Thursday, October 10, 2013

History Lesson, Part II: from The Birth of a Nation to a Federal Income Tax

Odd tangents, moments of strange intersections, events seemingly unrelated but with a thread pulling them together: this is the theme of this post (Part II), the previous one (Part I), and one more to follow (Part III).
I ended Part I of this series with a reference to Senator Oscar Wilder Underwood of Alabama, the man who helped lead the anti-Klan faction of the Democratic Party at the 1924 Convention. As I said, he would retire from the Senate in 1926 at the conclusion of his current term. But prior to his efforts to defang the Ku Klux Klan, he was involved in some other historic events. So let's go back to 1913, one hundred years ago this very week, and look at some legislation passed by Congress

At the time, Underwood was not yet a Senator. He was a member of the House of Representatives, serving the State of Alabama in that role since 1897. Underwood was also the Majority leader of the House, a position he attained in 1911, following the election of 1910 when the Democrats gained control of the House after sixteen years of Republican domination. In that role, he helped to create and pass the Revenue Act of 1913 (also known as the Underwood Tariff Act).

This legislation did two significant things. First, it lowered almost all current tariffs, setting the base rate at 25%, much lower than the then-current rate of 40% (which was itself set in 1909 and lower than the previous average rates). The issue of tariffs had dogged the Federal Government for decades because there was no agreement on the basic issue, whether tariffs should be used in a protectionist manner or whether they should be kept as low as possible. The Republican Party was divided on the matter and the Democrats--led by Underwood and President Woodrow Wilson--were of one mind: lower tariffs as a means of increasing economic activity. The public by and large supported this approach, as evidenced by the fact that it handed Democrats control of both Houses and the Presidency in 1912, largely on the basis of the Democrats' economic platform.

But by taking an ax to tariff rates, the Democrats were concerned about replacing the "lost revenue" from such a move. They assumed, as did most everyone else in Congress, that a decrease in a given tax rate was a static event, that it would lead to a directly corresponding decrease in taxes collected. There were very few voices arguing differently at the time. Now, we know their fear of lost revenue was predicated on a misunderstanding of how economies actually function: they could not come to terms with the idea that lowering rates could increase economic activity to such an extent that more taxes were collected, not less.

Regardless, the Democrats assumed there was a revenue problem and Underwood addressed it with the second major aspect of the Revenue Act of 1913: the establishment of a tax on individual incomes, a full-bore income tax (which was now Constitutional, thanks to the ratification of the Sixteenth Amendment earlier in the same year, 1913). By today's standards, the tax seems pitiful. The base rate was a mere 1% and incomes under $4000 per year were exempt. The tax was, however, progressive as higher incomes paid an "additional tax" (in the language of the bill) of 1% in a series of steps:
In addition to the income tax provided under this section (herein referred to as the normal income tax) there shall be levied, assessed, and collected upon the net income of every individual an additional income tax (herein referred to as the additional tax) of 1 per centum per annum upon the amount by which the total net income exceeds $20,000 and does not exceed $50,000, and 2 per centum per annum upon the amount by which the total net income exceeds $50,000 and does not exceed $75,000, 3 per centum per annum upon the amount by which the total net income exceeds $75,000 and does not exceed $100,000, 4 per centum per annum upon the amount by which the total net income exceeds $100,000 and does not exceed $250,000, 5 per centum per annum upon the amount by which the total net income exceeds $250,000 and does not exceed $500,000, and 6 per centum per annum upon the amount by which the total net income exceeds $500,000.
Thus, the typical income tax rate was 1% for yearly incomes between $4,000 and $20,000 while the top rate was 7% for incomes over $500,000. If the numbers are adjusted for inflation, essentially the 1% tax would not kick in until around $90,000. The top rate would only be felt by people with incomes in excess of $11 million or so.

There were still various exemptions and loopholes written in to the law, to the extent that maybe 1% of the population actually had to pay an income tax. Today--on the basis of the above rate and with no exemptions--this tax structure would mean that around 20% of the population would be subject to income taxation, no more.

But getting back to 1913, the Revenue Act was signed into law by President Wilson on October 3, 1913 and thus began in earnest the history of individual income taxation by the Federal Government in the United States. At the time, the legislation was deemed a huge success, mostly because of the tariff issue. And that's easily understood since so very few citizens were subject to an income tax. The bulk of those who were subject to the tax paid under 5% of their incomes (very, very, very few people had yearly incomes greater than $100,000 in 1913). And the bulk of that group paid only 1%. Who could have imagined--at the time--how high those rates would climb, how many people would be impacted by them, in the following one hundred years?

Oscar Underwood, a seemingly highly principled man who stood strong against injustice, was still a skilled politician. He knew there was a price to pay--in the eyes of the public and most of Congress--for tariff reform. By fixing income tax rates as he did, he made sure that price was born by a tiny minority of the populace, a group easily targeted then--as now--for punitive action on the basis of their wealth, nothing more. Which of course requires one to revisit those principles, especially considering a very obvious bit of inconsistency here.

For both Underwood and President Wilson were on the same page with regard to tariffs and taxes. After Underwood had gotten the legislation through the House, the Senate (in a way eerily reminiscent of today) loaded the bill up with special exceptions, to the extent that the overall tariff rate would not have been lowered at all. Wilson used his office to publicly shame the Senate, forcing it to remove almost all of the changes made to the original bill and pass it so Wilson could sign it into law. Yet at the same time, Underwood and Wilson were on very different pages when it came to civil rights, the South, and the Ku Klux Klan, as was noted in Part I.

Here's a question, predicated on the assumption that Underwood--being a smart guy--knew the income tax was an easy sell because it targeted a very small group and knew that it would expand over time: why was he concerned about protecting marginalized groups on the one hand while he was engaged in explicitly creating them on the other?

Stew on it. We'll dig deeper in Part III, as we step back a little further and look at the background of the Sixteenth Amendment.

Cheers, all.

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