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Оглавление2. Federal Income Taxes: Funding the Welfare State
The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
—Sixteenth Amendment to the U.S. Constitution, ratified February 3, 1913
The seeds of today’s big-government welfare state were sown during the post–Civil War industrial boom in the United States. Industrialization caused the gap between America’s rich and working-class families to widen, and that growing income disparity was instrumental in creating popular support for a federal income tax. Motivated by a sense of social justice, many Americans, especially western and southern farmers, hammered by the effects of financial crises and deflation during the late 1800s, came to believe that the government should tax the income and wealth of the upper class. A small number of business-owning families had become phenomenally wealthy after the Civil War, and the public resented their political influence, as well as their anti-competitive business behavior, which was viewed as being responsible for the high prices U.S. consumers paid for finished goods. In addition, the financial manipulations of these business tycoons were considered a primary cause of the periodic financial crises that plagued the nation.
The U.S. tax system in place at the time allowed the super-rich to accumulate and retain their fortunes while avoiding major tax burdens. State and local governments relied primarily on property taxes for their revenue, and most wealthy industrialists were not large landowners. The federal government collected the bulk of its revenue from taxes on imported goods (called tariffs, or customs duties), along with excise taxes on tobacco and alcohol. Although upper-class Americans paid those taxes, they did so in amounts that were nowhere nearly as large a proportion of their incomes as was the case for ordinary Americans. Wealthy capitalists earned their incomes as profits from businesses they owned, and that income was not taxed. Another important source of their income was interest earned on bank accounts and bonds, and that wasn’t taxed either. So the super-rich families of the era were able to earn essentially tax-free incomes that middle- and lower-class Americans believed were being earned at their expense. It was a situation rife for creating resentment.
Americans vented their frustration with this state of affairs by supporting a federal tax on personal incomes and corporate profits. That tax came about in 1894 when Congress imposed a 2 percent tax on incomes above $4,000, a very high income at that time. However, in 1895 the U.S. Supreme Court declared the tax unconstitutional on the grounds that it was a “direct tax” that, according to the U.S. Constitution, had to be apportioned among the individual states based on their populations. Thus, the 1894 income tax suffered a quick death and by doing so made its supporters realize that a permanent income tax would require a constitutional amendment. The effort to bring that about took place during the early 1900s and eventually resulted in the Sixteenth Amendment, which was ratified in 1913.
The great irony of the U.S. federal income tax is that the original supporters apparently gave little thought to what to do with the revenue it would generate other than to use it to reduce the federal government’s dependence on tariffs and excise taxes as funding sources. This lack of foresight likely occurred because income tax advocates had no idea how much revenue the tax would actually bring in. In fact, what happened was the income tax—originally created to shift the tax burden away from the middle and lower classes and toward the upper-class capitalists—turned out to be the mother of all cash cows. It brought in unprecedented amounts of revenue, and by doing so had the unintended consequence of allowing the enormous expansion of the federal government. The income tax was instrumental in helping create the huge federal bureaucracy that many Americans complain about today.
Rise of the Super-rich
In 1789, the upper strata of American society consisted of landowners in the South and merchants who were primarily located in the North. For example, Virginians George Washington and Thomas Jefferson were wealthy because they owned large amounts of property in the form of land and slaves, and they earned their incomes primarily from selling crops produced by that property. Wealthy landowners paid property taxes, and those taxes were the major source of revenue to state governments at the time.1
The merchants earned their incomes from exporting goods produced in North America, such as tobacco and rum, and importing finished goods and slaves. These merchants paid tariffs, or customs duties, on imported goods, and that revenue was the primary source of funds for the federal government. The government collected tariffs from the merchants, but consumers actually paid the tariffs in the form of higher prices for the imported goods.
This system of taxation was essentially unchanged until the Civil War (1861–1865). When the conflict erupted, the government needed additional revenue to finance the U.S. military effort. So Congress passed several tax laws that raised tariffs; increased excise taxes on many products, including alcohol and tobacco; and imposed the nation’s first federal income tax. The public was amenable to these taxes because they supported the war. But when the war ended, the taxes were no longer viewed as necessary, so Congress eliminated many of them, including the income tax. It retained the higher tariffs on imports and the excise taxes on alcohol and tobacco. The federal government was once again largely dependent on import tariffs and excise taxes on alcohol and tobacco for revenue. States continued to rely on property taxes.
The rise of the capitalists during the post–Civil War era changed the composition of America’s elite by replacing landowners and merchants with business owners, such as Andrew Carnegie (steel), John D. Rockefeller (oil), J. P. Morgan (banking), and Philip Armour (meat packing). These capitalists owned land and paid property taxes, but those taxes were not a major consideration to them. Tariffs were not a burden either; in fact, many industrialists benefited enormously from import taxes because they offered protection from foreign import competition. So the capitalist business tycoons had an incredible deal: they were able to accumulate unprecedented amounts of income and wealth, largely free of taxes, and were made even richer by the protective tariff that was primarily paid by the middle class.
Vast fortunes allowed the upper class to enjoy lifestyles that were mind-boggling by the standards of the day: multiple mansions, scores of servants, yachts, private railcars, fabulous collections of art and jewelry, grand tours of Europe. A social observer of the era reports that “in the mansion of the genteel captain of industry there must be five or six servants to receive you, as well as a butler. The butler and three servants in livery served you dinner. . . . To serve a cup of tea two servants were necessary” (Josephson 1934, 334). Many of the United States’ so-called 400 richest families led lives similar to European royalty, something that did not go over well with many citizens of the democratic United States.
As the industrial boom continued, public resentment built up against both the wealthy capitalists and the U.S. system of taxation. Farmers, who dominated the politics of western and southern states, accumulated a long list of grievances. They were increasingly bitter over their belief that they paid more than their share of the tax burden. They resented the protective tariff that lined the pockets of the industrialists by causing the high prices the farmers paid for finished goods. They were being decimated by bouts of farm price deflation that occurred during the frequent economic recessions. Farmers attributed these business downturns to financial machinations of eastern capitalists, such as the 1873 crisis set off by the failure of Philadelphia financier Jay Cooke’s bank. Farmers also abhorred the gold standard, the monetary system in place that was blamed for the deflation taking place during the era. The gold standard was widely supported by eastern manufacturing and financial interests who valued “sound money.” Southerners had an additional item on their list of complaints: federal tax revenue was being used to pay increasingly generous pensions to Union army veterans and their families. By the late 1890s, those pensions consumed as much as 45 percent of federal revenue (Brownlee 1996, 31). Former Confederates paid taxes to support those pensions but, of course, did not receive them.
As a result of these and other factors, the Republicans experienced a gradual erosion of political rule. The Democrats, who had western and southern support, won control of the House of Representatives in the 1874 elections and the Senate in 1878. During the ensuing years, Democrats and Republicans traded power back and forth. But when Democrat Grover Cleveland was sworn in for his second term as president (1893–1897), the Democrats held both houses of Congress. Now was their big chance to enact the United States’ first peacetime income tax.
Early Federal Income Taxes
As noted earlier, the first federal income tax was imposed in 1861 to help pay for the Civil War. Viewed as temporary (it expired in 1872), the tax was designed to collect revenue from high-income earners. It exempted the first $800 of income (later lowered to $600) at a time when a typical worker earned about $300 per year. Tax rates were altered twice, varying from 3 percent to 10 percent.2 During the war, the tax provided about 25 percent of federal revenue.3 As an indicator of where high-income earners lived at the time, well over half of the income tax’s revenue was paid by residents and businesses located in New York, Pennsylvania, and Massachusetts (Seligman 1914, 472). Prosperous New York, with roughly 17 percent of the U.S. population, paid 33 percent of U.S. federal income taxes.
When the Democrats resurrected the income tax in 1894, it had strong public support. Included as part of a tariff bill, the first $4,000 of income from all sources, including dividends and interest, was exempted, and income above that amount was taxed at a rate of 2 percent. During congressional debate on the bill, northeastern politicians were opposed, in part because they were aware that their constituents would pay most of the tax. Supporters framed the debate as rich versus poor, where the rich should pay their fair share. Opponents countered that an income tax was a socialistic seizure of property. The bill passed Congress and became law in August 1894.
The following year, a court case involving the income tax was argued before the U.S. Supreme Court. The major issue was whether the income tax was a “direct” tax. If so, then the U.S. Constitution clearly states that it must be apportioned based on states’ populations. In other words, if New York had twice the population of Georgia, then total taxes collected from residents and businesses in New York should be two times the amount collected from Georgia. But at the time, with so much of the nation’s financial wealth and income concentrated in New York, a tax on high-income earners would cause total taxes paid by New Yorkers to be far more than twice the amount paid by all residents and businesses in Georgia. Thus, the tax would not be apportioned according to the two states’ populations, which would violate the Constitution’s clause on direct taxes.
It is not exactly clear what the Framers of the U.S. Constitution meant by the term “direct tax” because many of those involved in writing and ratifying the document had different things in mind. But the term became interpreted in constitutional law as meaning a tax on property or a head tax (an identical tax imposed on each person). The issue in the court case hinged on the following: a tax on property is clearly a direct tax, but what about a tax on the income earned from property?4 Is that a direct tax or an indirect tax? If it was a direct tax, then the 1894 income tax law was unconstitutional; but if it was an indirect tax, then it would be constitutional and not subject to the clause about apportionment based on states’ populations. This issue never came up while the Civil War income tax was in effect, apparently because the members of Congress thought it was an indirect tax.
In a decision that set off a major legal debate that lasted years, the U.S. Supreme Court ruled in 1895 that the income tax assessed on income derived from land was a direct tax.5 Thus, the 1894 income tax law was ruled unconstitutional. Following a rehearing on the case, the Court later stated that taxing income earned on personal property (which includes assets such as stocks and bonds) was a direct tax. Income tax proponents were devastated by these rulings because they meant that the creation of a lasting income tax law would require a constitutional amendment that could take years to bring about.
That effort did take years, in part because the nation’s focus shifted to the debate over the gold standard, which was the major issue in the hotly contested 1896 national election. During his campaign, Democratic presidential candidate William Jennings Bryan made his famous “Cross of Gold” speech, claiming that farmers were being crucified by the gold standard and the deflation it caused. The Republicans and their candidate William McKinley firmly backed the gold standard. It was East and Midwest versus West and South, and McKinley won a close race while congressional Republicans managed to retain their majorities in both the House and Senate. With the Republicans in control, the gold standard was retained and the income tax was moved to the back burner. Yet public support for an income tax continued.
Moving toward a Constitutional Amendment
The protective tariff was another major political issue during the late 1800s and early 1900s. Westerners and southerners continued to blame tariffs for high finished-goods prices, thereby making eastern capitalists wealthy at their expense. At the same time, many Americans, regardless of where they lived, believed that corporations and wealthy Americans should pay income taxes. President Theodore Roosevelt, who occupied the White House from 1901 to 1909, never advocated tariff reform, but in 1906 he did come out in support of an income tax.
Three years later, incoming president William Howard Taft pressed the Republican Congress to modify the tariff law, and the result was the 1909 Payne-Aldrich Tariff Act. Passed after a frenzy of lobbying by various manufacturing groups, the bill lowered tariff rates on some items, but in many cases they were goods that were not imported, or imported only in small quantities. Meanwhile, well over half the tariffs were raised. Congress had hardly “reformed” the law, and everyone knew it. In disgust, a group of congressional Republicans split from their party and aligned themselves with the Democrats. President Taft tried to defuse the party revolt by coming out in support of a corporate profits tax and recommending that Congress approve a constitutional amendment making an income tax possible. These bills passed Congress, apparently because many Republicans in the House and Senate viewed them as the political cost of keeping the protective tariff in place (Carson 1977, 78–80).6
The proposed amendment would give Congress the authority to impose an income tax that was not apportioned among the states according to population. In 1909, Congress approved the following and sent it to the states for ratification:
The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
Many have speculated about whether the Republicans actually wanted the states to ratify the amendment, contending that it was political cover for the upcoming 1910 congressional elections. If so, the strategy failed miserably, because the Republicans lost the House in 1910 and the Senate in 1912. Also in 1912, Theodore Roosevelt ran for president as a third-party candidate, which split the Republican vote and allowed Democrat Woodrow Wilson to emerge victorious. Once again, the Democrats controlled both the federal executive and legislative branches.
The Amendment Passes
Garnering considerably more support in the East than contemporary observers predicted, the Sixteenth Amendment was ratified on February 3, 1913. President Wilson was inaugurated in March, and during the summer Congress debated an income tax law that was ultimately included in the Underwood Tariff Act. Tariff rates were dropped to their lowest levels since before the Civil War. The new income tax was supposed to make up for the lost tariff revenue, and this part of the bill was short and simple, taking up only 14 pages of U.S. law. The four-page tax form (including instructions) defined income as coming from several sources, including wages, dividends, interest, business profits, and capital gains. It allowed deductions for expenses, including interest, taxes, casualty losses, depreciation, and uncollectible debt. All information was self-reported, and after determining net income, the following tax table applied for married couples:
| Income | Tax Rate |
| $0–$3,999 | 0% |
| $4,000–$20,000 | 1% |
| $20,001–$50,000 | 2% |
| $50,001–$75,000 | 3% |
| $75,001–$100,000 | 4% |
| $100,001–$250,000 | 5% |
| $250,001–$500,000 | 6% |
| Greater than $500,000 | 7% |
Source: www.irs.gov/pub/irs-utl/1913.pdf.
At the time, a middle-class family earned an annual income of around $500–$700 per year, so the vast majority of Americans were exempt from the tax.7 Largely for this reason, the arrival of the personal income tax was greeted with little public fanfare.
More Revenue Needed
The first tax returns were filed in the spring of 1914, and just a few months later World War I began in Europe. Initially, most Americans wanted no part of the conflict, but attitudes changed in 1915 when the German navy torpedoed the passenger ship Lusitania, killing 1,198 people, of whom 139 were Americans. This event inflamed anti-German feelings in the United States, and the U.S. federal government responded by increasing expenditures on defense goods. By 1916, higher defense spending combined with falling revenue from customs duties (due to fewer imports from war-torn Europe) caused the government to incur a sizable budget deficit. More revenue was needed, and the income tax was suddenly, conveniently available.
The Emergency Revenue Act of 1916 raised the tax rate on incomes above $4,000 from 1 percent to 2 percent, and pushed the top rate to 13 percent on incomes above $2 million. Several other taxes were also raised, including excise taxes on alcohol and tobacco and taxes on the profits of war munitions manufacturers. In addition, a federal inheritance tax was imposed. However, the deficit continued to expand because of the ongoing military buildup. So Congress raised rates again in 1917, just months before the United States finally declared war. The War Revenue Act of 1917 lowered the tax-exempt income level from $4,000 to $2,000 for a married couple and established tax brackets that ranged from a tax rate of 2 percent to 50 percent on incomes over $1 million. In addition, tax rates were increased on corporate profits and inheritances, and several excise taxes were raised.
The 1917 War Revenue Act was a significant event because, as Witte notes, “the crucial result was the discovery of how easily and quickly large sums of revenue could be raised through the income taxes” (1985, 81). The next year another Revenue Act (1918) was passed that returned the exempt income amount back to $4,000, but elevated the bottom tax rate to 12 percent and the top rate to 77 percent on incomes above $1 million. Higher tax rates in conjunction with the booming war economy caused federal revenue to soar. Here are federal revenue data from 1915 to 1920:
| Year | Revenue (millions) |
| 1915 | $683 |
| 1916 | $761 |
| 1917 | $1,100 |
| 1918 | $3,645 |
| 1919 | $5,130 |
| 1920 | $6,648 |
Source: U.S. Bureau of the Census (1975, 1106).
During these years, taxes on individual incomes and corporate profits accounted for about two-thirds of total revenue (Faulkner 1960, 598). The top rates were now punitive, a fact recognized by both President Wilson and Treasury Secretary Carter Glass. They believed that high tax rates could have an adverse affect on economic activity by reducing the incentive to earn income (Witte 1985, 88).
In summary, World War I was a very important event in the history of the U.S. income tax because it starkly demonstrated the income tax’s ability to raise major amounts of revenue quickly. In addition, it marked the first time the government instituted punitive tax rates. It was also the era when the income tax replaced excise taxes on tobacco and alcohol as the major source of federal revenue.8
Changing of the Guard
World War I and its aftermath cost the Democrats dearly in the 1918 and 1920 elections. They lost control of Congress in the 1918 elections, and incurred further damage by losing more congressional seats along with the White House in 1920. The Republicans assumed control of the government in March 1921 and held power for the remainder of the decade.
A major economic policy figure during the 1920s was Pittsburgh industrialist Andrew Mellon, who served as U.S. treasury secretary from 1921 to 1932. Mellon agreed with Woodrow Wilson’s and Carter Glass’s claim that high income tax rates reduced the incentive to earn taxable income, but Mellon took the argument a step further. He believed that if the disincentive to earn income was strong enough, then high tax rates could yield less revenue than if rates were lower. In other words, lowering income tax rates might cause people to earn enough additional income to cause an increase in tax revenue. This view was an important part of Mellon’s case about why income tax rates should be reduced, and congressional Republicans and Presidents Warren Harding and Calvin Coolidge were amenable to it.
The result was a series of tax laws passed during the 1920s that reduced income tax rates, including lowering the top rate from 73 percent to 24 percent. Many economists consider these lower tax rates to be one of the reasons that the U.S. economy performed so well during the decade. The income tax was also made more broadly based by reducing the income exemption so as to raise the number of taxpayers (although the tax was still directed at high incomes). In the early 1920s, the income exemption for married couples was reduced from $4,000 to $2,500.9 Given the tremendous economic growth that took place during the decade (per capita income rose about 30 percent from 1920 to 1929), ever-increasing numbers of Americans paid taxes.10
Meanwhile, the federal government was shrinking in relation to the overall economy. In 1920, federal outlays were $6.6 billion, which represented 7.3 percent of that year’s economic output. By 1929, federal outlays were $3.8 billion, or 3.5 percent of economic output.11
Raising Taxes during the Depression
The Great Depression (1929–1941) ranks among the most significant events ever to occur in the United States. The severity of the initial economic recession (1929–1933) is important to the history of the income tax because it caused plummeting incomes, which resulted in a huge decline in tax revenue. Consequently, the federal government experienced sizable budget deficits. The prevailing view at the time was that budget deficits should be avoided, and one way to balance the budget was to raise revenue. Mellon’s idea that lower tax rates could yield more revenue was thrown out the window. The government instead opted for higher tax rates.
President Herbert Hoover started the tax increase ball rolling in 1932. Figure 2.1 shows the top and bottom federal income tax rates from 1913 to 2011. The budget deficit was a major issue in the 1932 presidential election between incumbent Herbert Hoover and challenger Franklin Roosevelt, and both men pledged to balance the budget. In 1932, before the election, Hoover supported higher tax rates as a way to raise revenue, and Congress passed the tax increase in June. Figure 2.1 shows that tax rates rose substantially for high-income taxpayers as the top rate went from 24 percent to 63 percent. The corporate profit tax rate was increased as well. These higher tax rates, however, did not eliminate the budget deficit because the economy continued to plunge in 1932, in part because the higher tax rates reduced both spending and the incentive to earn income.
Figure 2.1 TOP AND BOTTOM FEDERAL MARGINAL TAX RATES ON INCOME, 1913–2011
SOURCES: 1913–2002, IRS, www.irs.gov; 2003–2011, Tax Foundation, www.taxfoundation.org.
The 1929–1933 recession had a huge impact on the fortunes of the country’s two major political parties. The Republicans went from enjoying substantial congressional majorities in the late 1920s to very thin margins (one seat in the Senate, two in the House) following the 1930 elections. The coup de grâce came in 1932, when the Democrats gained 12 Senate seats and nearly 100 House seats. The Democrats also won the presidency that year when Franklin Roosevelt scored a landslide victory over Hoover. The incoming president’s plans for economic stimulus included various New Deal programs for work relief and welfare that would require significant funding. Since the government’s budget was already in deficit and Roosevelt intended to spend even more, the plan was to raise tax rates to generate additional revenue. The public, many of whom blamed the Great Depression on a failure of capitalism, supported higher taxes so long as the increases were targeted at the upper-class capitalists.
Figure 2.2 shows federal revenue and spending data from 1929 to 1940. Roosevelt’s New Deal began in March 1933, and during the next few years, the programs required ever more funds. The economic recovery combined with the higher income tax rates that took effect in 1932 caused revenue to rise, but not fast enough to eliminate the federal budget deficit. So beginning in 1934, Congress passed and President Roosevelt signed a series of tax laws that substantially raised rates on personal income, corporate income, and inheritances. For example, the 1936 Revenue Act maintained the $2,500 exemption for a married couple, but raised tax rates to a maximum of 79 percent on incomes above $5 million. Corporate income was taxed at a maximum rate of 15 percent, plus a tax was instituted on undistributed profits. Francois Velde estimates that for households earning more than $4,000, this law nearly doubled the average tax rate from 6.4 percent to 11.6 percent (2009, 19). Another major tax change during the decade was the institution of the Social Security tax in 1937.12 The Social Security Act (1935) imposed a 2 percent payroll tax on the first $3,000 of wage income beginning in 1937. That year, the new tax accounted for 10.5 percent of federal tax revenue (Velde 2009, 19).13
Figure 2.2 FEDERAL RECEIPTS, SPENDING, AND BUDGET SURPLUS, 1929–1940
SOURCE: Economic Report of the President (1963, p. 238). Data are for fiscal year July 1–June 30.
Except for the Social Security levy, taxes assessed on income during the Depression were directed at high earners. This feature of the tax laws provided the upper class with a strong incentive to avoid paying taxes. After all, these income tax increases were not temporary war-funding measures; instead they were peacetime measures that might be in place for a long time. Wealthy Americans—some of whom considered Roosevelt (who was descended from an upper-class New York family) a “traitor to his class”—hired lawyers and accountants to figure out ways to avoid paying.14 For example, business owners could compensate themselves in the form of nontaxable fringe benefits instead of taxable wages and business profits. Corporations did similar sorts of things; one common method was to move operations offshore to avoid paying taxes. During congressional hearings in 1937, members of Congress were shown photographs of small shacks on Caribbean islands that served as corporate headquarters for tax purposes (Carson 1977, 120).
High tax rates also increased the opportunity for politicians to hand out more political favors in the form of tax breaks. Taxpayers subject to high rates had a strong incentive to appeal to their political representatives for relief. Members of Congress were able to hand out benefits in the form of tax exemptions for various activities, the implied quid pro quo being that the beneficiaries would lend political support and campaign contributions to their representatives and senators. Such an arrangement is less likely to occur if tax rates are low because income earners have a smaller incentive to avoid taxes.
When World War II broke out in Europe in 1939, President Roosevelt was concerned that the conflict would eventually engulf the United States. So he pushed for additional taxes to fund a military buildup. Rates were raised again in 1940, and that year the exempt amount for a married couple was lowered to $2,000. Then in 1941, the married exemption was lowered to $1,500, and the bottom tax rate was raised from 4 percent to 10 percent. The middle class was now paying federal income taxes.
World War II
Funding the enormous U.S. military effort during World War II led to a major expansion of the income tax. Just days after the December 7, 1941, Japanese attack on Pearl Harbor, the United States was formally at war with Japan, Germany, and Italy. And it was painfully clear to Americans that carrying out military operations in both Europe and the Pacific would require an enormous amount of physical and financial resources. There was considerable discussion about how this undertaking would be financed, and the Roosevelt administration decided that taxes would play an important role.
The income tax law was altered in 1942 to capture even more income earners. The marriage exemption was lowered to $1,200; for single earners, the amount was $624. Tax rates were raised again, the bottom rate to 19 percent and the top rate to 88 percent (on incomes above $200,000). This huge tax increase was initiated to help support the war effort: more income earners would now pay taxes, and those already paying would be subject to substantially higher rates. President Roosevelt hailed the new law as “the greatest tax bill in American history.”15 The following year, payroll withholding was instituted; this is the system under which income taxes are withheld from paychecks throughout the year. Previously, taxpayers paid their entire tax bill when filing their returns.
As was the case during World War I—only this time on a much larger scale—the combination of the lower income exemption, the higher tax rates, and the booming war economy caused both the number of taxpayers and taxes paid to soar. During fiscal year 1939, 7.5 million income tax returns were filed and $890 million was collected in taxes. In 1945, 49.9 million returns were filed and $17 billion in income taxes were collected (U.S. Bureau of the Census 1975, 1110). Corporate income taxes (including the tax on “excess profits”) also soared by a similar order of magnitude, from $1.2 billion in 1939 to $14.9 billion in 1944 (U.S. Bureau of the Census 1975, 1109). However, despite this surge in revenue, it was not enough to keep pace with wartime expenditures. From 1942 to 1945, the federal government incurred budget deficits totaling $184 billion (Council of Economic Advisers 1962, 207, 272).16 During World War II, tax revenue funded about 45 percent of U.S. federal expenditures (R. A. Gordon 1974, 85).17
The Postwar Era and the Cold War
At the conclusion of prior U.S. military conflicts, the federal government reduced defense spending and lowered tax rates. This process took place after World War II, but to a lesser extent than had been the case before. Beginning in 1945, the federal government downsized but remained larger than it had been just before the war, and much larger than before the Great Depression. This expanded government was partly because the New Deal had created several permanent federal spending programs and regulatory agencies. The other major cause was change on the international political scene.
When World War II ended, the Soviet Union’s Red Army occupied Eastern Europe. As a counterweight to the communist threat, the United States maintained military bases in Western and Southern Europe. The United States also maintained a presence in the Pacific, with bases in various locations, including Japan and Okinawa. U.S. concerns over communist aggression proved correct when in 1949 the Soviets cut off West Berlin from West Germany, which precipitated the Berlin Airlift. Also that year, the communists won the Chinese civil war. The following year, the North Korean communists attacked South Korea, which ignited the Korean War. The Cold War was on, and it would require a permanently large U.S. military.
Table 2.1 contains data on federal employment, both total employees and the number of federal workers employed in national defense. In 1929, the U.S. federal government employed 579,500 workers, and during the Great Depression, the number expanded because of the New Deal programs. Defense employment grew slightly faster than overall federal employment, rising from 18 to 21 percent of federal employment. World War II caused a surge in the number of federal employees, largely for defense. At the war’s end in 1945, the federal government had 2.6 million defense workers, the vast majority of them in uniform, which constituted 69 percent of all federal employees. The military was then reduced, but by 1949 it still accounted for 42 percent of federal employment. During the Korean War (1950–1953), defense employment expanded to about 50 percent of federal workers, then remained above 40 percent during the ensuing Cold War era.
Table 2.1 FEDERAL EMPLOYMENT IN SELECTED YEARS, 1929–1964 (THOUSANDS OF PAID EMPLOYEES)
| Year | Federal Employment | Federal Defense Employment | Defense as % of Total |
| 1929 | 579.5 | 103.1 | 18 |
| 1933 | 603.6 | 101.2 | 17 |
| New Deal | |||
| 1934 | 698.6 | 133.1 | 19 |
| 1939 | 953.9 | 196.0 | 21 |
| World War II | |||
| 1941 | 1,437.7 | 556.1 | 39 |
| 1942 | 2,296.4 | 1,291.1 | 56 |
| 1945 | 3,816.3 | 2,634.6 | 69 |
| Post WWII | |||
| 1949 | 2,102.1 | 879.9 | 42 |
| Korean War | |||
| 1951 | 2,482.7 | 1,235.5 | 50 |
| 1953 | 2,558.4 | 1,332.1 | 52 |
| Post Korean War to Pre-Vietnam War | |||
| 1958 | 2,382.5 | 1,097.1 | 46 |
| 1960 | 2,398.7 | 1,047.1 | 44 |
| 1964 | 2,500.5 | 1,029.8 | 41 |
SOURCE: U.S Bureau of the Census (1975, p. 1102).
The permanently larger government provided a reason to maintain the World War II tax rates, although the Republicans did try to lower them. They took control of Congress after the 1946 elections and promptly passed tax rate reductions. But President Truman vetoed these changes, citing as his reasons the budget deficit and concerns that unemployment and inflation would rise after the war (Witte 1985, 131–44). Congress was unable to override his veto. By 1948, however, a postwar depression had not appeared, and the federal government was running a budget surplus. With two of Truman’s reasons no longer valid, congressional Republicans were able to attract enough Democratic votes to override another Truman veto and enact a modest tax reduction.
Despite these reductions, tax rates were still much higher than they had been during the 1920s. These higher rates, combined with the expanding postwar U.S. economy, provided the funding for another major expansion of the federal government.
The Growth of Transfer Payments
Figure 2.3 shows U.S. federal outlays from 1929 to 2009. The series that excludes transfer payments (the dotted line) consists of outlays for defense, the post office, foreign affairs, general government, and spending on infrastructure (roads, harbors, airports, etc.). The solid line includes transfer payments, which are primarily Social Security and Medicare benefits, but also federal poverty programs (including Medicaid) and interest on the debt.
Figure 2.3 FEDERAL GOVERNMENT OUTLAYS INCLUDING AND EXCLUDING TRANSFER PAYMENTS, NOMINAL VALUES, 1929–2009
SOURCE: Federal Reserve Bank of St. Louis, FRED data set.
As Figure 2.3 makes clear, the major growth in federal spending during the past several decades has been in transfer payments, which reflects the rise of the welfare state. The two series diverged in the 1950s, and the gap continued to widen during the decades that followed. Major sources of transfer payments’ growth have been Medicare and Medicaid, both created in 1965, and Social Security benefits, which became more generous during the 1960s and 1970s. More recently, increased numbers of retiring baby boomers (with millions more in the pipeline) have led to further expansion of transfer payments.
The data plotted in Figure 2.3 are not adjusted for inflation, nor do they account for the fact that the U.S. economy has expanded over time. Figure 2.4 makes these adjustments by plotting federal outlays as a proportion of annual U.S. gross domestic product (GDP), which is the standard measure of the nation’s economic output. In 1929, federal spending was 2.7 percent of GDP, of which 1.6 percentage points were transfer payments. The 1930s’ New Deal programs caused these values to rise, and then during World War II, the government soared in size, peaking at almost 50 percent of economic output in 1944 and 1945. Transfer payments began diverging from the other outlays after the Korean War. Since then, federal spending excluding transfer payments has declined relative to economic output; in fact, the series is now roughly where it was in the late 1940s. Meanwhile, transfer payments rose to nearly 12 percent of GDP by the mid-2000s.
Figure 2.4 FEDERAL GOVERNMENT OUTLAYS INCLUDING AND EXCLUDING TRANSFER PAYMENTS, AS PERCENT OF GROSS DOMESTIC PRODUCT, 1929–2009
SOURCE: Federal Reserve Bank of St. Louis, FRED data set.
Table 2.2 shows various components of federal receipts and outlays during two recent years. In 2007, federal receipts were 19.4 percent of GDP, with the individual income tax accounting for 8.8 percentage points and the Social Security and Medicare taxes comprising 6.6 percentage points. That same year federal outlays for transfer payments—Medicare, Social Security, income security, and net interest—were 11.8 percent of GDP. The 2007–2009 recession caused tax receipts to decline relative to income, to 16.2 percent of GDP by 2010. Meanwhile, a federal spending binge caused outlays to expand to 25.8 percent of GDP, of which 14.8 percentage points were transfer payments. Since receipts were 16.2 percent of GDP while outlays were 25.8 percent, the government borrowed the difference (9.6 percentage points of GDP).
Table 2.2 FEDERAL RECEIPTS AND OUTLAYS AS PERCENT OF GROSS DOMESTIC PRODUCT, 2007 & 2010
| Receipts | |||||||
| Year | Total Receipts (%) | Individual Income Tax (%) | Corporate Income Tax (%) | Social Security & Medicare Tax (%) | Other* | ||
| 2007 | 19.4 | 8.8 | 2.8 | 6.6 | 1.2 | ||
| 2010 | 16.2 | 6.7 | 1.4 | 6.5 | 1.6 | ||
| *Other receipts include gift and estate taxes, excise taxes, customs duties, and Federal Reserve deposits. | |||||||
| Outlays | |||||||
| Year | Total Outlays (%) | Defense (%) | Medicare (%) | Social Security (%) | Income Security (%) | Net Interest (%) | Other** |
| 2007 | 20.6 | 4.2 | 2.8 | 4.4 | 2.8 | 1.8 | 4.7 |
| 2010 | 25.8 | 5.2 | 3.4 | 5.3 | 4.6 | 1.5 | 5.8 |
| **Other outlays include international affairs, health, and post office. | |||||||
| Federal Deficit | |||||||
| Year | |||||||
| 2007 | 1.2 | ||||||
| 2010 | 9.6 |
SOURCE: Federal Reserve Bank of St. Louis, FRED data set.
In other words, in 2010 the federal government collected about 16 cents of every dollar of income produced in the United States, and spent 25 cents (of which 15 cents were transfer payments). This shortfall required federal borrowing of almost 10 percent of GDP produced that year. The federal government has evolved into a monolith that taxes “Peter” (those with jobs or earning high incomes, or both) to pay “Paul” (primarily senior citizens receiving Social Security and Medicare benefits). In effect, this is an intergenerational transfer scheme that taxes workers and pays older retirees. Retirees, of course, feel entitled to these benefits because they have paid taxes into this system while they worked, and the current workers accept the arrangement so long as they believe benefits will be available when they retire.
The huge expansion of transfer payments has required higher tax rates to help fund them. Recall that in 1937, the original Social Security payroll tax rate for OASDI (old-age, survivors, and disability insurance) was 2 percent. Figure 2.5 shows the payroll tax rates for OASDI and Medicare hospitalization insurance.18 The Social Security tax has risen more than sixfold (from 2.0 percent to 12.4 percent), whereas the Medicare tax went from 0.7 percent when first instituted in 1966 to the current rate of 2.9 percent. Another difference between the two levies is that the Social Security tax has an annual income limit beyond which the wage earner pays no further taxes (in 2010, the amount was $106,800), whereas the Medicare tax has no income limit.
Figure 2.5 SOCIAL SECURITY AND MEDICARE TAX RATES, 1937–2010
SOURCE: www.ssa.gov/OACT/ProgData/taxRates.html.
Our Modern Federal Tax System
In 2010, the U.S. federal tax system collected about 90 percent of its revenue from taxes assessed on various types of income. Of that amount, 41 percentage points came from the personal income tax, another 40 percentage points from Social Security and Medicare taxes, and 9 percentage points from the corporate income tax. The remainder of the federal government’s revenue that year (the 10 percent of total revenue that did not come from taxing income) was primarily from taxes on gifts, estates, excise taxes, and customs duties. Therefore, at the federal level, by far the most important item being taxed is income. Since wage income is the major component of household income, work is the predominant economic activity being taxed.
Most of the revenue from federal taxes on income is collected from a fairly small group of taxpayers. In the case of the personal income tax, the reason is because the first several thousand dollars of income are exempted (in 2010, the amount was $18,700 for a married couple with no dependent children), and after that amount is reached, tax rates increase along with income. Even though current top marginal tax rates are considerably lower than they were in the early 1960s, high-income families pay a disproportionate share of personal income taxes. For example, in 2008, the top 1 percent of U.S. income earners (who earned 20 percent of all income) paid 38 percent of the federal personal income tax, whereas the top 5 percent (who earned 38 percent of all income) paid 58 percent of the total.19 For the Social Security and Medicare taxes, the effect is less pronounced because they tax labor income at a constant rate, and the Social Security tax has the income ceiling beyond which earners pay no more taxes that year. Yet it is still true that higher-income earners pay most of the taxes. In 1997, the top 30 percent of wage earners paid an estimated 58.7 percent of all Social Security taxes (Wilson 2000, charts 1 and 2).20
Tax systems structured this way can result in a tyranny of the majority, where the majority of voters impose their will on the minority. To see how that situation can occur, consider a simple case of a country with 100 voters who earn varying amounts of income. This country’s income tax law exempts enough income so that only the top 25 income earners pay income taxes (or pay a disproportionate share of taxes). Thus, the voting population consists of 75 voters who pay no taxes or who pay only small amounts and 25 high-income workers who pay nearly all of the taxes. Now suppose this country’s government is running a budget deficit (perhaps because of burdensome transfer payments to retirees) that causes political leaders to consider higher tax rates as a way to raise additional revenue. A likely outcome is that the 75 voters who are paying small amounts of taxes will support higher tax rates on the 25 who are already paying. The minority (the high-income earners) will oppose this arrangement, but they don’t have the votes to block it. Of course, the situation in the United States is considerably more complicated than this simple example, but the gist of the argument is correct. It helps explain why tax increases are often directed at taxpayers who are a minority of the population. This argument applies to both high-income earners and cigarette smokers, regardless of the rationale offered by their proponents.
Defending the Transfer Payments Status Quo
The U.S. transfer payment expansion took place with widespread public support, and it was funded with income taxes. Social Security and Medicare have been popular programs, in part because many Americans appreciate having a federal “safety net” of pension income and health care insurance during their retirement years.21 Another reason for their popularity is that many beneficiaries collect more during retirement than they paid in taxes while they were working.
Table 2.3 contains calculations on benefits and taxes paid for the Social Security OASDI and Medicare under different income scenarios. These numbers are taken from Steuerle and Rennane (2011) and assume that the income earners paid Social Security and Medicare taxes and that those funds were kept in an account that earned an inflation-adjusted interest rate of 2 percent. The calculated benefit amounts are the funds necessary upon retirement (while still earning 2 percent interest) to pay the beneficiaries’ Social Security and Medicare benefits during their expected retirement years. For example, Case 1 describes a single man who earned the average income each year during his working career (ages 22–64). He retired in 2010 at the age of 65 and began collecting Social Security and Medicare. Assuming he lives the average life expectancy, he loses on Social Security ($290,000 in taxes paid versus $256,000 in benefits) but does well with Medicare ($55,000 paid in taxes versus $161,000 in benefits). The woman in Case 2 earned the same wage as the man in Case 1, which is why she pays the same amount in taxes, but she collects more benefits because of a longer life expectancy.
