Читать книгу Preserving Democracy - Elgin L Hushbeck - Страница 11

Taxes and the Welfare State

There is no part of the administration of government that requires extensive information and a thorough knowledge of the principles of political economy so much as the business of taxation.

Alexander Hamilton⁷

I t ALL SEEMED SO SIMPLE and straight forward. The war had lasted seven years, and was in fact the most expensive the country had ever waged to that point in its history. Over the course of the war, the national debt had more than doubled. The war had been fought, at least in part; to defend a remote area governed by the country, and in fact had been started by those living in that area.

Compounding the problem was the fact that those who lived in that area, while prosperous, paid only one-fiftieth of the taxes compared to the average citizen in the rest of the country. Making matters even worse, large amounts of tax money from this area were being lost each year due to tax evasion. What better way to pay off the debt incurred during the war than by raising taxes on the very people who had most benefited from it, especially given the fact they were not in any event paying their fair share to begin with.

But it wasn’t quite so simple. Taxes never are, especially to those who have to pay them, and abstract concepts of fairness normally do not have as much weight as the more concrete reality that suddenly one has to do with less because now they have to give more money to the government than they did before. Even those who did not have to pay the new taxes were split. Dr. Samuel Johnson, one of the leading thinkers of this period, wrote defending the actions of the government saying that taxation was “the supreme power of every community” and that it was, in fact, “considered, by all mankind, as comprising the primary and essential condition of all political society.”⁸ Yet, his close friend and biographer, James Boswell, disagreed with the government’s action, believing that the newly taxed were “well warranted to resist.”⁹

And resist they did, which only brought on a more determined effort to collect the taxes on the part of the government. Before long what had been a resistance to paying increased taxes, became a resistance to the government in general, and then a desire for independence from that government and then finally another war, this one a war for independence. So, what had started as a means for Great Britain to pay off its debt from the Seven Years War^c (1756-63), ended in the American War of Independence.¹⁰

A Strange Paradox

It is a strange paradox that taxes are the lifeblood of the government while at the same time they are one of its greatest dangers. During the Middle Ages, government, if it could be called that, was financed by the wealth of the king or ruler. But as the state evolved, and the need for a standing army and more consistent government services grew, the King had to seek additional sources of revenues. Taxes became the primary funding source. This was a necessary and important precursor to the establishment of democracy. After all if the King pays for the government, how can you get rid of the King? So taxes are not only important; they are required for a democracy.

Yet while they are required, taxes present one of the greatest single dangers for a democracy, particularly a democracy that seeks to better the lives of its citizens. The more a democracy tries to do, the more it costs, and the more it tries to meet those costs, the more it places itself in danger. This paradox is the reason for Alexander Fraser Tytler’s famous quote,

A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy followed by a dictatorship.¹¹

The reason for this paradox has long been recognized. Plato speaks of this process as resulting from the leaders’ desire to please. In order to please, the leader needs money to pay for programs that will help the people. To get the money one has to go to those who have it. Thus the ruler will “deprive the rich of their estates and distribute them among the people.”¹²

Naturally the rich will not appreciate their wealth being taken from them and as a result they will resist these taxes. Soon the citizens of the government are split into two groups: the rich, i.e., those who have the money that government wants, and the people, those who want whatever the money buys. If the rich resist too much, the ruler will “charge them with plotting against the people.” In order to defend themselves against the rich, the people always get,

some champion whom they set over them and nurse into greatness… This and no other is the root from which a tyrant springs; when he first appears above ground he is a protector… How then does a protector begin to change into a tyrant? Clearly when he does what the man is said to do in the tale of the Arcadian temple of Lycaean Zeus. ¹³

Plato’s view does not translate directly into the 21^st century. Few know what the man did in the tale of the Arcadian temple of Lycaean Zeus.^d Yet while the details and specifics deal with Ancient Greece, not modern America, the underlying principles have not changed. Plato was concerned with the origin and rise of tyranny, what we would now call a dictatorship or totalitarian government. The tyrant starts out as one protecting the people, either actually or at least as one who rises to power on a claim of protecting the people. But the bottom line for Plato is that tyranny “has a democratic origin”¹⁴

The Core Problem

At its core, the problem that threatens democracy is the same one that most families face with their home budgets – there always seems to be more month than money. Except for the very rich, and perhaps even for them, there is never quite enough money to do everything that you would like. Even the rich are limited to some extent. While they can afford a lot, they can’t afford everything. At least, that is, if they wish to remain rich, as many former rich have found out.

For most this is not just a problem of luxuries, there are medical bills to pay, braces for the kids, educational costs, not to mention food, clothes, the roof over your head, utility bills, and even the cost of transportation to and from work so that you can make the money to pay all the bills. This all goes under the general heading of The Rat Race. In short, there never seems to be quite enough money and most families have to live within some sort of budget, either a structured and planned budget, or an unstructured one where you basically spend until you run out of money and then wait for the next paycheck.

Democracies face many of these same problems. This is particularly true of the modern welfare state that seeks to better the lives of its citizens through a whole range of government programs. Not only are there the traditional functions of government such as the military and the courts, it is now pretty much taken for granted by many that government should be involved in a whole range of other activities such as building roads, education, health care, the arts, broadcasting, and scientific research, to name just a few. Like the family budget there never seems to be enough money to do everything that people, or at least their politicians, want.

When a family faces a money crunch, the options for additional money are limited: families can either borrow, or they can change their employment situation by either getting a raise, a better paying job, or getting additional jobs. Some families try to get around the shortage of money by borrowing the extra money they need. If the borrowing is for a major purchase that they will be using for a long period of time, such as a house or a car, this can make sense. But if they are using credit cards simply to add to their monthly income, while it will work in the short term, it will only be a temporary fix. Credit cards are not a good option in the long term.

For a short period of time, one can artificially increase their disposable income by using credit cards. Need an extra $200 per month to make ends meet? Transfer $200 per month of spending onto credit cards and the problem is solved; but only temporarily. As credit cards are used, their balances go up. And as balances go up so do minimum payments. Before long that extra $200 per month is consumed by $200 in monthly payments to credit card companies that now must be made. In short, using credit cards creates new bills that must be paid and in the long term this only adds additional burdens to the monthly budget. Thus for individuals, the only real long-term solution to additional money is either a raise, a better paying job, or an additional job.

Governments can also borrow money, but this has a similar effect as with individuals. Again for major long-term projects this can make sense. It can also make sense when dealing with short-term problems with long term implications such as wars or recessions. Government also has the additional rationale that when the Government borrows money for long term projects such as a road, the money will be paid back by those using the road over its lifetime, at least theoretically.

An option that governments have, which families don’t, at least not legally, is to simply print the money they need. However, this is not a very good option, as simply increasing the number of dollars only makes each dollar worth less. In short you have inflation, and while you have more money, everything now costs more.

One other option governments have is to raise taxes. This is somewhat like an individual asking for a raise. However whereas an employee can ask, governments demand under penalty of law. Therein is the danger, for taxes act as a burden on the economy. If this is already clear to you, you can skip the next section and go directly to Taxes in Action. However if it is not clear, or if you question this, then continue reading.

Foundations

The foundation of our entire economic system is providing goods and/or services for a fee. Businesses either succeed or fail, based on whether they are providing goods or services that people want, at a price that they are willing to pay.^e The businesses that do this well tend to make a lot of money, the ones that don’t, do not stay in business very long.

When someone gets a job, they are to some extent a business providing a service.^f Their ‘customer’ is their employer. If they can provide a service that an employer is willing to pay for, then they get a job. Now just as some businesses are able to charge more for their goods and services, likewise some jobs pay more.

Discussion of the specific price difference involves going into the theory of supply and demand and is beyond the scope of the discussion here, but in short to get a better paying job, or to have a successful business, a person must find a need that is not being met, or not being met well, and then address that need in a way that is better than the competition. We will look more in depth at competition in the next chapter. But this boils down to a question of simple value. If a business can deliver more value per dollar they will get more business. If not, people will go elsewhere.

An employee’s service is of value to the employer because it helps the business to meets the needs of its customers more effectively. In addition, as the employee has more disposable income, they are then able to purchase more goods and services. The businesses that people purchase from are able to generate more revenue, and thus are able to purchase more goods and services, hire additional employees, or distribute the additional funds to their owner who can now purchase more goods and services. In short, it is a classic win-win situation where everyone does better. The economy grows.

The problem for government is that it does not provide goods and services in this fashion. Many people can think of stores they like to shop in, or businesses they like to deal with. But who likes to deal with the government? When was the last time you heard somebody say they wanted to go to the DMV or to the IRS when they were not being forced to go by government itself? While government does provide goods and services they do not compete in the marketplace for business, but rather, often require people to be their “customers.”

A business charges for its services based on people’s willingness to pay. This is how a business gets its money. From these monies the business must pay for its costs such as raw material, labor, taxes, etc. What is left over, if anything, is profit for the owner(s).¹⁵ Again if there is a lot of profit, the owner(s) will probably want to invest back into the business, so that it grows even larger. If there is not enough profit, the business fails. As a result there is a strong incentive for businesses to provide services that people want, and at a price they are willing to pay. Even when they are doing so successfully, they must be on guard for others who may come along and do it better.

No such incentive exists for government. Most people deal with the government only when they have to, and avoid it as much as possible. When people do deal with government, the service is generally not good.^g This is not because the people who work for government are not as smart or as talented, but because they operate in a different system with different incentives and objectives.

If government revenues were based on a willingness to pay, government would cease to function very quickly. In a few areas, such as the National Parks, people probably would still go because they wanted to, but the vast majority would ‘go out of business’ very quickly. After all, how many people would want to go to the DMV and pay to have their car registered because they liked the services they provide and the way they provided them? As such, government services must be mandated and paid for in the form of taxes or required fees.

A classic example of how this leads to different approaches can be seen in the area of transportation in which there are both government and private choices. When privately run modes of transportation, such as the airlines, don’t have enough money, their approach is to try to attract more customers by providing better service, or by cutting fares. Lower fares mean more riders, more riders means increased revenues.^h

When government run means of transportation such as local bus systems or subways have similar problems, their normal response is to raise rates. The reason for this difference is that they have different incentives, and therefore they have different responses.

Be it a private business, or a government office, both are focused on satisfying those who provide the money to pay the bills. In a private business, that is the customer. If the customer is not happy, they will take their business, and their money, elsewhere. But for a government office while the person coming into the office could be deemed the customer they are not the one who provides the money to pay the bills, except in the general sense that they are taxpayers. But even as individual taxpayers they have very little say in how the government spends tax dollars. In addition, most of the time they cannot take their business elsewhere. For a government office, the ones who provide the money to pay the bills are the politicians who appropriate the funding for the program. They are the ones that must be kept happy.

Ultimately the problem with taxes is that they act as a burden on the economy. As we saw earlier, a business or an employee can get increased revenue by providing additional value for a lower cost and the net effect grows the economy. Taxes have the opposite effect; they reduce the spending ability of those being taxed while not providing any direct additional value, or at least a value that is less than the amount paid. If your taxes increase, your ability to spend is reduced.

I am not saying that nothing government does has value, it does. However, this is an issue of value in relation to cost. Given the competition in the marketplace, a primary concern for business must be providing the best value for the lowest cost, lest customers go elsewhere. For government there is no competition and as a result government tends to be very wasteful.

Thus there is little incentive to keep costs down, and in fact for most of government, the incentive is reversed. An agency or department that works hard to reduce costs and save money, will be “rewarded” by having their budget cut, while those that waste money will often have their budgets increased. This is why so much of government spending occurs at the end of the fiscal year, as large amounts of moneys are spent to demonstrate that they were really “needed.” Furthermore the government budgeting process often has built in automatic yearly increases, which further insulates government from any pressure to cut costs.

Thus government does not “price” their services based on a willingness to pay in the market place but instead based on how much money they think they will need. Because of these different incentives, and ways of thinking, any value provided by government will come at a greater cost, often a much greater cost than that provided by private business.ⁱ Taxes are then set accordingly.

While getting a better job has a net positive effect on the economy, taxes, because of the inefficiencies, act as a burden on the economy that will slow economic growth.

Taxes in Action

This effect has been demonstrated time and time again when tax increases depressed the economy and thus failed to bring in the expected amount of revenue as a result. While many examples of this effect could be given, one clear example of this occurred in California during the early 1990s.

Like many states California spent freely during the good times of the 1980s. During the decade, economic growth was strong and as a result revenues to the state increased at a very healthy eight percent per year. With all that money flowing in, politicians spent freely, so freely in fact that, as often is the case, the increases in spending outstripped the increases in income. While income increased at an average rate of eight percent per year, spending increased at about eleven percent per year. As a result the state budget grew from $32.8 billion in 1980 to $72.6 billion by 1989, an increase of 121 percent.

Now while the economy was strong, California could get away with this. The problem was that such economic growth can’t last forever. When the economy eventually did begin to slow, so did revenues and California ended up with a huge budget deficit of $8 billion, the largest state budget deficit in the country at that time.¹⁶

In response to the deficit, California did what governments tend to do when there is a shortage of money; they ‘asked’^j the taxpayers to give them more. While in this case they did make some ‘cuts’ in the state budget the majority of the shortfall in revenue was to be made up by new taxes. Thus California passed a mixture of sales tax and income tax increases on ‘the rich,’ i.e., on those in the upper tax brackets, and these tax increases were supposed to produce $7 billion of the $8 billion needed to close the deficit.

While it may have looked good on paper what the politicians failed to take into account was the negative effect that taxes have on the economy. Rather than bringing in the expected $7 billion in new revenues and thereby closing the budget deficit, the increased taxes caused the economy to slow even more. In fact it slowed so much that not only did the state fail to increase revenue by the expected $7 billion, revenues actually went down by $1 billion per year over the subsequent two years.¹⁷

To make matters even worse, while the rest of the nation was recovering from the recession that had initiated the problem in the first place, the burden from the 1991 tax increase slowed California’s recovery such that real per capita personal income fell 5.6 percent over the next three years.¹⁸ In short, increasing taxes, rather than bringing in more money, cost the state money and reduced people’s incomes.

Update: It would seem that California politicians learned little from this experience. After getting out of this hole, politicians once again went on a spending spree as if nothing had happened. When the current economic down turn hit budget deficits once again soared, to become once again the largest in the country. Yet rather than the $8 billion deficit that they faced last time, this time the short fall exceeded $40 billion.¹⁹

Lessening The Burden

Now if increasing taxes can depress the economy thereby resulting in less tax revenues than expected, should not cutting taxes conversely stimulate the economy? If the economy is stimulated won’t that mean that the government will get more money in tax revenues than it had expected; that the tax cuts will not “cost” the government as much as predicted?^k

The answer is yes and this also has many historical examples, such as the Kennedy tax cuts in the 1960s, the Reagan tax cuts in the 1980s, and more recently the Bush tax cuts that took effect in 2003. As a result of the Bush tax cuts, for example, by mid 2005 the economy had recovered such that revenues were 14 percent higher than what had been expected, while the budget deficit was reduced by nearly $100 billion more than had been projected.²⁰

While it is not always the case, some tax cuts have resulted not only in more revenues than had been predicted but in actual increases over even the pre-tax cut projection. Part of the Bush tax cuts, involved cutting the capital gains tax from 20 percent to 15 percent. At the time the Congressional Budget Office (CBO) predicted this cut in the capital gains tax would correspondingly reduce the amount of money the government would receive. Without the tax cut, the CBO estimated that the government would receive $186 billion in revenues from capital gains taxes over three years.²¹ But when the tax cut was passed the CBO reduced this to $147 billion; a reduction of $39 billion dollars because of the lower rates.²²

Once the tax cuts actually took effect the results were somewhat different. Rather than the reduction in revenues that the CBO had expected, revenues actually increased, not just over the $147 billion predicted following the tax cuts, but even over the $186 billion that had been predicted before the tax cuts were passed. By the time that the CBO finished its analysis of the results, the CBO noted that the actual revenues received from capital gains taxes over the three years following the tax cuts were $216 billion. This was $30 billion more than had been expected prior to the tax cuts and $69 billion more than expected as a result of the tax cuts.²³ In this case cutting taxes actually resulted in more money.

Theoretical Limits

Now there is, at least in theory, a limit on a democratic government’s ability to raise taxes, and that is the people’s willingness to pay them. If taxes are increased too much, people will complain, politicians will get worried, and the new programs the taxes were supposed to pay for will be seen as unnecessary. At least this is the theory.

The Founding Fathers understood this well. One of the main issues that sparked the Revolution had been taxes, and the subject of taxation was a major concern for writers of the Constitution. Federalist Papers 30-36 were devoted to this subject. The subject of taxation deserved this much treatment, for as Hamilton observed early in Federalist #30 that,

Money is, with property, considered as the vital principle of the body politic; as that which sustains its life and motion and enables it to perform its most essential functions.²⁴

Not only did they recognize it as a necessity, they also recognized its dangers. Madison noted that,

the apportionment of taxes on the various descriptions of property is an act which seems to require the most exact impartiality; yet there is, perhaps, no legislative act in which greater opportunity and temptation are given to a predominant party to trample on the rules of justice.²⁵

Hamilton wrote on this subject that,

The ability of a country to pay taxes must always be proportioned in a great degree to the quantity of money in circulation and to the celerity with which it circulates.²⁶

Then in a later Federalist paper Hamilton added,

There is no part of the administration of government that requires extensive information and a thorough knowledge of the principles of the political economy so much as the business of taxation. The man who understands those principles best will be least likely to resort to oppressive expedients, or to sacrifice any particular class of citizens to the procurement of revenue. It might be demonstrated that the most productive system of finance will always be the least burdensome.²⁷

The concern was not just that taxation would become too burdensome on the economy, but that the burden would not be fairly distributed. “Every shilling with which they overburden the inferior number is a shilling saved to their own pockets.”²⁸ The tax the Founding Fathers designed was an attempt to strike a balance between the needs of the government for revenue, and the dangers inherent in taxation.

A major change to this balance occurred during the early part of the 20^th century, with the passage of the 16^th amendment to the U.S. Constitution, which allowed for the progressive income tax system. The problem was further compounded when the collection of taxes was made much easier in 1943 with the establishment of the current income tax withholding system. The combination of these two changes has allowed government to tax at ever-growing rates while greatly reducing the opposition of those paying the taxes. The resulting effect on government’s ability to tax has been dramatic.

How Much Do We Even Pay?

The Federal Government’s budgeted spending for fiscal year 2008 was $2.9 trillion. This is such a large sum that for most people it is completely incomprehensible. It is just a number with no real meaning, other than that it is really, really big. When this is combined with increases due to inflation and growth in the population, it is hard to get an understanding of just how much government has grown.

To make matters even worse, the current tax code is extremely complex. So many things are taxed in so many ways, and there are so many exceptions, deductions, and credits that it is virtually impossible for anyone to know how much they actually pay in taxes even to the federal government, much less state, county, and city. Then there are the hidden taxes, taxes passed on to you in the cost of the goods and services you purchase such that it is virtually impossible to find out exactly what you pay in taxes even if you wanted to.

As a result of all of this complexity and confusion there is a real disconnect between what government spends and what we actually pay in taxes. For example, if the 2008 budget had been $2.8 or $3.0 trillion would you know what impact that would have had on your taxes? Would it have any at all? And yet that is a difference of $100 billion dollars.

In an attempt to try and get some sort of handle on this, every year for the last 30 years, an organization called the Tax Foundation has waded through state and local government economic reports to come up with its own summary on government spending and just how much it costs us. In order to put all this confusion into some sort of perspective, they have come up with a way of measuring this, which they call Tax Freedom Day.

Tax Freedom Day is calculated by taking government figures on income and taxes to determine what percentage of income on average that is taken by government to pay for all the programs it funds, and thus get one overall “effective tax rate.” This is then used to determine “Tax Freedom Day,” the day in the year on which you theoretically have earned enough money to pay all your taxes for that year, and thus the point at which you are free to start working for yourself, instead of for the government. Given the vast complexities of the tax system, this is not a good measure of any one person’s individual taxes, but it does give a good idea of the relationship between the taxes people pay and the spending that government does.

More importantly for the discussion here, it very clearly shows the overall trend in taxes from year to year, and from decade to decade; and the trend is both very clear and very worrisome. For the early part of the nation’s history, as the Tax Foundation Report notes,

The United States has traditionally been a low tax nation. From the founding of the country until the early part of the twentieth century, the United States was in part defined by its mistrust of government power and its correspondingly low taxes.²⁹

As such, it would appear that the checks and balances the Founding Fathers put in place to control the dangers of taxation worked pretty effectively.

At the beginning of the 20^th century, Tax Freedom Day was January 22^th, which meant that you had to work the first 22 days of the year to pay your taxes, after that, everything you earned in the other 343 days was left over for your own expenses, housing, food, vacations, whatever you wanted. This was an overall effective tax rate of 5.9 percent between federal, state and local taxes.

As can be seen in Figure 2.1, Tax Freedom Day declined slightly until 1918, when it jumps sharply, which coincides with our entrance into World War I. Given the increased government expense during a war this is not too surprising. After the war, however, while Tax Freedom Day did drop from its wartime high of 53 days, it only dropped to 35 days in 1923 and again in 1925. This new “low” was about 60 percent higher than the pre-war level. Following this post-war low, Tax Freedom Day started a steady increase.

The next big jump occurred during the 1930s with the Great Depression, when Tax Freedom Day exceeded its World War I highs jumping to the 50s and then even to the low 60s reaching a new high of 66 days in 1940. In this light the reason for the depression lasting so long becomes much clearer. At the very time the economy was struggling, government greatly increased the tax burden, making it impossible for the economy to recover.

Then came the start of World War II. At this point levels of taxation were already at historic highs, three times their pre-World War I levels, but the demands of the war meant it had no place to go but even higher still. By 1943, a new high was set with Tax Freedom Day occurring on April 4, 94 days into the year for an effective tax rate of 25.7 percent. This marked a whopping 327 percent increase over the tax burden at the start of century.

Given the demands of World War II, this is somewhat understandable. But following the war, while there was some drop, it was not very much. By 1949, Tax Freedom Day had been cut back to only 81 days, over double its pre-depression value, and four times the lows of the early part of the century. By the following year it was back into the 90s where it spent the rest of the decade normally exceeding even its World War II highs.

In 1960, Tax Freedom Day exceeded 100 days for the first time in American history. Following Kennedy’s tax cuts it dropped back down hitting a “low” of 98 days in 1965, a low that still exceeded the highs reached during World War II. Following this new “low,” it started up once again heading for new highs. In 1966, it passed 100 for the last time, topping out at 114 in 1981. Following Regan’s tax cuts it again dropped back to a new “low” of 107 by 1984. But then once again, it started to climb ever higher and higher.

As we started the 21^st century, Tax Freedom Day set a new record, occurring on May 3, 123 days into the year, with an effective tax rate of 33.6 percent. Following the Bush tax cuts, Tax Freedom Day once again dropped back to a “low” of 106 days by 2003, but, as it has so many times before, it started up once again rising to 113 days in 2008.^l

This represented an astounding 459 percent increase in taxes over the century. More importantly this new high in 2000 occurred at a time of peace and economic growth. The country was not at war. Even the cold war had been over for a decade. There were no other unusual events to require extra spending by government, and while the economy was slowing and heading for a recession, this had not been recognized and so was not the reason for any of the spending. This was the new “normal” level of spending. When we did slide into a recession and then later went to war following the attacks of 9/11, the need for government spending once again shot up from this new low.

Looking over the entire century a few things become clear. Before World War I the tax burden on the American people remained fairly low and in fact even declined slightly. The major increases in the tax burden that occurred between 1917 and 1945, occurred during times of major problems facing the government: World War I, The Great Depression, World War II.

Another clear trend, however, is that once these problems had passed, while there normally was some movement back towards the pre-problem tax burden, it was for the most part marginal and temporary. So while new taxes may have been justified by clear problems (though the higher taxes actually lengthened, not shortened, the depression) once the justification went away, the taxes for the most part remained.

Since World War II there has on the whole been a fairly steady increase in the overall burden. While this was in some part due to the Cold War with the Soviet Union and conflicts such as Korea, and Vietnam, these do not explain the steady increases. Nor do they account for the increase during the 1990s when the Cold War was over and the country had both peace and prosperity.

Another thing the graph shows is that while we have had what were called “major tax cuts” at times, the effect of these cuts have actually been fairly minor and on the whole have been only temporary. Even after the tax cuts, the overall total tax burden increased 459 percent over the century. This is before we take into account that the first decade was a period of decline where the effective tax rate went from 5.9 percent in 1900 to a low of 4.9 percent in 1909, while the years 1906 and 1907 had 5.1 percent rates, and the rate for 1910 was 5.0 percent. That was nearly a 17 percent decrease. If the later increase is compared with the low for the century instead of the rate in 1900, the increase would be an amazing 585 percent!

Looking Ahead

Such a phenomenal increase cannot be maintained. If taxes go up only 300 percent during this century, we would be at a 100 percent effective tax rate by the end of the century. At such a rate, all of your time would be spent working to pay your taxes with nothing at all left to pay for your own living expenses! This is clearly impossible. A more rational projection would be to take the rate of increase in taxes over the last 100 years and project this out into the future. I have done this in Figure 2.2, and it shows that if this trend were to continue we would reach a 100 percent tax rate somewhere around the year 2200.

But again this is impossible, as a 100 percent effective tax rate is impossible.^m The point here is not to show that we will reach a 100 percent effective tax rate in any particular year. Any number of assumptions could have a very large effect on this projection.

Rather it is to show that the trends that have existed over the last 100 years cannot be maintained. At some point, long before a 100 percent effective tax rate is reached, the burden on the economy will become too great, and the system will collapse.

Unfortunately, no one knows where this collapse will take place. We are on a ‘stroll into the desert’ and the point of no return is approaching. But we don’t know if it is close, or if it is still some distance away. We know only that we cannot continue in this fashion forever. We certainly will not be able to maintain this rate of increase in taxes for another 100 years. And yet as we look to the future the need of the government for even more money to fund programs such as Medicare and Social Security is vastly larger than even today’s record highs; yet politicians are forever promising more.

A major problem with all this is that a primary reason for the growth in the tax burden is that government has become more and more involved in daily life, providing more and more services that people then come to depend on. The real danger is that once the tax burden reaches the point that the economy can no longer support it, the economy will begin to decline. At that point the only thing that can be done to revive the economy will be to reduce the burden that is the cause,. However since the economy is declining, the demand for government services will be increasing at the very time government needs to cut back.

Frankly if the history of the last century is any indication at all, in all likelihood, the burden will actually be increased even more, and as a result further hastening the collapse of the economic system. As the Great Depression showed, an increase in taxes in a time of economic problems only prevents any sort of recovery. In short, if the trend

continues we are headed for exactly the type of failure predicted by Alexander Fraser Tytler’s quote at the beginning of this chapter,

with the result that a democracy always collapses over loose fiscal policy followed by a dictatorship.³⁰

The Problem With Theory

Now this, of course, is based on the assumption that the trend continues. As was pointed out earlier, in theory, in a democracy, if the tax burden becomes too high, the people can always demand that their taxes be reduced. But herein lie two additional problematic trends. While over the last century the tax burden was steadily increasing, on the one hand the tax code was also becoming more complex and difficult to understand, and on the other it was becoming increasingly more progressive.

A tax code that is complex and difficult to understand is a problem, for how can we know if our taxes are too high if we do not know what we are actually paying in taxes? This problem is further compounded by withholding, as many people do not really look at their gross pay or how much the government is taking in taxes. They simply focus on how much they get to take home, particularly if they have direct deposit; out of sight out of mind. Probably the quickest way to start a tax revolt would be to stop withholding, and make people write a check to the government each pay period, for this would remind people how much they pay every time they get a paycheck.

Percentiles Ranked by AGI*	Adjusted Gross Income Threshold on Percentiles	Adjusted Gross Income Share Percentiles	Percentage of Federal Personal Income Tax Paid
Top 1%	$313,469	20.81%	37.42%
Top 5 %	$128,336	35.30%	56.47%
Top 10%	$92,144	46.01%	67.33%
Top 25%	$55,225	67.15%	84.01%
Top 50%	$27,682	87.01%	96.09%
Bottom 50%	<$27,682	12.99%	3.91%

*Adjusted Gross Income

Percent of Income and taxes for 2000 by Income.

Table 2.1

The problem with the second trend, that taxes have become more progressive, can be seen in Table 2.1, which is from IRS data provided by the Joint Economic Committee and it shows the distribution of taxes for the year 2000.³¹ As can be seen in this table, the bottom 50 percent of people filing returns during that year paid only 3.91 percent of the taxes. This is down from 6.46 percent in 1986, or a 39 percent reduction. The top 25 percent increased their share from 76.02 percent to 84.01 percent in the same period. Thus the overall tax burden was not only increasing, but it was increasingly being shifted onto an ever smaller percentage of the population.

Now at first glance this may seem like it is a good thing. Those who have the most money carry the greatest burden while those who can least afford it, pay the least. While in general this is not a bad concept, the problem is that it creates a dangerous imbalance and threatens one of the main checks in the system.

Figure 2.3

This imbalance can be seen in Figure 2.3, Income and Taxes which shows the share of income earned in relation to the share of income taxes paid. As this figure shows the first 90 percent of those filing income tax returns pay a smaller share of income taxes than their share of income, while the top 5 percent paid a higher share of income taxes than their share of income.

This imbalance can be seen more clearly by looking at the share of taxes paid minus the share of income earned, as is done in Figure 2.4. As is clearly shown in the figure the first 90 percent of income earners pay less of a share of income taxes than the share of income they earn while those above 95 percent pay more.

As we said earlier, if taxes get too high, people can always vote to lower them. But what does this mean when the majority of people are paying only 3.91 percent of all income taxes? And this is only personal income taxes. This does not take into account the monies paid by corporate income taxes or other forms of taxes that individuals do not have to pay, or at least pay directly. Thus the real percentage is even lower.

Figure 2.4

Since the average income tax rate for the lowest 50 percent is only 4.6 percent,³² they are very likely to have a vastly different view on whether taxes are too high than those in the top 25 percent whose average rate is 19.09 percent or those in the top 1 percent whose average rate is 27.45 percent.³³ And again this is only federal income tax.

Thus why shouldn’t the majority of people continue to demand and vote for more and more government services and programs, when they pay only 3.9 percent of the bill? There is little incentive against such demands, and in fact, great incentive in favor of them doing so. If these three trends, i.e., a difficult and confusing tax code, steadily increasing tax burden, and a tax burden that is increasingly progressive continue, then disaster is inevitable.

On the positive side there are periodic calls for tax cuts, some of which are actually passed. But as we have seen, these only slow the growth in taxes somewhat and temporarily. Once the burden of taxes is reduced, the economy begins to grow strongly, and in a growing economy the burden of taxes becomes a less important issue. In addition, as the economy grows revenues to the government increase, monies which politicians of both parties are all too eager to spend.

Tax Cuts For The Rich?

As a result, even with periodic tax cuts, the overall trend of the tax burden is to increase. To make matters worse, to get these cuts passed in the first place, those proposing the cuts have to try and mitigate the charge that inevitably comes from opponents: that the tax cuts are “for the rich.” In order to avoid these charges, the tax cuts normally result in an even more progressive tax system.

Thus it was with Bush’s recent tax cuts, “the highest percentage tax cuts go to the lowest income Americans.”³⁴ While such cuts do improve the short term situation by temporarily easing the tax burden, they do so at the cost of further unbalancing the system by shifting taxes onto an ever smaller percentage of taxpayers making further cuts even harder. After all, how can you have meaningful tax cuts that are not “for the rich” when the rich are paying the vast majority of the taxes?

This shifting of the burden is at times disputed, but was clearly seen in a 2004 CBO study on the effects of the Bush tax cuts. The CBO projected that if the Bush tax cuts had not occurred; the top 20 percent of those filing income tax returns would have paid 78.4 percent of the total income tax burden in 2004. Yet, as a result of the Bush tax cuts, this increased nearly 4 percentage points to an even higher 82.1 percent. On the other hand, those in the lowest 40 percent saw their share of income taxes drop from -0.1 to -2.8 percent.³⁵ Yes those last numbers were negative.

How can you have a negative percentage of taxes paid? Easy; it means that because of the various credits that are given to low income earners, on average more money was paid out to the people in this group than was received in taxes. Thus on average, for the lowest 40 percent of those filing returns, the income tax was actually a source of additional income rather than something they had to pay.ⁿ So while cutting overall taxes, the Bush tax cuts further increased the imbalance by shifting the burden of taxes away from the majority and onto an ever smaller minority.

This was done to avoid the charge of “tax cuts for the rich.” Yet the reason this charge is effective is because of the very progressive nature of the income tax system. If the rich pay the majority of the taxes, then any effective tax cut will be a tax cut for the rich. As a result, any tax cut is attacked with complaints of how many government programs could be funded with the money ‘given’ to the rich by the tax cuts, and how the rich are not paying their ‘fair share.’

There are numerous problems with such claims. For one, just who ‘the rich’ are is rarely specified. This is because it is much more effective to leave this term vague. For example if the rich are the top 25 percent of income earners, then as we saw in Table 3.1 ‘rich’ starts at $55,225. I would guess that few if any who make this income level think of themselves as rich. Even if we limited this charge to only those with the highest incomes, there are still some problems.

For example, one IRS study reported on the top 400 income tax returns for the years 1992-2000. One of the interesting findings was that most of the people were not on this list very long. Of the 400 people in any given year, only about half could expect to be on the list the following year. Only 21 people were on the list for all nine years, while 1,679 people fell in to this category only once. Thus people who do really well in one year are treated by the IRS as if they have been rich all of their life, and will remain rich for the rest of their life.

This points out another problem with the concept of ‘rich’ when it comes to income taxes. This is because when we think of the rich, we normally think of people who have lots of money. But having money and earning money are not quite the same things. After all, would we really consider someone who works very hard one year and as a result with salary, overtime and bonuses, etc, earns $100,000, to be as ‘rich’ as someone who does not work, but has millions of dollars invested, such that they earn $100,000 from these investments? Probably not; but to the IRS, they are both equally ‘rich.’

In fact, from the IRS’s point of view, the person who works hard to earn $100,000 may be ‘richer’ than the person who has millions of dollars. This is because what is important to the IRS is not just income, but taxable income. A multi-millionaire with all their money invested in tax-free bonds, while they may have considerable income, may have little or no taxable income and thus may pay little in taxes.

In any event, the real problem is that this tax-the-rich rhetoric feeds into exactly the problem with democracy stated by Plato that was mentioned earlier in this chapter. Again Plato said that the leader, in order to gain favor, would “deprive the rich of their estates and distribute them among the people.”³⁶ This also goes to the heart of Tytler’s statement that,

the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy followed by a dictatorship.³⁷

The European Example

Thus, based on the long-term trend that has existed for the last 100 years, we are heading for disaster. The ever increasing tax burden will continue to burden the economy until it can no longer maintain economic growth, at which point we will enter into an economic decline. Once this happens, the only way to correct the problem would be to reduce the tax burden, but given the increasingly progressive nature of the tax system and the growing dependence on government programs this will be extremely difficult, if not impossible for as the economy declines, the need for these very services will increase. As such the system will collapse into chaos.

To get some idea of the problems that will face the government at this time, one only has to look at Europe. Most of the countries in Europe have very large welfare states, and the correspondingly high taxes to support them. The burden on the economies in many countries of Europe is so high that they are increasingly falling behind. Jean-Philippe Cotis, chief economist at the Organization for European Cooperation and Development, based in Paris, warned in early 2006 that,

At current trends, with demographics the way they are, the average U.S. citizen will be twice as rich as a Frenchman or a German in 20 years.³⁸

When politicians have attempted even modest reforms to address the growing stagnation, the results have frequently been thousands taking to the streets in protests and in some cases riots. For example, in March 2006, the French Government tried to address the growing problem of unemployment among younger workers that had reached a rate of 24 percent. The problem was that, given the very high cost of benefits and the difficulty in firing problem workers under French law, employers were very reluctant to hire younger workers with little or no track record. ³⁹

The solution by the government was to allow employers to fire a younger worker without cause any time during their first two years. This would take away the risk of hiring a younger worker that was making employers so reluctant to hire them, and thereby reduce the high unemployment rate for that age group. As one news story described the result in their opening paragraph,

PARIS – French students and unions insisted Sunday they will go ahead with a one-day national strike and more street protests unless the government withdraws a youth labor law that has sparked violent demonstrations and shut down universities.⁴⁰

In other European countries, attempts at any sort of economic reform to reduce the burden stifling their economies is met with strong resistance. In 2004, an estimated 495,000 people turned out in Berlin, Cologne and Stuttgart to oppose economic reforms proposed by German Chancellor Gerhard Schröder.⁴¹ The German protests were part of a much larger series of protests across Europe as people resisted their governments’ attempt to reduce the burdens that were stifling their economies.⁴² At the very time the changes are most needed, public pressure by those who have come to depend on the services and protection of government can make the necessary changes extremely difficult, if not impossible to carry out. It is possible Europe might have already passed the point of no return.

What Can Be Done

How can this be avoided? The best way to fix the system is to restore the checks and balances and this can only be done through some sort of tax simplification. As we have seen, the current system is so complicated that it is very difficult for people to know what they actually pay, and impossible to know how the taxes they pay relate to government spending.

For most people, taxes are one of their largest if not the largest expense. Yet, unlike their other expenses, few really know how much they have to pay in taxes. Frankly many people, and probably most, do not even know how much they pay just in income tax. They only know how much their refund was. But their refund is only a measure of how much they overpaid during the year, not how much they paid. Thus many see tax time as a time when they get money, not a time when they have to pay.

There are many proposals, such as replacing the current progressive income tax system with a flat tax, where everyone pays the same rate after personal deductions. This would retain some of the progressive nature of the tax code, so that those who earned more would still pay more. The key, however, would be that everyone would pay the same rate.

To keep the math simple let’s say there was a 15 percent flat tax rate with a personal deduction of $10,000. A person who made $35,000 would first subtract the personal deduction of $10,000 leaving $25,000 in taxable income. At a 15 percent rate this would result in a tax of $3,750. On the other hand, if a family of three made the same amount of income, they would have a personal deduction of 3 x $10,000 or $30,000. This would leave a taxable income of $5,000, with a resulting tax of $750. If a single person made $100,000 they would do the same. They would subtract their personal deduction of $10,000 leaving $90,000 in taxable income for which the tax would be $13,500. So even with a flat tax you would maintain the principle that those who make more pay more.

Yet since the rate is the same, any increase in tax rates would affect all, or at least all of those with incomes that were above the amount allowed for personal deductions. Government could still increase the progressive nature of the tax system by increasing the personal deduction, but even here all would have the same deduction. In the current system, not only do the rates go up as you make more, but you also lose deductions at higher incomes, resulting in more taxable income and thus higher taxes paid.

Another benefit of such a simplified system would be a much closer link between the tax rate that people pay and the spending that government does. In the current complex system, with its many different rates and vast number of deductions, it is not at all clear how spending increases affect taxes. But with a flat tax, it would be possible to estimate how much a spending increase would affect the tax rate.

Again to keep the math simple, let’s say that the 2008 budget of $2.9 trillion was met with a 15 percent tax rate. If everything else remained the same, increasing the federal budget to $3.0 trillion would mean increasing the tax rate to 15.52 percent in order to keep up. On the other hand, cutting federal spending to $2.8 trillion could result in decreasing the tax rate to 14.48 percent.

While it would not be quite this simple, for as we saw above changes in taxes effect the economy, the key point is that it would at least be possible to talk somewhat intelligently about the relationship between government spending and taxes. With the current system government spending is almost completely disconnected from taxes. Even when there is a discussion of how a new program will be paid for, rarely does this translate down into terms such that the average citizen could understand how much more they are being asked to pay.

Yet with this system, if spending went from $2.9 trillion to $3.0 trillion, the family of three mentioned above who was paying $750 would see their taxes go up $25.86 to $775.86 The single person making $100,000, on the other hand, would see their taxes go up $466 to $13,966. This would be a vast improvement over the current system, where it is virtually impossible to tell what effect such an increase would have, and as a result, there is seemingly little if any link between our taxes and government’s spending.

Another Way

Another proposal is called “The Fair Tax”⁴³ and it scraps the income tax altogether, replacing it with a national “consumption” or sales tax. Under the Fair Tax there is an equivalent of the personal deduction that was seen in the flat tax, but here it takes the form of a ‘rebate’ for a portion of the tax paid in advance each month.

At the beginning of each month everyone would receive a check from the government reimbursing them for a portion of the sales taxes they could be expected to pay that month. The rebate would be determined based on poverty level so those at or below the poverty level would not pay tax. In fact for those below the poverty level this would be additional money. For those above the poverty level, they would effectively be paying taxes only on money they spent beyond the poverty level.

Again there would still be a level of progressiveness in that the rich would pay more simply because they consume more. More importantly, like the Flat tax, the rate and the rebate (deduction) would be the same for everyone. As such, this would have the same benefits of simplicity and of linking taxes to spending as did the Flat Tax. There are additional economic benefits to such a tax, but they are outside the scope of this discussion.^o

The key aspect of both of these approaches is that if taxes needed to go up to pay for additional government programs, they would go up on everyone. The majority of people would not be able to impose higher taxes on a minority to pay for government programs they want, but do not wish to pay for themselves. Thus either of these proposals would restore one of the key checks and balances needed to preserve democracy. With the increasing visibility of taxes and the clearer link between taxes and spending, the steady growth in taxes seen over the last century would quickly be brought under control.