The Daily Reckoning PRESENTS: How did we, as freedom-loving Americans, end up with the beast that is our present tax code? Our current system is widely accepted today as a fact of life. Steve Forbes, in part one of this two-part essay, explains how this is a huge break from our traditions and far from what was intended in the early days of the republic... THE BIRTH OF THE TAX BEAST, PART I
by Steve Forbes “Would it not be better to simplify the system of taxation rather than to spread it over such a variety of subjects and pass through so many new hands.” - Thomas Jefferson, 1784 Our nation was founded, as every schoolchild knows, as a consequence of our aversion to “taxation without representation.” The North American colonies rose up in rebellion, after Britain imposed a raft of new taxes - including the much despised Stamp Tax, which required that stamps, for a fee, be put on most legal and commercial papers and documents1 to defray the expense of defending the newly expanded North American frontiers and the broader British empire. After winning the fight for self-determination, the Founding Fathers sought to establish a nation whose citizens were free to enjoy the fruits of their labors, unimpeded by a tax-hungry government. No less a figure than Thomas Jefferson wrote that excessive taxation was in direct opposition to this ideal. In fact, Jefferson’s writings on taxation favor the concept of a simple system based on a single tax. “Having already paid its tax as Income, to pay another tax on the thing it purchased, is paying twice for the same thing; it is an aggrievance on the citizen . . . [and] contrary to the most sacred of the duties of a government,” he wrote in 1816. Alexander Hamilton, our first secretary of the treasury, discouraged the idea of an income tax. He asserted in the Federalist Papers, “It is evident from the state of the country, from the habits of the people, from the experience we have had on the point itself, that it is impracticable to raise any very considerable sums by direct taxation.” Hamilton backed the dollar with gold, consolidated debt, instituted a simple system of taxation and allowed government bonds to be used as currency to pay taxes. His initiatives produced a steady stream of revenue that propelled the nation to solvency and bolstered the economy - all the while maintaining relatively low taxes. Imagine what Hamilton and Jefferson would think of today’s mammoth tax code, with its multiple rates and convoluted system of deductions! In our earliest days, America had no income tax. The biggest source of tax revenue was tariffs on imported goods. There were also internal levies on a variety of items, including whiskey. Not only were our taxes light back then, but any attempt to raise them was met with fierce opposition from our independent-minded citizens. The whiskey tax, for example, provoked a furious uprising in the backwoods of Pennsylvania. Tax collectors were run out of town - that is, if they were lucky. The unlucky ones were tarred and feathered. Washington had to raise an army and respond by force. The rebellion was eventually put down. The episode played a critical role in shaping America’s view of how the tax system was supposed to work. We believed that taxes should be minimal. They should be imposed by the representatives of the people. Yet once levied, they had to be paid - or else. Ferocious disputes, however, continued over import tariffs. To help protect its emerging industries, the North favored high tariffs; the agricultural South, more dependent on imports, opposed them. The socalled Tariff of Abominations - which substantially raised duties on both manufactured goods and raw materials - was passed in 1828 and further polarized the North and South, precipitating a national crisis. Southerners felt the tariff would not only raise prices on necessary goods but might also reduce British exports to the U.S., thereby making it harder for the British to pay for Southern cotton. Siding with his fellow Southerners, Vice President John Calhoun of South Carolina made history by defiantly opposing his own boss, President Andrew Jackson. Calhoun asserted that states could declare the tariff - or any federal law - null and void, the so-called Doctrine of Nullification. President Jackson furiously responded that he would personally hang his vice president from a lamppost if Calhoun followed through on his threat to have the South Carolina militia forcibly obstruct enforcement of the tariff or any other federal law that Calhoun’s state didn’t cotton to. Fortunately, in the face of Jackson’s implacable opposition, Calhoun and South Carolina rescinded their Ordinance of Nullification, when given a face-saving nominal cut in tariff duties. The only other times the government tried to impose new taxes was in times of war, such as during the War of 1812 against the British. By taxing land, slaves, and estates and by raising tariffs, the federal government was able to collect the money to meet its military challenges. It may be hard to believe today, but between 1817 and the start of the Civil War in 1861, the federal government operated successfully without having to levy any new internal taxes. In fact, Andrew Jackson eliminated the national debt during his presidency by deftly managing existing revenues and through the sale of federal lands. The onset of the Civil War, though, marked a milestone in the history of American taxation. Insatiable demands for money to fund that conflict forced the federal government in 1861 to enact a first-ever federal income tax. Slowly, the tax beast, as we know it today, began to rear its ugly head. Of course the beast was a lot smaller back then: The government started out by imposing just a 3 percent tax on all incomes higher than $800. Politicians at the time heatedly and prophetically debated whether there should be a single, flat rate or a graduated rate system. In 1862, the forces of complexity won out, resulting in a simple version of a graduated system: 3 percent on incomes more than $600 up to $10,000; any incomes higher were taxed at 5 percent. There were exemptions for rental housing, repairs, losses, and other taxes paid. In 1864 rates were raised again and still more layers were added: 5 percent on incomes up to $5,000; 7.5 percent on incomes between $5,000; and $10,000 and 10 percent on incomes above $10,000. The monster as we know it was born. The income tax was a dramatic departure. But tax-loathing Americans were still not ready to make it permanent. The Civil War ended and the tax was subsequently repealed. For the moment, the tax monster was defeated. But Pandora’s box had been opened. Over the next century, Americans would be gradually lured back into the beast’s embrace. Twenty years later, the monster’s minions tried again. The federal government enacted an income tax in 1894. As Peter Dobkin Hall of Harvard’s Kennedy School of Government recounts in the April 15, 2005, edition of the New York Times: “By the early 1890s, the annual incomes of tycoons like John D. Rockefeller and Andrew Carnegie were greater than the tax revenues of most states. Concerned about the implications of such a concentration of wealth . . . Congress enacted a federal income tax . . . ” Almost immediately, writes Dobkin, the complexity and confusion began: “The income tax legislation left many questions unanswered. A single page of small print summarized ‘instructions relative to annual returns’ . . . ” Dobkin writes that, although “the full legislation and accompanying regulations totaled a mere forty pages.” That’s brief by today’s standards - but far from clear. Rockefeller’s attorneys had to submit questions on everything from “what kinds of income needed to be declared” to “how to treat depreciation of assets and investment losses.” When the new income tax was announced, Rockefeller had considered not filing a return at all. His lawyers persuaded him to do so. Otherwise, they said, the government “‘will assess Mr. Rockefeller at some outrageous figure and add the penalties.’ By filing his own return, they concluded, Rockefeller’s payment, ‘would be far less than anything they would put down.’” Some things, alas, never change. Rockefeller filed his return - he paid a 2 percent tax totaling $14,961 - in 1895. But he and others were later granted a reprieve. The Supreme Court declared that law unconstitutional a year later. Yet pressure for a national income tax persisted. Tariffs, which raised the cost of essential goods, were depicted as unfair to working people. And the still-agrarian South continued to oppose them. In 1909, President William Howard Taft’s successful enactment of a corporate income tax laid the groundwork for acceptance of the idea of a personal income tax - allowing the beast to rise again. Four years later, in 1913, the Sixteenth Amendment to the Constitution was finally ratified, and a personal income tax was imposed. Congress passed a progressive income tax beginning at 1 percent and moving up to 7 percent for those having incomes of more than $500,000 (the equivalent today of about $15 million in income). So the tax monster made a comeback - though fortunately it was still lot smaller than what we know today. As a result of the new law, only 4 people out of 1,000 paid income tax - in contrast to the more than 130 million who now file individual tax returns. But, being voracious, the beast swiftly grew. The simple, low-rate tax system became a victim of the First World War. Our entry into the war in 1917 sent levies rocketing upward. Tax revenues collected by the federal government were soon nearly equal to all collections for the previous 125 years combined. Before the war was over, the top tax rate had risen from 7 percent to an astounding 77 percent. World War I not only saw the growth of the beast but also an unprecedented accumulation of power by the federal government. To help mobilize for the war effort, Washington seized railroads, as well as the telephone and telegraph industries. War boards were established that gave Washington huge powers over the private sector - allocating raw materials, setting prices and wages, closing and opening plants, and controlling the prices, production, and distribution of food - all in the name of boosting wartime production. This immense power was intoxicating to those who worked in and around government, including Assistant Secretary of the Navy Franklin D. Roosevelt. Not surprisingly, Roosevelt and others were entranced by the notion of the supposedly great things that could be achieved in peacetime by a federal government whose powers were expanded as in war. Fortunately, America’s low-tax tradition kept these fantasies in check - at least for a while. During the 1920s, income taxes were cut across the board; the top rate was slashed from 77 percent to 25 percent. The national debt was reduced by a third. America boomed. The 1920s was a decade of fantastic innovation. Movies, radios, automobiles, and numerous new household appliances, such as refrigerators and washing machines, became affordable for millions of middle-class Americans. The U.S. underwent the world’s greatest road-building program since the days of the Roman Empire. Then came the Great Depression, the most devastating smash-up the American economy - and the world - had ever experienced. Millions of jobs were rapidly destroyed. Millions of farmers lost their land. American incomes precipitously shrank - drastically reducing living standards for even those who still had jobs. Thousands of banks went bust, which wiped out the savings that could have helped countless people better absorb the hammering blows these desolate times dealt them. The key cause of this catastrophe was the Smoot-Hawley tariff, which imposed extremely high taxes on countless imports.2 European nations retaliated by taxing or banning U.S. goods and a disastrous trade war resulted that killed world commerce and caused the economic collapse. But the politicians didn’t get it. Despite the role of taxes in triggering the crisis, President Hoover sought in 1932 to “restore confidence” by balancing the budget through - that’s right - a massive, calamitous increase in taxes. The top income tax rate was boosted from 25 percent to 63 percent. Hoover’s tax hikes only made the economy worse, sending unemployment from 15 percent to 25 percent, almost five times today’s level. The Depression would have been far less harsh and the recovery far quicker had Hoover lived up to his historical image as a do-nothing chief executive. In reality, he was a big-government activist, and his activism in instituting higher taxes did immensely more harm than good. His successor, the buoyant, extremely confident Franklin Roosevelt, dramatically, excitingly revived the morale of the nation. But again, contrary to many historians’ perceptions, his economic policies were mostly counterproductive. FDR raised taxes even more. He imposed a breathless array of new, anti-business regulations. For the first time in American history, an economic recovery did not exceed the peak of the previous expansion. Early in his second term, Roosevelt presided over another sickening economic slide. America didn’t truly recover from the Great Depression until the advent of the Second World War. With America’s entry into World War II after Japan’s attack on Pearl Harbor on December 7, 1941, taxes were expanded as never before. Personal income tax rates rose to 23 percent for those in the lowest bracket and to 94 percent for those with incomes over $1 million. What a change from the 1 percent to 7 percent brackets of the original 1913 income tax! The tax beast was here to stay. Americans, for the most part, accepted it as the price a free people must pay to preserve freedom and defeat a monstrous, murderous tyranny. When the war was won, however, income tax rates were not brought down the way they had been after World War I. The subsequent Cold War and the three-year Korean War kept rates high. Political leaders didn’t understand in those days that punitive rates hurt economic growth. They failed to comprehend that reducing high tax levels would have actually enabled the economy to get stronger, generating more revenue for the government. Regards, Steve Forbes
for The Daily Reckoning Editor's Note: The above essay has been adapted from Steve Forbes' latest book, Flat Tax Revolution. To order your copy, click on the link below: Flat Tax Revolution: Using a Postcard to Abolish the IRS Steve Forbes is president and chief executive officer of Forbes and editor-in-chief of Forbes magazine. Forbes is also chairman of the company's American Heritage division and publisher of American Heritage magazine. In both 1996 and 2000, Forbes campaigned for the Republican nomination of the presidency. Key to his platform were a flat tax, medical savings accounts, a new Social Security system for working Americans, school choice, term limits, and a strong national defense. Forbes continues to promote this agenda. He lives with his wife and family in New Jersey.
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