A Brief History of the US Tax Code (and How to Fix It)

In Part I, I will assess the relative desirability of different tax types and argue in favor of a progressive consumption tax.

In Part II, I will examine the history of the modern US tax code, and explain why the Left and Right are wrong to idealize the tax codes of the 1950s and 1986 respectively. Instead, I will describe how the US tax system has generally improved since 1986 by evolving toward a progressive consumption tax.

Part I. The Ideal Tax System

1. The Four Types of Taxes

Taxes can be grouped into four categories: positive goods, neutrals, necessary evils, and unnecessary evils.

The first two kinds of taxes should be the first resort in raising revenue. Positive good taxes include levies that directly improve society’s well-being, like congestion and pollution taxes, user fees such as tolls, and sin taxes; however, the latter should generally be delegated to the most local level practicable and if the public interest is a motivated by solidaristic paternalism rather than negative externalities, regulation is generally more effective than taxation. Neutral taxes, which do not directly promote social well-being but also do not deter productive activity, include revenue from natural resource rent auctions, such as spectrum and fishing rights on public lands.

An important question is whether land values should be taxed as such a “neutral” levy on economic rent. This heavily depends on the planning system; under a free-market land-use system (such as 18th or 19th century London’s private estates, or zoning-free Houston’s private deed restrictions, HOAs, and MUDs) landowners capture many of the spillovers from their value-creating improvements and activities, which land taxes penalize. Additionally, LVTs can disincentivize agricultural land conservation. Hence, while an LVT can be a comparatively efficient revenue source up to a point, it should be non-confiscatory, with the optimal rate varying depending on the land-use system. The economic, ethical, political, and social objections to retroactively confiscating paid-in equity also imply that an LVT should be structured as an unrealized capital gains tax (payable in installments over an extended period) on the real growth or “increment” of land values. Along similar lines, natural resource exploitation on private land is best taxed through a non-confiscatory “resource rent tax” on profits above a break-even rate of return, with receipts from non-renewable resources deposited in a sovereign wealth fund.

Positive good, neutral, and near-neutral (like optimal land and resource-rent taxes) revenue sources alone are rarely sufficient to support even a minarchist state, and lack the elasticity necessary to credibly finance a globally competitive military. Therefore, any modern state requires a broad-based source of “necessary evil” internal revenue. A value-added tax is the best option, since it is relatively administratively simple and minimally interferes with the structure of the economy. Furthermore, as I will elaborate on later, a VAT can be made progressive via deductions for wage payments.

Taxes which are “unnecessary evils” are those for which better alternatives exist to achieve the same revenue and distributional goals. These include tariffs, wealth taxes, (most) property taxes, and transaction taxes. As I explain here, although moderate tariffs and withholding taxes on foreign investors can be a positive good if imposed by a country with substantial market power to negotiate reciprocal tax-free trade and investment and burden-sharing in the provision of global public goods, and a necessary evil if tariffs are imposed to limit strategic dependence on adversaries, otherwise they tend to cause economic dislocation disproportionate to their yield.

Wealth taxes penalize both work and saving, making a country poorer in the long-run. The most common form of wealth tax is an inheritance tax. Inheritance is essential for expanding the human time horizon (and promoting a country’s long-term wealth) while avoiding the stagnation that would attend literal immortality. Additionally, inheritance can have positive social effects to the extent that independent wealth allows “elite human capital” a measure of independence from the state, bureaucratic institutions, and Tocqueville’s “tyranny of the majority”; furthermore, old money may be a transmission mechanism for taste, high culture, and elite civic responsibility.

However, if an inheritance tax is levied, it should be imposed on a per-heir basis, since large families already advance the tax’s distributional goals by splitting inheritances and benefit the public by raising future taxpayers and innovators, and should also price-discriminate based on donors’ demonstrated “bequest motive” by favoring gifts inter vivos. The existing US estate and gift tax fails on the first criteria, but does favor gifts through annual exemptions, a lifetime exemption which can be effectively multiplied through early gifts (since subsequent growth escapes the tax), and by taxing gifts given at least three years prior to death “tax-exclusively,” at a lower effective rate of 29%. That said, these pro-gift features are counteracted by the capital gains step-up basis for assets held until death (in contrast to a carryover basis for gifted assets), which inhibits the functioning of capital markets in addition to being inequitable.

Property taxes (which, unlike land taxes, tax improvements) are also generally bad; since savers can avoid them by exporting capital, they are built into local wages or prices, while arbitrarily penalizing construction, capital-intensive industries, and brick-and-mortar retail, contributing to excessive “virtualization” of the economy. Nevertheless, property taxes may have a role in local government finance as a kind of user fee for services like police and fire protection that benefit property owners. Transaction taxes, including on sales of real estate and securities, are a doubly-bad form of property taxation since they penalize the transfer of property to its best user.

Finally, the corporate income tax also has many drawbacks. In the context of a global capital market it largely constitutes a hidden payroll tax, but is particularly distorting for three main reasons. First, if companies are not allowed to immediately write off their investments in equipment, structures, and intangibles, it constitutes a de facto property tax on capital-intensive industries. Second, the deductibility of interest, without a correspondingly reduced taxation of dividends at the personal level (impossible for tax-free savings accounts and institutions), penalizes companies that finance their investments with equity capital rather than debt, a perverse incentive given the bankruptcy process’ disruptive and paralyzing effects. Finally, it imposes a penalty on the high-risk but high-margin ventures that advance a country’s or region’s agglomeration of innovative industries and right-tail talent. Although a corporate tax may partly fall on foreign investors when imposed by a country with market power due to sector-specific local advantages (such as agglomeration effects), they can be more directly reached through (reciprocally-reducible) withholding taxes, and as such the corporate tax is largely superfluous for this purpose.

The most compelling argument for imposing a corporate income tax is as a complement to a personal income tax, since partly taxing profits at the business level allows for capital gains and dividends to be more lightly taxed on the individual level, reducing the “lock-in effect” (all else equal, deferring taxable dividend distributions or capital gains realizations leads to a higher long-term compound savings growth rate) and promoting the recycling of capital into more efficient or new enterprises. Specifically, the corporate tax rate should be set to maximize the collection of revenue from foreign investors net of the costs of distorting the economy by imposing a differential payroll tax on high-margin businesses (this optimal rate will vary based on the country’s level of market power), with the dividend withholding tax rate correspondingly reduced and the top personal tax rate on capital gains and dividends set approximately equal to the difference between the ordinary top tax rate and the weighted-average global corporate tax rate (since capital mobility equalizes global after-tax returns). However, in my view both the personal and corporate income taxes should be replaced by a progressive consumption tax that eliminates the lock-in effect.

2. The Pitfalls of Income Taxation

The most important modern tax, the personal income tax, is really a kind of hybrid of a consumption tax, a wealth tax (due to its taxation of savings, albeit often mitigated by tax-free accounts and investment incentives), and a transactions tax (due to the lock-in effect). As such, the income tax’s desirability falls somewhere in between a VAT and the aforementioned “unnecessary evil” taxes. While taxing labor income is relatively straightforward, taxing capital returns poses four major challenges that point to the desirability of a consumption-based tax system.

First, there is the issue of adjusting for inflation; while some countries with a history of inflation like Chile adjust not only tax brackets but also business balance sheets, interest payments, and capital gains, this adds to the tax code’s administrative burden. Second, allowing capital and business losses to be freely offset against other income would reward opportunistic tax-planning (front-loading losses and deferring profits); hence, it makes sense to limit loss deductions to related income that may never appear or may only do so in the future, at which point the net present value (or real value without an inflation adjustment) of such offsets will have fallen, leading to excessive taxation of risky enterprises and investments, despite the spillovers of innovation. Third, under a progressive income tax, income that is received unevenly over time (such as business profits and investment returns) will be taxed at a higher average rate, a problem known as “bunching.” While inflation, risk, and volatility can lead to over-taxation of capital returns, capital income can also benefit from tax-deferred growth if investors delay realization of capital gains or companies retain earnings rather than distributing them as dividends, but this can create its own problems by stranding capital in incumbent companies and assets.

The US tax system imperfectly mitigates these problems of inflation, risk, volatility, and lock-in through several mechanisms. First, accelerated depreciation and first-year expensing provisions negate the business-level inflation tax on domestic investment in equipment. Second, many (domestic and foreign) borrowers are allowed to deduct the inflation premium embedded in interest payments, providing a rough offset to the taxation of inflationary interest in the hands of taxable (domestic and foreign) savers. Third, long-term capital gains and dividends, which receive no such implicit inflation adjustment (albeit offset by deferral benefits), are volatile and risky, bear the global weighted-average corporate tax rate, and are liable to the lock-in effect, are taxed at lower and flatter rates than ordinary income. Finally, privately-held business’ profits (representing a mix of managerial labor and risk-bearing capital), which are imputed to their owners’ individual tax returns, receive a 20% exemption.

These preferences for capital income are not unique to the US, and are generally stronger in Europe, where interest is usually taxed at the same reduced rate as capital gains and dividends (reasonably so, in light of the global trend toward limiting tax benefits for personal and corporate borrowing) and privately-held companies’ retained profits are not imputed to their owners. For instance, in Sweden (which also has no inheritance tax) investment income is taxed at a flat rate of 30% and privately-held firms are taxed at 20.6% if earnings are retained and 36.48% if distributed, rates which compare favorably to many US states (Sweden mostly funds its famous welfare state through a 25% VAT and high payroll and labor-income taxes, with an all-in top rate of about 62% on salaries above $65,000). While such regressive preferences mitigate the biases of the income tax against savings, transactions, and risk-taking (successfully so in the case of “socialist” Sweden, which has more billionaires per capita than the US), they do not eliminate them, while also undermining the tax system’s claim to fairness.

3. The Progressive Consumption Tax Solution

A VAT is preferable to an income tax because it does not penalize savings, lock up capital, or overtax inflationary, risky, and volatile forms of income. Nevertheless, consumption taxes are frequently criticized as regressive because higher-income people save at a higher rate, and they effectively exempt the time value of money from taxation. This is a misunderstanding; people save in order to smooth consumption over their own and their children’s lifetimes (since the latter may regress to the mean), which reduces inequality over the long-run. Furthermore, a VAT can be structured to be as progressive as an income tax (but still more efficient), while avoiding the economic distortions and aesthetic impoverishment resulting from luxury taxes on specific goods.

That said, it is first worth examining the argument for progressive taxation in general. In my view, the standard utilitarian argument that a marginal dollar is intrinsically worth more for someone with a lower income is fallacious due to “expensive tastes,” the capacity for enjoyment of which is correlated to intelligence and earning power. At a more fundamental level, I do not think there is good reason to accede to the “slavery of the talented.” Nevertheless, progressive taxation can be necessary to give the polity as a whole a stake in the prosperity of the wealthy and, in particular, to ensure that technological progress or international economic integration is broadly Pareto-optimal. An implication of this argument for progressive taxation is that it should not be confiscatory and that revenue should be raised as efficiently as possible.

The so-called “X-Tax” offers the most administratively feasible path toward a progressive consumption tax. Under this plan, businesses would be subject to a VAT or cash-flow tax (i.e. a tax on gross receipts less inputs and capital investment), with a deduction for wage payments and proprietors/partners’ share of value-added (the latter averaged over several years to fully address volatility), which would be taxed progressively, with the top tax rate equal to the VAT rate. Capital income would be taxed only once at the business level (at the top rate), eliminating both the lock-in effect and overtaxation due to its risky and volatile nature, with the expensing of capital investment exempting the time value of money (and inflation) from taxation.

One variation of the X-Tax, known as the “Destination-Based-Cash-Flow-Tax” would, akin to European VATs, impose a “border adjustment” or import tax and export rebate at the rate of the business-level VAT; this would lead to an appreciation of the dollar (negating any apparent protectionism). This dollar appreciation would have two main effects: in the short-term, it would provide a one-off windfall for foreign investors in US assets, at the expense of US investors in foreign assets, while in the long-term it would (akin to a sales tax) effectively rebate the business/wage tax for money earned in the US (notably by foreign investors) and ultimately spent abroad and conversely tax money originally earned abroad and spent in the US. As such, although the DBCFT would have certain advantages (notably ending the corporate tax’s penalty on on-shoring profitable operations and the opportunity for tax avoidance through transfer pricing), implementing it would require international cooperation; perhaps the most promising approach would be for the US’s economic partners to simultaneously also border-adjust their business taxes as part of a new framework for mutual free trade and investment (the “Mar a Lago Accord”?), which would both counteract the DBCFT’s currency market effects and ensure tax reciprocity for American investors. If such cooperation were not forthcoming, the X-Tax could still be adopted without a border adjustment, since the US's optimal unilateral corporate tax rate is likely in the ballpark of the required X-Tax business tax/top rate (30-40%), and consumption is already taxed at the state and local level.

These transitional complications notwithstanding, a progressive consumption tax along the lines of the “X-Tax” (with or without the border-adjustment) could simplify the tax code, boost the savings rate, promote industrial modernization, expand the housing stock, and facilitate the reinvestment of capital into new ventures.

Part II. The US Tax Code’s Hegelian Evolution?

The Left often points to the post-New Deal tax code as proof that high progressive taxation is compatible with strong economic growth. Conversely, the Right often praises the Reagan-era 1986 tax reform as the gold standard of modern tax policy. However, both sides are wrong, and in fact today’s tax code is closer than either to the ideal of a progressive consumption tax. Future reforms should continue this trend.

1. The Myth of 1950s High-Tax Prosperity

The tax code of the 1950s combined high statutory tax rates, including a top individual rate of 87%, with revenue levels equivalent to today’s (it should be noted that the federal budget’s structure was very different, with defense accounting for a majority of federal spending). There were several reasons for this discrepancy. First, payroll taxes were lower due to a younger population and the absence of Medicare. The second reason was high effective tax thresholds; a family of four in 1955 earning the relative equivalent of $1 million today (based on per capita GDP) in ordinary income and taking the standard deduction would pay 26% in federal income tax, compared to 31% today, the latter including Medicare surcharge/NIIT (that said, at $10 million, the rates would be 74% and 40%).

Third, those individuals actually facing high statutory tax rates largely received capital income, which benefitted from a range of preferences. The most important were for capital gains, which received a 50% exemption and a 25% alternative maximum tax rate as well as step-up basis at death, and tax-free whole life insurance. While the top estate tax rate was 77%, the top effective rate on inter vivos gifts was 37% (57.75% calculated tax-exclusively) with many gift recipients also getting a full capital gains tax step-up since the tax basis could be increased by the full amount of the gift tax paid by the donor (not just the gift tax paid on the unrealized gain as today), and unlimited generation-skipping transfers could be used to avoid successive taxation. Other major tax shelters included accelerated depreciation for real estate, excess depletion allowances of up to half of the profits from natural resource extraction, and tax-exempt municipal bonds, although it should be noted that in general equilibrium the benefit from these incentives would have been shared between wealthy investors, savers in general (benefitting from the diversion of wealthy investors’ capital to lower-yield tax-favored investments), and workers (benefiting from a larger capital stock).

Fourth the postwar tax system encouraged corporations to finance their activities with debt and retained earnings (including buying unrelated companies to form “conglomerates”), over paying dividends and issuing new stock, so as to return profits to shareholders in the form of preferentially-taxed capital gains. Finally, high-level employees and professionals also benefitted from unlimited tax-deferred pensions and tax-free life insurance, and leeway for companies to pay for and fully deduct tax-free tangentially business-related expenses and benefits.

Although the revenue yield and progressivity of the 1950s US tax code was mediocre, it did produce significant economic distortions. Some, like the employer-based health insurance system, are still present. The only tax that produced significantly higher revenue in the 1950s than today was the 52% corporate income tax, which in a closed economy general equilibrium fell on all savers and workers (not just shareholders) and which likely contributed to low levels of investment despite the era’s more tangible economy and baby-boom-fueled housing demand, and also magnified the sectoral distortions caused by special tax incentives. The 1962 and 1964 tax cuts, which sharply reduced effective tax rates on business investment in equipment through accelerated depreciation and an investment tax credit, and also reduced personal, corporate, and excise tax rates across the board, coincided with an internationally-exceptional boom; per capita GDP growth, which had averaged 1.3% during the previous decade, tripled to 3.9% from 1962 to 1967 (by contrast, British growth fell between these two periods).

John F. Kennedy’s reputation as a supply-sider has sometimes been exaggerated; for example, as a liberal corporatist, he proposed his investment tax credit as an alternative to Dwight Eisenhower’s proposal for a dividend tax credit (the modest 4% credit ultimately enacted in 1954 was repealed as part of the 1964 tax cuts), and also imposed an “interest equalization tax” on outbound American investment, which was driven in part by postwar continental Europe’s frequently more business-friendly tax, labor, and regulatory climate. Nevertheless, the US economy’s apparently strong response to the tax cuts of the early 1960s suggests that the postwar tax structure, despite its limited revenue yield, was in fact significantly harmful to economic growth.

As a side-note, the postwar British tax system also combined high marginal tax rates with a narrow base. Notably, capital gains were entirely untaxed, gifts given five years prior to death fully escaped taxation, and investment incentives were very generous. With low fixed-rate social-insurance contributions and no broad-based consumption tax, the postwar British tax system prior to Prime Minister Harold Wilson’s version of the “Great Society” collected much less revenue than today’s. That said, Britain’s high marginal tax rates likely contributed to its underperformance compared to continental Europe, which also had generous investment incentives but much more moderate marginal tax rates (most notably, Economics Minister Ludwig Erhard reduced West Germany’s top tax rate to 53% in the 1950s).

2. The 1986 Tax Reform Mirage

In the 1960s and 70s, the US tax system was transformed by the “Great Inflation.” First, it reduced effective tax thresholds in real as well as relative terms, allowing the federal government to pay for the Great Society and the Vietnam War. Second, while the tax burden on capital investment did not necessarily rise on net (the taxation of inflationary capital gains was balanced by corporations’ and homeowners’ ability to deduct inflationary interest, more generous depreciation schedules, and a higher investment tax credit for equipment), it did substantially distort the capital structure, in particular favoring debt over risk-bearing equity. Economic stagnation (especially apparent in productivity) and rising tax burdens were major factors in the election of Ronald Reagan and the enactment of two significant, but very different, tax reforms.

The 1981 tax cuts, in concert with Federal Reserve Chairman Paul Volcker’s taming of inflation, sharply moved the US tax system toward a progressive consumption tax. Notably, although tax rates were reduced across the board, the upper-bracket cuts applied only to capital income (the top rate on salary and professional income had already been limited to 50%); in addition, depreciation for structures and equipment was sharply accelerated, and estate and gift taxes reduced. Although the 1981 tax cuts have been criticized for increasing the federal budget deficit, the deficit’s rise was entirely accounted for by temporary increases in defense spending and interest rates, and the surging current account deficit (reflecting foreign investment) suggests that any “crowding-out” effect of the budget deficit on historically-high investment would have been modest. Finally, it should be noted that receipts contributed by the affluent, whose economic and tax-planning incentives were most altered by the tax cuts, soared after 1981.

In stark contrast to the 1981 tax cuts, the broadly revenue-neutral 1986 tax reform shifted the US away from a progressive consumption tax toward a “pure” income tax. The 1986 reform’s 28% top rate was achieved not only by (properly) limiting business loss offsets and personal consumption deductions, but also by decelerating depreciation, repealing the investment tax credit for equipment, and eliminating the capital gains preference for the first time since 1922, despite persistent elevated inflation and heavy double-taxation of equity capital on the corporate level. Despite a corporate tax rate cut, the 1986 reform led to a net tax increase for businesses, reflected in weakening investment. Also, the 1986 reform maintained the absurd combination of step-up basis and a 55% estate tax rate. In the international context, the much-ballyhooed 1986 reform was far less coherent than contemporaneous reforms in countries such as Australia, Britain, and Chile in dealing with issues including inflation adjustment, double-taxation of equity capital, and death taxation, as well as the balance between income and consumption-based sources of revenue.

3. The Long-Term Trend Toward a Progressive Consumption Tax

Since the 1986 tax reform, the US tax code has trended toward a progressive consumption tax, with important breakthroughs occurring under Newt Gingrich and Bill Clinton in 1997, George W. Bush in 2001 and 2003, and Donald Trump in 2017. The bad news is that the all-in top tax rate on earned and interest income has risen from 28% to over 40%. Furthermore, in light of growing foreign investment in the globally-dominant US stock market (driven in large part by Silicon Valley), it can be questioned whether the fall in the corporate tax rate from 34% to 21% was optimal without a broader reciprocal movement toward a consumption tax, compared to directly cutting tax rates for American workers and investors. However, this rate cut has reduced the tax code’s bias toward debt over equity, first-year write-offs for equipment have varied between 50% and 100% over the last fifteen years, and American companies are no longer disadvantaged overseas. Additionally, the top tax rate on inflationary, risky, and volatile pass-through business profits (29.6%) has barely risen, while the top rates on capital gains and dividends have fallen to 23.8%, also reducing the double-taxation of corporate equity. Furthermore, the estate tax has fallen from 55% to 40% (35% to 29% on gifts), and the lifetime transfer tax exemption has risen fivefold in comparison to per-capita income. Finally, the SALT deduction limit, the end of the the long-standing 16% federal credit for state estate taxes, and a tighter real home mortgage interest deduction limit have curtailed tax subsidies for wealthy high-tax and high-cost states. Future tax reforms, which may need to raise more revenue to pay for a rising federal debt burden, an aging population, and the retune of great-power competition without crushing economic growth, should continue this trend toward a progressive consumption tax.