Paying the Piper

Up until 1916 with but a brief time during the civil war, paying for the costs of government was a matter that more resembled user fees and excise taxes at flat rates, with customs duties to protect our nascent industrial sector being the principle among them. In 1916 Congress, following the adoption of the 16th amendment changed all that with the adoption of the first constitutionally sanctioned direct tax on personal income. The statute provided, “That there shall be levied, assessed, collected and paid annually upon the entire net income in the preceding calendar year… a tax of two percent….”

It was felt that a direct income tax was essential to satisfy the enlarged appetite of the federal government for revenue to meet the expanded need that came with America’s new position as a major power on the world scene. An additional element was the effect of the record flow of immigrants in the previous 30 years to fill thousands of jobs in industries transforming the country. Assistance programs newly fashioned to provide help to those left behind in the country’s mad dash from a predominantly rural to an urban economy and from agricultural to industrial were a humanitarian necessity.

The clouds of war soon transformed this federal appetite for revenue into a lust that saw the modest rate of 2 percent of 1916 rise to a high of 77 percent in 1918 as we were transformed into an arsenal for democracy. It can be noted that the US budget in 1917 almost equaled the entire sum appropriated by the Federal government since 1789. Revenue increased from $761 million in 1916 to $3.6 Billion in 1918, yet even with this startling growth, only 5% of the population paid income taxes.

The end of the war unfortunately did not bring a change to Congress’ taxing mania. Congress once bitten by the tax bug has been unsuccessful in its several previous attempts to achieve the fairness and simplicity that should be the public’s right. While there isn’t agreement as to what to do about it, most observers would agree that the tax code now consuming more than 21 megabytes and 2.8 million words has lost all rationality and seeks to fulfill social engineering goals far distant from simply meeting the nation’s revenue needs. In addition to the code, implementing regulations further confuse matters by arcane requirements that have generated as many as 250 pages of implementing regulations for just one paragraph. Is there any question that we are well beyond the time to scrap the present code and start over?

In recent days, two articles in the Wall Street Journal have focused on the slippery slope in reaching this goal and the need to keep rates low to insure our continued well being. Mike Huckabee’s strong support for the national sales tax that is the center point of HR 25, the Linder, Chambliss “Fair Tax Bill has focused a great deal of interest on this bill. HR 25 would substitute a 23% national sales tax for the current complex arrangement of payroll withholding, quarterly filings, complex calculations and for many the illusory deductions that fade away to nothing by the time you reach the “you owe” line on your Form 1040.

Bruce Bartlett, former Deputy Assistant Secretary of The Treasury for Economic Policy from 1989 to 1993 argues in his article, that the proposed 23 percent rate is really 30 percent of what you started with and is otherwise full of deception and intricacy that makes it an illusory solution that will fail to deliver the “fairness” or administrative efficiency it promises.

Mr. Bartlett’s article, by focusing only on the current bill, does not really answer the question of whether an effective and fair national sales tax could play a role with exemptions for sales to the government in conjunction with the flat tax approach favored by Steve Forbes and other economists who see it as a way to greatly simplify our tax code and still end up getting at portions of our untaxed economy that currently avoid taxation. It does however illustrate why it is so difficult to evaluate results in a static environment that doesn’t even try to evaluate predictable behavior.

The other article in the Journal of particular interest appeared on August 24 as its lead editorial under the banner of “How to Raise Revenues” and notes that the deficit this fiscal year is expected, at $158 billion, to be a mere 1.2% of GDP. “Since the Bush tax cuts of 2003, the budget deficit has fallen by $217 billion mostly because of a continuing torrid pace of revenue growth.”

It is good to see that almost twenty years after President Reagan flew off to California; Arthur Laffer’s curve still has some vitality. Further the revenue results put the lie to those who say that the upper income brackets avoid their fair share of responsibility. The top 1% of our population is carrying 35.7% of our income tax load. The top 5%, 56.2% and the top 10% two thirds of all income taxes collected. About this the journal says, “For the Bush tax cuts to have been a give-away to the rich, people paying the higher marginal tax rates would have to be carrying a smaller share of the income tax load, but the IRS data indicate that they are not paying less. Instead they are paying more—lots more.” And even exceeding estimates by a significant factor.

Preliminary data from The Treasury Department for 2005 show that this trend is accelerating. The amount of tax paid by those earning more than a million a year increased to $236 Billion in 2005 up from $132 billion in 2003. Additional data show a marked increase in high income earners further enlarging the broadening effect of the Bush tax cuts.

Only if you are a disgruntled supporter of big government as the ultimate arbiter of income transfer and that earning money is an “ignoble pursuit,” could you find anything wrong with this picture. Low rates work. Low rates create wealth that is more broadly shared. An additional fact to remember is that all this new wealth is not consumed. Record numbers of our new millionaires are giving chunks of their wealth to worthy tax exempt causes and investing a large portion back into our capital base. As noted in my last column, Americans gave away $260 billion last year. That is up more than $20 billion from just a couple of years before, and only includes measurable donations. The substantial “in kind” factor of hours worked gratis for charities is not included.

The Fair Tax isn’t the only proposal out there; The USA Tax Act would propose three brackets and a rejiggling of rates and deductions to favor capital creation. Other proposals favor a continuation of our income tax but elimination of most deductions and institution of a single, flat rate for all. This version long favored by former Congressman Armey and Steve Forbes would eliminate a host of taxpayers from the tax roles by raising the 0 bracket to eliminate all those who aren’t solid earners of middle class status. I can recall Congressman Armey indicating that under his proposal, a married taxpayer with two children wouldn’t have to pay until they were well above $40,000.

Whatever the “0” bracket, I also have long favored this approach along with a requirement of super majorities in both Houses of Congress to exceed 20% of GDP for spending by the Federal Government. I continue to believe that provisions encouraging home ownership and providing a deduction for charitable donations need to be retained. As for the super majority requirement, the Federal government is becoming too dominant in its impact and should resist breaking 20% of GDP except in wartime and other dire emergencies.

As a nation we are capable of figuring out a truly fair tax structure with few brackets, high threshold for coverage and limited calculations required. As recent experience shows, we all have a vested interest in reaching this goal and should make it a high national priority for the next administration. Time is critical as the Bush tax cuts will all expire in 2010, and we will revert automatically to the higher rates that prevailed before.

Copyright © 2007 by Robert E. Freer, Jr. All rights reserved

About the author: Robert E. Freer, Jr. is President of The Free Enterprise Foundation. He is a Visiting Professor, at The Citadel and elected in 2005 to be their first John S. Grinalds Leader in Residence. A regular contributor to the Mercury, He can be reached by E-mail at The Citadel . Copies of his earlier columns can be found The Free Enterprise Foundation.

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