Taxes and Taxation (Encyclopedia of Business)
To claim that taxes and taxation always have been unpopular is to state the obvious. Every American schoolchild learns about the Stamp Act of 1765 and how widespread resentment against "taxation without representation" precipitated the American Revolution. Few are aware of the fact that taxation with representation was just as unpopular: the Articles of Confederation of 1781 deprived the central government of the power of taxation. When a new constitution empowered Congress in 1791 to tax whiskey and other products, the Whiskey Rebellion ensued, nearly toppling the new government.
Taxationhe raising of revenues about power, a subject that has excited much controversy throughout history. The Magna Carta of 1215, considered a watershed in the evolution of representative government, came about because of an English king's arbitrary imposition of taxes, without the consent of those being taxed. The issue was not about taxes themselves, but how they were being imposed. From then on, English rulers were deprived of the "power of the purse," which, for the most part, shifted to the taxpayers as represented by Parliament.
The concept of consent endured, elevated by English philosopher John Locke (1632-1704) into a constitutional principle. Locke maintained that government existed in order to protect liberty and the right of property; even so, it had no inherent right to tax without consent. Hence, since the Magna Carta the matter of taxationhe power to raise revenueontinued to buttress representative government. In 1689 the English "Bill of Rights" explicitly guaranteed the right of taxation only to parliament. This was a dramatic departure in the 5,000-year history of taxation.
Another significant change has been the shared responsibility of all segments of society in the payment of taxes. In the United States, everybody from George Washington to the humble distiller of whiskey paid taxes. In medieval Europe and Russia, those least able to payhe oppressed peasantryarried most or all of the tax burden. Taxes were a social stigma. This changed with the evolution of the concept of taxation with representation, and its corollary: the responsibility of all to pay. In the early years of the American republic, so firmly entrenched was the idea that those who paid were those who ruled that the payment of property taxes (the only form of personal, individual tax in those days) became a more important voting criterion than mere citizenship.
Finally, the concept that those who are most able to afford to pay tax should pay the mosthe "progressive" concept of taxations perhaps the most recent evolution in the history of taxation. It is nevertheless limited to the income tax, which in itself is the embodiment of the concept of everyone's responsibility to shoulder the tax burden.
Despite these changes over time, taxation is as old as recorded history. Today as in ancient times, all taxes fall into broad categories: direct and indirect, internal and external. A direct tax is one that a person pays directly, as with income tax. An indirect tax is one that is usually figured into the price of a product, with the purchaser often unaware of its existence. External taxes usually refer to tariffs, or taxes on imports, including food products. Internal taxes are those, such as excise taxes or sales taxes, added on to the price of a product produced or grown in this country (many foods are exempt from sales taxes).
Once the principle of taxation with representation was firmly established in the Constitutionhich granted both the federal and state governments the right to taxederal, state, and local taxes proliferated steadily in the United States. This was not only in the number and types of taxes, but also in the numbers of those who paid them. Moreover, taxes that were meant to be temporaryuch as income tax and sales taxesnded up becoming permanent.
That taxes are as unpopular as ever, despite their proliferation in the 20th century, is beyond dispute. Beginning in the late 1970s, promises to lessen individual and corporate tax burdens provided the political fuel for conservative candidates, who met with unprecedented success throughout the 1980s. By the mid-1990s candidates representing all points of the political spectrum found that opposition to taxation had become a prerequisite to election. Opposition to federal taxation aroused particular fervor, bringing the continued existence of the Internal Revenue Service into question within the federal legislature. While proposals to abolish the IRS were never seriously debated, the House of Representatives did hold public hearings on the IRS and its practices in the spring of 1998, and promised to reform the service in due time. In any event, Americans today sacrifice as much as, and sometimes more than, one-third of their income to taxes. How this came to be is the story of taxation in America.
There are roughly two periods of taxation in the United States: post 1913, which saw the adoption of the income tax (first by the federal government, then by the states) and the birth of Social Security, Medicare, and the state sales tax; and the pre-1913 years, which is largely the story of the poll, property, tariff, and other nonincome taxes.
POLL AND PROPERTY TAXES
In the pre-1913 period, while there were attempts to impose a personal income tax, taxes were nonincome taxes. The oldest tax revenue sources, and the traditional fiscal bedrock of local and state government, were poll and property taxes. These concepts were brought over from England, and were direct taxes. The poll tax was a fixed, regressive tax (one in which everyone paid the same amount) that all adult males paid. It was this tax that writer Henry David Thoreau (1817-1862) refused to pay, and for which he was jailed. Because the poll tax had so many limitations and fell hardest on the poor, state after state discontinued it by the Civil War. Southern states revived it after 1870 in order to deprive newly enfranchised African Americans of the right to vote (with the payment of poll taxes becoming a voting requirement). In 1964 the 24th amendment made this practice illegal, but did not outlaw the poll tax itself.
The largest share of revenue for state and local governments prior to 1913 derived from property taxes, which, before the Civil War, included not only land and buildings but also slaves and cattle. In those days of limited government expenditures, revenue from property went to the federal government as well. By the time of the panic of 1893, property revenues became inadequate for most states, and other sources of income had to be devised (the first business tax, followed in 1911 by the first mandatory income tax, inaugurated in Wisconsin). Nevertheless, property taxes continued to be a major source of revenue.
The wave of political conservatism that swept the United States from the late 1970s to the early 1990s was triggered, in part, by opposition to property taxes. In 1978 California voters adopted Proposition 13, which restricted increases in property taxes and marked the first tangible manifestation of what was to become known as the taxpayer revolt. By 1996, 37 states had followed California's suit and placed restrictions on increases in property taxes. Although such measures were politically popular, the traditional tying of public school funding to property tax assessments ensured that any loss in property tax revenue would be most directly felt by school systems.
In order to maintain adequate school funding in the face of decreased property tax revenues, states turned to a variety of alternative means of funding public education. Michigan, for example, initiated a state lottery whose profits were in large measure channeled into public education; Michigan also raised sales taxes to recover lost property tax revenues. In fact, the great irony of the taxpayer rebellion of the late 20th century was that although certain taxes that were troublesome to the well-to-do were eliminated or reduced, taxation overall remained relatively unchanged. The main effect of the rebellion was, in the end, to shift the tax burden from the wealthy to the poor by reducing property and income taxes and raising sales and excise taxes.
The most important sources of income for the federal government prior to 1913, with one or two exceptions, were excise taxes and above all, tariffs. Alexander Hamilton (1755-1804), the treasury secretary under George Washington, favored a rational system of taxation and effective collection of taxes. The result was the Revenue Act of 1791, which imposed a variety of excise taxes (i.e., sales taxes) on "luxury" products, such as distilled liquor, refined sugar, snuff (including tobacco), horse drawn carriages, and more. The very significant sum of $210,000 was collected by the 400 revenue collectors a year later, though these taxes were extremely unpopular. They were discontinued and the revenue officials dismissed from their jobs when Hamilton's nemesis, Thomas Jefferson, took the oath of office in 1801. Jefferson was a staunch proponent of little government and maximum freedom of the individual. Thereafter, excise taxes were most often used by the states to raise revenue and by the federal government before the Civil War only as an expedient. After 1865 the only excise taxes that continued in force were on alcohol and tobacco.
Today, excise taxes exist on a variety of "luxury" goods produced in this country; they are indirect taxes, that is, usually the consumer is unaware that he or she is paying them (unlike sales taxes). The producer or manufacturer adds the tax to the price of the product. Other excise taxes are levied against tax-deferred retirement funds such as 401(k) plans and individual retirement accounts (IRAs). Finally, excise taxes are applied to special products such as hunting and fishing equipment and airline tickets.
Excise taxes have generally been raised in recent years as a means of replacing revenues lost by politically motivated cuts in other forms of taxation. The growing popularity of salary-reduction retirement savings plans, such as 401(k) plans and IRAs, led the IRS to waive a 15 percent excise tax on retirement savings account withdrawals in 1997.
Excise taxes can, and often have been, used by governments to encourage or discourage certain public behaviors. Recent examples of this use of excise taxes include: the 1995 reduction of excise taxes on fuels using ethanol in their composition; increased excise taxes levied, beginning in 1995, against chemical manufacturers to offset future environmental cleanup costs; and the 1998 campaign to raise excise taxes on tobacco products to discourage smoking.
In the early year of the Republic, excise taxes were not nearly as lucrative a source of federal revenue as tariffs. Particularly after 1816 the federal government raised much revenue on the taxes Congress imposed on imports, in opposition to free trade. Tariffs prevailed as the biggest source of federal revenue until the income tax appeared in 1913. After 1913 tariffs declined in importance, but never entirely disappeared.
Tariffs have had a long and stormy history down to the present day. As part of the federal government's revenue package in 1791, Congress added tariffs on a few imports. Alexander Hamilton wanted more, for he was strongly "protectionist," that is, favoring taxes on imports in order to protect fledgling American industries from foreign competition. Yet even then there was controversy over this view, with "free traders" opposed to any restraints on trade with foreign nations, in the belief that they would retaliate against American goods. Hamilton was aware of the downside of his arguments, and therefore advocated temporary tariffs, only until American industry was on more solid competitive ground.
Because tariffs were so controversial, the initial ones were selective and limited. When the destructive Napoleonic Wars came to an end in 1815 and European industry threatened to recover rapidly, however, Congress gave in to pressure from northern business interests to pass a specific tariff act the following year.
The Tariff Act of 1816 called for moderate tariffs, but these were too few and too low to satisfy northern industrialists. But southern cotton planters opposed any tariffs, which would raise prices on goods that they imported for their own use. When the Civil War resulted in a northern-controlled Congress, raising tariffs was a foregone conclusion. The Morrill Act of 1861 raised tariffs to the highest level in American history, followed by even higher rates during each successive year of the Civil War.
Even with the restoration of the southern states to the Union, northerners continued to control Congress. By the 1870s the federal budget was bloated with a huge surplus, far exceeding expenditures. Instead of lowering the high tariffs, Congressmen siphoned off the surplus to their own particular "pork barrels," with costly Civil War veterans' pensions on top of the list of every Congressman. Manufacturers as well as veterans were pleased. In the short run, the economy seemed to grow from high tariffs, and wealth appeared to be "trickling down" to the ordinary citizen.
At the same time, the downside of excessive protectionism was more and more in evidence. Prices rose precipitously on woolens and cottons, sugar, and sugar products, affecting mostly the poor. Monopolies gobbled up their competitors, and were themselves inefficient monoliths because of the absence of competition at home or abroad. By the time Democrat Grover Cleveland was reelected president in 1892, free trade was becoming an important issue. He persuaded Congress to slash tariffs by 40 percent. Before the benefits of a much lower tariff could be felt, a severe depression, the panic of 1893, struck, and four years later, the Republican Congress under William McKinley once again raised tariffs to an all-time high. Not until Woodrow Wilson was elected president in 1912 were tariffs once again lowered significantly. Nonetheless, they continued to zigzag from all-time lows, as during Wilson's two terms, to all-time highs, as during Calvin Coolidge's administrations in the 1920s. By then, international trade had all but shriveled up, as European countries enacted their own high tariffs in a belated revival of modem mercantilism. This only paved the way for the Great Depression to come.
What was becoming apparent in the first third of the 20th century was the declining importance of tariffs as revenue, compared with personal and corporate incomes taxes. By 1920 income tax revenues totaled over $5 billionen times more than tariffs. Nonetheless, despite the warnings of over 1,000 economists, President Herbert Hoover satisfied powerful business interests by signing the Smoot-Hawley Tariff Act of 1930, considered to be the highest tariff in American history. Even when the Great Depression accelerated during Hoover's administration, Congress stubbornly refused to lower tariff rates. Economists and historians alike have cited the Smoot-Hawley Tariff Act as a major contributing factor to the country's swift economic decline in the 1930s.
The undeclared war between protectionists and free trade advocates eventually was won by the free traders with consequences that have reverberated to the present time, with the passage of the North American Free Trade Agreement (NAFTA). Franklin D. Roosevelt, the first Democratic president in 12 years, took advantage of his enormous clout to get Congress to pass the Reciprocal Trade Agreements Act of 1934. Reciprocity was at the heart of this act: that is, if foreign governments would agree to lower their high tariffs, the United States would lower its tariffs accordingly. By the end of World War II, 29 countries had signed reciprocal trade agreements with the United States. This was enough to encourage the formation of a loose, free trade alliance in 1947 centered around the General Agreement on Tariffs and Trade (GATT). Thereafter, more and more countries joined GATT, and by 1990, 90 countries, accounting for 75 percent of the world's trade, had agreed to eliminate barriers to international trade. The adoption of the Uruguay Round of the GATT in 1994 pledged 100 signatory countries to reductions in overall tariffs to 6.3 percent by 1998, down from 40 percent in 1947. Most notably, overall global tariffs on pharmaceuticals, farm machinery, home and office furniture, medical equipment, paper products, and steel were to be reduced by one-third.
GATT may be a final nail in the coffin of protectionism, but opponents of total free trade are still heard from. Farmers the world over resent international competition, as do automakers and computer chip producers. International competition, aided by the artificially high dollar maintained by the administration of President Ronald Reagan, opened the door to the virtual takeover of whole industries by the Japanese in the 1970s and 1980s. Under pressure from U.S. automakers, GATT negotiations resulted in a trade pact in the early 1990s between the United States and Japan to limit the number of Japanese cars sold in the United States, and to enable more American cars to be sold in Japan. Vestiges of protective tariffs still exist, but these are disappearing in favor of regional free trade blocks, such as the European Union and NAFTA.
The history of tariffs as a tax on imported, foreign-made goods reveals how a tax, once considered indispensable, can decline in importance over time, and nearly disappear. In fact, the reduction of tariffs can sometimes be essential to a nation's participation in the global economy. This was seen in the case of the People's Republic of China, whose reentry into the World Trade Organization (WTO) in 1996 was made contingent upon its lowering its overall tariff rate from 35 percent to 23 percent. As tariffs have lessened in importance during the 20th century, income taxes have grown increasingly important and replaced revenue no longer generated from other sources.
Although tariffs have lost much of their revenue-raising importance, they are still widely used by governments wishing to influence the economic or political behavior of other nations. Threats of greatly increased tariffs were used by the United States in 1995 to force Japan to increase its importation of U.S.-made automotive parts and to pressure the People's Republic of China to crack down on the theft and unauthorized production of intellectual properties, including musical recordings and computer software. The unwillingness of governments and industries to abandon tariffs altogether was seen again in 1998, when the WTO nations were unable to agree on tariff reductions on paper and forest products.
Income tax is unique in that it is one of the few major types of taxes that has philosophical underpinnings. Adam Smith (1723-1790), an 18th century Scottish economist whose 1776 treatise, The Wealth of Nations, has gone down in history as a work of genius, proposed the radical idea that income should be taxed regularly and permanently. Smith was of the same opinion as John Locke when it came to government: that it defended liberty and property rights; to Smith, government should be limited to those functions. Moreover, in order for the "wealth of a nation" to increase, government must spend only what it needed to run itself and nothing more. The revenue to run itself should be derived from a tax on income that must be fair and made clear to all well in advance of being levied.
Even before Smith's treatise was written, the colony of Massachusetts had been the first in the New World to impose an income tax in 1634, even though the property tax still remained the most important source of revenue. Nevertheless, the idea had evolved (and been taken for granted by Smith's day) that wealth was more than just property consisting of land and buildings. That is, a person had certain skills and knowledge that could produce income, even if he had no concrete property. Hence in addition to the property tax, the colony imposed a tax on the income of artisans, doctors, and other professionals. The difficulty that the colony faced with income tax is an old one: taxpayers concealed their taxable income and paid as little as possible. How to collect income taxes efficiently became the chief problem, one that was not resolved until mandatory payroll deductions were introduced in the 19th century.
The concept of an income tax and its philosophical justification were thus in place by the time the United States came into being. In addition, income tax is considered by tax historians and economists alike as the most advanced form in the long history of taxation. In the Articles of Confederation, however, the concept of taxation was surprisingly absent, and apparently had not caught on with the general public. The central government was all but deprived of any power to tax, while state governments taxed as little as possible. Property and poll taxes continued to hold sway, as did excise taxes on various goods.
Under the Constitution's explicit guarantee of the central government's power to tax in Article I, Section 8, a tax on income was not mandated but was not rejected altogether, either. In fact, the first U.S. treasury secretary, Alexander Hamilton, highly favored the idea. But in matters of taxation, Hamilton is considered by 20th-century historians as ahead of his time. The Revenue Act of 1791, Hamilton's brainchild, did not go down well with the public. What is most noteworthy about this act was its creation of the office of Commissioner of Revenue, forerunner of today's Internal Revenue Service. This, too, was Hamilton's idea. The revenue commissioner and his agents would administer the tax law, which mostly stipulated excise taxes and selected tariffs.
After Thomas Jefferson, who had led the opposition to the Revenue Act, became president in 1801, the act was repealed and the office of the Commissioner of Revenue was disbanded. Far from collapsing, the federal government grew wealthy on the lucrative revenues derived from tariffs, and the treasury recorded surpluses annually until the eve of the Civil War.
In July 1862 President Abraham Lincoln signed into law the largest revenue bill in U.S. history up to that point. With $2 million a day going to fund the public debt incurred by war, the need for more revenue was desperate. The bill restored the office of Commissioner of Internal Revenue. The commissioner was empowered to establish a system to collect a progressive income tax based on mandatory income withholding (with a tax return form duly created), as well as to collect numerous other internal taxes. For the first time, failure to comply with the tax laws could result in punishmentrosecution and confiscation of assets in the most extreme cases. Tax returns had to be signed under oath.
By the end of fiscal year 1863, the new revenue bureau took in, through its assessors and collectors, nearly $40 million. By war's end, the Bureau of Internal Revenue had grown from one employee to more than 4,000. Despite the huge sums garnered, the public deficit stood at an unprecedented $3 billion in 1865.
The income tax was discontinued after the Civil War, despite the large sums it had taken in. Wartime patriotism had ensured compliance with the income tax law, but public perception of the law was that it was a wartime exigency. Nevertheless, the Bureau of Internal Revenue was not dismantled after the war, but was put in charge of collecting other taxes, notably the excise taxes on distilled liquor and tobacco.
The post-Civil War period, until 1913, witnessed the growth of huge corporate monopolies and the stifling of competition. Populists and Progressives criticized the lack of social responsibility on the part of the extremely wealthy, and lobbied on behalf of a graduated income tax which would ensure that the wealthy paid their dues. In 1894 Congress revived the income tax, only to see it struck down by the Supreme Court a year later. The problem lay in the vagueness of Article 1, Section 8, of the Constitution which gave the federal government the right to tax; according to the Supreme Court decision in Pollock v. Farmers Loan and Trust Co., such a tax would have to be apportioned among the states according to populationnd not just targeted to those with the most income. Since the intent of income tax proponents was to pressure those with the most income to pay the most, this decision was a resounding setback for their cause. Only an amendment to the Constitution could make income tax legal.
The Court's ruling precipitated a concerted movement toward adoption of an income tax amendment. Congress took the initiative in 1909, mainly in order to ensure the legality of its recently mandated I percent tax on corporate incomes over $5,000, which it disguised as an excise tax rather than as a tax on income. The amendment took nearly four years to be approved by three-quarters of the states, but finally, in February 1913, the 16th amendment was added to the Constitution. It invested Congress with authority to "lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration." The Bureau of Internal Revenue, a division of the U.S. Department of the Treasury, would administer and collect the new income tax, as it had during the Civil War. Nine years later, the bureau established an Intelligence Division for the surveillance of possible income tax evaders.
The graduated income tax was hailed by the reform-minded everywhere as a sound blow to "special interests." On October 13, 1913, an income tax bill was passed, the first since the abortive 1894 bill. It stipulated that all incomes above $3,000 would be taxed. An annual salary of over $3,000 in those days was a generous middle-class income; below that, no one paid income tax. Hence, less than 1 percent of working people would file tax returns. The new income tax bill repealed the 1909 excise tax on corporate incomes and levied a new corporate income tax on businesses. Mandatory withholding of income was reintroduced for the first time since the Civil War, but Congress repealed this measure in 1916 in favor of voluntary compliance.
The Revenue Act of 1916 raised income tax rates to new highs, and made more people eligible to file. A year later, incomes taxes were raised still more by the War Revenue Act of 1917. Nevertheless, as late as 1940 only 11 percent of working people were required to file, despite the huge cost of the preceding New Deal social legislation and the imposition of the Social Security Act of 1935.
The New Deal, however, had made deficit spending a respectable fiscal practice for the first time in American history. From then on, federal government spending would outstrip income, despite the increasing amounts of revenue derived from the income tax. In fact, mandatory payroll deductions, permanently enacted in 1943, increased revenue income tremendouslyo $45 billion in 1945, from a mere $7.4 billion in 1941. Nevertheless, unlike the Civil War period when payroll deductions were introduced for the first time, mandatory payroll deductions remained in force after the end of World War II in 1945. The additional categories of new taxpayers also were not discontinued after World War II, when virtually all working people filed income tax returns. Forty years later, revenue rose to almost $1 trillion, still too inadequate to reduce the deficit, fund the government overall, and pay for the costly Cold War.
The story of internal revenue since World War II is one of increasingly higher taxes (despite tax cuts under President Dwight D. Eisenhower), the expanding size and power of the Internal Revenue Service (the name the Bureau of Internal Revenue adopted in 1953), and the growing deficit burden, in large part because of the need to finance the Cold War. By the end of the Cold War, the "peace dividend" had all but been swallowed up by the federal deficit, which amounted to hundreds of billions of dollars.
In 1952 Congress passed what it regarded as the most sweeping tax law since the 16th amendment inaugurated the income tax. In retrospect, this new tax code reform did more to streamline and make the Internal Revenue Service (IRS) more efficient than to alter personal income tax. Henceforth, all politically appointed posts within the bureau, except for commissioner and deputy commissioner, were replaced by civil service positions; the agency was also significantly decentralized, with headquarters in Washington determining policy, and field offices given wide latitude in decision making. In addition, electronic machines were introducedredecessors of computerso speed up processing of forms, which in turn were further simplified.
The consequence of decentralizing the IRS and giving decision-making power to field offices has been a lack of uniformity in interpreting and enforcing tax laws: no two field offices are required to interpret the same tax law similarly, and there are often wide variations from field office to field office, for which the IRS is often criticized. The power of the IRS to enforce the tax laws has been increased. While in 1954 the IRS could impose only 13 penalties on an errant taxpayer, by 1990, the number of penalties had escalated to 150, including seizure of a taxpayer's assets. The IRS made nearly 3 million such seizures in 1990 alone. Moreover, the IRS has the legal authority to request information from any bank, and to inquire into any type of vehicle registration or business activity. This uncovers a huge range of information on a business, individual, or married couple. The size of the IRS has grown to more than 100,000 employees, making it the largest government agency in the world.
Ninety-five percent of Americans file tax returns. The federal government derives approximately 55 percent of its revenue from income tax, individual as well as corporate. In 1990 this revenue amounted to nearly $1 trillion. Excise taxes, or "consumption" taxes, on fuel, cigarettes, alcohol, and selected luxury items account for another 4.4 percent. Despite these and other sources of income, the deficit in the national treasury rose continuously; in 1994 it stood at over $250 billion. To service this debt, the government borrowed money and was forced to pay interest on the loans, adding billions to the deficit. The rising deficit more than offset the tax cuts of the Eisenhower and Reagan administrations.
Under President Reagan, tax reform became a high priority. The deficit was too big, taxes were too high, tax forms too complicated, and tax evasion too simple, Reagan concluded. In 1986 his tax reform package inaugurated the most sweeping changes in American income tax since 1913.
In essence, Reagan's tax measure slashed individual income taxes and drastically cut government spending on social programs, in the hope of putting more money into the consumer's pocket. Individual tax brackets were reduced to two: all incomes up to $17,600 were taxed 15 percent; over that amount, 27 percent. Six million low-income working people were exempt from paying any federal income taxes. Dozens of deductions were eliminated. The reform package also ended "revenue sharing," a program introduced in President Richard Nixon's administration that involved the federal treasury "refunding" some federal tax monies to the states. While the bill slashed individual taxes and doubled the personal exemption, corporate taxes were raised, business exemptions were reduced, and loopholes were plugged. The business and corporate world would carry the tax burden, according to the 1986 tax reform bill, and not the individual.
Reagan's tax reforms created reductions in government spending, but were more than offset by the highest military expenditures in U.S. history. Furthermore, the significant increases in corporate income taxes were passed on to the consumer in the form of higher prices; and the elimination of revenue sharing forced states to significantly raise their income taxes for individuals as well as for businesses. In the end, the federal deficit rose to unprecedented levels under the Reagan administration, and his successor, George Bush, was forced to raise income taxes in 1991.
Tax reform continues to bedevil presidents. Following his move to increase income taxes, Bush instituted a deficit reduction plan that placed a ceiling on the deficitutomatic spending cuts would go into effect if this ceiling were exceeded. President Bill Clinton's deficit reduction plan, passed by Congress in August 1993, sought to reduce the federal deficit by $500 billion over a period of five years through a special 4.4 percent fuel tax and reduced government spending. In addition, his tax reform measure hiked taxes for the wealthy (individuals with annual income exceeding $115,000) and corporations. Critics believed that the consequences of the Clinton tax bill would be higher consumer prices, a reduction in capital spending, and a reduction in the already low level of private savings. Despite these trepidations, a booming economy enabled Clinton to reduce the deficit well ahead of schedule and hold inflation in check through the late 1990s.
During the economic boom of the mid-to-late 1990s, individual income tax reform efforts centered on estate taxes, capital gains taxes, and retirement savings. The Taxpayer Relief Act of 1997 (TRA) included provisions that reduced capital gains taxes (taxes on gains in value of equities, properties, or other holdings) on equities held for more than 18 months; created the Roth IRA, which allowed investors to withdraw their original investment from an IRA without taxation or penalty (although the original investment was not tax deductible, unlike a "regular" IRA); and altered the rules governing estate taxes to reduce the taxation of small inheritances (those under $1 million). Income taxes on businesses were also altered by the TRA. Operators of home offices and other small businesses were allowed to claim federal income tax deductions for office expenses under the new tax law. This measure essentially reestablished a principle that had existed until 1993: that home office expenses were deductible (that year, the Supreme Court had greatly narrowed the definition of what constituted a home office, and the ability of small businesses to deduct office expenses had been eroded). Further tax relief for businesses was also contemplated by Congress in 1998, which debated exempting Internet and information technology industries from income taxation, but the growing revenue potential of this sector of the economy rendered its complete exemption from income taxation a remote possibility.
SOCIAL SECURITY TAXES
Social Security taxes were the next major new tax after 1913 to follow income tax, and were deducted from payrolls simultaneously with income taxes. Meanwhile, like income tax, social security taxes have been steadily on the rise since they were first introduced in 1935.
Although income tax and social security taxes (which include Medicare) are both collected by the Internal Revenue Service, income tax monies make up general federal revenues, while social security taxes go straight into the Social Security trust fund. Social security taxes are the next biggest tax that individuals must pay annually, and for some of the 39 million self-employed, they may be higher than income tax.
The most enduring social legislation to emanate from the New Deal was social security. In 1935 the Social Security Act instituted federally administered old age pensions, unemployment insurance, and aid to the handicapped as well as to dependent children. These benefits would be paid equally by the employer and the employee, making Social Security theoretically immune to the vicissitudes of the economy or to the size of budget deficits.
In 1950 Social Security benefits were extended to the self-employed, who, however, were compelled to pay not only their own share of the Social Security taxes but the employer's as well, all lumped into one tax called self-employment tax. In that same year, Congress raised the Social Security tax by an additional 2 percent (split between employer and employee) in order to fund disability medical insurance, which was added to Social Security benefits. Currently, Social Security taxes are 7.15 percent of gross annual income; the self-employment tax is 15.3 percent. Many economists believe, in fact, that most workers pay the full 15.3 percent of their wages to maintain social security, since their employers make up their portion of the payments by offering reduced wages and benefits.
Whatever is not paid out in the form of pensions from the Social Security fund is invested in government notes. This "surplus" has been growing steadily to the point where in 1994 alone, $56 billion was added to it.
In 1965 Medicare was inaugurated, providing government medical insurance mostly for the elderly; it does not, however, cover all medical costs, such as prescription medicine and doctor's fees. The government does cover these costs for the indigent elderly, although these costs are paid out of general federal revenue, rather than from the Social Security trust fund.
While federal taxes, including Social Security and Medicare, ate up an average 28 percent of individual incomes in 1993, this did not include state income tax, local taxes, or property taxes. Forty-three states require everyone to file income tax returns. Reliance on state income tax for state treasuries increased dramatically after revenue sharing was discontinued under President Reagan. The rising cost of education and the expanding role of the state in funding primary and secondary education was the original impetus for state income tax. By the time most states required income tax returns, payroll deductions already were used by the federal government, a practice adopted by the states.
Most states also rely heavily on the sales tax, which Mississippi was the first to adopt in 1932. The Great Depression magnified the need for social services, and to finance these, state after state began to inaugurate sales taxes. Between 1933 and 1938, a total of 27 states had instituted a sales tax, that is, a tax on goods and services. Today, 45 states have sales taxes, the highest sales tax being in the state of Connecticut. Half of a state's revenue derives from the sales tax in the states that have this tax. In the aftermath of the taxpayer revolt, many states have raised their sales tax rates further to make up for revenues lost to property and income tax reductions.
Sales taxes vary: in some states, only luxuries are taxed, similar to an excise or consumption tax. Food items, except for food prepared for immediate consumption, rarely are taxed; some states exempt from sales taxes not only food but also clothing. The reasons for this lack of uniformity in applying the sales tax is that it is a regressive tax, and hence falls hardest on those with the least income. So popular and necessary have sales taxes become that many cities have enacted sales taxes as well.
TAX EVASION AND AVOIDANCE
The willingness to risk not paying or underpaying taxes is prevalent today, despite vastly superior techniques of ferreting out the miscreant taxpayer. Of the two types of tax evasion, noncompliance (failure to submit a return or misrepresenting one's taxable income), is illegal, while "tax avoidance" is legal. Since the IRS audits only 10 percent of the 200 million tax returns it receives annually, many people are willing to risk noncompliance. Tax avoidance, on the other hand, is mainly the resort of middle- and upper-income Americans; a few of the many ways that individuals and businesses avoid taxes include establishing tax shelters, such as foreign bank deposits, which are not taxed and have strict privacy laws; deferring income into the following year; setting up business on an island that is a tax haven; and investing in a bankrupt business in order to claim the investment on one's tax return.
Corporations and small businesses take yet another route in avoiding huge and burdensome taxes, especially employment taxes: hiring part-time rather than full-time employees, or resorting to temporary workers. To many observers, this has become a worrisome trend, since part-time and temporary workers usually receive no benefits or health insurance and are among the most insecure and vulnerable members of the American workforce.
Income tax, federal as well as state, Social Security taxes, and sales taxes have been the primary new taxes of the 20th century in the United States, while taxes enforced in the 19th century have not disappeared (with the exception of the poll tax). The 20th century, unlike the 19th, also has witnessed an unprecedented rise in taxes in many other countries.
updated by Grant Eldridge]
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