Cutting Marginal Tax Rates; G. Smiley

674 THE FREEMAN • OCTOBER 1996 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 adapt ability 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 re form 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. D 1. Michael K. Evans, The Truth About Supply-Side Eco nomics (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 ex pense investment, which is the present-value equivalent of allowingthem to exempt the competitive yield on those invest ments. 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 con sumption 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. How ever, 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, Sim plify," in Edwin Mansfield, ed., Leading Economic Contro versies 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. Cutting Marginal Tax Rates: Evidence from the 1920s by Gene Smiley R ecent 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 aver age 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 de bates and in the press. Among the criticisms Dr. Smiley teaches at Marquette University. 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 ex acerbate the already swollen federal gov ernment 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 inCUTTING MARGlNAL TAX RATES: EVIDENCE FROM THE 1920S 675 come 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 progres sive marginal rate structure which remain in the code. Such a system leads to an emphasis on obtaining more through politi cal redistribution rather than the expansion of economic activity. And by separating the perceived benefits of a governmental activ ity 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 to ward 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 1percent in 1915 to 6 percent in 1918; at $25,000 net income from 2 percent to 23 percent; at $100,000net 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 1925the highest marginal rate was 25 percent for $100,000 and more net income. By the late 1920sonly 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 adop tion 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 distri bution. 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, obvi ously, 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 $750,000of 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 taxa tion. When rates had been increased be tween 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 high er-income brackets fell. As examples, for the $500,000to $1,000,000net 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 676 THE FREEMAN • OCTOBER 1996 total personal income taxes paid by taxpay ers with net incomes of $1,000,000or more rose from 5.75 percent in 1923 to 15.9 percent in 1927. For taxpayers with net incomes of $250,000to $500,000their share of total personal income taxes rose from 6.82percent in 1923 to 12.40percent in 1927.

The share for taxpayers with net incomes of $100,000to $250,000rose from 15.7percent 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 in come 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 al ways 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 re ported on income tax returns and separate estimates of total income in the economy.

However, as tax rates fell during the twen ties, higher-income individuals began shift ing 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 in come 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 invest ments 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 mar ket 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 allof the rise in income inequality in the twenties disap peared.

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 wealth ier taxpayers. It would encourage them to shift wealth from tax-sheltering investments to taxable investments to receive larger after-tax returns .. The movement of eco nomic activity out of lower return tax shel tering 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 appro priate channels rather than into activities which were primarily directed to tax avoid ance, and to reduce the widespread legal tax avoidance by the upper-income taxpay ers. For example, Andrew Mellon, Secre tary of the Treasury, reported that when William Rockefeller (John D.'s brother) died in 1922 he held less than $7,000,000in Standard Oil bonds but over $44,000,000of 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 CUTTING MARGINAL TAX RATES: EVIDENCE FROM THE 1920S 677 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 retro actively to 1925. On average marginal per sonal income tax rates were reduced 33.6 percent by these changes. Rather than fall ing, real federal personal income tax reve nues 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 redistribution ist 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 10wer-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 util ities, airplane manufacturers, rubber tire manufacturers, supermarket chains, and so forth. The 1920s were a vibrant, growing decade, and the tax cuts of the 1920s cer tainly were an important part of what brought this about. D 1. See Robert Higgs, Crisis and Leviathan: Critical Epi sodes 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 Per sonal 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 1950to 1959,3.26 percent per year from 1960to 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.