It’s staple fare in opinion pages and textbooks these days that “inequality” has been on the rise in this country over the past generation. President Obama’s economic policy, for what it’s worth, has been based on this premise. The introduction to Obama’s first budget, back in 2009, went on at length:
For the better part of three decades, a disproportionate share of the Nation’s wealth has been accumulated by the very wealthy. [Yet] instead of using the tax code to lessen these increasing wage disparities, changes in the tax code over the past eight years exacerbated them. … By 2004, the wealthiest 10 percent of households held 70 percent of total wealth, and the combined net worth of the top 1 percent of families was larger than that of the bottom 9 percent. In fact, the top 1 percent took home more than 22 percent of total national income, up from 10 percent in 1980.
These statistics—all this about the “top 1%,” which inspired the ne’er-do-wells of Occupy Wall Street—came out of mediocre research. I lay it all out in an extended paper published last week by the Laffer Center for Supply-Side Economics.
The funny thing about “income inequality” is that it uses taxable income as its measuring point. The problem with this, obviously, is that if high taxes reduce the rich’s taxable income, the rich in turn will not be able to carry the burden of paying taxes—their income will be too low. High taxes on the rich will necessitate further taxation of the middle class.
A look at history shows that the original designers of our income tax system understood this reality all too well. Before 1913, when the income tax was started, the main way the federal government financed itself was through tariffs. But tariffs hit the little guy. Every time you bought an imported good, the price was marked up. Moreover, domestic prices were artificially high, because they didn’t have to compete with cheap foreign goods. It all made for appreciably lower purchasing power for everyone in the nation.
Therefore, in 1913, Congress devised a switch whereby the tariff would be lowered, in exchange for a small rate of income taxation on the very rich. The top rate of the income tax was at first all of 7% (compared to 36% today). The receipts from this income tax were counted on to replace those of the tariff. Under the new system, the public at large would not carry the brunt of taxation—only those with high incomes would.
This arrangement was fated to work very well, with two important caveats. The first was that the income-tax rate had to be kept low. If ever that rate got high, the rich would begin to hide their income, through tax-shelters and so on, such that their income would no longer be available for taxation. Second, government had to be kept small. If government got big, taxes on even the rich would not be enough to fund it.
Sure enough, in time both of these caveats were transgressed, and that is where we got the modern tradition of the taxation of the middle class. As early as 1918, the top tax rate went all the way up to 77%, and after 1932, it was above 63% for fifty straight years. And the 2% of GDP that had amounted to government size in 1913 in time ballooned all the way up to the 22%-plus we are dealing with today.
Hence came all the payroll taxes, income-tax withholding, lower-level tax brackets, and all the rest that the average Janes and Joes in this country have been dealing with since roughly the New Deal. And it never had to happen.
Long ago, the government hit upon the secret to never taxing the middle class at all, not even by the stealth means of the tariff. A small rate of taxation on the rich would let the rich’s fortunes bloom and be big enough to finance a government purposefully moderate in size.
It’s one of the tragic tales of modern American history. The next time you hear a politician say the rich need to pay their fair share, make note that we’ve already figured out how to get the rich to do even more—to pick up the whole bill. It would require getting this bloated federal state of ours back to its old, growth-enhancing norms.
Books on the topic discussed in this essay may be found in The Imaginative Conservative Bookstore. Originally published at Forbes.com the essay is reprinted here with gracious permission of Brian Domitrovic.