By Nathan Bomey of USA Today
It might surprise some people to find out that in a recent tax year 33.4% of tax payers paid $0.00 in Federal Income Tax. In fact a significant number of them got tax refunds larger than the amount of taxes that had been withheld. Is this another case of the wealthy avoiding paying their fair share of taxes? No, it’s the result of the a tax code that includes an Earned Income Tax Credit, standard deductions and other opportunities made available to low income filers. In the latest information I came across (2016) the lowest 50% of filers by Adjusted Gross Income (AGI) paid only 3.04% of Federal Personal Income Taxes. That’s something that was never anticipated by those who first put forward the plan for a Federal Tax on Incomes.
I first became aware of the original income tax rates and formula when Steve Forbes’s organization, Americans for Hope, Growth and Opportunity, mailed out copies of the original tax forms. You can see a copy of the form on the Bradford Tax Institute website along with a brief history of the top tax rates.
The form was two pages long. The second page included a listing of the various types of income and a place to put the total for each. The first page included the seven rates and a way to calculate the amount of income each rate would be applied to. It is interesting to note that every citizen earning income was required to pay Federal Income tax. The bottom rate was 1% and it applied to income up to $20,000. There were six higher rates, each adding an additional 1%, making the top rate 7%. It was applied to income over $500,000 or over $11 million in today’s value. Those were the rates in 1913. Prior to 1913 there was no Federal Income Tax with the exception of during the Civil War. Prior to 1913 Taxing income was unconstitutional!
The low rates of the first Federal Income Tax didn’t last long with the top rate hitting 77% five years later in 1918. The top rate reached an all time high of 94% during WWII. Rates have varied since then in an attempt to encourage economic activity (lower rates) or to fund Federal spending (higher rates). Over this same period of time the two page tax form was increased to reflect new changes to the tax code. The changes reflected categories of income, deductions, allowances and credits reflecting various priorities of Congress. But those priorities often rewarded one at the expense of others. I offer two examples:
Mortgage Interest Deduction: This deduction was introduced to reward home ownership and spur the real estate market. The result of the deduction is those with large and expensive homes pay less in taxes than they otherwise would, while people who rent while saving for a home pay more than they otherwise would.
Child Tax Credit: The child tax credit was put in place to help families with children. Individuals who are saving to get married and eventually have families pay higher rates than those who have children. So do those who have previously raised children and are now saving for retirement.
One of the major issues over the years has been how to handle gains on the sale of assets. This includes the sale of one’s home. For many years selling your home could create a Federal Income Tax liability. The difference between what you sold your home for and what you paid (its basis) for it was called a “capital gain”. That required a home owner to keep an extensive set of records on what improvements they had made to their home because they could be used to increase the “basis” by being added to the original purchase price.
The term capital gain took on real consequences during the 80’s when we had high inflation. Inflation wasn’t considered in the formula so the capital gain you had on your home or other asset might only be the result of inflation, not a real inflation adjusted increase in value. Yet you still paid taxes on the increased value?
“It’s much harder to avoid taxes on your paycheck than on your investments.” This section of the article talks about the difference between wages and investment earnings and when taxes on both are paid. What it doesn’t address is how did the individual get the funds they invested. Typically funds for investment come from left over wages after the wages have been taxed. People make choices on what to spend their wages on. Some use it to pay for houses. Others for cars, vacations and lifestyle. Some opted for saving some of their wages for investment purposes. So if their original investment was made with money that was already taxed as wages is it fair for gains on those investments to be taxed? Especially since gains aren’t adjusted for inflation? Aren’t investments what spurs on our economy? Aren’t investment gains what helps many individuals have a successful retirement rather than depending solely on Social Security?
The article goes on to talk about “Unrealized Gains”. That is the amount an asset has increased in value since it was acquired. It implies that unrealized gains are somehow unfair. The solution to unrealized gains is to tax gains in the year they occur, rather than when they are realized (the asset is sold). There are two major problems with that. First taxing gains when they occur usually would require the sale of some of the asset(s) in order to pay the tax. One of the biggest sources of unrealized gains is land. So if farmers were required to pay for the increasing value of their land when it occurs, they most likely would have to sell some of their land to pay for it. Couple that with the fact that much of the increase in value of land is due to inflation and it would create real issues for them.
A second issue with taxing gains when they occur is investments go up and down in value. So a large increase in value one year may be followed by a decrease in value the following year. If you are required to pay tax on the increased value in the first year, where does the money come from to pay the tax? And what happens if it decreases in value the next? These are the reasons why taxes on investment gains are paid when the investment is sold, not as it occurs.
“Benefitting from death tax policies”: The basic question on “death tax” “is it fair to benefit from your ancestors’ decision to not spend all their wealth during their life time.” It is really important for business owners and farm families. If the heirs of business owners and farmers are required to pay taxes on the value of what they inherit will they have to sell the items they inherit to pay the taxes? But it applies to all of us when we die. If you decide to save some of the wages you earn, why should the government get it rather than your grandchildren?
The original income tax form required all individuals with income to pay at least some Federal Income Tax. We’ve come a far cry from that. Maybe it is time to go back to that simple formula. It would cost a lot of tax accountants their careers, but it would make the tax code much simpler and “fairer”. And it might cause voters to think differently about increased Federal spending.
The 16th Amendment to the Constitution allowed for a Federal Income Tax. It was passed in 1909 and ratified in 1913. While we can debate whether it was a wise policy to implement, one thing is certain. By not including, in the amendment, the actual rates that would be used and a formula for calculating the income the rates would be applied against, Congress was allowed to buy votes by proposing changes that favored one group of voters over others. We see that occurring in every election!
That, and the failure to have a Balanced Budget Amendment in the Constitution, will result in the downfall of our nation, just as the Founding Fathers predicted it would. That’s probably why they made it unconstitutional for the Federal Government to tax incomes!