Tax Analysts®Tax Analysts®

Article Archive

September 20, 2012
Tax History: Soaking the Rich for Fun and Profit
Joseph J. Thorndike

Full Text Published by Tax AnalystsTM

Paris has long been the arbiter of the avant-garde when it comes to fashion. Now French politicians are setting the pace on tax policy, too. Earlier this year, Socialist President François Hollande announced plans for a new 75 percent tax rate on individual incomes over €1 million ($1.23 million). The rate would catapult France to the top of the list of high-tax countries.

Hollande has defended the new rate as part of his effort to shrink France's growing budget deficit. But the new supertax is about more than simply raising money. It's also designed to make a point. "It's symbolic," Hollande said in recent public comments. "It will show an example."

Indeed, that's the essential nature of very high rates on very rich people. They aren't really about raising money, although they can do that pretty well sometimes. Rather, they are designed to make a political statement about fairness and economic justice.

What's High?

For most Americans, a top rate of 75 percent probably seems shocking. Democrats and Republicans have been locked in a death match for years over extending the Bush tax cuts, but even letting them expire would raise the top rate from 35 percent to only 39.6 percent.

By contrast, other nations impose much heavier taxes on the rich. Numerous countries have top rates in the low to mid-50s, including Austria, Belgium, Denmark, Finland, Japan, Sweden, and the United Kingdom. The world's highest rate is levied in sunny Aruba, where people making more than $171,000 face a top rate of 58.95 percent, according to figures compiled by KPMG LLP.

Still, that's a long way from Hollande's 75 percent. But U.S. history offers a refuge for Hollande and other fans of supertaxes on the rich. The United States had a top rate of 70 percent as recently as 1980 -- not exactly yesterday, but still within living memory for many taxpayers.

Famously, President Reagan convinced Congress to slash that rate (and others) dramatically. High rates were a drag on the economy and a barrier to prosperity, he argued. By the end of Reagan's second term, the economy was booming and the top rate was just 28 percent. Coincidence?

Well, yes, at least according to fans of raising taxes on the rich. If the history of the 1980s seems to bolster the connection between tax cuts and economic growth, the record of the 1950s seems to undermine it. Growth in the '50s was generally brisk -- if not exactly great. Growth averaged more than 4 percent annually, but the good times were punctuated by a pair of back-to-back recessions.1 Marginal tax rates remained high throughout the decade, never dropping below 91 percent.

Republicans complained loud, long, and more or less continually about those rates. But even after the GOP won control of the presidency and both houses of Congress in 1954, the rates stayed high. President Eisenhower was a genuine budget hawk, and he convinced his party colleagues to swallow hard and accept high rates as a fiscal necessity.

The solid growth of the 1950s seems to vindicate Eisenhower's intuition that fiscal probity was more important than tax cuts. So high tax rates are good for the country, at least in the face of deficits, right?

Not exactly. Most economists writing in the 1950s thought high rates were deeply pernicious. "Most of those who still favor very high income tax rates as a matter of social philosophy have recognized that on balance they are bad," wrote Dan Throop Smith, a Harvard economist and Treasury tax expert during the Eisenhower administration. "They distort personal and business decisions and lead to action and attitudes which may jeopardize the income tax itself."2

Smith and his like-minded colleagues weren't arguing that high rates made growth impossible. "The nonpecuniary incentives for economic activity are numerous and powerful," he stressed. Rich people would keep right on working even if rates climbed into the stratosphere.

But they wouldn't work quite as hard on making money. Instead, they would focus their efforts on finding ways to avoid high tax rates. "With high taxes, it becomes much more important to save a dollar of taxes than to earn another dollar of income," Smith pointed out. High rates would necessarily "divert attention from production to tax minimization," he wrote.

Worse, high rates had a tendency to make the public more tolerant of tax avoidance, at least if that tolerance could be measured by the willingness of politicians to facilitate it. High rates inevitably spawned loopholes and other special relief provisions.

The United States could not allow that sort of moral and legislative decay to undermine its tax system, Smith warned. "We still have among most social groups in this country a feeling that tax fraud is morally reprehensible," he wrote. "This is a tradition as precious as it is rare in the world."

Parisian Pitfalls

Opponents of raising taxes on the rich often warn that taxpayers will simply flee high-rate jurisdictions for greener pastures. And in fact, France's richest man seems to be making good on that threat. Bernard Arnault, head of the luxury goods company LVMH, recently announced that he was seeking Belgian citizenship, ostensibly for nontax reasons. (And he may be telling the truth; Belgium is hardly a low-tax country, with a top rate of 50 percent on personal income. If Arnault is looking to keep more of his money, he would do well to look elsewhere -- Kazakhstan, maybe, where all income is taxed at a flat 10 percent.)

But fleeing billionaires are not the biggest problem to come from superhigh rates on superrich people. As Smith understood in the 1950s, the real threat is to the income tax itself, not to mention the nation's civic culture. "Very high rates strain the integrity of individuals," he wrote. "The rates put a premium on subterfuge, on expense account living, and on all devices which may come within the letter though they violate the spirit of the law."

Income taxes -- particularly of the self-assessed variety -- do not function well in such an environment. Which is why tax experts of the postwar era argued consistently -- and even passionately, at least by policy-wonk standards -- for generalized rate reduction, coupled with a rollback in tax preferences.

Today, of course, no one is arguing for a return to Eisenhower-era 90 percent rates. And reasonable people can disagree about where the pernicious effects of high rates really begin to show up. Is it at 40 percent? 50? 75? There's no easy or definitive answer, although some recent research from progressively minded economists would suggest that the number could be surprisingly close to Hollande's 75 percent.3

Ultimately, however, such research is immaterial, at least in political terms. The argument for raising tax rates on rich people has never really been about revenue, incentives, or even growth. It's been about fairness, plain and simple. Fans of "soaking the rich" are certainly happy to embrace studies that support their policy agenda. But it seems fair to say that many fans of high-rate supertaxes would still like them even if they lost money or slowed growth.

Certainly that's been the lesson of U.S. history. After all, it's not like economists of the 1930s thought that New Deal tax hikes on the rich were cost free in terms of incentives. Indeed, even those economists who designed the New Deal tax regime -- certified liberals like Carl Shoup and Roy Blough -- understood that extreme progressivity in the rate structure came at a price. But by and large, they understood that such rates were necessary, politically if not fiscally.

Ultimately, those high rates came down, thanks in no small part to the arguments offered up by those same economists. But it took a long, long time, and the damage caused by those rates played a key role in shaping the conservative revival of the 1970s. As Smith had warned, high rates corroded the tax system through the postwar decades, undermining popular faith in its fairness. By the late 1960s, Republicans were ready to challenge that system, and the new GOP rode an antitax wave into power.

So if you're looking for the roots of modern antitax politics, you can start with the progressive tax rates of the 1930s. Soaking the rich can seem like a good idea, especially when times are tough. But it's a perilous agenda, at least for fans of progressive taxation.


FOOTNOTES

1 GDP data from the Bureau of Economic Analysis.

2 Dan Throop Smith, "A Program for Federal Tax Reform," 50 Am. Econ. Rev. 470 (May 1960).

3 For a notable example, see Peter Diamond and Emmanuel Saez, "The Case for a Progressive Tax: From Basic Research to Policy Recommendations," 25 J. Econ. Persp. 165 (2011).


END OF FOOTNOTES