One of the byproducts of free people making different choices with their time, talents, and treasure is the unequal distribution of economic outcomes. I suspect that no western tradition generates more passion among Occidentals than the concept of inequality. Whether we like it or not, or whether it is true or not, many Americans believe inequality is one of America’s greatest moral failures. During the 2012 presidential debates between President Obama and Governor Romney, large segments of the discussion centered on the topic of taxing the rich more while preserving the relatively low tax rates for everyone else. As we will see, the policy of taxing the wealthy significantly more is not new. I want to demonstrate from history why a steeply progressive tax code, where the rich pay significantly more and the poor pay significantly less, doesn’t achieve its intended purpose of raising more revenue.
Our Founding Fathers weren’t big fans of the income tax. In fact, it wasn’t until 1913 that the 16th Amendment was ratified allowing the federal government to directly tax the incomes of individual Americans. The ensuing Revenue Act of 1913 called for a tax that ranged from a modest 1% on incomes exceeding $3,000 to 7% on incomes exceeding $500,000. It wasn’t long before a policy of “taxing the rich” significantly more was implemented. In order to pay for WWI, Congress passed a law in 1916 that raised the tax rates on incomes over $300,000 to 70%.
Ironically, from 1916 until 1918, the number of Americans earning more than $300,000 dropped in half! This caused President Woodrow Wilson himself to urge Congress to reconsider whether very high tax rates were productive in collecting revenue. Wilson said that, beyond some point, “high rates of income and profits taxes discourage energy, remove the incentive to new enterprise, encourage extravagant expenditures, and produce industrial stagnation with consequent unemployment and other attendant evils.” In the midst of a deep depression and hundreds of thousands of Americans unemployed, those who successfully implemented the steeply progressive tax policy found themselves elected out of office.
In contrast to the poor economy experienced during the Wilson administration from 1916 to 1920, the Roaring 20’s was a time of unprecedented economic prosperity. Americans both rich and poor were buying radios, washing machines and automobiles. Unemployment was virtually non-existent, and it was the first and only time in American history when blacks had lower unemployment numbers than whites. What was the cause of such a positive economic turnaround? Many believe it was the reduction of excessive progressive era tax rates. The treasury secretary at the time, Andrew Mellon, convinced both President Warren G. Harding and his successor Calvin Coolidge, that the most effective way to raise tax revenues was to flatten the tax code. From 1921 until 1929, marginal tax rates shrunk from a high of 77% to 24%.
The result? Record collections of tax revenues that were so large the government almost paid off the national debt. As for getting the wealthy to pay their fair share, In 1918, when marginal tax rates were over 70% only 20% of taxes collected came from incomes over $300,000. However, by 1926, 65% came from top earners! Mellon proved that the way to raise revenue was not to raise marginal tax rates, but to lower them enough to make work and investment meaningful to wealthy people.
At first glance, lowering tax rates on high incomes for the purpose of raising revenue seems counterintuitive. However, Secretary Mellon knew that productive Americans would not produce if taxes were too high. Mellon wrote in 1924, “The history of taxation shows that taxes which are inherently excessive are not paid.”
One of the ways that the wealthy produce less income is they invest in tax advantaged investments that are usually less attractive when tax rates are lower. Growth stocks, insurance annuities, sophisticated and expensive retirement trusts, and tax-free municipal bonds, all become incrementally more attractive to wealthy people as their income tax rates increase.
A second way wealthy people avoid income taxes is they invest overseas in countries where their investment income is taxed less. There are many countries where investment opportunities are unattractive when U.S. tax rates are low. However, at some point even risky overseas investments become relatively more attractive as tax rates on U.S. investment income are increased.
Finally, when productive people get taxed more, they produce less. If you think I am fibbing, try this experiment at home. Tell your children that if they clean their rooms by noon on Saturday, you will take them all out for ice cream; however, whoever cleans their room first will be forced to clean the bedrooms of their less efficient siblings. Productive people tend to have less debt, so they don’t need much income to flourish. When income tax rates are high, wealthy people spend more time in leisure activities and less time in activities that require them to pay excessive taxes on their productivity.
Art Laffer, a distinguished economist and advisor to Ronald Reagan, developed the concept of the Laffer Curve. Laffer postulated that no revenue would be collected when tax rates were 0% (for obvious reasons), but he also believed no revenue would be collected at rates of 100% because no one would have an incentive to produce income. Somewhere between 0% and 100% lies a sweet spot where the greatest amount of revenue will be collected. History has demonstrated that tax rates above 24% tend to result in reductions of revenue collected. With our national debt at unprecedented levels, our economy in dangerous waters, and our own economic futures uncertain, it is critical that we take into the voting booth with us an understanding and historical appreciation for tax policies that actually work.