We have become accustomed to thinking that taxes, like hemlines, can only go up or down. This isn't true. Over the centuries changes in the form of U.S. taxes have been at least as dramatic as changes in the rate of taxation.
For instance, most federal revenues now come from personal and corporate income taxes, and from the payroll taxes that fund Social Security and Medicare. But most government revenues originally came from excise taxes on luxury items such as tobacco, spirits, and sugar, and throughout much of the nineteenth century the bulk of federal revenues came from tariffs on imported manufactured goods. In fact, the federal income tax, which we tend to think of as an eternal fixture, was introduced as an emergency measure during the Civil War, and did not become permanent until the Sixteenth Amendment was ratified, in 1913. Even then income taxes were levied on only the richest Americans. Not until World War II did the income tax metamorphose into something we would easily recognize today: a mass tax that reached the middle class.
Our tax system has continued to evolve in the postwar era. The second half of the twentieth century witnessed a decreased reliance on progressive taxes (those that, like the income tax, charge higher earners at a steeper rate) and an increased reliance on regressive taxes, such as payroll and sales taxes.
In analyzing the tax system we need to look not just at rates but at the forms that taxes take. There are three basic questions to consider: Is the system fair? Does it encourage efficiency? Does it raise enough to pay for government spending? Let's take each question in turn.
Are today's taxes fair? In some ways this is the hardest of the questions to answer, because it requires a definition of "fairness." This could be rephrased as: To what extent is one's overall tax burden commensurate with one's ability to meet it? In this regard taxes are much less fair than they were a generation ago, because over the past several decades tax reformers have focused on reducing the federal income tax while ignoring the explosive growth of other, more regressive taxes.
In a sense the federal income tax remains one of the most progressive taxes there is: half of all the revenue it generates comes from workers earning more than $200,000 a year. But income-tax rates are actually not nearly as progressive as they were several decades ago: the top marginal income-tax rate has declined since the Kennedy Administration, from 91 percent in 1960 to 35 percent in President George W. Bush's plan. Meanwhile, the corporate income tax—whose effects are felt more directly by shareholders than workers—has contributed less and less to overall federal revenues, as changes in the tax code have allowed corporations to shield more and more of their income. At the beginning of World War II the corporate income tax provided almost 50 percent of federal revenues; today it accounts for only 10 percent.
Decreasing the progressivity of certain taxes, and relying more on regressive taxes, shifts the tax burden down the income scale from the rich to the middle class and the working poor. This is exactly what has happened over the past several decades. Since the end of World War II state and local taxes—which are far less progressive than federal taxes—have more than doubled as a share of the American economy, while total federal tax revenues have slightly decreased as a percentage of GDP.
Social Security and Medicare payroll taxes, also regressive, have grown to the point where they are the largest federal taxes that most American families pay. Though the basic structure of the federal payroll tax has hardly changed in fifty years, its rate has been raised repeatedly. Today it is 15.3 percent, and all earners, whether they make $25,000 a year or $250,000, pay it on the very first dollar of earnings. But the 12.4 percent Social Security tax applies only to wage earnings below $87,900—meaning that the $25,000-a-year earner (every dollar of whose income is taxed at 15.3 percent) pays a higher effective tax rate than the $250,000-a-year earner (most of whose income is exempt). And investment income and employer benefits—which accrue disproportionately to high-income earners—go completely untaxed, making the system still more regressive. People who live entirely off inherited wealth pay no payroll taxes at all.
Of course, reasonable people—and even reasonable economists—can disagree about how the tax burden should be distributed; a tax system's relative progressivity can affect how efficiently an economy functions and how quickly it grows. (More on this in a moment.) But current economic realities suggest that we should be making taxes more progressive, not less. For instance, the benefits of recent productivity growth—the result of rapid technological advances—have not spread evenly through American society; most of the gains have flowed to investors and high-income professionals. The result? A degree of economic inequality not seen in this country since before the Depression. If fairness means taxing people in accordance with their ability to pay, it is unfair to shift taxes away from the few who have benefited most from the New Economy and toward the many who have benefited much less (or even been hurt). But that is exactly what many of the tax reforms of the past several decades have done.
Is today's tax system efficient? In other words, does it send the right signals to individuals and businesses, and promote economic growth? Not really.
The dominant economic themes of our time have been globalization and technological change. Both these forces have intensified international competition, particularly in the manufacturing sector—a fact that has enormous implications for our tax system. Globalization has made it easier for multinational corporations to follow the lowest labor costs and tax rates around the world; countries that can keep their tax burdens low have a competitive advantage over those that can't. During the past two decades efforts to reduce taxes on dividends and capital gains have all been aimed at lowering the cost of capital—and thereby encouraging investment and boosting competitiveness—in the United States. This is a sensible strategy as far as it goes—but its application has been only piecemeal, and has produced uneven effects.
Furthermore, the number of elderly people as a percentage of the overall U.S. population will rapidly increase in the decades ahead. Common sense dictates that our tax system encourage saving—both to boost the economy and to help pay for the Baby Boomers' retirement. The current system, however, favors consumption, which is one reason why we have one of the lowest saving rates among advanced industrialized countries. As a consequence, we are staring at not only trillions of dollars' worth of payments we cannot afford to make to future Social Security and Medicare recipients but also a growing international debt. At some point we will finally have to finance the retirement of millions of Americans and pay off the foreign investors who have lent us money over the years—a task that will be made much easier if we start saving now.
Given increased global competition and our graying population, it is very important that our tax system not only encourage saving but also discourage harmful consumption. Too many behaviors that impose "negative externalities"—social costs that are not factored into the direct accounting figures—go untaxed. For instance, Humvee owners don't have to pay taxes for the environmental destruction wrought by their vehicles. Moreover, many of the indirect costs of the country's dependence on oil—such as the expense (including national-security expenses) of shipping oil from the Middle East, along with the damage it does to the environment— go untaxed. A more efficient tax system would discourage this waste, and provide incentives for more-productive investment.