Basic Tax Question Jude Wanniski January 10, 1997

Supply-Side Economics Lesson No. 6

Memo To: Web site economics students
From: Jude Wanniski
Re: Basic tax question

Kevin Isbister asks this most basic question: What are the "taxable things" (in our society in particular)? I realize that anything, whether possession or action, can be taxed if the government dictates it and the constituency's disapproval doesn't cut into the government's power. But, historically, are most taxes basically of three types: taxes on earned income, taxes on property, and taxes on investment earnings?

When the United States began, there was only one type of federal taxation, a tariff on all imported goods. The Constitution preserved this tax for federal purposes and prohibited states from exacting duties on goods entering from other states. Among Alexander Hamilton's most important contributions as Treasury Secretary to President Washington was to have the national government assume all the debts of the 13 states, which they carried into the union. In exchange, the states agreed to sit still for a federal excise tax, to help fund the debt. The tax applied to whisky and led to the whisky rebellion in Pennsylvania, which was put down. The consolidated debt with a hard source of revenue enabled Hamilton to persuade the nation's domestic and foreign creditors that our sizeable federal/state debt could be paid in gold, which is how the U.S. began life on a gold standard instead of a fiat money system.

Revenues from these sources and from the sale of public lands were sufficient to meet federal expenses, and there came a point where the U.S. might have paid down all its debt. Military expenses grew, skyrocketing with the Civil War, which led to a variety of taxes including a small income tax — which the Supreme Court deemed unconstitutional. Unable to finance the war with higher taxes and, in the absence of winning early battles, President Lincoln took the nation off the gold standard and thereby raised revenues by simply issuing greenbacks — dollars that were not redeemable in gold or silver.

It was not until 1902 that modern governments seriously began taxing income, when the British began the practice in a small way to finance its imperial burdens. The United States imposed a progressive income tax in 1913, after it was made constitutional by the Sixteenth Amendment. It started small, with a bottom rate of 1% that you did not pay until you reached an income that today would be $60,000 for a single person and $80,000 for a couple, and a top rate of 7% that would apply to annual income above what today would be about $10 million. But as the United States entered the European conflict, the top rate shot up to as high as 77% in 1918, which would apply at an income of $1 million, which at today's gold price would mean an equivalent of $20 million. A capital gains tax was passed in 1921 to lighten the tax burden on gains from invested capital, which represents after-tax ordinary or wage income.

There are a multitude of ways to think about how we tax ourselves, most of them becoming part of our language since the 1930s. The personal income tax became a more and more important part of government finance in the Great Depression, especially after the dollar was devalued from $20.67 per ounce of gold to $35 in 1934. The inflation that followed began the process we later saw as "bracket creep," in which tax rates designed for the rich began to apply to the middle-class. At the time of WWII, there were no income taxes levied by state or local governments. The burdens of war and Cold War and the expansion of the welfare state caused all governments to look for more and more sources of revenue. We now are roughly at the point the British found themselves in back in 1815, at the end of 22 years of Napoleonic wars. Almost everything under the sun is taxed at least once, and many things are taxed two and three times.

The way I personally conceive of our tax system is that there are three forms of tax. The first is a tax on the original production of goods or services by a human individual or a corporate entity. The second is a tax on the transfer or exchange of what remains of the original production after it has been taxed once as income. The third is a tax on after-tax income that has increased in value, having been put at risk.

The first is a tax on original production, by an individual or by a legal entity owned by an individual or individuals. When an individual or a corporate bakery produces ten loaves of bread and the government applies a tax of 10%, it takes one loaf. The income tax applies to production. All taxation on production that has already passed through an income-tax gate is a tax on the consumption or transfer of wealth. That is, wealth is what you have after you have paid your income tax. When you save your nine loaves, you are not taxed. If you use the nine to exchange for other goods and services, the government can exact another tax. It is in this sense that a sales tax is a tax on wealth. A property tax is a tax on wealth. A gift or estate tax is a tax on the transfer of wealth.

For a business entity that has borrowed funds to conduct business, it can deduct the cost of interest paid as a cost of doing business. The entity (a bank or insurance company or credit union) that has loaned the funds can expect to pay a tax on the profits it makes on the interest received. To that part of the interest it has borrowed from depositors, it can deduct the interest paid out as a cost of doing business. The depositors are subject to income tax if they have received a portion of the interest paid. If, on the other hand, a business entity sells a part or share of itself to another entity, and pays it a share of the after-tax profits as a dividend, the individual who receives the dividend is subject to income tax on it. This double-taxing of a business dividend can be avoided by reinvesting the profits instead of paying the dividend. The funds thus continue to remain at risk. If this reinvestment of profits by a business entity is accomplished by buying back the shares of itself originally sold, the original investor may enjoy a capital gain if the price he receives is higher than the price he paid.

This capital gains tax is a third form of taxation. It is not a tax on the interest received for the use of credit, nor is it a tax on a dividend received for a share of profits on capital put at risk. A capital gain can only occur if after-tax income is put at risk in an asset that increases in value.

These three categories constitute the universe of possible taxation. A tax on production. A tax on the transfer of wealth. A tax on an increase in the value of an asset put at risk.