FEDERAL INCOME TAXFEDERAL INCOME TAX

Introduction to the American Legal Introduction to the American Legal System, Law 103System, Law 103

20102010

By Robert BoyleBy Robert Boyle©©

Preliminary QuestionsPreliminary Questions What is the best tax system?What is the best tax system? Provides adequate revenuesProvides adequate revenues Has the least adverse impact on economic Has the least adverse impact on economic

activity and growthactivity and growth Is fair and equitableIs fair and equitable ““A well-designed tax system raises revenue A well-designed tax system raises revenue

for necessary programs as efficiently, fairly, for necessary programs as efficiently, fairly, and simply as possible.” (The Tax and simply as possible.” (The Tax Foundation)Foundation)

Quotes of NoteQuotes of Note ““No taxation without representation.” (Reverend Jonathan No taxation without representation.” (Reverend Jonathan

Mayhew, Boston, 1750)Mayhew, Boston, 1750)

““Nothing in this world is certain but death and taxes.” Nothing in this world is certain but death and taxes.” (Benjamin Franklin, 1789)(Benjamin Franklin, 1789)

““The power to tax is the power to destroy.” (Chief Justice The power to tax is the power to destroy.” (Chief Justice John Marshall, John Marshall, McCulloch v. MarylandMcCulloch v. Maryland, 17 U.S. 327 (1819)), 17 U.S. 327 (1819))

““Taxes are what we pay for civilized society.” (Oliver Taxes are what we pay for civilized society.” (Oliver Wendell Holmes, 1904)Wendell Holmes, 1904)

““Taxes harm the economy.” J.D. Foster, PhD, “No Economic Taxes harm the economy.” J.D. Foster, PhD, “No Economic Sliver Lining in Tax Hikes”, The Heritage Foundation (Web Sliver Lining in Tax Hikes”, The Heritage Foundation (Web Memo)Memo)

““No new taxes.” (H.W. Bush)No new taxes.” (H.W. Bush)

Quotes, Cont’dQuotes, Cont’d ““From each according to his abilities, to each From each according to his abilities, to each

according to his needs.” (K. Marx, according to his needs.” (K. Marx, CritiqueCritique)) ““The subjects of every state ought to The subjects of every state ought to

contribute toward the support of contribute toward the support of government as nearly as possible in government as nearly as possible in proportion to their respective abilities, that proportion to their respective abilities, that is in proportion to the revenue which they is in proportion to the revenue which they respectively enjoy under the protection of respectively enjoy under the protection of the state.” (A. Smith, the state.” (A. Smith, The Wealth of NationsThe Wealth of Nations))

Income Tax PolicyIncome Tax Policy Premised upon “ability to pay.”Premised upon “ability to pay.” Avoid unnecessary interference with Avoid unnecessary interference with

the operations of the marketplace.the operations of the marketplace. Fairness – distributive justice.Fairness – distributive justice. Redistribution of wealth (?)Redistribution of wealth (?)

Redistribution of WealthRedistribution of Wealth Democracy does not work well when Democracy does not work well when

economic power is concentrated in a economic power is concentrated in a few;few;

Public support for the tax system;Public support for the tax system; Perceived fairness = voluntary Perceived fairness = voluntary

participation;participation; Prevent “class warfare.”Prevent “class warfare.”

AlternativesAlternatives

Consumption TaxConsumption Tax National Sales TaxNational Sales Tax Flat TaxFlat Tax

Web Sources of InformationWeb Sources of Information Office of Management & Budget (Office of Management & Budget (

www.whitehouse.gov/omb/www.whitehouse.gov/omb/)) US Dept. of Treasury (US Dept. of Treasury (www.ustreas.govwww.ustreas.gov)) Internal Revenue Service (Internal Revenue Service (www.irs.govwww.irs.gov)) The Brookings Institute (The Brookings Institute (www.brookings.eduwww.brookings.edu)) The Tax Policy Center (The Tax Policy Center (

www.taxpolicycenter.orgwww.taxpolicycenter.org)) The Tax Foundation (www.taxfoundation.org)The Tax Foundation (www.taxfoundation.org) The Heritage Foundation (The Heritage Foundation (www.heritage.orgwww.heritage.org)) The Citizens for Tax Justice (The Citizens for Tax Justice (www.ctj.orgwww.ctj.org))

Too Much or Not Enough ?Too Much or Not Enough ? Total income taxation as a Total income taxation as a

percentage of gross national product percentage of gross national product (GNP);(GNP);

Total income taxation as a Total income taxation as a percentage of personal income.percentage of personal income.

National debt.National debt.

Federal Budget DeficitsFederal Budget Deficits The combination of the Great The combination of the Great

Depression and WWII resulted in a Depression and WWII resulted in a long, unbroken string of annual long, unbroken string of annual budget deficits that led, in 1946, to a budget deficits that led, in 1946, to a national debt that was 109 % of the national debt that was 109 % of the GNP for that year. GNP for that year.

Federal Budget Deficits, Federal Budget Deficits, Cont’dCont’d ““The U.S. federal budget is on an The U.S. federal budget is on an

unsustainable path . . . [F]ederal government unsustainable path . . . [F]ederal government deficits are expected to total around $5 deficits are expected to total around $5 trillion over the next decade. Such deficits trillion over the next decade. Such deficits will cause U.S. government debt, relative to will cause U.S. government debt, relative to GDP, to rise significantly. Thereafter, as the GDP, to rise significantly. Thereafter, as the baby boomers increasingly reach retirement baby boomers increasingly reach retirement age and claim Social Security and Medicare age and claim Social Security and Medicare benefits, government deficits and debt are benefits, government deficits and debt are likely to grow even more sharply. The scale of likely to grow even more sharply. The scale of the nation's projected budgetary imbalances the nation's projected budgetary imbalances is now so large that the risk of severe is now so large that the risk of severe adverse consequences must be taken very adverse consequences must be taken very seriously . . .” seriously . . .”

(Brookings Institute, Jan. 5, 2004)(Brookings Institute, Jan. 5, 2004)

History of Federal Income TaxHistory of Federal Income Tax

Prior to the Civil War, the Federal Prior to the Civil War, the Federal Government relied on flat rate Government relied on flat rate consumption taxes: excise taxes and taxes consumption taxes: excise taxes and taxes on imports;on imports;

Abraham Lincoln enacted the first federal Abraham Lincoln enacted the first federal income tax during the civil war. It was income tax during the civil war. It was repealed in 1871.repealed in 1871.

The gov’t reverted to its pre-war reliance The gov’t reverted to its pre-war reliance on taxes on goods. on taxes on goods.

William Jennings BryanWilliam Jennings Bryan Began in 1893 to draft a bill for a Began in 1893 to draft a bill for a

graduated income tax.graduated income tax. Criticized as socialist. Said to Criticized as socialist. Said to

discriminate against business.discriminate against business. Wealthy interests supported tariffs Wealthy interests supported tariffs

that made consumer goods expensive that made consumer goods expensive for wage-earning consumers.for wage-earning consumers.

Pollock v. Farmer’s Loan and Trust CompanyPollock v. Farmer’s Loan and Trust Company

Article 1, § 2 of the Constitution said that a “direct Article 1, § 2 of the Constitution said that a “direct tax” must be “apportioned among the several tax” must be “apportioned among the several states . . . according to their respective numbers”. states . . . according to their respective numbers”. Opponents argued that the income tax was a Opponents argued that the income tax was a “direct tax” that fell disproportionately upon “direct tax” that fell disproportionately upon wealthy, industrial states (NY, MA, NJ, PA, CT).wealthy, industrial states (NY, MA, NJ, PA, CT).

The U.S. Supreme Court held that the 1894 Income The U.S. Supreme Court held that the 1894 Income Tax was unconstitutional in Tax was unconstitutional in Pollock v. Farmer’s Loan Pollock v. Farmer’s Loan and Trust Coand Trust Co., 157 U.S. 429 (1895) ., 157 U.S. 429 (1895) afterafter rehearingrehearing, , 158 U.S. 601 (1895).158 U.S. 601 (1895).

““The present assault upon capital is but the The present assault upon capital is but the beginning. It will be but the stepping stone to beginning. It will be but the stepping stone to others, larger and more sweeping, till our political others, larger and more sweeping, till our political contests will become a war of the poor against the contests will become a war of the poor against the rich; a war constantly growing in intensity and rich; a war constantly growing in intensity and bitterness.” – U.S. Supreme Court Justice Stephen J. bitterness.” – U.S. Supreme Court Justice Stephen J. FieldField

History, Cont’d (2)History, Cont’d (2) On Feb. 3, 1913 Wyoming became the 36 state to On Feb. 3, 1913 Wyoming became the 36 state to

ratify the XVI Amendment, satisfying the ratify the XVI Amendment, satisfying the requirement that 3/4ths of the States ratify an requirement that 3/4ths of the States ratify an amendment. amendment.

Amendment XVI: “The Congress shall have power Amendment XVI: “The Congress shall have power to lay and collect taxes on incomes, from whatever to lay and collect taxes on incomes, from whatever source derived, without apportionment among the source derived, without apportionment among the several states, and without regard to any census several states, and without regard to any census or enumeration.” or enumeration.”

May 8, 1913, Congress enacts federal income tax. May 8, 1913, Congress enacts federal income tax. (While William Jennings Bryan serves as Secretary (While William Jennings Bryan serves as Secretary of State to President Woodrow Wilson)of State to President Woodrow Wilson)

History, Cont’d (3)History, Cont’d (3) Legislative History:Legislative History:

““Section 2 of the bill imposes a tax upon Section 2 of the bill imposes a tax upon the annual net incomes of individuals the annual net incomes of individuals and corporations. This is in response to and corporations. This is in response to the general demand for justice in the general demand for justice in taxation . . . The tax upon income is taxation . . . The tax upon income is levied according to levied according to ability to payability to pay, and it , and it would be difficult to devise a fairer tax.” would be difficult to devise a fairer tax.” (Emphasis added) (Emphasis added)

Income Tax Becomes Mass TaxIncome Tax Becomes Mass Tax

The Current Tax Payment Act of 1943 The Current Tax Payment Act of 1943 enabled U.S. Govt. to withhold income taxes enabled U.S. Govt. to withhold income taxes from wage earners for the first time. This from wage earners for the first time. This resulted in 36 million more tax filings resulted in 36 million more tax filings comparing 1939 to 1943. Ten times more comparing 1939 to 1943. Ten times more filings from 1939 to 1945 (i.e., 1000 % more). filings from 1939 to 1945 (i.e., 1000 % more). In 1939, income tax revenue was 1 billion In 1939, income tax revenue was 1 billion dollars, compared to 19.7 billion in 1943.dollars, compared to 19.7 billion in 1943.

Barlett & Steele, Barlett & Steele, America: Who Pays the TaxesAmerica: Who Pays the Taxes

Changes in the Top Marginal Changes in the Top Marginal RateRate

For highest tax bracket, the percentage of For highest tax bracket, the percentage of income tax paid on the “last dollar earned.”income tax paid on the “last dollar earned.”

1913 = 7 %1913 = 7 % 1918 = 77 % (WWI)1918 = 77 % (WWI) 1944 = 94 % (WWII)1944 = 94 % (WWII) 1950 through 1959 = 91 % (Cold War-- 1950 through 1959 = 91 % (Cold War--

Korea)Korea) 1970 through 1980 = 70 % (Cold War– 1970 through 1980 = 70 % (Cold War–

Vietnam)Vietnam) 1987 through 2007 = less than 40 %1987 through 2007 = less than 40 % Currently: 35 %Currently: 35 %

Impact of Democratic Impact of Democratic ProcessProcess

Problems posed by the private financing of Problems posed by the private financing of election campaigns.election campaigns.

““The original income tax had low rates and The original income tax had low rates and few loopholes. Seventy years later [in 1984] few loopholes. Seventy years later [in 1984] we have a system that verges on being more we have a system that verges on being more loophole than tax.” Robert McIntyreloophole than tax.” Robert McIntyre

““If you evade your taxes, you go to the If you evade your taxes, you go to the penitentiary. If you want to avoid taxes, you penitentiary. If you want to avoid taxes, you go to the Congress— and see what they can go to the Congress— and see what they can do for you.” Senator Andrew Jacobs do for you.” Senator Andrew Jacobs

Income Tax Rule No. 1Income Tax Rule No. 1 ““Tax Rule No. 1: If someone does not Tax Rule No. 1: If someone does not

pay taxes, or pays less than his or pay taxes, or pays less than his or her share, someone else will have to her share, someone else will have to make up the difference.” make up the difference.” Barlett & Steele, Barlett & Steele, America: Who Pays America: Who Pays the Taxesthe Taxes (1994) (1994)

Tax Shelters & Loopholes:Tax Shelters & Loopholes:The 1969 Tax Reform ActThe 1969 Tax Reform Act

““It should not have been possible for 154 It should not have been possible for 154 individuals with adjusted gross incomes of $ individuals with adjusted gross incomes of $ 200,000 or more to pay no Federal income 200,000 or more to pay no Federal income tax. Ours is primarily a self-assessment tax. Ours is primarily a self-assessment system. If taxpayers are generally to pay system. If taxpayers are generally to pay their taxes on a voluntary basis, they must their taxes on a voluntary basis, they must feel that these taxes are fair . . . Moreover, feel that these taxes are fair . . . Moreover, only by sharing the tax burden on an only by sharing the tax burden on an equitable basis is it possible to keep the tax equitable basis is it possible to keep the tax burden at a level which is tolerable for all burden at a level which is tolerable for all taxpayers.” taxpayers.”

(Senate Finance Committee Report) (Senate Finance Committee Report)

1969 Tax Reform Act, 1969 Tax Reform Act, Cont’dCont’d

““The middle classes are likely to The middle classes are likely to revolt against income taxes not revolt against income taxes not because of the level or amount of the because of the level or amount of the taxes they must pay, but because taxes they must pay, but because certain provisions of the tax laws certain provisions of the tax laws unfairly lighten the burdens of others unfairly lighten the burdens of others who can afford to pay.” who can afford to pay.”

Treasury Secretary Joseph Walker BarrTreasury Secretary Joseph Walker Barr

““Loophole Mania”Loophole Mania” ““The Tax Reform Act of 1976 requires The Tax Reform Act of 1976 requires

annual publication of data on individual annual publication of data on individual income tax returns reporting income of income tax returns reporting income of $200,000 or more, including the number of $200,000 or more, including the number of such returns reporting no income tax such returns reporting no income tax liability and the importance of various tax liability and the importance of various tax provisions in making these returns provisions in making these returns nontaxable.”nontaxable.”

IRS, SOI (Statistics of Income) Tax StatsIRS, SOI (Statistics of Income) Tax Stats

Top Earners Paying Top Earners Paying Zero Income TaxesZero Income Taxes

1969 – 154 tax filers;1969 – 154 tax filers; 1974 – 244 tax filers (57 % increase since 1969);1974 – 244 tax filers (57 % increase since 1969); 1986 – 659 tax filers (up 170 % from 1974 and 1986 – 659 tax filers (up 170 % from 1974 and

up 325 % from 1969);up 325 % from 1969); 1989 – 1,081 tax filers (up 64 % from 1986);1989 – 1,081 tax filers (up 64 % from 1986); 2004 – 5,028 tax filers (up 465 % from 1989)2004 – 5,028 tax filers (up 465 % from 1989)Barlett & Steele, Barlett & Steele, America: Who Pays the TaxesAmerica: Who Pays the Taxes;;IRS, SOI (Statistics of Income) Tax StatsIRS, SOI (Statistics of Income) Tax Stats

Economic Impact of Tax Economic Impact of Tax SheltersShelters

Tax shelters distort economic decision Tax shelters distort economic decision making.making.

““Tax sheltering, rather than the Tax sheltering, rather than the marketplace, has become the driving force marketplace, has become the driving force behind many investment choices. Bad behind many investment choices. Bad investments, entered into only for their tax investments, entered into only for their tax advantages, have crowded out good advantages, have crowded out good ones.” Robert McIntyre, “Just Taxes, & ones.” Robert McIntyre, “Just Taxes, & Other Options” (1984)Other Options” (1984)

Abusive Tax SheltersAbusive Tax Shelters ““Abusive shelters are sold exclusively for the Abusive shelters are sold exclusively for the

tax benefits. They are structured to abandon tax benefits. They are structured to abandon virtually all realistic chances of economic profit virtually all realistic chances of economic profit in order to greatly magnify the tax benefits. in order to greatly magnify the tax benefits. They typically involve artificially inflated They typically involve artificially inflated ‘costs’ that serve as the basis for claiming cost ‘costs’ that serve as the basis for claiming cost recovery deductions and credits based on recovery deductions and credits based on these ‘costs.’” these ‘costs.’”

Ault, H. et. als., Ault, H. et. als., Federal Income Taxation: Federal Income Taxation: Cases and MaterialsCases and Materials, (The Foundation Press, , (The Foundation Press, 1986), page . 9921986), page . 992

Increasing InequalityIncreasing Inequality ““For over thirty years, members of Congress and For over thirty years, members of Congress and

Presidents – Democrats and Republicans alike – Presidents – Democrats and Republicans alike – have enacted one law after another to create two have enacted one law after another to create two separate and distinct tax systems: One for the separate and distinct tax systems: One for the rich and powerful . . . Another for you and rich and powerful . . . Another for you and everyone else . . . [T]hey have taken tax and everyone else . . . [T]hey have taken tax and economic policies that once nurtured the growth economic policies that once nurtured the growth of history’s largest middle class, and replaced of history’s largest middle class, and replaced them with policies that are driving the nation into them with policies that are driving the nation into a two-class society, eroding living standards for a two-class society, eroding living standards for most Americans, and causing – for the first time most Americans, and causing – for the first time since the Great Depression – a decline in the since the Great Depression – a decline in the population sandwiched between the haves and population sandwiched between the haves and the have-nots.”the have-nots.”

Barlett & Steel, Barlett & Steel, America: Who Pays the TaxesAmerica: Who Pays the Taxes

Increasing Inequality, Increasing Inequality, Cont’dCont’d

““America has experienced a large increase America has experienced a large increase in income inequality in recent decades. The in income inequality in recent decades. The changes have been particularly pronounced changes have been particularly pronounced at the very top of the income distribution. In at the very top of the income distribution. In 1979 . . .the before-tax income of the most 1979 . . .the before-tax income of the most affluent 1 percent of the U.S. population affluent 1 percent of the U.S. population already equaled that of the bottom 26 already equaled that of the bottom 26 percent . . . That share has since risen percent . . . That share has since risen continuously, reaching 45 percent in 2004.” continuously, reaching 45 percent in 2004.”

Steve Wamhoff, “President’s Reckless Tax Steve Wamhoff, “President’s Reckless Tax and Fiscal Policies . . .” (CTJ, 9/13/07) and Fiscal Policies . . .” (CTJ, 9/13/07)

Pulling Out of the Stimulus / BailoutPulling Out of the Stimulus / Bailout ““Federal tax rates are lower today than they were in Federal tax rates are lower today than they were in

the 1940s, 1950s, and 1960s – periods of healthy the 1940s, 1950s, and 1960s – periods of healthy economic growth . . . A modest increase in the economic growth . . . A modest increase in the marginal rates from their present low level would marginal rates from their present low level would increase tax revenues substantially, probably with increase tax revenues substantially, probably with little offset due to the distortions that any tax little offset due to the distortions that any tax produces . . . But the bulk of any feasible produces . . . But the bulk of any feasible augmentation of tax revenues will have to be augmentation of tax revenues will have to be devoted to paying down the depression-enhanced devoted to paying down the depression-enhanced national debt.”national debt.”

Richard A. Posner, Richard A. Posner, A Failure of Capitalism: the Crisis A Failure of Capitalism: the Crisis of ’08 and the Descent into Depressionof ’08 and the Descent into Depression, (Harvard , (Harvard University Press 2009), pages 226-227.University Press 2009), pages 226-227.

Taxing “Economic Rent”Taxing “Economic Rent” ““Consideration should perhaps be given to Consideration should perhaps be given to

increasing the marginal income tax rate on increasing the marginal income tax rate on persons who have very high incomes, in order to persons who have very high incomes, in order to reduce their appetite for risk-taking. Such incomes reduce their appetite for risk-taking. Such incomes typically contain a good deal of economic rent. typically contain a good deal of economic rent. Think of the boxing champion who makes millions Think of the boxing champion who makes millions but whose next best job would be as a bouncer. . . but whose next best job would be as a bouncer. . . paid the minimum wage. Taxing economic rents is paid the minimum wage. Taxing economic rents is efficient because it has, by definition . . . minimal efficient because it has, by definition . . . minimal substitution effects. It will not deflect the taxpayer substitution effects. It will not deflect the taxpayer to a different occupation just because it taxes the to a different occupation just because it taxes the income available to him only in his present one.”income available to him only in his present one.”

Posner, Posner, Failure of CapitalismFailure of Capitalism, page 300., page 300.

No new taxes – for nowNo new taxes – for now ““Taxes will have to be raised at some point in Taxes will have to be raised at some point in

order to finance the anti-depression order to finance the anti-depression programs, and income taxes are more programs, and income taxes are more efficient taxes than, say, corporate taxes. The efficient taxes than, say, corporate taxes. The refusal or inability ot the Bush Administration refusal or inability ot the Bush Administration either to raise taxes or to reduce spending either to raise taxes or to reduce spending caused a dangerous increase in the national caused a dangerous increase in the national debt. This is not the time to raise taxes, but debt. This is not the time to raise taxes, but were are an undertaxed nation.”were are an undertaxed nation.”

Posner, Posner, Failure of CapitalismFailure of Capitalism, page 300-301., page 300-301.

Credits / BibliographyCredits / Bibliography Robert McIntyre, Robert McIntyre, Just Taxes & Other OptionsJust Taxes & Other Options (Citizens for (Citizens for

Tax Justice, 1984);Tax Justice, 1984); Barlett & Steele, Barlett & Steele, America: Who Pays the TaxesAmerica: Who Pays the Taxes, Simon & , Simon &

Shuster (New York 1994)Shuster (New York 1994) Steven Weisman, Steven Weisman, The Great Tax WarsThe Great Tax Wars (Simon & Schuster, (Simon & Schuster,

2002)2002) Ault, H. et. als., Ault, H. et. als., Federal Income Taxation: Cases and Federal Income Taxation: Cases and

MaterialsMaterials, (The Foundation Press, 1986), (The Foundation Press, 1986) Richard A. Posner, Richard A. Posner, A Failure of Capitalism: the Crisis of ’08 A Failure of Capitalism: the Crisis of ’08

and the Descent into Depressionand the Descent into Depression, (Harvard University Press , (Harvard University Press 2009), pages 226-227.2009), pages 226-227.