America’s Tax Burden

April 9, 2008

April showers

With tax day fast approaching, the Internal Revenue Service is projecting that close to 140 million American individuals, families, and businesses will file returns by April 15. In total, the U.S. Department of the Treasury expects to fill its coffers with an estimated $2.5 trillion in tax revenue in 2008. According to data released by the IRS in 2007, the average American household paid $22,100 in federal taxes–a dramatic increase from 1965, when the average household’s tax burden was $10,800 (inflation adjusted).

Reports from the U.S. Department of the Treasury indicate that, since World War II, gross federal tax receipts have averaged 18 percent of total U.S. gross domestic product (GDP). According to IRS projections, tax revenue for 2008 is projected to decline slightly, to 17.6 percent of GDP. The IRS attributes this expected decrease to the overall economic slowdown in 2007 and the 2008 tax rebate/economic stimulus package.

Collecting and spending these revenues have become a focal point of this year’s presidential campaign. Democratic U.S. senators and presidential candidates Hillary Clinton and Barack Obama have outlined plans to add more exemptions and tax cuts that they say will alleviate the tax burden of poor and middle-income families. Both candidates endorse plans to let the tax cuts enacted under the Bush administration in 2001 and 2003 expire. The putative Republican presidential nominee, U.S. senator John McCain, advocates a reduction in corporate taxes and a repeal of the alternative minimum tax (AMT), currently set at 28 percent.

As Hoover senior fellows Robert E. Hall and Alvin Rabushka point out in their landmark book, The Flat Tax, that, regardless of who is elected and whatever tax code changes are implemented, disagreement over the fairness--more precisely who and how much one is obliged to pay--is a certainty.

Taxing times

The collection and distribution of taxes in the United States predate the American Revolution. In his new book, Taxation in Colonial America, Rabushka illustrates how colonists both avoided and resisted taxes levied by the British and other countries and used indirect taxes and tax incentives as a means to encourage settlement. Taxation in Colonial America also examines how the colonists’ attitudes toward taxation helped shape the Revolution.

The U.S. Constitution provided Congress with the power to “lay and collect taxes, duties, imposts, and excises, pay the Debts and provide for the common Defense and general Welfare of the United States.” During its first hundred years as a nation, most of the U.S. government's tax revenues came from tariffs on goods, excise taxes, and customs duties. According to tax historians, the imposition and collection of federal, state, and local taxes are largely attributed to specific historical events, such as the declaration of war or the expansion of government.

The Treasury Department documents the history of tax collection from prerevolutionary times. According to the Treasury, the first federal taxes were enacted in the late 1790s, which estate and slave owners paid directly to the government based on the value of their holdings. President Thomas Jefferson terminated direct taxes in 1802; until the outbreak of the Civil War, the government relied on custom duties for revenue. During the war, Congress passed the Revenue Act of 1861, which reinstated former excise taxes and instituted a 3 percent tax on annual incomes of $800 or higher. In 1862, a cash-strapped Congress levied new excise taxes on various goods and made several reforms to the income tax legislation, including allowing a standard deduction and creating a two-tiered rate structure. Most taxes were repealed in the years following the Civil War; the income tax was abolished in 1872. For the next forty years, the government relied mainly on excise taxes for revenue.

Disagreements between states regarding tariffs and excise taxes eventually led to the ratification of the Sixteenth Amendment to the Constitution in 1913, giving Congress the authority to levy income taxes nationwide. Soon after, Congress enacted a variable income tax rate of between 1 and 7 percent for the highest earners.

Wartime expenses created a demand for additional federal revenue and thus  new and increased taxes. During World War I, the 1916 Revenue Act raised  tax rates to between 2 and 15 percent and instituted an estate tax. Revenue acts passed in 1917 and 1918 further increased the tax burden, lowering exemptions and raising tax rates. In the 1920s, a postwar booming economy led to a series of tax cuts.

The Depression led to a massive decrease in federal tax revenue. In an effort to make up for the dramatic loss, Congress passed the controversial Tax Act of 1932, which imposed much higher tax rates. By 1936, this and other tax reforms had increased the lowest tax rate to 4 percent; the highest earners were subject to a 79 percent tax rate.  In addition to those new taxes, the Social Security Act in 1935 added a 2 percent tax to fund entitlement programs.

Numerous tax hikes enacted before and during World War II vastly increased federal revenue, from less than $9 billion in 1941 to more than $45 billion in 1945. Taxes as a percentage of GDP grew as well, from barely 8 percent in 1941 to more than 20 percent in 1945. Changes in the minimum level of income at which taxes were imposed resulted in a sharp increase in the number of taxpayers as well, with 43 million filing returns in 1945, compared to only 4 million six years earlier.

In the decades following World War II, tax rates remained relatively stable, but rising inflation during the late 1960s and throughout the 1970s increased the tax burden, creating strains on the economy. Endorsed by President Reagan, the Economic Recovery Tax Act of 1981 provided an across-the-board 25 percent reduction in marginal tax rates and increased economic tax incentives for businesses and individuals. This and other tax cuts enacted during the 1980s (most notably the Tax Reform Act of 1986) operated on the assumption that high tax rates diminish incentives for additional work, discourage saving and investing, and create the impetus for people to find ways to avoid paying taxes or seek out tax shelters.

Throughout the 1990s and early 2000s, tax rates and policies shifted mainly along political lines, with rate hikes during the Clinton years, followed by tax cuts enacted by the current administration.

The real tax burden

Numerous sources cite the enormous length and complexity of the tax code. According to one source, the current tax code and its associated regulations “contain almost 5.6 million words--seven times as many words as the Bible.” One website that provides access to the tax code and its related documents notes that the complete tax code is 24 megabytes in size and, if printed 60 lines to the page, would fill more than 7,500 letter-size pages.

Contempt for the current tax system is rampant. In The Flat Tax, Hall and Rabushka note that President Jimmy Carter stated that the income tax was “a disgrace to the human race.” President George W. Bush commented that "the tax code is a complicated mess. You realize, it's a million pages long." Even Albert Einstein once quipped, “The hardest thing in the world to understand is the income tax.”

Hall and Rabushka argue that the current federal tax system is not only impossible to understand but “imposes two huge costs on the American people: direct compliance costs …and indirect economic losses from disincentives.”

Ironing out the flat tax

In 1981, Hall and Rabushka, building on the work of famed economist and Hoover fellow Milton Friedman, elaborated on the idea of a flat income tax of 19 percent. According to their plan, all income (business and individual) would be taxed at that rate. Most deductions would be eliminated altogether, resulting in a drastic simplification of the tax code and a tax return form that would fit on the back of a postcard.

Over the years, the flat tax has gained bipartisan support from various business leaders, legislators, and presidential candidates, including U.S. representatives Bob Kasten (R), Jack Kemp (R), and Richard Gephardt (D); U.S. senator Bill Bradley (D), and publisher Steve Forbes. Thanks to the efforts of these and other flat tax proponents, numerous flat tax proposals have been introduced before Congress, culminating with the passage of President Reagan’s Tax Reform Act of 1986, which replaced multiple tax brackets with two rates, 15 and 28 percent.

Although the 19 percent flat tax has not been adopted in the United States,several eastern and central European countries, including Bulgaria, Russia, and the Czech Republic, have adopted flat taxes, with more countries expected to convert to flat tax systems within a few years. The flat tax, according to Rabushka, has been “a resounding success story.” He states that the flat tax countries have experienced fiscal and social results “as good or better” than predicted. Despite its successes abroad, Rabushka believes the flat tax in America has fallen victim to partisanship and the growing influence of special interests groups. In a recent interview, he commented that implementing the flat tax in the United States would remain “impossible” until a major country such as China successfully adopts the idea.

“Strong fiscal restraint”

In a joint op-ed published in the Wall Street Journal, Hoover senior fellow (and former deputy director of the Office of Management and Budget under President Reagan) John F. Cogan and R. Glenn Hubbard (chairman of the Council of Economic Advisers under President George W. Bush) warned that the increased government spending and tax increases proposed by some of the presidential candidates will “drive the personal income tax burden up by 25 percent–to its highest point relative to GDP in history.”

If such comes to pass, the two argue, “the tax increases and tax avoidance behavior will prevent the promised revenues from being realized.” Instead, Cogan and Hubbard predict that the promise of higher tax revenues will “encourage Congress to continue its profligate spending. As a result, a tax increase won't lower the budget deficit.”

According to Cogan and Hubbard, balancing the federal budget during an economic slowdown without raising taxes will require “strong fiscal restraint.” The pair proposes three key actions the federal government should implement to counteract the current pace of unchecked spending: “change entitlements to slow their cost growth; eliminate all nonessential spending in the remainder of the budget; and…adopt policies that promote economic growth.”

For Cogan and Hubbard, stimulating economic growth will improve the overall health of the budget. As they explain, “The greater the economic growth, the larger the economic pie, and the greater the public and private resources available to finance entitlement obligations and other national priorities.” —Michelle Bussenius, Editor