“My grandmother used to tell me the folk tale of the frog,” recounted Commissioner Herman Cain of his childhood in Atlanta, Georgia. “If you put a frog in a pot of hot water, he would jump right out. But if you put him in a pot of cool water and gradually turned up the heat, he wouldn’t notice the rising temperature and would eventually boil to death.”
The American taxpayer is in hot water. Escalating marginal tax rates, increasing complexity, and advancing intrusiveness have created a system that has reached the boiling point. Over the years, Americans have surrendered more and more of their freedom to higher taxes. The result has not been to enhance economic security or to close the gulf between rich and poor. Instead, it has led to fewer jobs, slow economic growth, diminished hope and opportunity, an erosion of trust and confidence in government, and an ebbing of the American spirit of enterprise. It is a history that echoes James Madison’s warning that “there are more instances of the abridgment of the freedom of the people by gradual and silent encroachments…than by violent and sudden usurpation.”
The time has passed for incremental reform. The problems with the current system have grown too deeply entrenched to be solved with quick fixes and cosmetic repairs.
We believe the current tax code cannot be revised, should not be reinvented, and must not be retained. Therefore, the commission is unanimous: It is time to throw out the seven-million-word mess of tax laws and regulations and begin anew.
Marc Negri of Santa Rosa, California, wrote to tell us that, “The current system is so wrong and such a disincentive to the everyday worker that it cannot be saved.” Lawrence Madsen of Mills, Wyoming, prepares peoples’ taxes for a living, and yet wrote: “I am so disgusted with the [system] that I must urge you to completely abolish the Internal Revenue Code and start over.” A couple from Astor, Florida, was even more blunt: “The current tax structure is way out of date with the real world, too complicated with too many loopholes. We say dump it!”
Americans’ eagerness for real change reflects in part their frustration with a system that in the past forty years has seen 31 “significant” reforms and an astounding 400 additional “revisions” through public laws . And yet the tax code is more complex, more costly, and more economically destructive than ever. This is the story of how we got here.
THE ROAD TO TAX OPPRESSION
The New York Times, in a 1909 editorial opposing the very first income tax, predicted: “When men get in the habit of helping themselves to the property of others, they cannot easily be cured of it.” The history of our tax code, in economic terms, mirrors the course of most addictions: advancing dependence, diminished returns, and deteriorating health of the afflicted.
Supporters of the Sixteenth Amendment touted the income tax as the rich man’s burden – forcing “the Carnegies, the Vanderbilts, the Morgans, and the Rockefellers” to pay while sparing the middle class from pain. Indeed, after the income tax was enacted in 1913, fewer than two percent of American families were required to file a tax return. Rates ranged from 1 to 7 percent – with the highest rate applying only to Americans who had the equivalent of $7.7 million in income in today’s terms.
The rates did not stay that low for long. In 1916 the top rate doubled. A year later, on the eve of America’s entry into World War I, it soared to 67 percent. With the Second World War, the rate was raised to 94 percent. In the 1950s the top rate remained at the sky high level of more than 90 percent. President Kennedy initiated legislation that cut the top rate to 70 percent, but it was not until the Reagan growth years that the top rate was lowered dramatically to 28 percent. Under the current administration, the rate has resumed its ascent, with combined federal taxes pushing the top rate above 40 percent, including Medicare taxes and phase-outs.
With every attempt by politicians to “soak the rich,” the water mark has risen on the middle class. Author Frank Chodorov has summed up the incremental march of encroaching taxation: “At first it was the incomes of corporations, then of rich citizens, then of well-provided widows and opulent workers, and finally the wealth of housemaids and the tips of waitresses.” Congress expanded the income tax into the ranks of the middle class for the same reason Willie Sutton robbed banks: that’s where the money is.
This shift was mainly achieved by gradually multiplying the number of taxpayers required to file income tax returns and by raising average tax rates on ordinary citizens. Until World War II, the average tax rate (that is, the total tax paid divided by income) on a family with a 1991 income of $50,000 never rose above 4 percent. Since World War II, it has never fallen below 14 percent.
Marginal rates on the middle class have risen even more dramatically. Marginal rates are the “tax bracket” rates that apply to any extra dollar of income — such as raises, overtime, bonuses, or a second family income. The marginal middle class tax rate never rose above 8 percent prior to World War II. Since then, it has never fallen below 22 percent, rising as high as 33 percent during the high-inflation, bracket creep years of the 1970s.
Today, there are three principal defects of our income tax system that must be fixed immediately.
* Economically Destructive: Steeply graduated tax rates on both labor and capital destroy jobs, penalize saving and investment, and punish personal efforts to get ahead through hard work.
* Impossibly Complex: The mind-boggling complexity of the current tax code imposes an unacceptable burden on taxpayers and a huge cost on the economy.
* Overly Intrusive: The vast enforcement powers conferred on the I.R.S. are increasingly seen as infringements of privacy and personal freedom.
In the famous Supreme Court case, McCulloch v. Maryland, Chief Justice Marshall wrote: “The power to tax involves the power to destroy.” Some of the ways in which the current tax code destroys our economic vitality include:
* High marginal tax rates that weaken the link between effort and reward, depress productivity, and kill jobs.
* Multiple layers of taxation on work, saving, and investment that dry up new capital for investment.
* Capital gains taxes that act as a barrier to capital formation – preventing the flow of investment to new enterprises and would-be entrepreneurs.
* An “alternative minimum tax” that imposes immense compliance costs on businesses, sapping resources that could otherwise be put to constructive use.
* Double-taxation of corporate income which shrinks business investment and encourages companies to take on extra debt.
* Estate and gift taxes that force families to sell their businesses or family farms.
A fundamental principle of economics is that the more you tax something, the less you get of it. And if you tax success, you get less success. The current confiscatory system begs the questions: Why work harder if each extra dollar earns you less? Why save for tomorrow when spending today is cheaper? Why dream bigger, when little dreams are less expensive? The disillusioned answer of many Americans is simply: Why bother?
But the current system does not simply sap the initiative and aspirations of individual taxpayers, it undermines the economic strength of our nation as a whole. As President Kennedy once observed: “An economy hampered with high tax rates will never produce enough revenue to balance the budget, just as it will never produce enough output and enough jobs.”
High marginal tax rates combined with multiple taxation of work, saving, and investment act as a “double-barreled shotgun aimed at the American economy,” accountant Ted Krauss told the commission during a hearing in Washington. The price tag was estimated by Professor Dale Jorgenson of Harvard University who told the commission that the income level in the United States could be 15 percent to 20 percent higher than today if these biases did not exist.
This translates to losses of as much as $4,000 to $6,000 per year for typical middle-income families. The tremendous economic drain caused by an anti-work, anti-saving, and anti-growth tax system does not even take into account the enormous waste of resources — the time, money, and brainpower — lost in trying to comply with the current code.
Today’s tax code is so complex that many Americans despair that only someone with an advanced degree in rocket science could figure it out. They are wrong. Even a certified genius such as Albert Einstein needed help in figuring out his Form 1040. Consider this example from the Internal Revenue Code’s rules on the Earned Income Tax Credit. Here’s how they describe the little human creature we call a child:
(A) IN GENERAL.-The term “qualifying child” means, with respect to any taxpayer for any taxable year, an individual-
(i) who bears a relationship to the taxpayer described in subparagraph (B),
(ii) except as provided in subparagraph (B)(iii), who has the same principal place of abode as the taxpayer for more than one-half of such taxable year,
(iii) who meets the age requirements of subparagraph (C), and
(iv) with respect to whom the taxpayer meets the identification requirements of subparagraph (D).
This may look like English to the experts, but it is total gibberish to most other Americans. If nothing is done to simplify the impossible language of the current tax code, every American will need a laptop just to figure it out.Professor James Eustice of NYU Law School once defined an “expert” as “a person who avoids small errors as he sweeps on to the grand fallacy.” The problem with the tax code, he says, “is that it has been written and interpreted by so many ‘experts’ that it has lost sight of the fact that [real people] have to function under this system.” The result is a tax code so complex that even the ‘experts’ themselves can’t figure it out. This was illustrated by an annual survey of tax experts conducted by Money Magazine. Each year, the magazine would send a hypothetical tax return to 50 professional tax preparers, and every year it got back a startling range of responses, often encompassing 50 different answers. Needless to say, if the “experts” have trouble understanding the tax system, the odds are stacked against the rest of us.
Convoluted rules and regulations force small businesses to hire expensive accountants, forgo expansion or new opportunities, or in some cases avoid the entire mess by going underground. Tim Sabus of Denver, Colorado, wrote to the commission: “As an entrepreneur, I experience first hand the horrors of our tax system. It has grown into a monstrous predator that kills incentives, swallows time, and chokes the hopes and dreams of many. We have abandoned several job-creating business concepts due to the tax complexities that would arise.”
Another exasperated business owner, Frank Goodnight, told the commission at our Charlotte hearing that “during the recession of 1992, our company paid our accounting firm more money than we paid in taxes.” He is not alone: in 1991, the Tax Foundation reported that small corporations spent a minimum of $382 in compliance costs for every $100 they paid in income taxes.
According to 1995 I.R.S. estimates, businesses will spend about 3.4 billion hours and individuals will spend about 1.7 billion hours embroiled in tax-related paperwork. That means nearly three million people — more people than serve in the U.S. armed forces — work full time all year just to comply with tax laws, at a cost of about $200 billion a year, according to the Tax Foundation. In economic costs, this is like taking every new car, van, and truck that General Motors builds in a year and driving them off of a cliff.
In a recent hearing before the House Ways and Means Committee, William Dakin, senior tax counsel of Mobil, brought with him a six foot high stack of bound papers, weighing 150 pounds. These were Mobil’s corporate tax forms for 1993. It cost Mobil an estimated $10 million, and the equivalent of 57 people working full time for a year, just to figure how much tax the company owed. This is the essence of a brutally complicated tax system.
Jeff Renner, a real-estate developer from Bellevue, Nebraska, voiced the concern of many witnesses about the costly burden of compliance: “That time and effort and money did not educate a single child, it didn’t feed a single family, and it didn’t produce a single tangible object to improve the life of anyone.” And Roger McCarthy who runs an engineering firm in Menlo Park, California, complained of how the tax industry absorbs the high-tech talent that could be working in productive fields: “It is disturbing that we are not competing with companies like Intel and Hewlett-Packard for these top stars, but rather with Big Six accounting firms.”
There is no simple way of administering a monstrously complex tax code, just as there is no fair way of enforcing an unfair system. Former Treasury official Ernest S. Christian told the commission: “The present federal income tax code is a national disgrace that…has characteristics that would be condemned in any human personality. It is inexcusably class conscious, it is hypocritical, it is meddlesome, it is overbearing, it is mean and hurtful, it is covetous, and above all, it is downright foolish.” It is no wonder that the agency charged with enforcing such a system has become the object of increasing public ire.
Perhaps the most troublesome consequence of our modern-day income tax system is the enormous power that Congress has conferred on the Internal Revenue Service to force taxpayers to comply with the tax code. Twice as big as the C.I.A. and five times the size of the F.B.I., the I.R.S. controls more information about individual Americans than any other agency. Without a search warrant, the I.R.S. has the right to search the property and financial documents of American citizens. Without a trial, the I.R.S. has the right to seize property from Americans. What the I.R.S. calls its own “presumption of correctness” leaves many taxpayers feeling that they are “guilty until proven innocent” – a standard which turns norms of justice upside down.
Even those within the I.R.S. hierarchy concede the inquisitorial nature of the powers granted the agency. Fred Goldberg, former Commissioner of Internal Revenue, laments that “while it is unfair to the many fine people who work there, the I.R.S. has become a symbol of the most intrusive, oppressive, and non-democratic institution in our democratic society.”
The code is so complicated that the I.R.S. itself has trouble understanding it. “As a retired revenue agent, I feel qualified to attest to the monstrosity that the Internal Revenue Code has become,” a citizen from Michigan wrote to the commission. “When people who are employed to enforce the tax laws have difficulty understanding its complicated and sometimes incomprehensible provisions, it’s time for a change.” Of the liens the I.R.S. filed in 1990, a General Accounting Office study found 16,000 errors. The error rate for penalty notices to employers on tax deposits has stood as high as 44 percent.
Even when the I.R.S. is not in error, many of its practices make little sense. For example, tax documents are not treated as “timely filed” if sent by Federal Express rather than the U.S. Postal Service. The I.R.S. charges taxpayers interest even when the taxpayer is due a refund. In another example, one particularly exasperated citizen wrote to the commission and enclosed a notice just received from the I.R.S. assessing a penalty against his company. For an underpayment of one cent on his tax returns, the company received a letter from the I.R.S. imposing a penalty of more than $150. Others should be so lucky. Many who testified before the commission told tales not just of tax penalties, but of thousands of dollars in legal fees and countless hours with lawyers in efforts to rectify minor and unwitting infractions, or clear their records of unjust charges.
In Charlotte, businessowner Jean Hodges recounted a tale of horror in which she was forced to pay tens of thousands of dollars and spend untold hours trying to correct an error made by her company’s bookkeeper. “I would like to see Congress pass legislation affording small businesses relief from onerous and intimidating I.R.S. regulations,” she said.
The preceding pages illustrate what is wrong with the current tax system. But the case for a 21st century tax system must be made by more than a mere indictment of the status quo. To paraphrase Peter Drucker: You have to decide what’s right before you decide what’s possible. The following chapter outlines principles upon which a better future can be built.