Fair Income Taxation, 1913-Style

With the latest debate about “fair” tax policy coinciding with the 99th anniversary of the federal income tax, it’s interesting to look back at what Congress considered fair when it all began.

The income tax was originally sold to the American people as a means of “soaking the rich”—a phrase that seems refreshingly candid when compared to today’s cushioned yet calculated talk of asking the rich to “pay their fair share.”  While many early 20th-century politicians shared the feelings of our founders and resisted the notion of a direct federal tax on the product of a citizen’s work or investment, their fear of being tarred as protectors of the wealthy outweighed their conviction and the income tax was unleashed in 1913.

Official White House portrait of William Howar...

President Taft: Champion of the Income Tax

The original income tax, which Democrats defended as “the fairest and cheapest of all taxes”, bore very little resemblance to the version confronting individuals and businesses today. Reviewing the first IRS Form 1040, four attributes are particularly striking:

  • It was far simpler.  The instructions for the original 1040 fit on just one page, compared to 100 today.  Meanwhile, the full tax code spanned 400 pages, while today’s leviathan consumes more than 72,000.
  • Hardly anyone paid it.  While the relentless growth of the federal government would force it to eventually engulf a huge swath of the population, the original income tax focused on only the most prosperous Americans.  Thanks to a generous personal exemption, only those with taxable income greater than today’s equivalent of $67,000 were snared by it, which meant 98 or 99% of Americans kept everything they earned from either their own work or from their savings and investments.
  • Those who paid did so at much lower rates than today.  The original income tax applied a mere 1% rate on income all the way up to $452,292 in today’s dollars, according to the Tax Foundation.  Like our current code, the 1913 version applied higher rates to higher incomes—but topped out at just 7% on income over the equivalent of  a whopping $11.3 million today.  In stark contrast, there are many politicians in 2012 who think it’s perfectly reasonable for the federal government to lay claim to a full third of a citizen’s income above a far lower threshold than that.
  • Received dividends were exempt from income tax.  At the outset, the income tax avoided what many consider an unjust aspect of today’s tax code:  the double-taxation of corporate dividends.  That is, dividends are paid out of after-tax profits, and those same dividends are taxed again when received by the investing shareholder.  Those arguing today that dividends should be taxed at the same rates as ordinary income would gain allies if they also embraced corporate deductions for dividends— preventing our gluttonous government from taking two bites from the same profit.

Imagine if, instead of proposing the far less invasive original version, politicians in 1913 tried to implement the income tax as we now know it.  Starting from a fresh slate, would Americans have considered it a reasonable proposal?   

Certainly not.  And yet today, after nearly a century over which the income tax has insidiously expanded its intrusion into our economy, our politics and our lives, millions of Americans who never knew a world without the income tax accept its continuation as inevitable.  Without consciously doing so, they surrender to what Milton Friedman called “the tyranny of the status quo,” where existing policies are fiercely guarded from change by politicians, bureaucrats and those who directly benefit from those policies.

Reconsidering the Income Tax

That said, Americans’ tolerance of the income tax could be on the cusp of a steep decline.  Spurred by a growing appreciation of the income tax’s many inherent flaws, legislation to repeal it and replace it with the FairTax—a national sales tax on new goods and services—has attracted 66 co-sponsors in the House of Representatives and eight in the Senate, along with the support of Libertarian presidential candidate Gary Johnson.

Of course, the most prominent voice calling for income tax repeal is Republican presidential hopeful Ron Paul, who would accomplish his goal via passage of the Liberty Amendment.  Like his stand on most issues, Paul’s position on the income tax seems firmly rooted in principle, not politics.  Indeed, when Paul recently discussed the basic concept of rights, he summarized it by saying, “Rights mean you have a right to your life, you have a right to your liberty (and) you should have a right to keep the fruits of your labor.”

Ron Paul at the 2007 National Right to Life Co...

Ron Paul

Like many of his other principled stances, Paul’s strident opposition to the income tax prompts some observers to dismiss him as extreme.  Perhaps, however,  what’s truly extreme is the notion that our government should have a presumptive claim on the income of its individual citizens.

If Ron Paul’s growing popularity is any indication, more and more Americans are reaching the conclusion that the “fairest” approach to income taxation is to have no income taxation at all.

Brian McGlinchey is principal at Liberty Messaging—a communications firm serving libertarian causes. He is the founder of 28Pages.org and a contributor at The Libertarian Institute.
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The Income Tax Turns 99: Bring on the Death Panel

On February 3, 1913, the United States ratified the 16th Amendment to the Constitution and the federal income tax was born.  Friday thus marked the 99th anniversary of a dark day in American history, one that continues to cast a long shadow over the nation.  Sadly, that shadow is so broad and omnipresent that it defies detection by the vast majority of Americans, who don’t realize how much brighter their lives could be without it.

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As we enter the hundredth year of this failed experiment, it’s time to seek a completely different alternative.  Building a consensus for that starts with fostering a more acute understanding of the income tax’s many fatal flaws.

Complexity is in the income tax’s DNA.  From its original 400 pages in 1913, the IRS code has exploded to span more than 72,000.  Some of that growth springs from the never-ending competition between lawmakers and those who rightfully and legally exploit gaps in the code to minimize their tax burden.  However, even more so, it’s due to the flexible nature of the code itself, which offers lawmakers an irresistible temptation to leave their own mark for posterity and political gain.

Created for revenue, it’s used for social engineering, economic manipulation and special favors.  The tax code promises countless blessings if only we make the “right” choices in life.  The government uses tax law to entice us to buy electric cars, go to college, have kids, adopt children, buy houses, move to take new jobs, donate money to charity, save for retirement, buy public school bonds, install residential windmills…and on it goes.

Of course, the real action is on the corporate side of the code, where it’s much harder to suspend disbelief about the government’s good intentions—and where special provisions favor both big industries and smaller constituencies like thoroughbred horse owners, Eskimo whaling captains and manufacturers of toy wooden arrows.

It’s a magnet drawing money into politics.  The reason there’s so much money in federal elections is that Washington—with its carrot-and-stick tax code and runaway spending—has undue influence on trillions of dollars coursing through every household and business in the economy, and the ability to alter its course through law.  There’s simply too much money at stake inside the beltway and too many tax-code buttons for legislators to push.

It’s an enormous drain on productivity and resources.  According to IRS estimates, individual taxpayers and businesses collectively burn more than 7 billion hours a year complying with federal income tax filing requirements, diverting the workpower equivalent of 3.5 million people working full-time.

The vast majority of Americans have given up on trying to crack the IRS code single-handedly: 90% shell out money for tax software or a human’s help, to say nothing of the legions of attorneys and accountants retained by corporations.  (Resist the temptation to consider the employment of income tax professionals as a net positive for the economy:   It’s never a good thing to use society’s resources to produce…nothing.)

IRS Form 1040, Circa 1913 (click to enlarge)

It masks the cost of government.  Thanks to the insidious practice of  income tax withholding from employee paychecks—first enabled by the Revenue Act of 1942—it’s fair to say most Americans have little idea how much federal income tax they pay in a given year.  If you doubt that,  just wait for mid-April and ask friends and co-workers how much they paid for 2011.  Many will happily reply, “Nothing! I got money back.”  Concentrating on the final ledger-balancing act that is the filing of an income tax return, they forget that Uncle Sam steadily siphoned their money all year long.

Imagine if, instead of having taxes steadily withheld from their wages, people were required to write one large check representing their entire income tax liability.  If the cost of government were more explicit, it would surely check Americans’ collective appetite for our ever-expanding federal government.

It takes money out of the treasury.  According to the Joint Committee on Taxation, 30% of American “taxpayer units” actually made money from the tax system in 2009—thanks in large part to “refundable” tax credits. Unlike deductions and exemptions—which are used to calculate taxable income—a tax credit is a dollar-for-dollar reduction of your actual tax bill after you’ve calculated your income.

Refundable credits take that notion to an extreme—not only do they reduce your tax bill, but if the credit is larger than what you owe, the U.S. Treasury will actually send you money.  A major trend toward refundable credits prompted IRS National Taxpayer Advocate Nina Olsen to lament that “the IRS no longer is just a revenue collection agency but is also a benefits administrator.”

It opens a wide door to plunder and spillage.  Two examples among too many:

  • Remember the first-time home-buyer credit rushed into law during the financial crisis? In 2008 alone, the IRS processed more than $600 million in credits for people who hadn’t purchased a home or who weren’t qualified first-time buyers.   Among them: 580 claimants under age 18, including a budding 4-year old real estate tycoon. It was later revealed that 1,295 prison inmates had used the credit to defraud the government of more than $9 million; 241 of them were lifers.
  • The refundable Earned Income Tax Credit (EITC), targeted at low to moderate income individuals, offers an even more glaring example:  In 2009 alone, the IRS processed $11 to 13 billion in fraudulent or erroneous EITC claims.
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Credit: Kevin Dean, BetaArt.com

It’s an invasion of privacy.  When it comes to government intrusion in the lives of citizens, nothing holds a candle to the income tax, which requires businesses and individuals to disclose a vast amount of information about their endeavors and their finances and then hold detailed records available for scrutiny by federal inspectors years later.

Filing a 1040 form is the tax equivalent of a TSA backscatter X-ray:  Among other things, the government demands to know how much you earned, where you keep your money, which investments you bought and sold,  how many children you have, how much alimony you paid, which charities you gave to, the medical procedures you had and how many nights you slept in your vacation home.  Is that in any conceivable way consistent with the principle of liberty that once defined our nation?

Finding a better way

While the under-100 crowd has lived under the income tax their entire lives, our nation has lived most of its life without it.  Almost a century after its creation, the income tax must now be recognized for what it is—an unmitigated economic and political disaster that unleashes unintended consequences that still grow in number and magnitude.  At a time when most talk of tax reform focuses on merely tinkering once more with rates, deductions and credits, we should instead focus our collective energy on ending the income tax altogether.

If we aren’t to tax income (something Americans generally feel they have too little of), one alternative is to tax consumption (something Americans tend to do in excess).  Consumption taxes—such as sales taxes—are routinely dismissed out-of-hand by critics claiming they unfairly burden the poor.  Perhaps they don’t realize some models address that concern head-on by providing advance sales tax rebates on spending up to the poverty level.

The most prominent and well-researched of those concepts is the FairTax—which is essentially a national sales tax on final retail purchases of new goods and services.  I’ll write more about the FairTax in the future; until then, visit FairTax.org…and imagine all of the personal work, worry and waste of the income tax vanishing, replaced by a simple and transparent tax paid at the register.

Brian McGlinchey is principal at Liberty Messaging—a communications firm serving libertarian causes. He is the founder of 28Pages.org and a contributor at The Libertarian Institute.