No one likes to pay taxes. Even if you don't begrudge the government taking part of your paycheck, tax season is a stressful time, as many of us worry that we'll do a calculation wrong or get an audit letter from the IRS.
Taxes aren't a force of nature. Who gets taxed, and how much, is the result of laws that are the product of political struggles over the past century. There is plenty that is wrong with the U.S. tax system. To understand how we ended up where we are, it helps to look at the history of taxation in the U.S.
HISTORY OF U.S. TAX SYSTEM
In the early United States, the federal government's revenue came from tariffs - taxes on foreign trade - although to pay for the Civil War a temporary income tax was levied. The first peacetime personal income tax, instituted in 1894, was overturned by the Supreme Court as violating a constitutional requirement that income tax be exactly proportionate to state population. In 1909 the first corporate income tax was enacted and it was ruled to be constitutional. The same year, Congress passed the 16th Amendment, allowing an income tax "without apportionment among the several states." By 1913 the 16th Amendment had been ratified by the states and went into effect. The income tax passed by Congress in 1913 established the principle of progressive taxation - that the wealthy should pay a higher percentage of their income in taxes than workers. By World War I, the top income tax rate on those making over $500,000 a year was 77 percent.
But in the 1920s - a period of blatant Big Business political domination - taxes became less fair. Pittsburgh banker Andrew Mellon, the third-wealthiest American, served as secretary of the treasury under three Republican presidents. His "Mellon Plan" - also known as trickle-down economics - theorized that cutting taxes on the rich would not reduce the government's revenues, since the wealthy would now be less inclined to use loopholes to cheat on their taxes. Through the 1920s taxes on the wealthy were cut four times, dropping to a low of 24 percent.
The "Mellon Plan" proved utterly incapable of dealing the Crash of 1929 and the Great Depression. Today Mellon is remembered for his post-Crash advice to President Herbert Hoover: "...liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate...high living will come down. People will work harder, live a more moral life." As UE President John Hovis told delegates to the 2011 UE Convention, this "Mellon Doctrine" is once again the platform of the Republican Party.
To restore solvency, President Franklin D. Roosevelt returned to the pre-Mellon standard of high taxes on the wealthy and large excise taxes on corporations. In 1939 taxes climbed to 75 percent on incomes over $5 million. During World War II, the rate rose to 94 percent on incomes over $200,000. (This was a compromise from FDR's proposal to set a national "maximum wage" of $25,000 after taxes.) In the 1960s and 70s, rates slowly fell, but top tax rate was still 70 percent when Jimmy Carter was president.
With Ronald Reagan's inauguration in 1981, the "Mellon Plan" came back into political fashion, renamed "supply-side economics." Reagan cut taxes on the wealthy three times, reducing the top rate to 28 percent by 1988. In some ways Reagan was worse than Andrew Mellon because he increased income taxes on the poorest Americans from 11 percent to 15 percent. On the other hand, Reagan eliminated many tax loopholes, such as the use of real estate as a tax shelter, and after cutting the capital gains tax he restored it to the same rate as in the Carter years.
TAXES TODAY
Since Reagan left office, income taxes were increased twice, and then reduced in the Bush tax cuts. But in some ways, we are still living in the Reagan era. The tax code has not been reformed since 1986. With taxes on the wealthy at a historical low, it's clear that they pay significantly more. But there are other crippling flaws in our tax system that need to be addressed.
Taxes are needlessly complex. In 1913, Form 1040 was only four pages, and some congressmen complained that it was too long. Since then, loopholes in both personal and corporate income taxes have proliferated. Historically most loopholes were written to benefit the rich, but in recent decades, with social spending under attack, the government has used "tax credits" as a policy instrument. Some of these, such as the Clinton-era expansion of the Earned Income Tax Credit, have had positive effects on working people, but they also make the system more complicated. That's why nearly 60 percent of Americans now hire an outside agency to file their tax returns.
The number of tax brackets is lower than it's been in the past (six brackets today, 55 brackets in 1932.) Because of a failure to adjust the rates for inflation, the top income tax rate now covers a much bigger portion of the population than in the past. In 1942 the top rate applied to income over $200,000 (equivalent to $2.75 million in current dollars.) Today the top rate of 35 percent kicks in with an annual income of $388,361, but a person making many millions a year - or even a billion - is in the same bracket. Unfortunately there is almost no political discussion of adding brackets in order to tax the super-rich at higher rates.
Capital gains (profits from investment) have long been taxed at a special rate, lower than normal income. The current maximum rate of 15 percent is unusually low. During the Reagan era capital gains never fell below 20 percent, and rose to 28 percent by 1986. Clinton agreed to reduce the rate in 1997 to get Republican vote for expanding the Earned Income Tax Credit. The 2001 Bush Tax Cuts reduced the rate to its current 15 percent - the lowest since the Mellon Plan. Like the 1920s, the past 10 years have been a time of skyrocketing income for the top 1 percent and rampant financial speculation. The super-rich make most of their income from investments, not salaries, and the low capital gains tax is a major reason people like Mitt Romney get away with paying taxes at a lower rate than people who work for a living.
Payroll taxes add another regressive element. Social Security taxes are paid only on the first $110,100 of wages. According to a 2010 study by the New America Foundation, simply removing this taxation cap would raise an additional $377 billion for Social Security annually. This would not only eliminate fears of Social Security eventually becoming insolvent, but would also provide 60 percent of the funding needed to double Social Security benefits.
Legalized corporate tax dodging is scandalous. UE members are well aware of GE's multi-year avoidance of corporate income taxes. But GE's behavior is neither unusual nor unexpected. The official corporate tax rate peaks at 35 percent, higher than most other industrialized countries. But in February the Wall Street Journal reported that in 2011 the real corporate tax rate, after loopholes, was 12.1 percent - the lowest in 40 years. In 1955, 27 percent of federal government revenue came from corporate taxes. By 2010, it was only 9 percent.
State and local taxes are generally even more regressive than the federal system. Most states rely upon sales tax for at least some revenue. Even with exemptions for food and other necessities, sales taxes fall more heavily on the poor than the wealthy. Nine states have no personal income tax, and six have a flat tax, with the poor paying the same rate as the wealthy. Local property taxes are almost invariably higher in poor municipalities than in wealthy ones. When the effects of state and local taxes are taken into account, the wealthy in virtually every state pay a smaller percentage of their total income in taxes than do workers.
WHICH WAY FORWARD
If Congress does nothing, the unfair U.S. tax system will get a little better. That's because the 2001 Bush tax cuts are set to expire next year, and that would restore the income tax rates, the capital gains tax, and the estate tax to what they were in the final Clinton years. Obama says he will not extend tax cuts for the wealthy again. He is willing to extend cuts for those making under $200,000, but for this to happen Congress would have to pass a new bill before the end of 2012.
Obama's recent proposal to lower the theoretical corporate tax rate to 28 percent, but close most loopholes and raise corporate taxes overall, could be a small step forward, in particular in imposing a minimum tax on offshore tax havens. Obama's proposed lower tax rate meant to encourage U.S. manufacturing could have benefits, but there may be pitfalls. Will cooking French fries and producing TV shows be defined as "manufacturing"?
The problem with the unfair tax system is not the American people, it's the politicians. A poll in March showed two-thirds of Americans support a minimum tax rate of 30 percent on those who earn more than $1 million a year. Nearly half of registered Republicans agreed. If we want more justice and rationality in the tax system, we should keep that in mind when it's time to vote in November.