A Century of Progressive Taxes: Targeting the Rich but Hitting the Middle Class and Poor

Since income taxes were introduced in 1913, the wealthy have always been 'a step ahead' of the IRS, economist says

Arthur Laffer speaks after U.S. President Donald Trump presented him with the Presidential Medal of Freedom at the White House on June 19, 2019. (Jim Watson/AFP via Getty Images)

Economist Arthur Laffer’s newly published analysis of the United States’ 110-year history of income taxes is rife with paradoxes, among them that the higher the tax rates that the U.S. government imposes on the rich, the smaller the share of taxes the rich pay.

Or put another way, the more the government attempted to capture the wealth of the top 1 percent of earners, the larger the tax burden that the lowest 95 percent of taxpayers ended up paying. According to Laffer and his co-authors, the history of income taxes in the United States is a perpetual case of the government’s ostensibly trying to take rich people’s money and the rich finding creative ways to avoid giving it up.

Over the past century, while the top marginal income tax rates have ranged between 7 percent when they were introduced in 1913 and 94 percent during World War II, one thing has remained constant. Over the years, the amount of taxes paid by the rich as a share of their actual income has generally remained steady, at about 20 percent.

‘Rich People Are Different’

“Rich people are different than we are,” Laffer told The Epoch Times. “They can change the location of their income, they can change the volume of their income, they can change how many hours they work, they can change the composition of their income—how much of it is capital gains and how much of it is ordinary income. They can also change the timing of their income—things that normal people don’t think of, but rich people do.

“And rich people can hire lawyers, accountants, deferred income specialists, favor grabbers, lobbyists.”

In his new book, “Taxes Have Consequences,” Laffer and co-authors Brian Domitrovic and Jeanne Cairns Sinquefield recount the numerous, and often colorful, ways that the United States’ top 1 percent have dodged the IRS since 1913, when Congress, via the 16th Amendment, gave itself the power to “lay and collect taxes on incomes, from whatever source derived.” They also examine the effects of high taxation on Americans’ prosperity, even making an argument that economic crises such as the Great Depression have their roots in punitive tax policies.

During times of high taxation, incomes usually fell for the rich, the poor, and the middle class, the authors reported. But for the rich, not only does their income fall in absolute terms, but also the gap between their actual and reported income expands, sometimes tremendously. And in this way, a substantial portion of their wealth gets diverted from productive, profitable uses into unproductive tax shelters designed to keep their money out of government hands.

To illustrate the point, the authors charted retention rates, which is the inverse of the tax rate, or the portion of income that the top 1 percent get to keep after taxes, against income over the past century. What they found was a remarkably close correlation between retention rates and reported income, suggesting that when the government allowed the wealthy to keep more of their income, more income was reported by the top 1 percent, providing a larger tax base.

The more income they keep, the more they report: Reported income correlates closely to retention rates for the top 1 percent of earners. Source: Tax Policy Center, PSZ

Retention rates for the top 1 percent were chronically low from the 1930s to the Reagan era of the 1980s, with the exception of tax cuts implemented under the Kennedy administration in the early 1960s. During the 1980s, retention rates and reported income for the rich shot up in lockstep. While rates have been adjusted up and down since then, the United States never returned to federal income tax rates above 50 percent, which were the norm during prior decades.

To illustrate how reported income could fluctuate to such an extent, Laffer cited the case of Warren Buffett.

“In 2011, he wrote a letter to the editor of the New York Times that said, ‘Me and my friends don’t worry about taxes,’” Laffer said. “So I looked at his letter, where he went through the details of his income tax.”

Buffett, who was one of the richest people in the world at that time, wrote an op-ed titled “Stop Coddling the Super-Rich,” in which he claimed that he paid just under $7 million in taxes that year, on a reported income of about $39 million.

“What I paid was only 17.4 percent of my taxable income,” Buffett wrote. “And that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

“Some of us are investment managers who earn billions from our daily labors but are allowed to classify our income as ‘carried interest,’ thereby getting a bargain 15 percent tax rate. Others own stock index futures for 10 minutes and have 60 percent of their gain taxed at 15 percent, as if they’d been long-term investors.”

“For an economist, the concept of income is not what you report; that’s the tax definition,” Laffer said. “For an economist, income is what you spend during a period of time, what you give away during a period of time, and the increase in your wealth.”

Calculating income as economists do, rather than reported income, Laffer estimated that Buffett’s actual income that year, as defined by economists, was about $12 billion, suggesting that his effective tax rate was less than 1 percent. In short, Buffett, like many Americans, took full advantage of all legal tax deductions to minimize what he gave away to the government.

‘Always a Step Ahead’

Other tax avoidance schemes cited by Laffer and co-authors range from mundane investments such as municipal bonds to more inventive alternatives such as personal holding companies, foreign incorporation, yachts and private jets, farms and horse estates, hunting lodges, lavish expense accounts, art collections, and movie productions. These additions to a lavish lifestyle are tax deductions for the rich and, during high tax periods, become welcome substitutes for simply handing their money over to the government.

Whatever plans get cooked up in Washington to seize wealth, those who have it “are always a step ahead,” Laffer said. “That’s why when you cut tax rates on the rich, they actually do report more income, because they shelter less because it’s not worth it.”

Why this matters to the rest of us is that whenever Washington concocts new schemes to “tax the rich,” the rest of the country ends up paying the bill. This leads to another paradox: At lower marginal tax rates, the rich end up paying a higher share of the country’s tax bill.

Examining top marginal tax rates against the share of taxes paid by the 1 percent, the authors found that, as the top rate was cut, the share of taxes paid by the richest Americans went up while the share paid by the bottom 95 percent declined.

In 1986, during the Reagan administration, the highest federal tax bracket hit a low mark of 28 percent. At that point, Laffer said, the rich found it cheaper and easier to just pay taxes instead of pursuing avoidance strategies.

As the tax rate on the top 1 percent of earners decreases, their share of total taxes increases. Source: IRS, Laffer Associates

Federal deficits were high during the 1980s, but the authors say that was the result of escalated spending, “not because of lack of revenue from the rich ... the revenue from this source was enormous.”

‘Prohibitive Range’

This concept is illustrated in the “Laffer curve.” Developed while Laffer was teaching economics in the 1970s, the curve predicts that if taxes are raised above a certain optimal rate, revenues will decline as the tax base shrinks. This is called the “prohibitive range” of taxation.

Although this concept, which Laffer deems a logical tautology, has become widely accepted, economists and politicians disagree on what the optimal rate actually is, with more progressive economists putting it at about 70 percent for top earners.

However, the authors argue, “High tax rates on top earners of the 1960s and 1970s did not result in a higher revenue share of income from this group, and cutting tax rates increased the tendency of this group to pay taxes. Therefore, in terms of income tax rates at the top, the United States has been in the prohibitive range of the Laffer curve.”

Laffer’s study reveals other myths and misconceptions about U.S. income tax. For example, progressives argue that hiking taxes on the rich creates income equality, and they cite periods of high marginal rates, claiming that they correlate to a smaller wage gap between rich and poor. But Laffer argues that these analyses don’t really capture the true incomes of the rich or the poor.

Because progressive analyses are done on the basis of reported income, they miss vast amounts of income among the richest Americans that go unreported when taxes are high. In addition, Laffer argues, taking so much capital out of the economy that could have gone to build new companies and create more jobs but is now diverted to uneconomic tax shelters does reduce the incomes of the rich in real terms, but it also tends to reduce income for everyone else. People who don’t have jobs don’t report income at all, and thus the income of the poorest Americans is also removed from calculations of the wealth gap.

By using reported income to calculate the wealth gap during high-tax periods, “you’re way overstating the average income of the bottom 99 percent, or whatever group you want to talk about, and you’re way understating the income of the top,” Laffer said. “Therefore this measure is, forgive me, but acres of soapsuds in horse manure. But they use that as their measure of inequality.”

In reality, Laffer argues, the pursuit of income equality does reduce the wealth of the rich, both in actual and imagined terms, but it ends up hitting the poor and the middle class much harder. Across the economy, he said, “the more you redistribute, the greater will be the drop in total income.”

Additionally, because punitive tax rates often lead to a lower tax base and reduced actual income, they can create a vicious cycle. For example, high-tax states and municipalities experience an exodus of companies and residents, forcing them to raise taxes even more on those who remain to cover revenue shortfalls, driving more of them out.

A report (pdf) co-authored by Laffer and the American Legislative Exchange Council ranked all 50 U.S. states according to their “economic performance” and found that “generally speaking, states that spend less—especially on income transfer programs—and states that tax less—particularly on productive activities such as working or investing—experience higher growth rates than states that tax and spend more.”

Today, although tax rates remain close to the range set by the Reagan administration, the decades since 2000 have been “one of the longest periods of economic senescence and necrosis that you’ve ever seen,” Laffer said. Taxation has taken a less visible form, including government spending, regulation, unfunded government liabilities, and ballooning federal debt.

“What it is that takes the money away from [Americans] doesn’t really matter,” he said. “It matters that it is taken away from them. And it can be from higher expenses, increased costs of production, strikes, the whole deal. Taxes are one of that list.

“I’m not an anti-government person at all. We need a judiciary, we need schools, we need highways, we need defense, we need all of those things. What you want to do is to collect taxes in the least damaging fashion and you want to spend the money in the most beneficial fashion.”