One original sin was the separation of the corporate and personal tax, giving lawyers, accountants and the wealthy a chance to game the system.
Before the modern era, however, the federal tax system was manifestly unfair by any reasonable standard, grossly biased in favor of the well off. Ironically, attempting to fix that unfairness is what has brought us to the present moment, with a federal tax system that is grotesquely complex, often arbitrary, and corrupted by mutual back-scratching between members of Congress and influential lobbyists.
After the Civil War, nearly all the wartime taxes—including the nation’s first income tax—were repealed and the federal government relied mostly on the tariff for revenues. It provided the government with more than ample peacetime income. In 1882, the government had revenues of $403 million, but expenses were only $257 million, a staggering budget surplus of nearly 36%. The reason the tariff was so high was, ostensibly, to protect America’s burgeoning industries from foreign competition.
Of course, the owners of those burgeoning industries—i.e., the rich—were greatly helped by the protection, which enabled them to charge higher prices and make greater profits than if they had had to face unbridled foreign competition.
But the tariff is a consumption tax, which is simply added to the price of the goods sold. And consumption taxes are inherently regressive. The poor, by definition, must spend all of their income on necessities and thus pay consumption taxes on all of their income. The rich, while living in luxury, bank most of their income and largely escape these types of taxes.
As the vast surpluses piled up in the Treasury, the political pressure to institute an income tax on the rich grew steadily. In 1894, with Democrat Grover Cleveland in the White House and Democratic majorities in both houses of Congress, a federal income tax became law. The new tax, however, was very different from the Civil War income tax, which had exempted only the poor. The new one hit only the rich, imposing a 2% tax on incomes above $4,000. Less than 1% of American households in 1894 met that income threshold.
Needless to say, the tax was attacked in court, in a 1895 test case called Pollack v. Farmers’ Loan & Trust. The case turned on the definition of a “direct tax,” which the Constitution requires to be apportioned equally among the states according to population, something obviously impossible with an income tax.
The court split 4-4 as to whether the new income tax was constitutional. One member of the court, Justice Howell Jackson of Tennessee, was absent because of illness (and died less than three months later). But with the case drawing enormous public attention, the court agreed to reargue it and Justice Jackson rose from his deathbed to hear it.
Jackson was known to favor the income tax and it was assumed that it would now be upheld 5-4. But one of the other justices switched his vote (the opinion is unsigned and we don’t know by whom or why) and it was voted down 5-4.
The income tax was dead. But the pressure to tax the incomes of the largely untaxed rich only increased, especially as the Progressive wing of the Republican Party grew in strength under Theodore Roosevelt. By the time of the administration of President William Howard Taft (1909-13) the pressure was becoming overwhelming. One representative suggested simply repassing the 1894 tax bill and daring the Supreme Court to overturn it a second time.
That idea horrified Taft, who revered the court. He feared that it would weaken its position as the final arbiter of the Constitution. He came up with a brilliant, very lawyerly, alternative: He proposed a constitutional amendment to legalize a personal income tax, while meanwhile imposing a tax on corporate profits. In the early 20th century such a tax was, in effect, a tax on the rich. As the corporate income tax is technically an excise tax, there was no constitutional problem. Taft’s solution was implemented and in 1913 the 16th Amendment was declared ratified, just as Taft was leaving office.
The new president, Woodrow Wilson, and the strongly Democratic Congress promptly passed a personal income tax. It kicked in at 1% on incomes above $3,000 (a comfortable upper middle-class income at the time) and reached 7% on incomes over $500,000. But there were many deductions, bringing the effective tax rates down sharply from the marginal ones—a feature of the tax system ever since.
Unfortunately the corporate income tax, originally intended as only a stopgap measure, was left in place unchanged. As a result, for the last 98 years we have had two completely separate and uncoordinated income taxes. It’s a bit as if corporations were owned by Martians, otherwise untaxed, instead of by their very earthly—and taxed—stockholders.
This has had two deeply pernicious effects. One, it allowed the very rich to avoid taxes by playing the two systems against each other. When the top personal income tax rate soared to 75% in World War I, for instance, thousands of the rich simply incorporated their holdings in order to pay the much lower corporate tax rate.
There has since been a sort of evolutionary arms race, as tax lawyers and accountants came up with ever new ways to game the system, and Congress endlessly added to the tax code to forbid or regulate the new strategies. The income tax act of 1913 had been 14 pages long. The Revenue Act of 1942 was 208 pages long, 78% of them devoted to closing or defining loopholes. It has only gotten worse.
The other pernicious consequence of the separate corporate and personal income taxes has been a field day for demagogues and the misguided to claim that the rich are not paying their “fair share.” Warren Buffett recently claimed that he had paid only $6.9 million in taxes last year. But Berkshire Hathaway, of which Mr. Buffett owns 30%, paid $5.6 billion in corporate income taxes. Were Berkshire Hathaway a Subchapter S corporation and exempt from corporate income taxes, Mr. Buffett’s personal tax bill would have been 231 times higher, at $1.6 billion.