The main purpose of this book is to outline recent developments and ideas about taxes, tax policy, and theory in the United States. To begin to understand the crosscurrents of thinking about these issues, it is helpful to know something of the economic background and problems besetting the American economy.

Since the early 1970s, the large industrial sectors have suffered a long and debilitating recession. Traditional large-scale industries, such as mining and steel, are all but dying out and being replaced by more efficient foreign competitors. Moreover, rapidly growing industries, such as communications and computers, do not require vast amounts of the output of traditional sectors.

Large-scale shifts in the configuration of modern products and services have been taking place for some time. Nevertheless, it is now more than a decade since the American economy turned sour, and the growth in real per capita income has continued to sputter along with general economic conditions. Recoveries are relatively short-lived, and economic indicators are often lower than during the preceding upturn in activity. The economy appears to be in a long period of decline, relieved by periodic but anemic recoveries. Some of the ground lost during recession is regained, but advances are neither robust nor lasting. No single factor is responsible for this poor economic performance. Worldwide shocks to the system, such as the Viet Nam War, the movement to a generalized, floating foreign exchange, and the oil embargoes, have had notable effects.

Introduction

Much of government's work gets done at the local level. This fact is reflected in both the structure and sheer numbers of local jurisdictions. Table 12.1 shows the numbers and dynamic character of local governments. The most dramatic change during the twenty years tabulated in the table is the decrease in the number of school districts from nearly thirty-five thousand in 1962 to only fifteen thousand in 1982. This shift reflects the strong move toward consolidation of schools, especially in rural and suburban areas.

The other marked change in the structure of local jurisdictions is the rapid rise of special districts. Special districts are independent, limited-purpose governmental units that have substantial fiscal and administrative independence from general-purpose local jurisdictions, such as counties and municipalities. Most special district governments are created to fulfill a single function, although a few are authorized to provide two or more public services (“Special Purpose …” 1982:3).

Table 12.2 shows both the number and type of functions performed by the nearly twenty-nine thousand special district governments in the United States during 1982. Natural resources is the largest single category. These jurisdictions perform such varied functions as drainage, flood control, irrigation, and soil and water conservation. The other functions are for the most part selfexplanatory. The list does, however, give a feeling for the richness and diversity of the public services that are financed through taxes and fees.

Incidence studies seek to determine who actually pays how much in taxes (Break 1974:119–237). Two objects of research on incidence are to determine whether the tax structure of a country has had an effect on the distribution of income and to ascertain if the tax structure is equitable as perceived by the majority of voters. To help find the answers to these questions, researchers study the vertical equity of taxes. Unlike the rule of horizontal equity, which implies that individuals in like economic circumstances should be taxed similarly, vertical equity is concerned with the distribution of taxes between and among different income classes.

Most governments, societies, and countries either explicitly or implicitly use individual or household income as a measure of the economic well-being of the taxpaying unit. Vertical equity in taxation is concerned with the relationship between taxes paid and the income of the taxpayer. Even though a rich individual's tax bill is larger than that of a less wealthy person, if the tax as a proportion of income is lower than that of the person with a smaller income, the levy is characterized as a regressive tax. If the ratio of taxation is constant for all individuals, regardless of the level of income, it is proportional tax. Finally, if the share of income a person pays in taxes increases as income increases, it is a progressive tax.

Historical background

The fascinating early history of the U.S. income tax centered on three main factors:

1. budgetary deficits and surpluses;

2. the redistribution of income;

3. the question of direct versus indirect taxation.

Each of these issues proved to be important forces in the final and permanent adoption of the individual income tax.

Budgetary deficits and surpluses

In many instances throughout history, war proved to be an important factor in revolutionizing the fiscal system of a country. The Civil War was no exception. Tariffs, which had been the principal form of federal taxation until 1861, proved to be an inadequate revenue source for a government struggling with seceding southern states (Paul 1954:7).

A rather vague revenue law passed by Congress in 1861 committed the North to the use of an income tax. It was strengthened in 1862 when the levy was made mildly progressive, and provisions for withholding taxes at the source, including interest and dividends, were instituted (Paul 1954:7; Groves 1964:162–4).

After the usual administrative difficulties associated with introducing a new levy, the income tax proved to be a substantial source of revenue. Because funds were needed to prosecute the war, rates were increased and made more progressive in 1864. During the postwar period, Congress increased the personal exemption, made the tax proportional, and twice reduced rates. Nevertheless, large budgetary surpluses emerged, exercising a strong fiscal drag on economic activity (Olson 1973:8; Paul 1954:12–13).

To understand the effect of inflation on corporations, it is necessary to understand the impact on the firm's income of traditional accounting practices together with the tax code. Inflation changes the prices of the items an enterprise buys and sells, thereby affecting costs and revenues, income, and the effective tax base. In addition, the use of the convention of historical cost accounting has a very important impact on business tax liabilities.

Introduction

There is almost universal agreement that the historical cost method of accounting significantly increases nominal profits during periods of inflation. Profits are higher than what they would be if all of a firm's costs and receipts were expressed in similar and constant prices (Mathews 1975:338).

Martin Feldstein (1979b:57) has discovered that the effective tax rates on capital income of various kinds increased substantially during the inflationary decade of the seventies. The reason was not due to increases in the statutory rates of taxation but to the mismeasurement of capital income. Mismeasurement occurs during inflation because of two main features in the present U.S. tax code: depreciation allowances on structures and equipment permitted by the government are based on the original or historical costs of the capital rather than the current replacement costs; and inventories are valued at current prices, and nominal or paper profits that accrue because of this practice are subject to the corporate income tax.

How do U.S. taxes and policy stack up against the various criteria for a sound and effective tax system enumerated in Chapter 1? The answer is not encouraging.

By the mid-1980s, the chorus of critics of the tax structure had grown enormously. As Pechman (1982:145) notes, there is an almost universal demand for tax revisions and tax reduction. The reason for this state of affairs is the intense and near universal dissatisfaction with the way taxes actually work in practice. They fail to a significant degree to meet the principles of a good tax. Chapters 1, 2, 3, 5, 6, 7, and 8 chronical a long list of important and critical defects in the federal tax structure.

Despite the recent legislation authorizing the indexing of the individual income tax, the tax system as a whole has not been able to cope effectively with the capricious and counterproductive effects of inflation. Moreover, there is danger that this partial indexing of the system will be repealed by a Congress deeply concerned over unprecedentedly high and continuing budget deficits.

Other serious defects embedded in the tax structure include the existence of a socially unproductive tax shelter industry; the extreme complexity of the system with the concurrent growth of the tax preparation and avoidance industry; the inequitable and inefficient marriage, payroll, capital gains, and individual and corporate income taxes; and the high cost of administering these levies.

Introduction

The sales tax, after the federal income tax, is probably the tax most familiar to the American taxpayer. Most consumers confront retail sales taxation on a daily basis and give it little thought. It is simply a part of the shopper's life. The sales tax has an obvious meaning to consumer and economist alike; it is a tax, generally ad valorem, on the transfer of commodities and services, usually at the retail level. An ad valorem tax is one in which the product bears a uniform percentage of the purchase price.

The sales tax is not necessarily a single-stage tax. It can be levied at any number of points in the production and distribution process. In reality, the sales tax is often a combination of a turnover tax and a single-stage tax (Morgan 1964:7). Although the sales tax base can vary considerably, the sales tax is not an excise tax that is a specific selective levy (Due 1957:3). Normally, the sales tax applies to a general category of goods (e.g., all retail commodities), with any exemptions made explicit. Although the sales levy is very similar in economic effect to the business occupation tax, it can be distinguished by legislative intent. The sales tax is implicitly or explicitly made with the intent that the levy will be passed forward to the purchaser, whereas the gross receipts occupation tax is on business per se for the privilege of doing business (Due 1971:2).

From the late 1930s until sometime in the 1970s, the exact date is too nebulous to pin down, the major influence on U.S. stabilization and tax policy was Keynesian aggregate theory. As we shall see in the forthcoming sections, Keynesian macrothought and policy has since been challenged by the monetarists, the rational expectationists, and the supply-siders.

Monetarists believe that appropriate control of the money supply will help foster the conditions necessary for the growth of a healthy economy. In the short run, changes in the stock of money are crucially important in determining fluctuations in real output and employment. In the long run, however, the quantity of money can only influence nominal gross national product (GNP). Real income is affected by many of the same elements that supply-side, neoclassical economists emphasize. These micro-economic factors include such real variables as the suppliers of labor, raw materials, and capital, the state of technology, the amount and quantity of human capital, the health and resourcefulness of individuals, a sound legal framework, and a stable and constructive public policy that contains the incentives necessary to put productive resources to efficient use (Meiselman 1982:9).

Monetary macromodels have not been especially successful in predicting the path and turning points of such important economic variables as consumption, investment, saving, and GNP. Moreover, the Federal Reserve has not followed the macrorecommendations of monetarists because it has been unwilling or unable to follow a consistent policy of steady growth in the stock of money.

The state-local sector is the most dynamic and experimental in the use of taxes in our federal system. Since World War II, state-local tax revenues have grown more rapidly than those of the federal government. Furthermore, these governments have led the way in trying out such diverse revenue devices as lotteries, user fees, and constitutional limits on the level of taxation (Courant, Gramlich, and Rubenfeld 1980:8–20).

Reasons for growth in state-local taxes

There are several reasons for the relative growth of the state-local government sector of the economy. These factors help account for an increasing decentralization of financial affairs in federal countries since the end of World War II. A discussion of several of the factors pushing up state-local taxes follows (Davies 1977:65–82):

1. State-local governments in a federally structured country are originally assigned and tend to keep a wide variety of government functions that require resources for their fulfillment. The important areas of education, highways, health, welfare, and fire and police protection illustrate important responsibilities that are often assigned to state-local governments by constitutional authority. State-local jurisdictions will grow more rapidly than central governments if the income elasticity of demand for their services increases more rapidly than it does for federal programs. This factor has been operative in most countries since the end of World War II. Large increases in population and its density have fostered strong and increasing demands for precisely those goods and services that state-local governments provide.

The United States corporate income tax was passed into law in 1909, predating the individual income tax by more than four years. This tax has been an integral part of the federal revenue system for almost fifty years but has been declining as an important source of revenue since the Korean War. In 1950, it accounted for 28 percent of total federal receipts; in 1960, 23 percent; and in 1970, 17 percent (U.S. Bureau of Census 1974:222). By 1982, the figure had dropped to 12 percent (U.S. Bureau of Census 1983:4). The estimated figure for 1985 was also 12 percent (Council of Economic Advisers 1984:220, 304–5).

Introduction

Currently, the corporate tax is the center of much attention because many analysts believe it to be both inequitable and inefficient. They argue that it has inhibited economic growth by stifling capital formation, and that the net real rates of return provided by investment are not sufficiently high to attract the funds of investors. Moreover, the enormous and continuing federal budgetary deficits have created extremely large demands in the money and credit markets, driving up interest rates, attracting the relatively small amount of savings now available, and generally exacerbating the problem of capital formation. The issue of economic growth has caused analysts, investors, and politicians to focus attention on the nature and structure of the corporate income tax.

In addition to the cross-sectional analysis cited in the text, Feldstein and Slemrod (1978c: 134) have used time series analysis to study the lock-in effect and its impact on government revenue. They compared the two years before the 1969 Act that increased taxes with the two years most recently available. Realized gains increased by 18 percent during this period for individuals with income less than $100,000. Investors with incomes between $100,000 and $500,000, and those in excess of $500,000 whose tax rates were more substantially affected by the 1969 law, realized gains decreased by 12 percent and 35 percent, respectively. The time series data support the idea of sensitivity developed in their massive NBER cross-sectional study (Feldstein 1978b:508).

Feldstein and Slemrod (1978c: 134) conclude that under high rates of taxation unrealized gains remain locked into portfolios. Lowering tax rates would unlock them and permit a substantially higher volume of trading in assets, which would not only make investors better off but also make Treasury richer in the process, at least in the short run (Feldstein 1979b:55).

Otto Eckstein, the president of Data Resources, Inc., agrees with the NBER finding. He notes that investors in the top tax bracket “don't sell stock and don't take their capital gains” (Zucker 1978:24). Researchers at Data Resources, who analyzed a series of tax proposals, estimated that if the tax on capital gains were totally eliminated, federal tax receipts would decline by $5.1 billion in 1978 but then rise by approximately $38 billion during the next five years (“Footnotes to the Above” 1978:20).

Nature of capital gains

According to United States tax law, capital is defined as any property except that held for sale in the ordinary course of business. Inventories, depreciable business property, real property used in a trade or business, and debt obligations sold or exchanged by financial institutions are not normally subject to the capital gains tax, but they may be subject to income and property taxes.

Capital gains taxation is concerned mainly with individuals but also with certain types of businesses that own property. When the nominal value of property rises above the price paid its owner, there is a capital gain; the increase in value of the asset is subject to capital gains taxation when the asset is sold. For example, the owner of a house purchased in 1975 for $50,000 and sold in 1986 for $115,000 realized a $65,000 capital gain, which in most cases is subject to taxation.

A more precise determination of a capital gain (or loss) involves the difference between the amount realized, which is the gross amount received for the sale of property less commissions and other selling expenses, and what the Treasury calls the adjusted basis. The latter normally includes the original cost of property augmented by improvements but adjusted downward for depreciation.

The United States payroll tax began under authorization of the Social Security Act of 1935. This law established two important social programs: one for retirement benefits and the other for unemployment compensation. Each has exerted a powerful influence on the economy, but social security is the largest and most pervasive of the two programs.

Several programs now comprise what is popularly known as social security. The original statute was designed strictly to provide retirement benefits to workers covered by the law and was called old age insurance (OAI). By 1939, Congress had changed the law to provide survivior benefits, and the system became known as OASI. When disability benefits were added in 1954, the program was immediately renamed OASDI. The last major functional expansion came in 1965 with the adoption of medicare and, predictably, the social security program became known as old age survivors, disability, and health insurance or OASDHI (Social Security Administration 1982a: 1–20). Today, it is the largest government program in the United States.

Early history

Weaver (1982:58–124) has written an excellent history of social security, in which she relates its controversial beginning. The program was started partly in response to the depressed economic conditions of the 1930s. Savings that had been set aside for retirement were lost in the economic turmoil of the times; unemployment was at an unprecedented high level; and middle-aged workers were hard pressed to provide for their immediate families, without the added burden of providing for their aged parents.