Many people think their taxes are too high and that the tax system is unfair. While those who favor individual liberty might find this encouraging, the specific reasons for discontent are not entirely positive. Many Americans think the current system is unfair because of how it affects income distribution and intervenes in markets. That is, most Americans think that the tax system should redistribute and intervene—just in a different way.

There are many arguments against using taxes to redistribute income and reallocate resources. Economists like Gordon Tullock and Mancur Olson have explained why we should expect much special-interest bias and waste (rent-seeking) in large activist government. Public-opinion polls indicate that people oppose special-interest bias and waste in the tax system. However, lots of Americans see the system as a means of partial economic planning for the achievement of “social goals” like poverty reduction or pollution abatement. In his classic book, The Road to Serfdom, F. A. Hayek explained why comprehensive economic planning would ultimately destroy individual liberty. Tax policy in the United States does not aim at comprehensive planning, but it does serve as a vehicle of partial planning. A close examination of public discontent over taxes and the tax system itself reveals that the use of income taxes as a means of partial economic planning has already resulted in a loss of individual liberty.

An Ipsos poll last year noted that 58 percent of Americans believe the middle class pays too much in taxes. Fifty-four percent believe the poor pay too much. Sixty percent believe the rich do not pay enough. Others complain that the top 5 percent of income earners pay too much. Still others say the top 5 percent get too many tax breaks. Small businesses and the self-employed pay too much, while large businesses pay too little, according to this poll.

Complaints also target the tax code’s complexity and lobbyist influence. These are valid complaints. The Standard Federal Tax Reporter has 66,498 pages of federal tax rules. These rules are incomprehensible. A slight majority of Americans hired a professional to work on their tax returns this year. This work was done by 1.2 million professionals and generated revenue of $2.4 billion for H&R Block alone. Some people think that a flat tax rate of 17 percent would solve this problem. Other people favor consumption taxes or value-added taxes. Still others favor heavy tariffs to protect American industries.

Thus most of the discontent with federal taxes and spending is with the current form of fiscal redistribution and fiscal activism, not with redistribution and fiscal activism itself. Most Americans disapprove of the current fiscal structure of government, but not because they oppose any form of high and complex taxes, which large activist governments require. To put it simply, most Americans want a tax system tailored to their own political or ideological beliefs, one that would tax different people according to what they each see as fair.

One might say that this is simply democracy in action. In a democratic society different people assert different points of view and enlightened public debate resolves these differences. There are sound reasons to doubt this is the case. In The Road to Serfdom, Hayek argued that democracy functions best when it is limited to enforcing a few general rules of conduct that do not favor any particular group or individual. Rules concerning which side of the street we should drive on are uncontroversial. Rules against violent crimes are essential to the functioning of any society. Constitutional rules guaranteeing free speech and free association are necessary for promoting freedom. A democracy that enforces a few simple and common-sense rules can function without threatening individual liberty.

Problems arise when we attempt to use democracy toward specific ends. The difference here is between enforcing general rules of conduct without aiming at any particular outcomes and activist government that tries to bring about particular outcomes. A limited government would need to raise revenue for only its limited purposes. An activist government uses taxes to achieve broader purposes: to redistribute income from less to more “deserving” people, to protect the environment, to protect American jobs, or to achieve some notion of “social justice.” We do not, and can never, agree on which of these priorities is the most important. As Hayek wrote, any attempt at such social planning will derive from an incomplete set of values. Different people will have different views on such matters. The attempt to form a single plan necessarily favors some views at the expense of others. Only a few can see their views put into action through tax policy.

Consequently, the attempt to plan even part of society through tax incentives or redistribution will be based on a “partial scale of values” that will leave most people discontent. People who think that the tax system would be fair if their views were adopted should realize that each of their views is only one among many and that most differences over policy can never be resolved in a society of independent thinkers. The form of discontent revealed in recent polls is simply a product of the forces Hayek described.

Worse still, activist government is vastly complex. In a complicated and changing world elected officials must delegate substantial powers to bureaucrats. As Hayek noted, parliaments that assume an activist role in planning society will become “ineffective talking shops.” So elected officials must delegate discretionary powers to bureaucrats who can judge particular cases on their individual merits. This is in fact what has happened with the IRS. The tax code is not only complex but vague. Ambiguity allows IRS auditors discretion in how they enforce the code. In the 1990s congressional hearings on the IRS revealed many instances of officials’ abusing their authority.

“The Worst Get on Top”

Of course, one could dismiss these cases as anecdotal evidence from one particular period. However, Hayek demonstrated that “the worst get on top” of any government that seeks to plan economic activity, and this rule doesn’t apply only to heads of state. He noted that “To be a useful assistant in a totalitarian state, it is not enough that a man should be prepared to accept specious justification of vile deeds; he must be prepared to break every moral rule he has ever known if this seems necessary to achieve the ends set for him.” When it comes to competing over governmental power, those with good intentions and high ideals are always at a disadvantage with those who will stop at nothing to acquire more power. Of course, the IRS is not a part of a totalitarian government. Yet it is a part of an activist government that attempts to do far more than enforce a few simple rules.

We have not traveled the full length of Hayek’s road to serfdom, but we have gone far enough to see where it leads. The IRS hearings revealed more than the abuse of taxpayers. Whistleblowers at the agency had their careers ruined. Thus fair-minded persons there could not advance to positions of authority. Only those willing to stop at nothing to achieve IRS goals could reach such positions. This strongly supports Hayek’s contention that those who acquire discretionary powers in government are not trustworthy.

Many of the more common concerns with the tax code are legitimate. Tax compliance is costly, and the laws favor special interests. Yet the discontent that most Americans have with the tax code is no cause for optimism. Since most of them want to change the tax system to reflect their conception of social justice, we must conclude that they are intent on taking at least a few more steps toward serfdom. This is cause for concern but not for hopelessness. Our primary task is to convince the public that they have come to expect too much of democracy.

There are also schemes circulating for supplementing the current income tax with, for example, a sales tax or VAT (value-added tax), but such plans are unlikely to gain much support from libertarians, given that they pose the obvious danger of providing the government with an additional way to collect revenue. Since they threaten to merely increase the overall tax burden on society without offering, from a libertarian point of view, any compensating benefits, I will not address them in this article.

However, suggestions for replacing the income tax with a sales tax, or simplifying it by taxing everyone at a single rate and eliminating all deductions (a “flat” tax) have caught the fancy of some libertarians. The main attractions of these ideas are that substituting a sales tax or flat tax for the current income tax appears to ease the burden of tax compliance. A sales tax in particular does not seem to penalize savings and investment the way an income tax does, and the promoters of such policy changes contend that their new system of taxation will produce results closer to those that would come about on the unhampered market than does the existing apparatus.

One popular proposal along such lines has recently been described in The Fair Tax Book, coauthored by talk-show host Neal Boortz and Georgia congressman John Linder. Because of its prominence, I will use it as a paradigm for all plans of its kind. I believe that the problems it contains are endemic to other similar schemes; so my case against Boortz and Linder also applies more generally.

The authors under discussion present their alternative to our present system as a virtual cornucopia pouring forth blessings on the American people. Implementing their idea, they contend, will do away with the oft-reviled IRS, reduce the effort devoted to complying with the tax code to almost nil, greatly lift the living standards of the poorest Americans, reverse the trend of U.S. firms relocating overseas, and provide a tremendous boost to the nation’s economy. Clearly, if these promises are realistic, everyone should enthusiastically support their plan. However, a clear-sighted analysis of the proposal reveals that the case for predicting these benefits is constructed on a foundation riddled with wishful thinking and flawed logic.

For example, Boortz and Linder argue that their tax system will greatly boost the purchasing power of most Americans’ incomes, since it eliminates the portion of the cost of every good that currently stems from the seller’s tax burden. However, their argument relies on a ludicrous assumption as to where the incidence of present taxation actually falls: On the one hand, they claim that eliminating the income tax will reduce the price of what you buy roughly 20 or 30 percent because producers all pass the tax they pay on to you through higher prices. On the other hand, they also point out all the money you’ll save by no longer paying your own income tax. Apparently, unlike those involved in making everything you buy, you can’t just pass on that tax to others. It seems the incidence of the income tax falls entirely on one special segment of American society: the readers of The Fair Tax! The authors are guilty of counting the savings their readers will see from ending the income tax twice, once in the price of the things they buy and again in their own paychecks. In reality, getting rid of any tax will result in some combination of lower prices and higher incomes, the proportion depending on the particular circumstances of each case. But the total of the two effects will only sum to the gross reduction in taxation, and certainly not to double that figure!

Another supposed advantage of the Fair Tax is that, unlike the present situation where taxes are withheld from every paycheck, obscuring the share of one’s income that the government takes, the Fair Tax will be clearly visible, listed on every sales receipt. However, given that it would be a ubiquitous aspect of all one’s shopping, it is hard to see why its presence won’t fade from view just as readily as the income tax has through withholding. After all, workers today get a “receipt” with every paycheck that plainly shows how much of their salary went straight to Uncle Sam, but that has not solved the problem.

IRS Unnecessary?

Another curious claim on the part of the authors is that the Fair Tax will make the IRS unnecessary. Apparently, people will simply pay this sales tax with no need for an enforcement agency. No one will ever claim that what are really retail sales are wholesale, and no one will ever hide cash transactions from the government—all because we’ve changed how we collect a tax burden that remains just as large as it is today.

To illustrate the lack of realism on display, I’ll offer just one example of how the Fair Tax could be avoided (with a little imaginative effort the reader will probably be able to come up with many others): the tax is imposed only on final sales, meaning those to consumers, and not on purchases made by producers along the way to that end point. So let’s say some executive is tired of paying 23 percent extra—that’s the sales tax rate our authors envision—on everything he buys. The way around the tax is to have the firm pay for as much of his consumption as possible, by devising some way to portray buying the items as important business expenses rather than personal purchases.

Boortz and Linder will no doubt respond that such a practice will be illegal, but that’s not the point. To catch people at such a game requires an investigative body on the lookout for its taking place—the players are not going to turn themselves in, nor will those uninvolved easily spot the activity and report the participants to the authorities. Even with today’s comparatively low sales taxes imposed by state and local governments, it is common for small-business owners to offer a customer a discount for paying in cash, thereby splitting the savings from tax avoidance between the two parties. The Fair Tax rate, three or four times higher than its present counterparts, will promise a proportionally larger reward for successfully dodging it. Fair Tax advocates may not call the agency tasked with enforcing compliance with the new law the IRS, but they will surely require such an agency if they plan to maintain government revenue at anywhere near its current level, which is a crucial element in their sales pitch.

Moving Offshore

The contention that this kind of tax reform will stem the tide of American businesses relocating overseas relies on firms taking into account the tax impact of corporate decisions. If moving headquarters to some tax haven, such as Bermuda or the Cayman Islands , can significantly lower the firm’s tax costs, then the move is likely to get serious consideration. It is true, therefore, that eliminating corporate taxation, as Boortz and Linder propose to do, will be an attractive change in the eyes of multinational companies. However, executives do not consider only corporate taxes in deciding where to locate. The taxes they and their employees will personally have to pay, as well as the amount the local tax system adds to the cost of the products purchased within the country, are also relevant factors. Therefore, the best bet for a nation wishing to retain existing businesses and attract new ones is to have a low total tax burden, rather than to eliminate one form of taxation while seeking to completely offset the lost revenue by introducing a new method of collection.

To be fair to our authors, I will note that they also suggest their support for reducing the overall tax take, but they have decided to separate that issue from their tax proposal and focus on the latter, since they believe it would prove highly beneficial even without any tax cuts. This, I suggest, is a major error.

There is a subtle matter of economic theory, expounded by the great Austrian economist Ludwig von Mises, that is worth examining here since it has great bearing on the topic at hand. In his crowning work, Human Action, Mises points out that the actual burden of any tax is determined by the market process rather than by the taxing authority. The deep import of Mises’s contention can easily be overlooked because it seems at first glance to merely reiterate a standard lesson contained in introductory economics courses. It is commonplace for beginning students to encounter a demonstration of how the portion of a tax on, say, alcohol, that is paid by the buyer versus the portion borne by the seller is quite independent of the government’s decision as to which party is legally obligated to pay the tax. If, for example, there were only one supplier of alcohol, while drinkers’ demand for booze dropped very little in response to increased liquor prices, then the consumers would wind up bearing most of the burden of any new tax, even if officials assign the seller the responsibility for remitting it. Indeed, Boortz and Linder sometimes seem to grasp this idea, although they ignore it in contending, as I noted, that all the cost of the present income tax is passed on through higher prices.

But Mises’s insight goes well beyond the typical analysis. The mainstream textbooks analyze the market for the taxed good as if it were entirely self-contained, isolated from the rest of the economy. But in the real world the supply and demand for any good is deeply intertwined with the markets for all alternative goods and services that might be produced or consumed. That means that although legislators might be seeking to tax the alcohol industry, in reality it could turn out to be, say, truck drivers who are hardest hit, if liquor companies shift toward shipping by rail in response to their new cost. Or perhaps soft-drink manufacturers will be the group most affected, if consumers decide to forgo a few sodas a week to maintain their previous level of alcohol consumption at the now higher price.

One crucial ramification of understanding that the market determines the true incidence of a tax is that the particulars of how a government collects its revenues are of decidedly secondary importance. Of course, it is possible to design tax schemes so Byzantine that trying to comply with them is even more onerous than paying the taxes themselves. But in general the market process will distribute the true incidence of a nation’s tax system according to the cumulative dictates of individuals’ supply-and-demand decisions, thwarting policymakers’ dreams of directing the burden by top-down planning.

Another fundamental error common to tax-reform schemes like the Fair Tax is that their proponents evaluate the attractiveness of their favored plan in an ideal world where powerful and wealthy special interests won’t greatly influence its realization. They then compare that fantasy scenario with the messy reality of the tax code we have today. But any method of taxation that attempts to divert as much of the output of society’s productive activities into the coffers of the state as does the current one will inevitably prompt intense efforts by a multitude of parties to tailor the actual details of the system to their liking. I see no reason to imagine that their lobbying would not complicate any “reformed” tax code until it is as convoluted as what we have today. The only reform that is likely to avoid that fate is a dramatic reduction in the total tax take, thereby greatly decreasing the potential payoff of successfully tilting the system in one’s favor.

I don’t mean to rule out the possibility that one or another tax reform might represent a genuine improvement over the present situation. But the key question is whether such proposals deserve any significant portion of the necessarily limited attention that libertarians can devote to policy issues. A small reduction in the penalties currently imposed for drug crimes would no doubt be a step forward, but I suggest that focusing on such a goal would be a distraction from the real libertarian aim of repealing all laws violating individuals’ freedom to decide on their own what to eat, drink, and smoke.

Similarly, while the hope of achieving any large decrease in the level of taxation may appear remote today, that hope will only recede further into the distance if we dissipate our energy in marginal battles that, even if won, would leave the core of the problem untouched.

Those who desire to relieve the crippling effect that today’s massive states have on their citizens ought to focus on reducing the share of private wealth that governments are able to claim as their due. To instead concentrate on tinkering with the means by which that claim is effected is like a doctor treating a person for athlete’s foot even while the patient is suffering a heart attack.

Last year’s election results in Japan and Germany are not only important for those countries but also have wider lessons, for they herald a decisive defeat for a once-fashionable doctrine—the Third Way. This was adopted by socialists in despair of the abject failure of “really existing socialism” but desirous to pre­serve their anti-capitalist credentials. They assumed we could secure all the benefits of the free market, in terms of its higher productivity and liberal social framework, without its unpleasant concomitants—excessive individualism, companies’ concern with shareholder value, the use of the takeover mecha­nism for industrial reorganization—all summed up by the morally loaded term “greed.” Fortunately for Third Wayers there were two economies that appar­ently evinced different virtues and were highly successful, the second and third biggest economies in the world, Japan and Germany. Indeed, at one time all America was frightened of Japan’s stu­pendous economic virility. The Japanese car industry, spearheaded by Toyota, Nissan, and Honda, was on the brink of taking over from Detroit, and although the Japanese were not great innovators, they could copy and make cars, washing machines, and com­puters more efficiently than the West. And Germany was the dominant economic power in Europe, whose industries, like Japan’s, were heavily geared toward exports. In both countries the shareholders were squeezed out of running companies they nominally owned and industry was geared toward serving the community more than the owners’ interests. Thus the huge Japanese corporations played a significant welfare role, and nobody ever lost his job. Even though private ownership was sedulously maintained, Germany and Japan did not have Anglo-American capitalism as exem­plified on Wall Street and in the City of London.

But both economies have been mired in recession for the past two decades and have begun to question their own economic models, as was seen in the election results, Japan more than Germany. What went wrong? Briefly, both countries became dominated by interest groups that used the political system to divert income created by others to themselves (“rent-seeking”); both had too much state welfare; and neither economy was flexible enough to cope with the demands of globalization. Overall, Japan and Germany have political systems that offer every incentive for political parties to preserve the current inefficient system and none for anyone who tried to break out of it. It was a classic “social dilemma”: everybody knew they would all eventually be better off if they dumped the obstructive labor laws, cramping regulations, and costly welfare, but political parties were beholden to interest groups that benefited from the preservation, indeed expansion, of the prevailing system. Mancur Olson, who analyzed the dilemma in immense detail and sophistication once suggested that it could only be overcome by a national catastrophe such as defeat in a major war.¹ And Japan and Germany had their economies devastated by defeat in World War II yet managed to make amazing recoveries in the early postwar years, while among the victors Britain languished until Margaret Thatcher. Britain, of course, was dominated by interest groups, especially trade unions.² I shall look at Japan first, and in more detail, because it appears as if it is getting over the aforementioned social dilemma better than Germany.

Japan has had a dominant party, the Liberal Demo­crats (LDP), which has been out of power only once since 1955, briefly in the 1990s.Yet it has no coherent program. It is really a bunch of pressure groups that profit from the bur­geoning state. There is no serious socialism in Japan, and it still has a rel­atively small public sector, but the Democratic Party of Japan, formed by disenchanted LDP members, is slight­ly more left-wing and under the influ­ence of trade unions. They know where the rents are.

Japan has always had a market economy, but it was not Anglo-Amer­ican. Shareholders were paid derisory dividends and kept out of annual meetings; companies were run by “stakeholders,” that is, managers and banks. Firms were also more interested in market share than profit, and the whole nation was mobilized to promote exports, not consumption. Companies themselves, if not socialistic, were certainly communitarian: they provided welfare benefits and lifetime employment. It was a rigid and inflexible system, but it worked well enough to make Japan the second biggest economy in the world—until 1990, when the stock market began to fall—from a high of 39,000 on the Nikkei to below 10,000, its nadir. The real economy went into a steady relative decline. Investors originally benefited from capital gains, but mil­lions of Japanese housewives, who had spent the family income buying up stocks, were badly hit by the fall in the 1990s. The country was at the same time building up a huge government debt—now 160 percent of GDP.

Prime Minister Junichiro Koizumi although from an establishment Japanese political family, knew something had to be done if the country were to get out of the stagnation of the 1990s. Japan had been very good at copying Western electronics, but he realized it would have to copy Western economic models too. Elected in 2001, he set his sights on the Japanese postal system. It is not only important in itself, but is also indicative of the Japanese malaise. He wanted to privatize it. His plan was defeated by the upper house of the Japanese Diet (Par­liament) early in the summer of 2005 (the lower house had barely approved it), which was the immediate cause of the election.

Privatization was not to improve the delivery of letters and parcels. I can speak from extensive personal experi­ence that, despite being state-run, the postal system is efficient. The real rea­son for privatizing the post office is that it is also a huge savings bank and provider of nationalized insurance. The Japanese have a legendary propensity to save, and they tend to put their sav­ings in the post office—at present it controls assets of $3 trillion. And where does that money go? It funds huge and mainly unnecessary public works. There is a medium-sized town near Tokyo that has two airports, which together have ten flights a day. All this is a gift to the LDP, which benefits from the useless jobs and wheels out the votes at election time. The post office has 400,000 employees. What Koizumi wants to do is to free up all this capital to be invested in the still-productive private sector.

Of course, all this upset the LDP establishment, and it defeated Koizumi’s first attempt at privatization. But he daringly called an election last September, fired dissi­dent LDP members, and sent in “assassins,” handpicked glamorous media personnel, to fight them at the elec­tion. He won an overwhelming victory: even if the upper house continues to oppose post-office privatiza­tion, he has enough votes from the lower house, with his coalition partners, the Komei, to use the constitution and override it.

Public Choice Defied

Koizumi’s victory was remarkable because it defied the lessons of Public Choice theory: it is normally impossible to defy an electorate that consists largely of rent-seekers. The future benefits of necessary reform are insufficient to compete with the attractions of short-term advantage. But Koizumi is an astute, possibly hon­est, politician, and he campaigned as if the election were a referendum on the privatization. If he had run on a regular manifesto it is almost certain his opponents could have defeated him on a rent-seeker’s program. He also has some charisma, unusual in Japanese politics.

But progress is likely to be slow in Japan—the priva­tization is not scheduled for completion until 2017. And the rent-seekers are likely to defeat him if he tries to reform the costly welfare system. The immediate problem is that Japan has an aging population and a declining work­force. That will also bring forth the need for increased health expenditure. Fur­thermore, Koizumi has to leave his post by next September; the LDP rules limit the leadership of the party to two terms, and there does not seem to be anybody with the drive and commitment to reform to take his place. However, there are already moves underfoot to persuade him to carry on. If Japan is to continue to defy the well-established theorems of Public Choice, the country will need somebody of his determination.

Germany

Germany has the world’s third biggest economy, and it has gone through an experience not unlike Japan’s. From being the powerhouse of Europe the economy is now almost shrinking, with over 11 percent unemployment. After World War II Germany established the “social market economy” under Ludwig Erhard, first as finance minister, then (unsuccessfully) as chancellor.³ The “social market economy” seemed to combine mar­ket-led economic progress with compassionate welfare policies, though in the last 30 years the social element has inexorably displaced the economic element in the model. (It is not at all clear that Erhard himself would have approved of this.) The original Bismarckian welfare state was extended, first to expanded pensions (unfund­ed and dependent on a rising birth rate) and then to conditions of employment. But the German birth rate has dramatically fallen; private pensions are virtually nonexistent; and rising nonwage labor expenses have made the costs of doing business unsustainable—much German capital is leaving the country. This can only worsen under globalization. German business is like Japan’s, with powerless shareholders. Takeovers are rare.

All this has been known for a long time, but entrenched interest groups made the political system more or less immobile. No political party dare risk offending these groups with serious reform. The parties are in an unconscious cartel, but while cartels are nor­mally overcome in private competitive markets, it is not so easy in the ersatz competition of representative democ­racy. Germany is in an insoluble social dilemma, and Erhard has been virtually forgotten.

Some progress was made, however, with the emergence of Angela Merkel as leader of the Christian Democratic Union (CDU). Unable to form even a tiny majority in alliance with the small but more free-market Liberal Demo­cratic party, Merkel has been forced into a “grand coalition” with the Social Democrats. That means the same inter­est-group immobility will continue for some time. A good example is tax reform. Merkel’s pro­jected finance minister is an obscure academic, Paul Kirchhof, who achieved notoriety by suggesting replacement of the complex German tax system, with its myriad exemptions, with a lowish flat tax of 25 percent. Immediately all those groups that benefited from the prevailing system protested and the scheme was quietly forgotten during the campaign. No German commen­tator seemed to realize that a carefully designed flat tax will actually increase government revenue through less tax avoidance and tax evasion, and the operation of the Laffer curve. A flat tax is not just for the rich, but bene­fits everybody, except tax accountants. It is a way of get­ting over the social dilemma.

Frau Merkel has suggested that laws on hiring and firing will be relaxed so that it will be easier to dismiss redundant workers, and her welfare reforms would remove the temptation not to work, the bane of German welfare policy. However, even the Social Democrats under Gerhard Schroeder offered tame versions of these policies, only to water them down even further after relentless opposition from Germany’s still powerful trade-union movement. Of course, Germany has certain unique problems, especially the cost of reunification, but this should not dis­tract us from the fact that the country illustrates all too well the universal problems of representative democracy, especially the ability of entrenched groups to prevent the pursuit of the genuine public good.

The experience of both Japan and Germany should alert us to the seductive but ultimately lethal properties of the Third Way. By locking ever more people into the state, especially through generous welfare policies, it only strengthens powerful interest groups and makes reform almost impossible. Perhaps only by the Swiss system of referenda on particular issues can the dilemma be got round. Indeed, the fact that Koizumi almost turned the Japanese election into a referendum on the post-office privatization supports this position. It is possible that if the flat tax were put to a referendum in Germany it would be approved.

And by restricting the power of shareholders the Third Way weakens the corrective mechanisms of the mar­ket and strengthens the managements of companies and banks, neither good defenders of free markets. There is only one form of successful capitalism, that is free-market exchange with a very limited state. As the president of the Czech Republic, Václav Klaus, once famously said: “The Third Way is the Third World.” Japan, which is on its way to recovery, might have resisted Public Choice tem­porarily, but Germany certainly has not.

Notes

1. See Mancur Olson, The Rise And Decline of Nations (New Haven, Conn.:Yale University Press, 1982).
2. See Norman Barry, “What Kind of Conservatism?” Margaret Thatcher’s Revolution, ed. Subroto Roy and John Clarke (New York: Continuity Books, 2005).
3. See Norman Barry, “The Social Market Economy,” Social Philosophy, vol. 10, 1992.

In his article “The Flat Tax: Simplicity Desimplified” (The Freeman, October 1996), Roger Garrison implies that those who favor the flat tax do not care about the size of the tax burden. Since the vast majority of flat-tax supporters are big advocates of lower taxes, and since all the major flat-tax proposals include a significant tax reduction, this claim is somewhat confusing. Moreover, evidence from the states shows that single-rate tax systems make it harder for states to raise taxes. As such, adoption of a flat tax presumably would impose limits on the growth of taxes on the federal level (primarily because politicians would have a harder time using divide-and-conquer tactics).

Garrison argues that the tax system cannot be simplified. Given that the flat tax eliminates all the most difficult and confusing aspects of the current system, this assertion is quite puzzling. No longer would individuals or businesses have to worry about capital gains, depreciation, estates and gifts, alternative minimum tax, foreign tax provisions, inventory accounting, phase-outs, itemized deductions, and so forth. It is certainly true that there is no free lunch, but there certainly are ways to reduce the cost of the lunch, and tax reform provides those efficiencies.

Garrison also claims that huge problems would be created as taxpayers reclassify W-2 income as business income in order to take advantage of business deductions. The incentive to play that game, however, depends on the tax rate. Since the tax rate will come down under a flat tax, there actually will be less income shifting.

Perhaps the most glaring error is Garrison’s claim that income from savings is not taxed under a flat tax. Even liberal economists admit that the core principle of the flat tax is to tax income only once. This means either taxing once when the income is first earned, but then leaving the returns alone (the Hall-Rabushka approach), or not taxing income that is saved, but taxing the interest and principal when spent (the IRA approach). Liberals admit that doing neither is double taxation, but justify it on pure income-redistribution grounds. It is difficult to imagine why anyone who believes in markets would adopt that position.

Garrison envisions a tax scam where employers give employees money to buy bonds, the interest to which would be nontaxable. He forgets, however, that the money provided to the employees under the flat tax would either be considered income to the worker (and thus taxable) or a fringe benefit (and thus taxable at the firm level). Either way the compensation is taxed (but not double taxed, since the interest properly is left alone).

Garrison believes that one rate has little to do with simplicity. In reality, one rate is critical if we want to tax all income at the source. One rate, for instance, allows us to tax AT&T one time on their income at the single rate of 17 percent. This is vastly preferable to tracking down all 2.2 million shareholders and imposing separate tax rates depending on their total income. The same thing with interest income. Not only will the single rate eliminate the one billion 1099 forms in the economy, it will also eliminate income shifting designed to have income declared to the low-tax person and deductions attached to the high-tax person.

All believers in limited government agree that the tax burden should be reduced to the maximum extent possible. This goal is not in conflict, however, with the idea of making sure whatever level of taxes is collected is taken in the least destructive, least intrusive manner possible.

—Daniel J. Mitchell
McKenna Senior Fellow
The Heritage Foundation Washington, D.C.

Roger Garrison replies:

Dan Mitchell’s challenging remarks, particularly his reference to a “glaring error” concerning the tax status of saved income, provide an opportunity for dealing with a common point of confusion. I take Robert Hall and Alvin Rabushka’s Flat Tax (2nd ed., Hoover Institution Press, 1995) to be ground zero for the modern resurgence of interest in simplifying our tax system. Hall and Rabushka leave little doubt about the status of saving in their proposed system:

Here is the logic of our system, stripped to the basics: We want to tax consumption . . . . We can measure consumption as income minus investment. A really simple tax would just have each firm pay tax on the total amount of income generated by the firm less that firm’s investment in plant and equipment. (p. 55)

Saving, then, which stands in contrast to consumption and underlies investment, is not taxed. Hall and Rabushka’s only significant departure from this “really simple tax” is one that exempts some consumption: the part of the firm’s (gross) income that is paid out in wages is untaxed until it is in the hands of wage earners, each of whom is allowed a generous personal exemption. This provision causes a substantial amount of consumption to go untaxed and gives a progressive character to average tax rates, but it does not bring saving into the tax base.

Given the ex post macroeconomic identity between saving and investment, Hall and Rabushka could hardly fail to recognize the nature of their proposal: “Our proposal is based squarely on the principle of consumption taxation. Saving is untaxed . . . .” (p. 54). Yet the authors themselves are at least partly responsible for the current confusion. At critical points, they misleadingly write “income” instead of “consumption,” and sometimes they write as if there were no difference between these two magnitudes. Although there are many such instances, I will cite just two: “The business tax . . . is carefully designed to tax every bit of income outside wages but to tax it only once” (p. 61). In fact, it is actually designed, as Hall and Rabushka had already stipulated, to tax only income net of investment, effectively converting the income tax to a tax on consumption. And virtually guaranteeing confusion, the authors explicitly affirm their “goal of taxing all income once at a common, low rate and achieving a broad consumption tax” (p. 63). This compound goal is simply at war with itself. Consumption and income are not the same thing; they differ precisely by the amount of income saved.

The confusion that has its roots in the original Hall and Rabushka proposal has caused Mr. Mitchell and undoubtedly others to see my exposition as involving a “glaring error.” Some supply-siders leverage the confusion by insisting that “consumed income” is, in fact, what “income” actually means. Others offer the all- too-facile claim (not supported by Hall and Rabushka’s basic logic) that saved income (or, alternatively, the yield on saved income) has already been taxed. These and other confusing claims stem from their using the rhetoric about taxing income once and only once in defense of a consumption tax. It is consumption, not income, that (beyond the generous personal exemptions) is taxed once and only once.

Several other points of disagreement raised by Mr. Mitchell are resolved once the tax status of investment (and hence saving) is established. For instance, there undoubtedly would be efforts in the private sector to disguise part of the (taxable) net income as (nontaxable) investment as well as efforts by the government to counter such attempts at tax avoidance.

Mr. Mitchell points to the vulnerability of our current system to the “divide-and-conquer tactics” of politicians trying to raise tax rates but fails to acknowledge that Hall and Rabushka’s generous personal exemption, which converts flatness into progressivity, would seriously weaken taxpayer solidarity and expose their proposed system to those same divide-and-conquer tactics.

Remaining differences between Mr. Mitchell’s views and my own are matters of perspective and judgment. Yes, some—maybe most—supply-siders would prefer tax reductions, but their willingness—even eagerness—to propose revenue-neutral or revenue-enhancing reform suggests their priorities lie elsewhere. And yes, given the complexities of the current system, there is plenty of room for reform in the direction of tax simplification. TANSTAAFL does not deny that some lunches are cheaper than others; TANSTAABST (There ain’t no such thing as a big simple tax) should be interpreted analogously. My arguments do suggest that a tax system involving (1) postcard-size tax forms and (2) the transferring of hundreds of billions of dollars from the private sector to the public sector is (not-so-unhappily) outside the realm of possibility.

—ROGER W. GARRISON

Professor of Economics

Auburn University

We will print the most interesting and provocative letters we receive regarding Freeman articles and the issues they raise. Brevity is encouraged; longer letters may be edited because of space limitations. Send your letters to: The Freeman, FEE, 30 S. Broadway, Irvington-on-Hudson, New York; 10533; fax (914) 591-8910; E-mail: iol@fee.org.

A progressive income tax violates the very heart and soul of the Constitution. Our constitutional government rests on the principles that individuals are equal under the law, that consent is the basis of just laws, and that the powers of the federal government are strictly limited. None of those principles are consistent with taxing incomes at progressively higher rates. It’s time to expose the pretense of morality that is inherent in progressive taxation and to end the system of tax socialism that has eroded economic and personal liberties in the United States.

A “Calamitous Monstrosity”

Prior to the passage of the Sixteenth Amendment in 1913, the Supreme Court consistently struck down attempts to legislate a federal income tax. There was little public support for such a tax. Indeed, when the first income tax was passed by Congress in 1894, the New York Times called the legislation a vicious, inequitable, unpopular, impolitic, and socialistic act, and the Washington Post added, It is an abhorrent and calamitous monstrosity.

Constitutional principle and justice require that individuals be treated equally under the law and that the law itself be just. A progressive income tax, which discriminates against individuals simply because they have higher incomes, is based on an arbitrary precept that would never gain universal consent. The minority would never consent to be enslaved by the majority.

Because there is no objective way to measure social justice, there is no end to the redistribution that can occur under a progressive tax system. Under such a system, neither persons nor property are safe from the hand of the state.

In his Constitution of Liberty, the late Nobel laureate economist F. A. Hayek wrote, “Progression provides no criterion whatever of what is and what is not to be regarded as just. It indicates no halting point for its application, and the `good judgment’ of the people on which its defenders are usually driven to rely as the only safeguard is nothing more than the current state of opinion shaped by past policy.”

Hayek was right and Marx and Engels were wrong. Yet conservatives and liberals alike fall into a populist trap by trying to justify progressive income taxation on the basis of majority rule. Elevating democratic values above individual rights to achieve equality of result, however, violates the very rules of just conduct that lie at the heart of a free society.

A flat-rate tax is consistent with the rule of law and with the principle of nondiscrimination. Everyone pays the same tax rate on their taxable income, and income from both labor and capital are treated alike—there is no double taxation of interest and dividends. If the flat-rate tax is applied to consumption rather than income, the current bias against saving would disappear and economic growth would increase.

One major benefit of a flat-rate tax is that it would make the cost of government expansion visible to all taxpayers, especially if government were required to balance its budget each year. There would be a built-in incentive to compare the costs and benefits of new government programs.

Under progressive taxation, on the other hand, there is a constant temptation to raise tax rates on productive citizens to pay for new programs. At the limit, persons with high incomes may face a marginal tax rate of 100 percent, while those with low incomes pay nothing. (During the 1950s marginal tax rates exceeded 90 percent in the United States.) That’s tax socialism in spades.

Progressive taxation is not a virtue but a vice. It presumes that the property rights of the wealthy are not as sacred as the property rights of the poor, and that the values of the majority are superior to the rights of the minority.

Those who support progressive taxation pretend to be on the moral high ground but, in fact, they have no ground to stand on. Envy, not justice, is at the root of the argument for discriminatory taxation. If we let constitutional principles be eroded by majority rule, in the name of social justice, then both freedom and true justice will be lost.

Law is the bond of civil society, and justice is equality under the law, wrote Cicero. If we are to restore civil society and move from tax socialism to tax justice, we need to abolish progressive taxation, institute a fair flat tax, and limit the size of government. Otherwise class warfare and welfare will prevail.

In modern American politics, advocating a flat tax is the surest way of labeling yourself as a supply-sider, a Jack Kemp/Steve Forbes Republican. Michael Evans^[1] made the case for the flat tax in his Truth About Supply-Side Economics (1983); Robert Hall and Alvin Rabushka^[2] have made it twice in their book-length treatment of The Flat Tax (1985 and 1995).

Libertarians, many of whom get their economics from the Austrian school and eschew the Republican label, also tend to favor a single rate. In explaining Why Government Doesn’t Work (1995), Harry Browne^[3] offers a flat tax as part of the fix, but he devotes barely more than a page to this issue. The space he allocated to the flat tax as compared to the space allocated to it by the supply-siders, as well as his attention to the size of the tax take rather than the shape of the tax schedule, suggests a significant difference in priority and perspective.^[4]

“How Much” and “Just How”

The primary concern of the libertarians is with how much the government might tolerably extract from income earners and only secondarily with just how it is best (i.e., least painfully) extracted. Browne, for instance, suggests a 10 percent rate, which might raise as much as $500 billion. Barely one-third of the current total tax take, this amount is to finance the correspondingly pared-down expenditures of the federal government. Supply-siders, by contrast, deal with the just-how question as if it can be answered independently of the how-much question. The most common proposal, for instance, is for a revenue-neutral reform: We should scrap our current progressive tax, which we know to be hopelessly complex and inefficient, and adopt a simple and efficient flat tax that would yield the same—or nearly the same—revenue. Some supply-siders (e.g., Evans) would hold out for even more revenue.

Opponents of the flat tax can easily point to perceived social inequities, exaggerated claims, and outright fallacies that conventional supply-side arguments entail. A more defensible case for the flat tax is one that keeps the questions of How much? and Just how? in proper perspective: A flat rate may do little to make a big tax simpler or more efficient, but it may be a near-perfect device for keeping a small tax small. The key issues are (1) the actual incentives created by eliminating deductions in the pursuit of simplicity and (2) the political alliances created by incorporating a large personal exemption for the sake of voter appeal. A healthy consideration of these and related issues suggests that reducing the total tax take should have priority over imposing a single tax rate.

TANSTAA . . .

We owe to Robert Heinlein the memorable if nearly unpronounceable TANSTAAFL (there ain’t no such thing as a free lunch), which expresses one of the most fundamental principles in all of economics. Each major field of study within economics would do well to find its own Heinleinian acronym so as to keep policy prescription anchored to the basics. Let me propose a suitable one for the field of public finance: TANSTAABST. There ain’t no such thing as a big simple tax. Head taxes, the only truly simple taxes, are never big; income taxes, the primary source of revenue for the welfare state, are never simple. The claim, made repeatedly by supply-siders, that with a flat tax our tax form would be the size of a postcard can easily be exposed as bad science fiction.

The gains in simplicity are supposedly achieved by the elimination of deductions. Instead of multiplying our income (minus a myriad of deductions) by the effective tax rate, we multiply our income (minus a single personal exemption) by the flat rate. The multiplicand that the tax reformers have in mind, of course, is the income routinely reported on W-2 forms (or on 1099s and the like). For taxpayers in the post-reform period who continued to earn W-2 income, filing would indeed be simple. We should realize, however, that the W-2 form remains a tolerable means of reporting precisely because it is only the starting point for calculating taxable income. To eliminate deductions, which give the taxpayers scope for bargaining with the tax collector, is to eliminate the acceptability to the taxpayer of receiving income on a W-2 basis.

Even under the current system, there are strong incentives for avoiding the W-2. In many areas of the business world the conventional employer-employee relationship is being replaced by the firm’s contracting with individuals for services rendered. The elimination of deductions that would accompany the institution of a flat tax would undoubtedly accelerate this trend toward self-employment—which has been driven from the start largely by tax considerations. Under a contractual arrangement, the payment by the firm to the individual is not W-2 income but gross receipts. Income is to be calculated by the individual, with advice from his or her tax accountant, as receipts minus expenses. Even a wholesale elimination of deductions, then, would not achieve a dramatic simplification; it would simply shift the battleground on which taxpayers and the tax collector confront one another. Tax-avoidance strategies would aim at minimizing receipts minus expenses rather than minimizing income minus deductions. TANSTAABST. And the very open-endedness of what might reasonably be counted, in each line of business, as an expense would quite likely make the tax system more complex rather than less.

The extent to which the taxpayers would resist clipping their checks onto a postcard-size tax form is measured by the tax rate itself. Current levels of government spending would require a high rate. Special features of the supply-siders’ flat tax would reduce the tax base and make the rate higher still. One of these features, not strictly implied by—and actually at odds with—the concept of the flat tax, is the source of the widely perceived inequity: Interest income is to be treated as if it were not income.^[5] This special reward to savers and hence to high-income earners (since they are the ones who can most easily save) derives from the belief that it is actually consumption and not income per se that should serve as the basis for taxation. According to this view, people whose current demands for consumer goods are being satisfied should pay the taxes. The preferential status accorded savings—and hence investment and economic growth—is what justifies naming supply-side policies for their one-sidedness.^[6]

The pro-saving feature of the flat tax means that the portion of income not saved will have to be taxed at a higher rate than would otherwise be necessary. At the same time, it constitutes one—possibly significant—way for taxpayers to avoid the tax. Instead of awarding raises to its employees, a firm may well offer them the opportunity to buy low-risk, high-yield bonds, whose coupon payments (interest-in-lieu-of-wages) are not taxable. The tax collector would, no doubt, attempt to police this and other such tax avoidance schemes, but the process through which the market tries to arrange them and the government tries to curb them is unlikely to contribute to either simplicity or efficiency.

With a tax base that includes salaries and pensions plus business income, the tax rate that achieves revenue neutrality would have to be about 19 percent, according to Hall and Rabushka. During his bid for the Republican nomination for president, Steve Forbes proposed a 17 percent rate, calculated to give most taxpayers a small tax cut—and to give them all a higher budget deficit. But any rate in this range (i.e., 17-19 percent) is certainly high enough to sustain a reconstituted tax-avoidance industry.

The Flatly Progressive Tax

All of the Republican proposals involve a second departure from a strictly flat tax applied to all income, namely, a relatively high threshold level below which no taxes are collected. A substantial personal exemption (Forbes would have allowed for about $36,000 for a family of four; Hall and Rabushka suggest $25,000) has the effect of blurring the distinction between a flat tax and a progressive tax. As a matter of terminology, flat means not progressive. How, then, could Hall and Rabushka^[7] argue that one advantage to their flat tax is its progressivity? The so-called single rate is actually two rates: 0 percent for income up to $36,000, using Forbes’s proposal for illustration, and 17 percent for all income above $36,000. Calculating the average tax rate for incomes up to ten times the personal exemption, we get the progressive pattern that rises from 0 percent at the threshold level to 8.5 percent at twice that level to 15.3 percent at ten times that level and that thereafter approaches 17 percent asymptotically.

Supply-siders do not consider this progressivity objectionable at all. What they do find objectionable is an unnecessarily high marginal rate, such as our current top rate of about 40 percent (on taxable income over $250,000). Why, then, do they allow for substantial inframarginal incomes to go untaxed? This, too, causes the top marginal rate of 17 percent to be higher than it needs to be. That is, if a positive rate of, say, 8 percent were applied to some portion of income below $36,000, then a rate of, possibly, 15 percent could be applied to all income above that level. And the lower the top marginal rate, the stronger the standard supply-side arguments about increasing employment, exploiting the Laffer curve, and reducing the federal budget deficit through economic growth.

It seems clear that the generous personal exemption is included in the flat-tax proposals largely if not wholly for its voter appeal. The prospects of earning lots of tax-free income and enjoying a progressivity in the average rate on incomes well over the threshold level is attractive to the so-called middle class—which is to say, to the median voter. But, whatever the benefits of a flat tax, political attractiveness achieved in this way is a double-edged sword. Once such a tax system is in place, that same political attractiveness would attach itself to government spending in the minds of low- and medium-income voters. An overly generous personal exemption creates an alliance between these voters and elected officials in their efforts to gain economically and politically at the expense of the higher-income taxpayers. Government spending could have (gross) benefits for us all or could benefit mostly the poor while being paid for by the rich. This pattern of benefits and costs and resulting conflict among the differently situated taxpayers is precisely what any worthwhile tax reform would have to preclude.

Actually Achieving Simplicity

The advertised simplicity of a flat tax cannot be achieved by the elimination of deductions. As already suggested, determining what constitutes income would be, if not more complex, just as complex as determining what counts as a deduction. Further, the flatness of a flat tax does not translate into simplicity in any relevant sense. Progressivity in the sense of multiple brackets with stepwise increases in the marginal rates eliminates big jumps in the tax schedule while adding little or no computational complexity. Taxpayers who look up their tax liability on a suitably constructed tax table, like the cashier who looks up the sales tax on a similar table taped to the cash register, may not even notice whether the table was constructed on the basis of one rate, two rates, or ten rates. And while reasonable people could disagree about the relative merits of having a single rate or having ten, the merits of having just two, as entailed by a flat rate with a generous personal exemption, are dubious. People may prefer living in a one-story house rather than having to cope with stairs. But it doesn’t follow that a two-story house can be simplified by removing the staircase. Similarly, replacing the several small steps in the current progressive tax schedule with one giant step at $36,000 is not an obvious improvement.

If tax simplicity is achieved, it will be achieved not by the tax rate’s flatness but by its lowness. TANSTAABST. There ain’t no such thing as a big simple tax. But a small tax can be simple—and for a simple reason: If taxpayers find it easier and less costly to pay the tax than to redesign their economic lives so as to avoid paying it, the incentives for creating and exploiting complexities are effectively blunted. The resulting simplicity, of course, is not a goal unto itself but rather a healthy indicator that we have achieved the prerequisite goal of low taxes.

As Hall and Rabushka have emphasized, the tax rate can be its lowest if the tax is applied broadly, although they would apply it broadly to all consumption rather than (even more) broadly to all income. Salary income encourages working; interest income encourages saving. With a broad base that encompasses both, the disincentive effects of taxing are minimized. Our current tax system has a strong anti-saving bias; Japan’s tax system has a strong pro-saving bias. Neither bias has a justification in economic theory, and both biases cut into the tax base. There is a strong and obvious case for avoiding a bias in either direction while at the same time broadening the base. A low rate applied to a broad base lets income earners make their decisions about working and saving on the basis of the actual—non-tax-related—tradeoffs that these decisions entail.

A lower rate still is facilitated by the elimination—or minimization—of the personal exemption. (Browne allows for none.) The paring down of government expenditures provides a double-barreled justification for eliminating this exemption. First, the rate would be low, so as not to significantly burden even the low-income taxpayer. Second, since the services actually provided by government would be only those considered as essential to our well-being as other necessities that low-income taxpayers buy in the private sector, no taxpayer would be unduly burdened. Subjecting the low- and medium-income taxpayers to a tax burden proportional to the burden of the high-income taxpayers is in full compliance with both the letter and the spirit of a flat tax. Stringent voting rules need to be in place to guard against uncalled-for increases in the flat rate, and even more stringent rules—possibly at the constitutional level—are needed to assure that the flat rate remains flat.

Importantly, a universal application avoids the perverse political alliance with respect to government spending mentioned earlier. In fact, a constitutionally guaranteed flat rate creates a healthy alliance among income earners at all levels and against elected officials who, under other tax arrangements, could more easily gain political advantage through targeted government spending to be financed by selectively adjusting the tax rates. Taxpayer solidarity as a check against increased taxing and spending should be seen as the sine qua non of the case for a flat tax.

The Flat Tax in Perspective

Currently we have a big, complex, and inefficient, progressive tax. It is folly to think that the complex and inefficient derive significantly from the progressive. The complex and inefficient derive from the big. Given the efficiency and adaptability of the market, there is probably no knee-of-the-curve below which the tax take can be declared small. But 10 percent can be declared smaller than 17 percent, and, at any rate, opportunities for further reform still exist.

TANSTAABST. Revenue-neutral tax reform is no solution. The smaller the tax, the greater the prospects for simplicity and efficiency. And a flat rate may be the best means of keeping a small tax from becoming a big one.

1.   Michael K. Evans, The Truth About Supply-Side Economics (New York: Basic Books, 1983).

2.   Robert E. Hall and Alvin Rabushka, The Flat Tax, Second Edition (Stanford, Cal.: Hoover Institution Press, 1995 [First Edition, 1985]).

3.   Harry Browne, Why Government Doesn’t Work (New York: St. Martin’s Press, 1995), pp. 182-83.

4.   Not long after his campaign book was distributed, Browne began advocating a complete abolition of the income tax and arguing that essential government services could be funded by (1) existing tariffs and excise taxes and (2) the proceeds from the sale of government assets, such as land holdings in the western states.

5.   Individuals would pay taxes only on wages, salaries, and pensions; business firms would be allowed to fully expense investment, which is the present-value equivalent of allowing them to exempt the competitive yield on those investments. Taken together, these provisions, which have the effect of excluding interest income (or, equivalently, saved in come) from the tax base, convert the income tax to a consumption tax.

6.   Critics of interventionist policies may be tempted to embrace supply-side theory as the antithesis of Keynesian theory, which focuses almost exclusively on demand. However, a critical assessment of both theories suggests a more balanced view: On analytical issues (How do markets work?), we should be both-siders: supply and demand. On policy issues (What kind of bias should be built into our tax system?), we should be neither-siders.

7.   Robert E. Hall and Alvin Rabushka, Simplify, Simplify, in Edwin Mansfield, ed., Leading Economic Controversies of 1996 (New York: W. W. Norton and Company, 1996). Reprinted from the New York Times, February 8, 1995. See also, Hall and Rabushka, The Flat Tax, p. 55 and passim.

Recent political debates have raised the issue of adopting a flat marginal rate federal income tax. Though the marginal rate would be flat, the addition of a generous personal exemption would make the average personal income tax rate rise as it approached the fixed marginal rate of, say, 17 or 20 percent. This issue has generated considerable controversy in political debates and in the press. Among the criticisms leveled at a flat marginal rate tax system are that, contrary to proponents’ claims, a flat marginal tax rate will provide a windfall of after-tax income for the already wealthy, worsen the distribution of income, and exacerbate the already swollen federal government deficits. Supporters have usually concentrated on extolling the virtues of reducing the distortions caused by rising marginal tax rates and of encouraging greater entrepreneurial activity.

Ideally, there would be no personal income tax. The history of the debates over an income tax in the 1890-1911 era makes it clear that an income tax was viewed by its advocates as a means to redistribute income and wealth. It has remained this way as indicated by the vestiges of the progressive marginal rate structure which remain in the code. Such a system leads to an emphasis on obtaining more through political redistribution rather than the expansion of economic activity. And by separating the perceived benefits of a governmental activity from any taxes dedicated to supporting that activity, the income tax made it easier to expand government and increase taxes.^[1] The creation of a federal income tax system aimed at the redistribution of income as much as creating a new source of federal tax revenues was one of the worst mistakes in American history.

The Tax Cuts of the 1920s

There are three periods where there were significant tax rate cuts which moved toward a flatter tax rate structure: the 1920s, the 1960s, and the 1980s. All exhibit some of the same characteristics, but the tax cuts of the 1960s were smaller than those of the 1920s, and in the 1980s the sharp increases in tax rates for the Social Security system partially offset the cuts in the federal income tax rates.

The first permanent federal income tax was enacted in 1913, and during the First World War there were dramatic increases in the rates in an attempt to generate increased tax revenues. At $4,000 net income, the marginal rates rose from 1 percent in 1915 to 6 percent in 1918; at $25,000 net income from 2 percent to 23 percent; at $100,000 net income from 5 percent to 60 percent; and, at $750,000 net income from 7 percent to 76 percent. The rates were reduced in 1922, 1924, and 1925. By 1925 the highest marginal rate was 25 percent for $100,000 and more net income. By the late 1920s only about the top 7 to 8 percent of Americans were subject to federal personal income taxes.^[2] Though the marginal rate was not constant, the changes were close enough to that which would occur with a flat rate tax that the results of the tax cuts of the 1920s can suggest what would happen with the adoption of a flat rate federal income tax.

Tax Cuts for the Wealthy?

A common criticism of the proposal for a flat marginal rate tax is that it would generate a windfall for the wealthy and create greater inequalities in income distribution. Such charges were also made in the 1920s, 1960s, and 1980s. In the 1920s, tax rates were reduced much more for the higher-income taxpayers because, obviously, they had much higher marginal tax rates in 1918. For example, the marginal income tax rate was reduced 51 percentage points (76 percent to 25 percent) between 1918 and 1925 for taxpayers with at least $750,000 of net income, while the reduction for a taxpayer with $6,000 net income over that period was only 10 percentage points (13 percent to 3 percent).^[3] However, the relative reduction (decrease as a percent of the 1918 marginal tax rate) was somewhat larger for the lower-income taxpayers than for the higher-income taxpayers.

More importantly, the reduction in tax rates shifted the effective burden of taxation. When rates had been increased between 1915 and 1918 the higher-income taxpayers had found various ways to shelter their income from taxes. At the same time as the number of returns in the lower net-income brackets rose as exemptions were reduced, the number of returns in the higher-income brackets fell. As examples, for the $500,000 to $1,000,000 net income class, the number of returns fell from 376 in 1916 to 178 in 1918, and for the $250,000 to $500,000 net-income class the number of returns fell from 1,141 to 629 over the same period. The result was that the share of income taxes paid by the higher net income tax classes fell as tax rates were raised. With the reduction in rates in the twenties, higher-income taxpayers reduced their sheltering of income and the number of returns and share of income taxes paid by higher-income taxpayers rose. For example, the share of total personal income taxes paid by taxpayers with net incomes of $1,000,000 or more rose from 5.75 percent in 1923 to 15.9 percent in 1927. For taxpayers with net incomes of $250,000 to $500,000 their share of total personal income taxes rose from 6.82 percent in 1923 to 12.40 percent in 1927. The share for taxpayers with net incomes of $100,000 to $250,000 rose from 15.7 percent in 1923 to 21.91 percent in 1927. However, taxpayers with net incomes of $25,000 or less paid 36.22 percent of all personal income taxes in 1923 but only 12.83 percent in 1927. Thus, cutting tax rates effectively shifted the tax burden from the lower-income taxpayers toward the higher income taxpayers.

The assertion that the tax cuts would primarily benefit higher-income taxpayers was tied to the contention that this would create more income inequality. It has always seemed contradictory to me to argue that allowing a person to retain more of the income he or she generated would create more income inequality, but that has been the common contention. The conventional measures did show significant increases in income inequality during the twenties but there were problems with these measures. They were developed from the income reported on income tax returns and separate estimates of total income in the economy. However, as tax rates fell during the twenties, higher-income individuals began shifting wealth so that less of their income was sheltered from taxes. A portion of the greater income gains of the higher-income individuals represented not additional income but income from wealth which was shifted from tax shelters to assets subject to taxation. Correcting for this significantly reduces the rise in income inequality during the twenties.

What of the rise in income inequality that did occur? Individuals receive earnings from the productivity of their capital investments and land as well as their labor. They also receive income in the form of the realized gains in the values of their assets. The values of financial assets, particularly stocks, began to rise by the mid-twenties and this culminated in the great stock market boom of the late twenties. To see what effect this had, I calculated income shares which excluded realized capital gains, and when this was done, essentially all of the rise in income inequality in the twenties disappeared.

Thus, this evidence suggests that the dramatic tax cuts associated with moving toward a flatter rate tax structure would not provide windfalls of income for the wealthier taxpayers. It would encourage them to shift wealth from tax-sheltering investments to taxable investments to receive larger after-tax returns. The movement of economic activity out of lower return tax sheltering into higher return taxable assets will create more efficiency and make people in the society better off.

Larger Government Budget Deficits?

Another argument frequently thrown at the supporters of a flat marginal rate income tax is that it would worsen the annual deficits of the federal government. This would occur because expenditures would continue at the same level while revenues would decline. Once more we can examine evidence from the twenties which is related to this. With the end of the First World War the federal government’s expenditures dropped sharply, though not to the prewar levels, and budget surpluses were created. There were calls to reduce the income tax rates to direct investment into more appropriate channels rather than into activities which were primarily directed to tax avoidance, and to reduce the widespread legal tax avoidance by the upper-income taxpayers. For example, Andrew Mellon, Secretary of the Treasury, reported that when William Rockefeller (John D.’s brother) died in 1922 he held less than $7,000,000 in Standard Oil bonds but over $44,000,000 of wholly tax-exempt securities. The inability of Congress to find legislation to effectively reduce this tax avoidance was one force leading to the twenties’ tax cuts.

The first of the major tax cuts was passed in November of 1921. On average it reduced marginal personal income tax rates by 13.8 percent, and this led to a decline in real total federal personal income tax revenues of 4.3 percent. The second major tax cut was approved in June of 1924 and it reduced marginal income tax rates by an average of 7.5 percent. This tax cut lead to an increase in real total federal personal income tax revenues of 5.9 percent. The final major tax cut was introduced in December 1925 and enacted in February 1926. It applied retroactively to 1925. On average marginal personal income tax rates were reduced 33.6 percent by these changes. Rather than falling, real federal personal income tax revenues increased by 0.5 percent with this large tax cut.

The evidence clearly indicates that, in general, tax revenues rose with the tax cuts of the twenties. The federal government’s budget surpluses were not reduced with the final two tax cuts and, over the course of the twenties, these budget surpluses allowed the federal debt to be reduced by 25 percent.

Conclusions

The flat marginal rate income tax may never be enacted. Many people, and this certainly includes many politicians, believe that it is only fair that higher-income individuals face higher marginal rates of income taxation. The tenacity with which supporters of progressive tax rates cling to this idea is indicative of their redistributionist philosophy. It also indicates their refusal to face reality. The tax cuts of the twenties as well as every major income tax cut has resulted in an effective shift of the tax burden from lower- to higher-income taxpayers. As the twenties show, it does not have to worsen the government’s deficit. Economic growth in the twenties surged with the tax cuts, and prices were nearly stable while unemployment rates averaged around 4 percent.^[4] The government ran surpluses which allowed it to reduce the federal debt by 25 percent. The decreases in marginal tax rates led individuals to pull their investments out of ones designed to avoid taxes—investments such as tax-exempt municipal bonds, personal service corporations, and other avenues to avoid distributing corporate profits. The result was a rising tide of investment in new, growing, and sometimes risky businesses and industries such as radio, consumer household electric appliances, electric utilities, airplane manufacturers, rubber tire manufacturers, supermarket chains, and so forth. The 1920s were a vibrant, growing decade, and the tax cuts of the 1920s certainly were an important part of what brought this about.

1.   See Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government (New York: Oxford University Press, 1987).

2.   Personal exemptions were also increased during the decade.

3.   Much of the following discussion relies upon two sources. Gene Smiley and Richard H. Keehn, Federal Personal Income Tax Policy in the 1920s, The Journal of Economic History, Vol. 55 (June 1995), pp. 285-303; and, Gene Smiley, New Estimates of Income Shares During the 1920s presented at Calvin Coolidge and the Coolidge Era, a library of Congress Symposium on the Politics, Economics, Social, and Cultural History of the United States in the 1920s, October 6, 1995, and forthcoming in a conference proceedings volume.

4.   Between 1919 and 1929 real per capita GNP grew 2.61 percent per year. (1920 was the first year of the 1920-21 depression and is not an appropriate starting point.) For comparison, real GNP per capita grew 1.48 percent per year from 1950 to 1959, 3.26 percent per year from 1960 to 1969 (with significant tax rate cuts), 2.68 percent per year from 1970 to 1979, and 2.09 percent per year from 1980 to 1988.

Mounting taxes push the Tax Foundation’s “Tax Freedom Day” out to May 6, a day when presumably John Q. Taxpayer stops working for government—federal, state, and local—and at last starts working for himself. But fiscal expert Grover Norquist and his Washington-based Americans for Tax Reform figure the truer Cost of Government Day occurs on July 3 by taking into account hidden taxes via deficit spending and regulatory burdens. Thus the estimated total cost of government in 1995 came to almost $3.3 trillion, including $720 billion in federal regulatory costs. This means working Americans have to toil 52 percent of the year for government.

If this strikes you as a sign of trouble on the tax front, you’re right.

Beyond the flat taxers are those who would bravely dump the income tax for a national sales tax. These advocates see solid advantages; no withholding deductions; no more tedious bookkeeping, including filing away receipts and canceled checks; no more IRS audits, penalties, interest charges, levies, liens, threats, and seizures; no more deadly April 15 and quarterly tax deadlines; no more hits on savings and investment—on capital formation, the very sinew of economic growth and job creation. And, hear this, no IRS, period.

In his hard-hitting brief for a flat tax, Heritage Foundation analyst Daniel Mitchell takes note that 12,609 special interests are officially registered to lobby in Washington. Assume three support persons behind each lobbyist, and you have an army of 50,000 pulling strings and making deals—many seeking special loopholes in the 14,000-page U.S. Internal Tax Code and rulings. So understandably members of the tax-writing House Ways and Means Committee get big PAC contributions, and Ways and Means and Senate Finance memberships are seen as plum assignments.

Dan Mitchell sees the flat tax as a way to end such “soft” political corruption and favoritism—simply cut out myriad tax deductions, preferences, loopholes, credits, and exemptions altogether.

That proposed cut takes guts and a lot of flak. Take the scare tactic used against the flat tax because it would eliminate deductions on home mortgages, supposedly forcing middle-income taxes up and house prices down. But this is static analysis, argues Mr. Mitchell. He holds the flat tax wipe-out of capital gains taxes, death taxes, and double taxation of corporate income will spur economic growth, cut interest rates, and boost housing prices by some 50 percent in five years after passage of a flat tax.

Another scare tactic is the alleged hit of flat-tax nondeductibility on contributions to churches, charities, universities, and think-tanks (such as FEE), cutting off their lifeline. Mitchell rebuts again with economic growth, noting that when people make more they give more. His chart shows how closely individual giving and personal income track each other over the years. Says Jack Kemp in the preface: “Only a pro-growth tax code can restore America’s confidence at home and her greatness abroad.”

Fine words to be sure but the catch here in this otherwise sharp Mitchell minibook is the paucity of argument for privatization, disentitilization, and deregulation of the economy—for greatly chopping down the size of the federal behemoth. Taxes are a drag on growth but the killer is the huge bite—around 42 percent—that government takes out of national income, let alone out of our civil liberties.