The following is an abridged version of the article originally published in the Winter 1996 issue of Working People.
Few issues are nearer and dearer to the hearts of workers than taxes. With wages stagnant and more and more workers struggling to maintain their standard of living, the taxes they pay are coming under increased scrutiny.
In the past few years, the much maligned federal tax system has increasingly become a battleground for political and economic philosophies. With 1996 a presidential election year, the rhetoric is heating up and there are nearly as many proposals for change as there are candidates. Although the current system is clearly in need of reform, the politicians are, as usual, long on promises and short on the truth concerning how their proposals will actually affect workers and their families.
Middle and lower income workers, who have been victimized by a series of tax "reforms" over the past 40 years, need to be particularly wary of any proposal for change. The current tax system and some of the proposed changes to it are highly complex.
Each proposal for reform favors one segment of the population at the expense of another. In almost every case, however, the reform proposals being touted this presidential year are at the continued expense of middle and lower income workers. It is important that workers understand the issues behind each proposal for reform and be able to "read between the lines."
In order to understand how we got to where we are today and whether any of the current proposals for reform makes sense, it is important to have a basic understanding of how the federal tax system evolved. When most people think of taxes, they think of the government taking away their hard earned money to pay for government services and operations, some necessary and some not. But over the years, taxes have been imposed for a variety of purposes. In addition to funding the government, taxes have been used as part of government policy in an attempt to allocate resources, redistribute income and promote economic stability and growth.
The American tax system that was adopted after the Revolution was the direct result of resentment over the British taxes that had driven the colonists to revolt. The British had tried and failed in imposing a series of excise taxes on goods such as sugar, paper and tea. The colonists resisted those taxes in part because they were levied directly on day-to-day necessities and in part because the colonists were not represented in the British parliament and therefore had no say in what taxes were levied.
After the Revolution, the new American Congress was left with a huge debt that had been accumulated to finance the war. Federal taxes, badly needed to service that debt, were established by Congress, primarily in the form of tariffs (taxes) on imported goods. An income tax wasn’t even a consideration during that period because almost all transactions were in cash and there was just no practical mechansim available to measure individual incomes.
But practicality was not the only reason that tariffs were established as the primary source of Federal revenues. The writings of Adam Smith, Scottish philosopher and economist, had a major impact on American economic thinking and policy. One of the tenets of Smith’s economic philosophy was the idea of fairness in taxation. In his book The Wealth of Nations, Smith wrote:
"The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities..."
In the post-revolutionary era, with the American economy being largely agrarian, tariffs were viewed largely as a tax on the rich. In 1811, Thomas Jefferson wrote"
"We are all the more reconciled to the tax on importation, because it falls exclusively on the rich...In fact, the poor man in this country who uses nothing but what is made within his own farm or family, or within the United States, pays not a farthing of tax to the general government...the farmer will see his government supported, his children educated, and the face of his country made a paradise by the contributions of the rich alone..."
After the Civil War, however, as the shift from an agrarian to a manufacturing economy accelerated, the large tariffs that were imposed became an increasing burden on the poor and middle class. Although tariffs were designed to protect American jobs as well as raise revenue to operate the government, the nearly 50 percent tariff on imported goods enabled American manufacturers to raise their prices abnormally high. American producers profited handsomely at the expense of the poor and working class, who had to pay more for everything they purchased.
The federal government’s answer to the tariff dilema was the income tax. In 1894, President Cleveland’s Democratic administration introduced an individual and corporate income tax, aimed at the rich. But in 1895, the Supreme Court declared the newly adopted income tax unconstitutional.
After the turn of the century, the emergence of the progressive movement, who were working to fight poverty and political corruption, helped provide a major impetus to the implementation of a permanent income tax. In 1909, the Repub-licans, feeling pressure from the Progressives, agreed to a constitutional amendment to establish an income tax, believing that it would never be ratified by the states. In the 1912 elections, however, Progressive Republicans and Democrats gained control of a sufficient number of legislatures to enable subsequent ratification of the amendment.
Aimed at corporations and the rich, the new income tax had progressive rates between 1 and 6 percent on incomes of $4000 or more for both individuals and corporations. Those minimal rates did not last long, however. The debts accumulated during World War I drove Congress to impose an increase in tax rates of up to 77 percent, although even after such a large increase, most Americans continued to pay no income tax.
After the stock market crash of 1929, with federal revenues plunging, the Republican Congress passed the now infamous Hawley-Smoot Tariff Act, which raised tariffs to nearly 60 percent. Unfortunately, far from accomplishing the goal of raising more revenues and protecting American jobs and industry from foreign competition, the resulting drop in trade and the regressive impact of the tariffs on an already suffering population probably exacerbated and extended the affects of the Depression.
The length and breadth of the Depression had a profound long term impact on the size and scope of government and the tax system required to support it. If there had been any question about the role of government, it was settled with the Depression - big government was here to stay.
In spite of the meger incomes of most Americans during the Depression, in the face of an eroding tax base, President Roosevelt took the opposite approach to what we might expect today and raised taxes considerably between his first inauguration and the start of World War II, including the institution of a payroll tax to pay for the new Social Security System introduced in 1935. Unlike previous income tax rates, aimed almost exclusively at the rich and corporations, these increases were targeted across the entire spectrum of taxpayers. Supporting the increasing size of government meant that income taxes could no longer be targeted just at the rich.
In 1942, to help pay for the huge costs of the United States’ involvement in World War II, both individual and corporate taxes were increased across the board, including an excess-profits tax for industry and a 5 percent surcharge on individual incomes. The impact on individuals was a sharp reduction in the progressivity of tax rates. As of a result of those increases, the number of Americans paying income tax more than doubled. By the end of the war, individual and corporate taxes accounted for more than half of federal revenue, surpassing income from tariffs and excise taxes for the first time.
The prominence and complexity of individual income taxes continued to increase after World War II. While individual tax rates have fluctuated back and forth over the past few decades, there seems to be little question that fairness and the progressive nature of the income tax, which began their decline under Franklin Roosevelt, have more and more fallen prey to the influence of corporations and the wealthy. Between 1950 and 1990, the percentage of corporate and excise taxes dropped from 45 to just 12 percent. During that same period, the share of revenue from individual income taxes jumped from 51 to 83 percent, most of the increase falling on middle and low income taxpayers.
The greedy, however, who have been a major force in the shift of tax burden from the rich to low and middle income families, are not yet satisfied. It is mostly these wealthy corporate and individual interests who hold sway in Congress that are pushing a series of income tax reforms. Couch-ed in terms such as simplification and fairness, these "reformers" would further line the pockets of the rich at the increasing expense of middle and low income families struggling to make the American dream a reality.
During the campaign of `96, we are likely to hear a lot about taxes, how unfair they are and how they should be reformed. The reforms being promoted from both inside and outside Washington focus around four basic proposals:
Since the introduction of a federal income tax in 1913, the rate of tax has been progressive, i.e., the more an individual earns, the greater the percentage of income that is paid in taxes. Over time, however, Congress has twisted that basic philosophy, building in special provisions. The result is a tax code virtually inscrut-able, even to most "experts," that allows scores of millionaires each year to avoid paying any tax at all. With the federal tax code now numbering some 6000 pages, it is no wonder that there are so many calls for reform and simplification of the income tax and, along with it, the elimination of the much feared and hated Internal Revenue Service.
The tax reform proposal which is getting the most attention and is likely to be the most prominent in the 1996 presidential debate is the flat tax. In its purest form, a flat tax equates to one rate applied to all income. Each of the major flat tax proposals, however, has some form of basic personal exemption, providing a range of incomes for which no tax is owed (or at least, that’s what proponents would have you believe). For incomes above the basic exemption, one rate would apply. Most of these flat tax proposals tax only wages, which is the approach favored by many Republicans because the proposed rates and exemptions for income from investments means a huge windfall for their rich constituents.
The most prominent flat tax proposal is from Representative Dick Armey (R-Texas), the Republican House Majority Leader, who calls his plan, ironically, "The Freedom and Fairness Restoration Act." Congressman Armey argues that his proposal simplifies the tax code, cuts taxes on families and promotes jobs and higher wages. Calling for a 17 percent tax rate, his plan would provide a personal exemption of $13,100 for a single person, $17,200 for a single head of household, $26,200 for a married couple filing jointly and $5,300 for each dependent. There would, however, be no other deductions. Gone would be mortgage, medical and state tax deductions.
Congressman Armey maintains that his proposal simplifies income tax calculations to the point that tax returns could be filed on a postcard. While most Americans would agree that simplifying the 6000 page tax code is a good thing, when you look under the hood of Congressman Armey’s proposal, it’s clear that it has nothing to do with fairness. Instead, his proposal is aimed at an enormous transfer of wealth from the middle class and poor to the wealthy.
Important to the debate on tax reform and fairness is the fact that the United States is already the most economically stratified nation in the industrialized world. The Organization for Economic Cooperation and Develop-ment, a highly respected economic group of which the United States is a partner, reported that the income gap between rich and poor in the United States during the 80s was the widest of any major industrialized country. And unfortunately, with poverty on the rise in the United States over the past few years, it appears that the trend toward a nation of haves and have nots continues in the 90s. Unfortunately, most Americans seem not to realize that our middle class has been shrinking and the egalitarian society that we pride ourselves on is slowly disappearing.
What Congressman Armey’s and all of the other reform proposals fail to acknowledge is the 15.3% payroll tax for Social Security, charged against all wages up to $61,200. While most politicians would like to hide Social Security under the rug because it is such a hot political issue, its taxes have the same affect on workers that any other income tax has and the revenue is used for the same purposes - the day-to-day operation of the government. Therefore, to have an honest dialogue about tax reform and fairness, Social Security taxes must be factored in.
In fact, the explosive increase in payroll taxes for Social Security over the past few decades is probably the biggest reason for the decline of the middle class. This is because Social Security is a highly regressive tax -- it actually decreases, from 15.3% to 2.9%, after the $61,200 individual income threshold is reached. Not only is it regressive but it is a double tax on the same wages -- workers get no deduction to their taxable income for the Social Security taxes withheld from their pay. As a result of factoring in Social Security taxes, when you look at the Armey proposal with such taxes included, the tax rate actually drops above the $61,200 wage threshold -- it’s no wonder that Republicans and their wealthy benefactors love this "reform."
In addition to the question of the fairness of a flat tax, there is also the critical question of what tax rate would actually be required. Many experts have questioned Congressman Armey’s contention that it can be done with a 17 percent rate, indicating that a much higher rate would be required. The Treasury Department, in fact, has said that the rate might have to be as high as 24 percent, most of which would be paid by low and middle income workers.
Another major proposal advertised as a flat tax (more false advertising) comes from Representative Dick Gephardt, the Democratic House Minority Leader. Called the 10% Tax, Congressman Gephardt claims that under his proposal, 75% of all taxpayers would pay federal income taxes at a rate of no more than 10%. But his scheme suffers from the same flaw as Congressman Armey’s plan, it doesn’t factor in the Social Security payroll tax.
In its favor (compared to the Armey proposal), the Gephardt plan does maintain more progressivity in tax rates. There are five rates, rising as high as 34% for net incomes above $264,450. The Gephardt plan also retains a deduction for mortgage interest.
A national sales tax is simply an extension of the sales tax mechanisms already in place in 45 states. Proponents argue that replacing the income tax with a sales tax would enable the elimination of the Internal Revenue Service and the billions taxpayers must spend each year preparing their taxes. They also argue that the sales tax has met minimal resistance in the states and is the largest revenue generator for state budgets.
The chief proponent for a national sales tax is Senator Richard Lugar (R-Indiana), a presidential hopeful. He offers a number of additional arguments for replacing the income tax with a sales tax:
Senator Lugar’s arguments aside, there is no proof offered that his predictions for increased productivity and better jobs will come to pass if his plan is implemented. For instance, the recent boom in corporate profits and stock prices would indicate that there is already an abundance of capital investment. Productivity has been increasing as well, but wages remain stagnant. And while it may make a good sound bite to say that Americans are taxed only on what they spend, most Americans have to spend most or all of their income just to maintain their standard of living.
To replace the income tax with a national sales tax is estimated to require a sales tax rate of between 17 and 20 percent. The Cato Institute, a conservative Washington think tank, has suggested a plan which would call for an 18 percent tax on all goods and services. Although 45 states have a sales tax, 41 states also have an income tax. While the sales tax has operated at the state and local level with what proponents call minimum resistance, recent attempts to raise the rate in some states has met with some strong opposition. State and local sales taxes currently range from 4.5 to 10 percent. Resistance to a combined sales tax rate of as much as 30 percent would probably be considerable and could have a major negative affect on the consumer-driven American economy.
The biggest argument against a national sales tax is its regressive nature. Poor and middle income families would be hit hard while the wealthy, with no income tax to pay, could easily afford the high sales tax rates. And like the proponents of other tax reform proposals, those calling for a national sales tax say nothing about replacing or changing Social Security taxes. The combined sales tax and Social Security tax of as much as 45% would be a crushing burden on over 75% of American families. There seems to be little doubt that the implementation of a national sales tax would result in another huge shift in the tax burden from the rich to the middle class and the poor.
And finally, there is the question of collection. Informal, or black market sales would be rampant for some commodities as consumers looked for ways to avoid having to pay the tax. While the implementation of a national sales tax would provide for the elimination of the IRS as currently constituted, a large enforcement mechanism would nonetheless be required to detect and eliminate tax avoidance schemes.
The elimination of the IRS would also have a major impact on the states. Most of the 41 state governments that collect a state income tax depend on IRS information for their income tax collections and pattern their taxes and procedures based on the federal system. Elimination of the IRS would cause those states to have to completely re-think their own systems and the required changes might have a significant impact on their revenue.
The value-added tax, or VAT, is very similar to a sales tax in that it is a tax on consumption. The difference is that while a sales tax is applied only at the point of final sale, a VAT is applied at each stage of production. The VAT is the tax of choice used by most other industrialized countries.
One of the reasons that the VAT is popular among so many other governments is that it is a hidden tax, i.e., it is included in the price of a commodity at point of sale instead of being added on as in the case of a sales tax. But like the sales tax, the VAT is highly regressive. VAT rates of up to 20% account for the high cost that Europeans pay for consumer goods compared to the cost of many of those same items in the United States.
Like the national sales tax, proponents of the VAT promise the elimination of the IRS as a major selling point. While that might be true, the complexity of computing and collecting the tax at each level of production would require a bureaucracy perhaps as large or even larger than the IRS.
The main argument for a VAT, like that for the national sales tax, is that savings would be free from taxation which would then boost investment. But because the VAT, like the national sales tax, is so regressive and covers virtually all goods and services, it places a disproportionate tax burden on low and middle income families. The fact that the United States economy has been consistently stronger than European countries, which have the VAT, would seem to be a powerful argument against either a VAT or national sales tax.
As the name indicates, only income that is spent is taxed under a consumption-based tax. The chief proponents of a consumption-based income tax are Senators Pete Domenici (R-New Mexico) and Sam Nunn (D-Georgia), who have called the bill they introduced in the Senate the Unlimited Savings Allowance (USA) Tax. The theory behind behind a consumption-based tax, like the national sales tax and VAT, is by not taxing savings, investment is encouraged which leads to economic growth.
Unlike the national sales tax and VAT, however, under the USA Tax plan, all income that is spent during the tax year, i.e., wages, dividends, interest and other capital gains, is taxed uniformly at progressive rates. Like the system currently in place, the plan does allow for a standard deduction and personal exemptions. Deductions are also provided for education costs, charitable contributions and mortgage interest.
The Nunn-Domenici USA Tax plan does address a valid need to spur savings among Americans. The United States has one of the lowest savings rates among major industrialized countries. The idea of more savings leading to greater investment and greater economic growth is doubtless a desirable outcome of any tax reform effort.
Another important feature of the USA Tax plan is the education deduction. While the deduction is limited to a maximum of $2000 per family member, it recognizes the critical role of education in maintaining or increasing the American standard of living. With technology changing at an rapid rate, education will be the key to workers’ maintaining their marketability in the global economy of the 21st century.
The tax rates in the USA Tax bill, which range from 19% to 40%, and the upfront personal, mortgage and educational deductions, provide for a degree of fairness not contained in most other reform proposals. But the tax rates are steep, with the 40% rate kicking in above $24,000 in taxable income.
One particularly unique feature of the Nunn-Domenici proposal, unlike the other proposals, is that it deals, in part, with the extreme regressivity of the Social Security tax. The USA Tax proposal reduces the net amount of tax owed by the amount of payroll tax withheld directly from the taxpayer’s wages, which is half of the Social Security tax collected. Unfortunately, this does little to offset the steep rates for middle income workers and does nothing to lift the disproportionate tax burden on low income families.
Federal tax reform is a high stakes game. Any change to the federal tax code is bound to produce both winners and losers among individuals at all income levels. And since most of the 41 states that have an income tax pattern their tax collections after the federal system, any change at the federal level will have a profound impact on many of those state governments and the way they generate and collect revenue.
Unfortunately, none of the major tax reform proposals provide, to any significant degree, relief from the heavy tax burden for middle and low income workers and their families. Most of these election year proposals are, in fact, more regressive than the current system. Replacing the current system with a system that is equally or even more unfair to more than 75% of the workforce does not make sense.
There are major elements in both the Nunn-Domenici USA Tax and the Gephardt 10% Tax which warrant further consideration. Features worth retaining or expanding from the USA Tax are the deductions for a portion of the Social Security tax and education expenses and the incentive for increased saving. The 10% Tax, which lowers tax rates for low and middle income families but includes progressively higher rates for the top 25% of income earners could also be part of a worthwhile reform package.
For reform to be fair, however, the enormous burden that Social Security taxes are placing on middle and lower income workers must be dealt with head-on. If Social Security were really a savings and retirement system, as some of our politicians would still have us believe, it would be a different story. But the reality is that these enormous taxes paid in by workers go directly to cover the current year expenses of the federal government, with nothing but an IOU for future retirees.
Unless Social Security is reformed, as the ratio of current workers to retirees continues to decline, the need to continue to meet current expenses will increase the pressure to raise the tax burden on workers. Such reform will also have to consider the declining share of federal taxes paid by corporations, which has dropped by two-thirds over the past 40 years.
The fairness debate should also include discussion about limits on mortgage deductions and tax-free income from state and municipal bonds. Americans must also factor in how much government they’re willing to pay for. In spite of the rhetoric, there is a need for government to provide a safety net for people and the environment, provide oversight for the economy and protect our national interests abroad. But since the size of government drives the amount of revenue required to support it, the role of government and how much of it there is must be a part of the tax reform debate.
Any move to enact a major change in the federal tax structure should be done only with full and open debate. With all of the misinformation being put forth by tax reform proponents, workers must be particularly dilligent in seeking out the facts. Once a reform proposal is pushed through Congress and signed into law, it will be very difficult to undo. The lesson of the Reagan years should not be forgotten. Workers don’t want to wake up after the next major change to federal income taxes and find that they are left holding the bag -- again!