Nearly everyone assumes that the taxation of income is as old and venerated as the U.S. Constitution. In fact, the federal income tax is a 20th century invention. The 16th Amendment to the Constitution was adopted just a few years before the (first) Russian Revolution of 1917. And, oddly enough, those who designed our income tax system drew their intellectual guidance from the same document that inspired Lenin. Of the ten economic "reforms" prescribed by Karl Marx's 1848 Communist Manifesto, "a heavy progressive income tax" was priority number two -- right after the "abolition of property."
The logic behind Marx's income tax was perfectly clear. Like every other classical economist, he saw the world as a zero-sum game. The economy, like a steam engine, could only run so fast and produce so much. A fixed total output meant that one person's profit had to come from somebody else's loss. To set matters right, the state had a moral obligation to tax income away from the undeserving rich and redistribute it to the exploited poor.
Once you accept the premise of a static, zero-sum economy, taxing and redistributing income does indeed become a moral imperative. But what if an economy is actually a positive-sum game? What if new technologies allow total output to expand faster than the population when the economy is properly cultivated?
Amazingly enough, this question -- undoubtedly the most critical of all economic policy question -- is only now being seriously examined by mainstream economists. With few exceptions, they cling to the static steam engine model. To this day, every single computer model used to predict the impact of changes in tax policies is a steady state model, complete with fixed input/output ratios that embody the economists' favorite phrase -- "Assume technology holds constant."
Reality, of course, is another matter. New technology relentlessly changes the economy's input/output ratios -- often by orders of magnitude. Since 1975, for example, the transmission capacity of optical fibers has jumped 10,000 times. As anyone familiar with high-tech knows, similar stories can be told in dozens of technologies.
But where does the money come from to pay for the innovation that creates growth in a positive-sum, high-tech economy? From the "excess" income (savings and profits) that the income tax is expressly designed to take away -- that's where. In short, Marx's income tax system, grounded on the assumption of a zero-sum economy, actually creates a zero-sum economy by choking off the natural flows of savings and profits that nourish new positive-sum technologies.
The long-term stagnation of the U.S. economy is testimony to the effectiveness of Marx's war on wealth. Our real output per person has not increased since the late Sixties. To pay for Lyndon Johnson's two lost wars -- on Poverty and Vietnam -- tax rates skyrocketed. Then, in the 1970s inflation, "bracket creep" pushed average earners into even higher marginal tax brackets. Launched in 1913 with a 1% rate on the tiny fraction of families with incomes over $4000 (about $60,000 in 1992 dollars), the federal income tax had metastasized into a mass tax with a 70% top rate.
To escape these confiscatory taxes, special interest groups employed friendly politicians to punch loopholes into the tax code. By defining certain kinds of income, like the gain on the sale of a home, not to be "income" for tax purposes; or by allowing certain expenses, like interest costs, to offset "income," Congress gradually created the world's most Byzantine tax system; one that's fed the families of generations of tax accountants and lawyers.
To everyone's astonishment, Congress passed a 1986 tax reform act that lowered the top rate to 28% (now 31%) and sealed off many of the escape hatches that had been carved into the code. Passive real estate losses, credit card interest expense, and capital gains haven't been the same since. But now, with the economy stuck in a monster recession, the pressure is on to "reform" the income tax system yet again. Simply put, this means repeating the sorry history of the Sixties and Seventies -- redrilling the holes closed off in 1986.
For high-tech investors, this has meant campaigning for a renewed capital gains break. But rather than trying to reinstate a self-serving exemption, the high-tech investor community should be attacking the very idea of income taxes. The argument must be made that by transforming investable funds (family savings and corporate profits) into government-subsidized consumption, the federal government has become the world's premier money launderer, exchanging tomorrow's prosperity for today's bloated consumption.
Far more powerfully than any other government policy, it is the income tax which has pounded the U.S. personal savings rate to its lowest level in history. Why save, when after inflation and taxes, real net returns are negative or just barely positive? Under these rules, it's smarter to consume as much as possible as soon as possible -- precisely what most rational Americans have been doing since the 1970s.
The erosion of savings has, in turn, driven up the cost of capital, shortened investors' time horizons, and made it all but impossible for American industry to keep pace with a Japan that saves and invests at four times our per capita rate. Though many think that Americans are spendthrifts by nature, before World War II set off the first huge jump in income tax rates, American families consistently outsaved their Japanese counterparts.
By accepting zero-sum thinking and with it the Marxist canard that income taxes are morally necessary, the investor community loses the political battle before it even begins. Instead of taking the moral high ground -- championing savings and investment by Americans of all income levels to help create the new technologies that propel economic growth -- high-tech investors are seen as no better than any other special interest, wanting only a tax break for those rich enough to own large stock portfolios.
But could we raise sufficient government revenues without the income tax? Consider this. A 16% federal sales tax (FST), with a $520 rebate per person, would raise about $450 billion -- as much as is now produced by personal and corporate income taxes. Why the $520 rebate? For a family of four that's a return of $2080, the FST paid on the first $13,000 of spending. At present, there is no federal income tax on families earning less than $13,000. In effect, the rebate solves the regressivity problem, making spending for basic necessities tax free. The FST would hit only families that demonstrate their ability to pay by consuming more than $13,000 in goods and services -- and it would hit fairly. You figure the FST on Geo Metro vs. a BMW 535.
Net consumer prices would jump, but without paycheck deductions for income taxes, so would take home pay. Those who choose to save rather than consume would earn tax-free returns be it through dividends, interest, or capital gains. There would be no special treatment for the rich; every American could play the capitalist game. The savings rate would climb, the cost of capital would fall, U.S. firms could jump back into the race for leadership in the 21st century, and America's real per capita growth would return to its long-term historical track. If the Russians can find the courage to dump their Marxist baggage, surely we can find a way to unload ours.