There was discussion of a flat tax during the presidential campaign of 1996.

Efforts to give tax breaks to middle-income earners figured in budget negotiations during the Fiscal Years 1996 and 1997 budget cycles. Legislation enacted in August 1997 provided tax cuts primarily for two groups of taxpayers: middle-income families with children under 17 or attending college and middle- to upper-income households receiving substantial income from capital gains. No comprehensive overhaul of the tax system was achieved, however, and it is likely that tax reform will remain an agenda item in Congress.

II. THE ATTACK ON PROGRESSIVITY
Catholic social teaching upholds the principle that a just tax system must be progressive in nature. In their 1986 Pastoral, Economic Justice For All, the U.S. Bishops described progressivity as “an important means of reducing the severe inequalities of income and wealth in the nation.”

In recent years, however, progressivity has come under increasing attack. Some politicians promoted the idea of a flat tax as a means of simplifying the federal tax code, which many feel is too complex. Others advocated localized flat tax systems to address specific needs. Some political leaders, for example, called for a flat tax for residents of Washington, DC in order to attract wealthier citizens back into the city.

The most organized and consistent assault on the graduated income tax, however, came from neo-conservatives. Their rationale for opposition to progressivity comes from their belief that it harms economic incentives and is therefore anti-growth. Despite numerous studies which refute this assertion, the neo- conservatives pressed their claims with some success during the 1980s. Randy Albeda, Research Director of the Massachusetts Commission on Taxes, has stated that their most significant victory during that decade was to transform the self-concept of a U.S. resident from “citizen” to “taxpayer.” This, coupled with a strong belief in the sanctity of private property, encouraged neo-conservatives to bolster their claim that progressivity is unfair. According to them, human nature is motivated by self-interest and is best served by free markets and limited government, while progressivity denies people the rights to the fruits of their labor. In basing their claims on this assertion, they conveniently ignored the writings of John Locke, a mentor of the neo-conservative movement, who stated that one’s exercise of property rights could not disadvantage others.

Polls in the mid- and late-1990s have revealed that many people in the U.S. continue to be frustrated by the complexity of the tax system and the misguided notion that the American tax burden is among the highest in the world. Playing to this discontent, House Majority Leader Richard K. Armey (R-TX) pushed a flat-tax plan while Bill Archer (R-TX), as Chair of the House Ways & Means Committee, advocated abolition of the income tax with the substitution of a consumption (sales or value-added) tax. Senate Majority Leader Trent Lott (R-MS), describing the progressive income tax system as a “threat to our freedom”, called for its elimination, along with that of the Internal Revenue Service, while he pushed for a flat tax or national sales tax.

In their assaults on the progressive tax system, these legislators ignored Catholic social teaching and the views of many that individuals can be defined primarily in terms of their relationships to others. This concept supports the idea of progressive taxation as shared responsibility for the welfare of one another. According to Law Professor Marjorie E. Kornhauser, “[progressive taxation] is one way in which I can be responsible to myself and non-proximate others…to the extent that the tax is redistributive I recognize and meet my connection to the other.” 

From Learning About Taxes: Toward a Just and Fair System published by NETWORK Education Program c 1997

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