The Promise and Peril of Symbolic Taxation
Joseph J. Thorndike is a contributing editor with Tax Analysts. E-mail: Joe_Thorndike@tax.org.
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By almost any measure, inequality is on the rise. Since 1980, gains in business productivity have enriched a few lucky souls at the top of the economic pyramid but done little to improve the lot of typical workers.
So what's driving that trend? According to many economists — and the right-leaning politicians who love them — it's all about education. In a modern, globalized, technology-driven economy, workers with relevant skills reap larger rewards than those without. If we want to shrink the growing gaps in wealth and income distribution, we should create a better educated, better trained workforce.
In recent years, a growing cohort of skeptics have challenged that prescription. While acknowledging the importance of education, those critics have also stressed the importance of political and institutional factors, including unionization, regulation, and — wait for it, wait for it — taxation.
According to a recent study by Frank Levy and Peter Temin, both of the Massachusetts Institute of Technology, nonfarm business productivity increased 67 percent between 1980 and 2005. But weekly compensation for full-time workers rose just 19 percent over the same period. If average workers aren't getting it, then where's the money going?
Straight to the top, according to many observers. Economists Thomas Pinketty and Emmanuel Saez have calculated that the top 1 percent of American families saw their share of gross personal income more than double from 8 percent in 1980 to 17 percent in 2005. Other studies have further narrowed the winners list, finding the most dramatic gains among the ranks of the superrich, including the fortunate few who cluster near the top 10th of that top 1 percent. (See, for example, Martin J. McMahon Jr., "The Matthew Effect and Federal Taxation," Tax Notes, Dec. 6, 2004, p. 1383, Doc 2004-21987, or 2004 TNT 235-40.)
Until recently, complaints about income and wealth distribution have been confined almost exclusively to the political left. Liberals have been beating that drum for years, with progressive bloggers making the most noise. Indeed, the Democratic netroots (their preferred neologism) deserve the credit for elevating that issue to the point that even many conservatives are prepared to acknowledge the trend.
Institutions and Distribution
But what to do about it? For most Republicans, education is the answer. Create a better educated workforce, and more people will share in the benefits of technology and trade.
Critics on the left, while acknowledging the importance of education, point to a variety of institutional factors that help shape the distribution of market rewards. Rates of unionization, for instance, and political protections for collective bargaining. Or minimum wage laws and other forms of business regulation. A few have even argued that tax policy can play a vital role in shaping the distribution of pretax income.
In their recent paper, "Inequality and Institutions in 20th Century America," Levy and Temin place recent inequality trends in a larger historical context. "A central feature of post-World War II America," they point out, "was mass upward mobility," with most workers enjoying a steady rise in income over the course of their careers and between generations. That "Golden Age" ran out of steam, especially after 1980. What happened?
Well, Ronald Reagan happened. For more than 30 years after the end of World War II, American society was shaped by a set of institutional arrangements that took shape during the New Deal and found a permanent home in the postwar political consensus. Those arrangements, which included labor protections and steeply progressive tax rates, helped keep a lid on inequality. But after 1980, the Republican ascendancy brought an end to that era. Deregulation and tax reduction helped recast the economic landscape, ushering in a new era of accelerating inequality.
The New Deal Order
According to Levy and Temin, Franklin Roosevelt deserves much of the credit for the Golden Age of broad-based income growth. Determined to pull the U.S. out of the Great Depression, FDR remade both state and society. He injected the federal government into economic decision-making on an unprecedented scale, first directly through the National Industrial Recovery Act (which gave officials a formal role in production and employment decisions), and later through the proxy of state-protected labor unions. Both techniques ensured that wages would rise significantly, boosting the propensity and ability to consume for millions of workers. Many New Dealers believed that wage hikes were the best way out of the depression.
But they were not the only way. As Levy and Temin point out, the New Deal policy regime also featured steep taxes on the rich. For most New Dealers, those taxes were a moral necessity. Relief and recovery programs were generating huge deficits, and new taxes were considered a fiscal necessity. But since poor and middle-income Americans were struggling just to stay afloat — and were already saddled with a host of regressive excise taxes on consumer goods — the rich would have to pick up the tab; "ability to pay" had a particular resonance in the face of mass destitution.
Moreover, reports of widespread tax avoidance by the rich left many observers outraged. Aggressive efforts to minimize tax liability struck Roosevelt and his allies as morally repugnant, even when they were technically legal. They believed that rich Americans should be forced to shoulder more of the fiscal burden, especially in the face of so much suffering among the working class. If heavier taxes on the rich could be made to raise substantial revenue, that was great. But for many liberals, including the president, "soaking the rich" was an end in itself.
For some New Dealers, heavy taxes on the rich also promised to aid the drive for recovery. Money stashed away in bank accounts was sterile, they argued, especially in an era marked by surplus productive capacity and feeble consumer demand (the most popular contemporary explanation for the depression). Those officials, often regarded as proto-Keynesians, wanted to liberate the power of that "hoarded" money, appropriating it with income and estate taxes and spreading it around with relief and recovery spending.
Persistently Soaking the Rich
To a remarkable degree, the institutional arrangements of the New Deal survived World War II, despite the ethos of business-government cooperation that emerged during the war. To be sure, business staged a counterrevolution in the postwar years, rolling back some pro-labor elements of the New Deal regime and even reducing tax rates a bit. But the broad outlines of the New Deal order remained largely intact.
In particular, steep marginal tax rates stayed on the books. Not for lack of complaining, mind you. Congress did, in fact, cut taxes modestly after the end of the war, largely in response to business complaints. But the essential structures of federal taxation — including marginal income tax rates reaching above 90 percent — remained a fixture of federal finance for almost 20 years after the end of World War II. So, too, did heavy estate taxes.
Rates stayed high because they served a moral and political purpose. As Levy and Temin point out, they sent a message about the distribution of economic rewards; for many Americans, it seemed entirely reasonable that the state might stake a claim to more than 90 cents of every marginal dollar earned by the superrich. Indeed, high rates reflected a larger political consensus — a set of norms - - that endorsed redistribution of wealth and income.
In June 1957 a Gallup poll posed the following question:
The Government now takes a large part of the income of well-to-do persons. Many states are asking that the Constitution be changed to place an income tax limit of 25 percent to 35 percent on what any person would have to pay. This would mean that the government would lose money which it would have to raise by other kinds of taxes. Would you favor or oppose changing the Constitution to place a top limit of 25 percent to 35 percent on the amount of income tax which any person would have to pay?
Only 17 percent supported a cap, while fully 68 percent opposed one.
Two years earlier, a Roper poll asked whether the income tax, then sporting a top rate of 91 percent, should be "changed to make the rate stiffer on people with big incomes, or not so stiff?" Seventeen percent took pity on the rich, endorsing "not so stiff." Another 39 percent thought current rates were adequate. But fully 38 percent were unmoved by the plight of the overtaxed elite and asked for even higher rates.
Yet another poll, conducted in 1954, asked respondents about tax reforms already passed in the early postwar years. Did they favor some groups more than others? And if so, which ones? Forty-five percent thought cuts had been skewed to help a lucky few. Of those respondents, 53 percent fingered "the rich, the big shots" for having gotten off too easily. (Another 38 percent said "big business," while only 5 percent thought "average people" had been the lucky ones.)
Politicians were well attuned to those sentiments. And it's important to note that Democrats were not the only ones who embraced progressive taxation on the New Deal model. Republicans of the 1950s regularly complained that high rates were unfair and inefficient. (For that matter, so did liberal economists, who recognized the disincentive effects associated with soaking the rich.) But a bipartisan majority appreciated the political utility of keeping rates high. As any number of observers have pointed out, high rates made tax preferences valuable. Lawmakers capitalized on that value by marketing preferences to well-heeled and well-connected constituents. To be sure, leaders of the tax policy community — including legislators like Wilbur Mills and many of his fellow taxwriters — pursued tax reform of the base-broadening, rate-lowering variety. But most lawmakers understood their vested interest in keeping rates high.
The End of an Era
Reagan's election in 1980 brought an end to the New Deal regime, including its tax components. But the process had started even earlier. High rates were in scholarly disrepute even during the late 1930s, and by the early 1960s, even many lawmakers were ready to bring them down. They did so in a series of revenue measures, beginning in 1964 and continuing through the mid-1980s.
The end of symbolic, "soak the rich" taxation was helped along by problems inherent to the New Deal model of revenue reform. High marginal rates had undermined the moral standing of the income tax, encouraging the sort of widespread avoidance that eroded public confidence in the regime. By the time Reagan rode a tax revolt to victory in 1980, Americans were already convinced that the income tax was easily gamed by the privileged — and well-lawyered — few. In such a context, base broadening and rate-reducing reforms of the 1986 variety seemed particularly attractive.
In other words, the tax regime inspired by the New Deal and implemented during World War II contained the seeds of its own destruction. To be sure, steep rates reflected a set of political norms that discouraged wide disparities in the distribution of wealth and income. And as Levy and Temin suggest, those norms — and perhaps even those taxes — might have helped keep a lid on inequality. Those rates are almost certainly unsustainable, at least over the long run.
But then again, as John Maynard Keynes famously remarked, "in the long run, we're all dead." Soak the rich taxation had a pretty good run, enduring for at least 20 years after the end of World War II (and perhaps another 20 years after that, depending on what rates you think might constitute a good soaking).
Today, many Democrats seem interested in at least a modest move back toward progressive taxation. Proposals popular among the current crop of Democratic presidential candidates would restore the top rates from the 1990s — hardly a return to soak the rich taxation, but still a sign of progressive proclivities.
The era in which tax rates serve a symbolic role — signaling popular disapproval for concentrated wealth and highly skewed income distributions — may not be gone forever. Economists may not like high rates, and those rates may in fact pose a danger to the long-term viability of the income tax itself. But those thoughtful objections do not always carry the day in the realm of tax politics. As Levy and Temin conclude:
The last six years of federal tax history have involved an inhospitable politics in which winners have used their political power to expand their winnings. But political sentiment does shift. Economic distress like the 1930s can induce such a shift. Even the smaller economic distress of the 1970s was enough to redirect American economic policy. Only time will tell if more economic distress is needed to change policy yet again.