Chapter 4: How Did We Get Here?

A BRIEF HISTORY OF TAXATION

Upon gaining independence in 1781, America was a newborn nation tucked away in a remote corner of the world, with a largely rural population of about 3.5 million people. Agriculture was the primary source of wealth, and industry was virtually non-existent. Most manufactured goods were imported, and capital for economic development also came from foreign sources. In this primitive financial environment, there was no national banking or monetary system, commerce was rudimentary, and barter was the leading medium of exchange.

For early Americans, life was simpler and more difficult at the same time. Farmers, tradesmen, and small-scale merchants did not require much formal education beyond bare literacy and the ability to do simple arithmetic. Public education did not exist, and higher education was reserved for a select few. Healthcare was similarly scarce since medical science was still in its infancy. Most early Americans accepted that if they had an accident, got sick, or suffered from a chronic illness, it was their fate to endure the consequences. In fact, few lived to cope with retirement, and those who did were either taken care of by their children or died quietly in poverty.

Despite their privations, early Americans enjoyed the luxury of having the expanse of the Atlantic and the Pacific to protect them from foreign encroachments. Except for the War of 1812, the Mexican War of 1845, and the Spanish-American War of 1898, the US managed to stay out of foreign conflicts, and as a result, avoided the maintenance of a costly military. For the first few decades, about all the government maintained was a national judiciary, a postal system, a skeletal navy and army, a patent office, and a tiny treasury to collect the small amount of taxes that were needed to pay for the national government. Although the numbers are only best guesses, the Census Bureau, in the Historical Statistics accompanying its Statistical Abstract published in 1949, estimated that the total cost of government as a percentage of “National Income” was only about 2% before the Civil War, and afterward, about 3%. National income, as calculated by the U. S. Department of Commerce, is a forerunner of GDP as a standard for measuring the size of the national economy and, because of imprecise and incomplete data, is less reliable than GDP.

The Consumption Tax Period, 1781-1918

For the first 140 years, except for the Civil War and a few years afterward, America paid for almost all of the cost of government through a variety of consumption taxes and a few insignificant miscellaneous taxes. Consumption taxes included the tariff and a variety of excise taxes, including liquor and tobacco taxes. Having the few foreign exporters of goods and producers of liquor and tobacco pay the tax was much easier and cheaper to administer than collecting taxes directly from the consumers. In fact, an income tax would have been almost impossible to administer in the pre-industrial economy.

Taxing consumption worked reasonably well in a simple economy in which barter was the primary medium of exchange and most wealth was illiquid in the form of land. However, while consumption taxes could raise sufficient revenue to pay for government with a small bureaucracy, they were insensitive to taxpayers’ ability to pay. Rich and poor, farmers, tradesmen, merchants, Northerners, Southerners, Westerners, and many other Americans paid varying amounts depending on how much they consumed of what was taxed.

Taxes have never been popular, and some taxpayers, no matter how little they pay, will fight like hell to pay less. For example, early Americans who purchased foreign manufactured goods that were subject to the tariff fought to exempt the goods that they purchased and to tax goods that others purchased. The tariff was popular among American manufacturers who were happy to have their competitors’ goods made less competitive, as well as those who consumed little of what foreign manufacturers sold. At the same time, the tariff was unpopular among those who consumed a lot of what foreign manufacturers sold.

Prior to the Civil War, the amount of revenue needed to run the government was relatively small, but as the government began to spend more, the sting of taxes became increasingly painful. However practical taxing consumption once seemed, as early America evolved into a modern country with its higher overall level of taxation, the insensitivity of consumption taxes to the ability to pay became less and less tolerable. By 1913, a substantial majority of Americans had concluded that consumption taxes were too harsh on middle and low-income Americans. Going to war in 1917 coincided with the emergence of modern America, and the tax needs of modernization demanded an overhaul of the tax system.

The Income Tax Period, 1919-Present

As World War I ended, America’s population had swelled to almost 120 million. After over a century of relative isolation, America suddenly found itself a global power with economic, political, and military interests spread throughout the world. As a leading superpower with a growing population and dynamic economy, modern America could no longer afford an inactive and cheap government. But with a more expensive government came the need for more revenue; and with the need for more revenue came the income tax.

America had levied its first income tax in 1861 because of a sudden need for a massive amount of revenue to fight the Civil War. The original income tax lasted only a few years until 1874 when the old mainstay tariff could raise enough revenue to pay for a peacetime government. However, at the dawn of modern America, consumption taxes could no longer provide enough revenues as the cost of government rose substantially above 3% of national income.

Increasing the tariff was not an option. As American commerce became more integrated with international commerce, increasing the tariff would have encouraged protectionism and discouraged the free flow of America’s goods and services in world commerce. Insulating American manufacturers from foreign competition and isolating American commerce from international trade were not sustainable policies in the modern world. Rather, abandonment of the tariff cut the cost of many imported goods and kept the prices charged by American manufacturers in check because of foreign competition.

To pay for the increasing cost of a more active government, many Democrats and Progressives pressed for raising less revenue from consumption taxes and more from income taxes as had been done during the Civil War. For a brief time, the income tax became a casualty in the Gilded Age contest between Democrats and Progressives on one side, and conservative Republicans on the other side. Then in 1894, after earlier Supreme Courts had upheld the income tax on four previous occasions, a conservative Supreme Court found it unconstitutional in Pollock v. Farm Loan and Trust Co.

Despite the Pollock decision, the political and economic pressures for an income tax continued to grow. Reacting to new political and economic realities, in 1909, President Taft, a conservative Republican, submitted the 16^th Amendment to undo the Pollock case. To the surprise of many conservative Republicans, the 16^th Amendment was quickly approved and took effect in 1913. The adoption of the 16^th Amendment made it possible for the income tax to replace consumption taxes as the dominant means of taxing in modern America.

The enactment of the Federal Reserve Act in 1913 also provided America with a national banking and monetary system, a prerequisite for economic expansion in an industrial economy with growing interstate and international commerce. Paper money replaced gold coins as the currency of commerce, and barter as a medium of exchange went the way of the buggy whip.

Finally, the adoption of the 17^th Amendment that year also made the Senate a more democratic institution by replacing the election of Senators by the state legislatures with direct election by the voters. In very early America, the electorate had been restricted to property-owning males who elected the politicians who decided what to tax. It was not until the middle of the 19^th Century that property ownership as a qualification for voting was eliminated. Women finally earned their right to vote with the 19^th Amendment in 1919. It would take even longer for African-Americans to earn theirs.

EFFECTS OF MOVING FROM CONSUMPTION TAX TO INCOME TAX

The transition from consumption taxes to the income tax as the mainstay of paying for government was completed quickly. The first significant income taxes were collected in 1916, and by 1918, income taxes accounted for over 75% of total revenue. Income taxes marked a major change from consumption taxes in that they taxed what a taxpayer made and not what they spent; were paid directly by the taxpayer; and were sensitive to a taxpayer’s ability to pay.

To understand the effects on taxpayers and America of taxing during the Consumption Tax Period and the Income Tax Period, it is necessary to know what there is to tax, what direct and indirect taxation is, and what the ability to pay a tax means. Taxes can tax (1) consumption, what people spend to consume, (2) income, what people make in terms of wages and the return on their assets, (3) wealth, the income that people accumulate, (4) the right of an individual or business to engage in commercial activity, (5) the right of an individual to do certain things, and (6) the use of public facilities.

Examples of these taxes:

• Consumption taxes include tariffs, excise taxes, and sales taxes.
• Income taxes include Social Insurance payroll taxes, the personal income tax, and the corporate income tax.
• Wealth taxes include the estate tax, inheritance taxes, and property taxes.
• Right to do business taxes include licensing fees, which confer on a business the right to engage in a commercial activity.
• The right of individuals to engage in certain activities such as poll taxes, which enable a person to vote.
• User fees include fees that entitle a business or individual to use public facilities like toll roads, parking lots, libraries, and swimming pools.

In direct taxation, taxpayers pay the tax directly to the government. Examples of direct taxes include the personal income tax, the corporate income tax, the employees’ share of social insurance payroll taxes, estate taxes, inheritance taxes, property taxes, licensing fees, poll taxes, and user fees.

In indirect taxation, third parties pay the tax and pass the cost of the tax onto taxpayers in the form of higher prices on the goods and services that are taxed. Examples of indirect taxes include sales taxes on goods and services paid by retailers and service providers, tariffs paid by exporters, excise taxes paid by manufacturers, and the employers’ share of social insurance payroll taxes. Unlike consumption taxes where taxpayers pay the tax in the form of higher prices on goods and services, the employers’ share of social insurance payroll taxes is passed on to employees in the form of lower salaries.

It is easy for taxpayers to know how much they are paying in direct taxes, but it is not easy for them to know how much they are paying in indirect taxes. Since indirect taxes are oftentimes invisible to taxpayers, they are sometimes called “hidden” taxes. Taxpayers who do not know how much they are paying in taxes are not as likely to get riled up as taxpayers who do, and so often these taxpayers do not know how to get into the tax game to protect their own interests.

The concept of “ability to pay” relates to the comparative economic pain that paying a tax inflicts on low-income taxpayers relative to high-income taxpayers. All taxes that have a flat rate inflict more relative pain on low-income taxpayers than high-income taxpayers. The most practical way to increase low-income taxpayers’ ability to pay a tax is to have graduated rates on whatever is taxed.

Suppose an income tax must raise $30 thousand from two taxpayers, and one taxpayer has an annual income of $50,000 and the other’s income is $100,000. A flat rate of 20% would raise $30,000 but graduated or progressive tax rates can also be made to raise the same amount. For example, a 10% rate on a taxpayer with an income of $50,000 and a 25% rate on a taxpayer with an income of $100,000 would also raise $30,000. While graduated rates increase the ability of a low-income taxpayer to pay the tax, they shift more of the tax burden to high-income taxpayers.

COMPLEXITY AND THE COST OF GOVERNMENT

The cost of government in early America was low, for the most part costing less than 3% of national income. After World War I and until the Great Depression, the cost of government rose to about 5-6% of national income. During the Great Depression and leading up to World War II, the cost of government rose again from about 8-12% of GDP. Following World War II, the cost of government took another leap from about 15% in the late 1940s to as much as 25% during the Great Recession in 2009. Since then, the cost of government has hovered around 22-23% of GDP.

Taken out of context, these tax increases may appear to some as evidence of the takeover of “big government.” These increases are the result of growing complexity in the country’s economic system as well as shifts in the expectations of American citizens, which began taking shape over a century ago. As industry replaced agriculture as the dominant force in the economy, and as commerce became national and international, millions of Americans were abandoning the farms for jobs in new industries in the cities. Free public education across America enabled most Americans to get the education essential to participation in the early stages of modernity. America’s institutions of higher education were well underway to making modern America the global technological leader of the world.

By the 1920s, the steel, energy, auto, and manufacturing industries dominated the economy and overshadowed agriculture. Modern America’s commerce was no longer primarily local as it was in early America. In fact, almost all commerce had become interstate, with a growing percentage becoming international. Instead of a nation of small towns and small farmers isolated from each other, modern America had become a nation of growing cities with a national transportation and communications system of railroads, highways, the telegraph, radios, telephones, and thousands of newspapers that linked more and more Americans to each other.

Medical science had also advanced by the 1920s, and so too had the availability of doctors and hospitals. With these advances, infant mortality declined and life expectancy in old age increased. As people began to live longer lives, their economic needs also changed.

Along with a modern industrial economy came an increase in the business cycle that periodically leads to recessions accompanied by mass unemployment. In early America when an economic downturn hit farmers, they could still eat what they grew. But in modern America when a recession hit urban industrial workers, they lost their income and had no money to eat. Modern urban Americans proved less willing to quietly accept serious deprivation from economic cycles than rural early Americans.

Modern America’s more democratic electorate demanded that when serious economic downturns inflicted too much pain on too many people, the government would no longer be a bystander. As a reaction to the Great Depression of the 1930s, the government enacted the Social Security Act of 1935, which saved millions of elderly Americans from spending their old age in poverty. It also softened the blow on those who were thrown out of work by instituting a national program of unemployment insurance.

In the 1960s, the government enacted Medicare and Medicaid to provide health care to the elderly and poor. It also enacted a range of income transfer programs to help the poor escape poverty and provide educational opportunities to those who could not afford it. Since 1962, government spending on social insurance and income transfer programs has risen from just over 4% of GDP to almost 12% of GDP while total government spending has risen from a little over 18% to a bit over 22%. Social insurance and income transfer programs now account for all growth in government spending over the last 50 years or more.

Today, modern America must cope with an aging population, which adds financial stress to Social Security and Medicare. Stagnant and falling wages for an overwhelming majority of Americans in turn adds financial stress to income transfer programs. With fewer and fewer Americans having enough income to pay for their own health care, save for their own retirement, and pay for their children’s post-secondary education, the pressures for increased spending on social insurance and income transfer programs will continue.

Domestically, modern Americans have demanded a more active and expensive government, and modern Americans have gotten what they demanded. In foreign affairs, World War I and World War II have taught modern America the stern lessons of isolationism. Now, most Americans understand that as distasteful and expensive as it is, for the foreseeable future, America must spend substantial amounts on national security to protect its vital interests. As new challenges confront modern America, including everything from natural disasters to economic dislocations to increased pressures for more social insurance and income transfer programs, the government will have to do something about each of them if enough Americans believe that it should.

With the income tax came direct taxation, and to collect it, a bigger and much more intrusive bureaucracy, the Internal Revenue Service. For the IRS to administer the income tax, it must, (1) keep track of the income of all individuals and businesses, (2) administer an ever-changing patchwork of exemptions, rates, and deductions, and (3) collect all amounts due.

Also, as the need for more revenue grew to satisfy the needs and wants of modern Americans, more and more taxpayers demanded special treatment for their pet tax preferences. These tax preferences have made the administration of the income tax far more complex and have put more burdens on the IRS. Proper administration of an increasingly complex income tax means adding to the cost, staff, and intrusiveness of the IRS, but the failure to do so makes it less likely that tax cheats will be caught for failing to pay what they owe.

At the same time, in modern America, being sensitive to taxpayers’ ability to pay has proved more important than a tax system with a relatively nonintrusive, less expensive, and smaller tax bureaucracy. While the income tax has inflicted an unpleasant bureaucracy on modern America, it has also accommodated millions of middle and low-income Americans in terms of taxing based on their ability to pay.

Unlike consumption taxes, the income tax can be fine-tuned to distribute the tax burden among different income groups with great precision. This fine-tuning can be done by exempting certain low-income taxpayers to avoid taxing them into poverty; setting rates to soften the blow to middle and low-income taxpayers; and providing middle and low-income taxpayers with deductions that keep their taxes low relative to higher-income taxpayers.

Summing up, in today’s America, government spending accounts for about 22% or 23% of GDP and is on the rise, and to raise that amount of revenue, America has chosen income taxation over consumption taxation. The ability to pay a tax does not matter very much when the level of taxation is around 5% of GDP or less, but when the level of taxation approaches 20% of GDP, the ability to pay becomes politically decisive as was shown by the adoption of the 16^th Amendment. Unless America decides to cut government spending dramatically, income taxation and the ability to pay are almost certainly going to be critical elements of tax policy.

THE LIBERTARIAN BARGAIN

For those Americans who want a cheaper government and a much simpler tax system, they should consider the Libertarian Bargain. Under the Libertarian Bargain, Americans would be given a choice: on the one hand, continue with social insurance and income transfer programs to help them pay for their retirement, health care, and the post-secondary education of their children, and for assistance in case of job loss and other emergencies, or on the other hand, give up all those government programs and do without any help. If Americans choose to continue getting government help, it will mean higher taxes, but if Americans choose to do without any government help, it will mean lower taxes. Under the Libertarian Bargain, Americans would do without help, and in exchange, pay lower taxes.

For those Americans who want a decent standard of living, adequate health care, a dignified retirement, quality post-secondary education for their children, and help if they lose their job through no fault of their own, they should consider the following:

• To provide for retirement, it cost about $1 million for a married couple (each aged 65) to purchase a lifetime annuity (from a rated insurance company) that guarantees a lifetime annual income of $44,000 beginning at 65. It would take about a $980 monthly payment into an investment account at 4.5% APR over a 35-year period for a 30-year-old to save the $1,000,000 needed to purchase the lifetime retirement annuity at 65. If the couple thinks that a $44,000 annual income will not be enough a generation from now when they retire, then they will have to save more. (Each individual is invited to shop the annuity market for themselves to see if they can beat the deal offered under Social Security and determine for themselves if they have the discipline and the assurance of continued income throughout their working lives to save to pay for it.)
• According to a June 14, 2014 report by the Peter G. Peterson Foundation, the national per capita costs of health care for each individual American (taking into account all costs) is about $9,000. For a family of four to pay for all their health care cost on a monthly basis, it would cost about $750 per person or $3,000 for a family of four.
• The cost of post-secondary education for each child ranges from a few thousand dollars a year to well over $100,000. Assuming that a family decides it will save $100,000 to pay for the entire post-secondary education of each of their children when they reach 18, it would take about a $300 monthly payment into a college-savings account at an APR of 4.5% over an 18-year period to save the $100,000 for each child.

While these costs are not exact, they represent a fair approximation of what a decent retirement, adequate health care, and the post-secondary education of children might cost in today’s America; and these costs omit the costs of job loss and other emergencies that almost all Americans will face from time to time. If the American Dream is to include these things for all Americans who work full time at the best job they can find, then these are the costs that must be paid. To the extent that individual Americans cannot pay for these costs out of their market income or savings, then they must either get help from the government or learn to do without.

Fending for yourself without any government help harkens back to the frontier west where most Americans lived under the principle of “you eat what you shoot.” As a personal aside, my grandparents lived all their lives under the principle of “you eat what you shoot;” my parents lived the first one-third of their lives under it; and I have lived my life free of it (I have had help when I needed it and am grateful for it). As an experiment in cheap government for libertarians who are confident that they can take care of themselves if they are not burdened by being over-taxed, they should think about what kind of standard of living they would have if they strike the Libertarian Bargain. So, imagine an America with no social insurance, including no Social Security and Medicare, and no subsidies for health care and the post-secondary education of children, and with Americans paying only one-half of current taxes.

Right now and for the last several years, social insurance and other income transfer programs have consumed about one-half of the total cost of government and that share is rising, as is shown in Table IV-1.

Table IV-1 shows the following:

• Except for the years 1998-2001, America has consistently spent more than it has taxed;
• The cost of social insurance and income transfer programs, as a percentage of total outlays, has steadily grown from 39% in 1979 to 51% in 2012;
• The cost of core government was less in 2012 than it was in 1979; and
• All increases in the cost of government from 1979 through 2012 are attributable to the increased cost of social insurance.

Over the last several generations, the American people have chosen more and more social insurance and income transfer programs to hedge them against the vicissitudes of having bad luck like job loss and/or some catastrophic and costly emergency or illness, and just growing old. Since taxes are collected to pay for the cost of government, taxes cannot go down unless the cost of government gets cheaper.

Table IV-2 is a monthly budget based on the “eat what you shoot” principle in which a libertarian pays for his or her own retirement, health care, and the post-secondary education of his or her children, and would have to pay only about one-half of the taxes they now pay.

The “eat what you shoot” budget shows that if a family of four with one or two wage earners expects to pay for their own retirement, health care, and the post-secondary education of their children, they need to be able to pay about $4,500 a month ($54,000 annually) before paying for whatever standard of living they can afford. According to the Chief Actuary of SS, only about 20% of wage earners made more than $55,000 in 2013.

So, while the “eat what you shoot” budget may work for some extraordinary wage earners and clearly works for super extraordinary wage earners and capitalists, it does not work for anyone else if they expect to have much of a standard of living and a decent retirement, adequate health care, and college for their kids. The libertarian bargain in which everyone pays about one-half of their current taxes in exchange for getting no government help would have very little appeal (if they fully understood the bargain’s implications) among almost everyone other than super extraordinary wage earners and capitalists.

WHY “NO NEW TAXES” IS NOT THE ANSWER

“No new taxes” is the cry of many Americans, and like the tune played by the Pied Piper of Hamlin, it has a compelling allure to it. When George Herbert Walker Bush ran for President in 1988, he promised “Read my lips, no new taxes,” and two years later as President, he backtracked and approved a significant tax increase. Political promises are one thing, and reality is quite another. Over the last 30 years or more, new realities have emerged in America which include the following:

• Income and wealth have intensely concentrated in the top 1%.
• America has refused to tax itself to pay for the full cost of government.
• The cost of government has grown to account for about 22% to 23% of GDP and is rising.
• The cost of social insurance and income transfer programs now account for over one-half of the cost of government and are increasing.
• Middle-class incomes have stagnated leaving almost all unable to save and pay for their own retirement, health care, and the post-secondary education of their children.

Given these realities, the middle class has become dependent on social insurance for its retirement, health care, and the post-secondary education of its children, as well as being a safety net for job loss. If social insurance is cut, so too will the standard of living of the middle class. Maintaining social insurance as it is will require increased taxes, and expanding social insurance above current levels will require an even greater increase in taxes.

Almost all middle-class workers, including all ordinary workers and most extraordinary workers, depend to a greater or lesser extent on social insurance (Social Security and Medicare for their retirement and Medicaid and other government subsidized programs for both their health care and the post-secondary education of their children, as well as food stamps and unemployment insurance to provide an income cushion if they lose their jobs). These social insurance programs rely on tax revenue to pay the beneficiaries, which means that income is being transferred from taxpayers to program beneficiaries. Without social insurance, hardly any middle-class workers would be able to retire, have decent health care, or provide for the post-secondary education of their children, or if they lose their jobs, hardly any middle-class workers would have any savings to enable them to make it to the next job.

Those who think America can do with less or no social insurance might put themselves in the place of median-wage families like the Middletons and prepare a monthly budget in which they pay one-half their taxes but have no social insurance and are responsible for saving and paying for their own retirement, health care, and the post-secondary education of their children, as well as providing for any family emergency or job loss. If such a family provided for its own retirement, health care, and the post-secondary education of their children, and maintained a cushion against emergencies, it is likely that the family would not have much of a current standard of living. If a median-wage family cannot make it on its wages without social insurance, imagine the stress that would be felt by below median-wage families and even some above median-wage families if they had no social insurance.

For those who think Social Security and Medicare for retirement and student aid for post-secondary education are too generous for median-wage workers, they should check with families like the Middletons to find out what it is like to have no income other than from these programs to live on in retirement, and what it is like for their children to try to get a post-secondary education with the funds provided by these programs. As tough as it is for median-wage families with social insurance, imagine what it would be like with none.

No one would dispute that life is better when one can pay one’s own way with no help from anyone, particularly taxpayers. However, since private market wages no longer enable any but a few Americans to do without social insurance, and, since social insurance for a growing number of Americans is expensive for taxpayers, the financial quality of life for the middle class will depend on America’s willingness to increase taxes to pay for it. As unpleasant as it is, The Iron Law of Wages has made the financial quality of life for the vast majority of middle-class Americans dependent on the maintenance and expansion of social insurance and America’s willingness to increase taxes to pay for it.