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Wednesday, June 5, 2013

How Did We Get in this IRS Mess?

“A hand from Washington will be stretched out and placed upon every man’s business; the eye of the Federal inspector will be in every man’s counting house.” — Richard E. Byrd, Speaker of the Virginia House of Delegates during the Ratification Debate for the 16th Amendment.

This year my 13-year old granddaughter produced a 10-minute documentary on the passage of the 16th Amendment. This was done for her participation in National History. Her documentary garnered her first place at the district level and third place at the county level. According to the remarks of the judges he only reason she did not advance to the state level was due to some technical glitches in the video and the lack of an interview with a constitutional expert.

If a 13-year old middle school student can research and understand the evils of the unintended consequences, or as Frederick Bastiat so well stated over 150 years ago the seen and unseen, and the moral hazards that would spring forth from the passage of this amendment why can’t many Americans do the same. The reason is clear. My granddaughter took the time to research the 16th Amendment and its consequences.

The two greatest defects with the 16th Amendments are the coercive power of the Internal Revenue Service and the moral hazards embedded in the amendment.

I have written extensively about the coercive powers of the IRS. This is what the ongoing hearings in Congress are about. The moral hazard is another story. n economic theory, a moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk. In other words, it is a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions.

Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information. In essence due to the coercive power to collect money from the taxpayers the federal government can take risks without consequences as the taxpayers will bear the costs. It allows politicians and bureaucrats to spend your money on programs that will keep them in power without concern of the consequences.

When our Constitution was written and adopted it contained two specific enumerations as to how Congress could raise money from the citizens.

The first was Article I, Section 8.1 that states:

“The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States.”

The second can be found in Article I, Section 9.4 that states:

“No capitation, or other direct, tax shall be laid, unless in proportion to the census or enumeration herein before directed to be taken.”

This clause basically refers to a tax on property, such as a tax based on the value of land, as well as a capitation — a poll tax; an imposition which is yearly laid on each person according to his estate and ability. One must also realize that “property” in the eyes of our Founders included everything from land and the realization of your labor, i.e. money to one’s opinions. In other words our Founders did not want the federal government to be able to take any of your property in taxes. They wanted to pay for the cost of maintaining all of the items enumerated in Article I, Section 8 through the collection of duties, imposts, and excise taxes

Here, the requirement is that taxes must be geographically uniform throughout the United States. This means taxes affected by this provision must function "with the same force and effect in every place where the subject of it is found." However, this clause does not require revenues raised by the tax from each state be equal.

Justice Story characterized this requirement in a light more relevant to practicality and fairness:

“It was to cut off all undue preferences of one state over another in the regulation of subjects affecting their common interests. Unless duties, imposts, and excises were uniform, the grossest and most oppressive inequalities, vitally affecting the pursuits and employments of the people of different states, might exist.”

In other words, it was another check placed on the legislature in order to keep a larger group of states from "ganging up" to levy taxes benefiting them at the expense of the remaining, smaller group of states.

A somewhat notable exception to this limitation has been upheld by the Supreme Court. In United States v. Ptasynski (1983), the Court allowed a tax exemption which was quasi-geographical in nature. In the case, oil produced within a defined geographic region above the Arctic Circle was exempted from a federal excise tax on oil production. The basis for the holding was that Congress had determined the Alaskan oil to be of its own class and exempted it on those grounds, even though the classification of the Alaskan oil was a function of where it was geographically produced.

To understand the nuance of the Court's holding, consider this explanation: Congress decides to implement a uniform tax on all coal mining. The tax so implemented distinguishes between different grades of coal (e.g., anthracite versus bituminous versus lignite) and exempts one of the grades from taxation. Even though the exempted grade could potentially be defined by where it is geographically produced, the tax itself is still geographically uniform.

Article I, Section 9.4 as stated above that “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.”

Generally, a direct tax is subject to the apportionment rule, meaning taxes must be imposed among the states in proportion to each state's population in respect to that state's share of the whole national population. For example: As of the 2012 Census, 38.04 million people populated California. At the same time, the national population was 313.9 million people. This gave California roughly a 12 percent share of the national population. Were Congress to impose a direct tax in order to raise $3 trillion before the next census, the taxpayers of California would be required to fund 12 percent of the total amount: $ 363,555,272 billion dollars.

Before 1895, direct taxes were understood to be limited to "capitation or poll taxes" (Hylton v. United States) and "taxes on lands and buildings, and general assessments, whether on the whole property of individuals or on their whole real or personal estate" (Springer v. United States). The decision in Springer went further in declaring that all income taxes were indirect taxes — or more specifically, "within the category of an excise or duty." However, in 1895 income taxes derived from property such as interest, dividends, and rent (imposed under an 1894 Act) were treated as direct taxes by the Supreme Court in Pollock v. Farmers' Loan & Trust Co. and were ruled to be subject to the requirement of apportionment. As the income taxes imposed under the 1894 Act were not apportioned in such a manner, they were held unconstitutional. It was not the income tax per se, but the lack of a provision for its apportionment as a direct tax which made the tax unconstitutional.

The resulting case law prohibiting unapportioned taxes on incomes derived from property was later eliminated by the ratification of the Sixteenth Amendment in 1913. The text of the amendment was clear in its aim:

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

Shortly after, in 1916, the U.S. Supreme Court ruled in Brushaber v. Union Pacific Railroad that under the Sixteenth Amendment income taxes were constitutional even though unapportioned, just as the amendment had provided. In subsequent cases, the courts have interpreted the Sixteenth Amendment and the Brushaber decision as standing for the rule that the amendment allows income taxes on "wages, salaries, commissions, etc. without apportionment.

The first 30 years of the twentieth century witnessed the rise of the modern income tax. More energized than demoralized by the Supreme Court’s invalidation of the 1894 income tax, fiscal reformers mounted a powerful campaign to resuscitate the levy. By 1913, they had engineered ratification of a new constitutional amendment, clearly establishing the federal government’s authority to levy an income tax.

In its first two years, the tax was modest, providing only a small part of the government’s total revenue. But World War I transformed it, moving income taxes to the center of federal finance. Democrats and progressive Republicans remained the strongest advocates of income taxation, but even mainstream Republicans came to accept the levy. By the early 1920s, it was firmly established as a centerpiece of the federal tax system.

1901: President William McKinley was assassinated in September, and Theodore Roosevelt assumed the presidency. The change was unsettling for GOP stalwarts, who had tried to derail Roosevelt’s soaring political career byWilliam_McKinley_by_Courtney_Art_Studio,_1896 installing him as vice president. In 1897, he had been named Assistant Secretary of the Navy by President McKinley. He soon resigned, however, to lead his famous Rough Riders in the Spanish-American War. Upon his return to the United States, he won election as governor of New York. Widely considered a reformer within his own party, Roosevelt worried the GOP establishment. Republican power brokers, including McKinley confidant Mark Hanna, believed Roosevelt would pose less of a threat once occupied with the exalted but largely ceremonial duties of the vice presidency.

After McKinley's assassination, those same leaders confronted the unsettling results of their handiwork. Roosevelt, however, moved quickly to reassure party leaders and the nation that he would continue the careful, conservative policies of his predecessor.

Roosevelt was slow to move on tax issues, at least early in his presidency. Congress, however, had other plans. In March, lawmakers passed the War Revenue Reduction Act, repealing or reducing most of the taxes enacted to pay for Spanish-American War. Several levies, however, remained largely intact, including the inheritance tax and numerous excises. Democrats criticized the law for failing to reduce consumption taxes adequately, especially in light of the Republican preference for steep tariffs. Democrats also argued for a new income tax on individuals and corporations, but GOP leaders easily defeated such ideas.

1902: House Ways and Means Committee Chairman Sereno Payne (R-N.Y.) introduced a bill to repeal all remaining taxes levied for the Spanish-American war. Reassured by predictions of a large surplus in the federal Treasury, lawmakers agreed. While most Democrats urged retention of the federal inheritance tax and various corporation taxes, they ultimately acquiesced in the GOP plan. Both the House and Senate passed the tax cut overwhelmingly.

1904: Theodore Roosevelt won an easy re-election campaign, despite the misgivings of conservative Republicans.

The Supreme Court found the oleomargarine tax to be constitutional. Originally enacted in 1886 at the behest of dairy interests, the tax was designed to prevent margarine — which was relatively cheap to manufacture — from competing with butter in the marketplace. The tax was almost purely regulatory, although it did raise significant revenue as margarine became increasingly popular.

1906: In a speech on April 14, 1906, President Theodore Roosevelt endorsed a progressive estate tax. Roosevelt stated:

“It is important to this people to grapple with the problems connected with the amassing of enormous fortunes, and the use of those fortunes, both corporate and individual, in business. We should discriminate in the sharpest way between fortunes well-won and fortunes ill-won; between those gained as an incident to performing great services to the community as a whole, and those gained in evil fashion by keeping just within the limits of mere law-honesty.

Of course no amount of charity in spending such fortunes in any473px-T_Roosevelt way compensates for misconduct in making them. As a matter of personal conviction, and without pretending to discuss the details or formulate the system, I feel that we shall ultimately have to consider the adoption of some such scheme as that of a progressive tax on all fortunes, beyond a certain amount either given in life or devised or bequeathed upon death to any individual — a tax so framed as to put it out of the power of the owner of one of these enormous fortunes to hand on more than a certain amount to any one individual; the tax, of course, to be imposed by the National and not the State Government.

Such taxation should, of course, be aimed merely at the inheritance or transmission in their entirety of those fortunes swollen beyond all healthy limits.”

Here we can see the progressive Roosevelt using the coercive power of the federal government to discriminate against one class of people for the purpose of advancing his progressive social agenda.

1907: Roosevelt stepped up his campaign for several progressive additions to the nation’s tax system. In his December 7 message to Congress, he urged lawmakers to consider an income tax.

“When our tax laws are revised the question of an income tax and an inheritance tax should receive the careful attention of our legislators. In my judgment both of these taxes should be part of our system of Federal taxation. I speak diffidently about the income tax because one scheme for an income tax was declared unconstitutional by the Supreme Court; while in addition it is a difficult tax to administer in its practical working, and great care would have to be exercised to see that it was not evaded by the very men whom it was most desirable to have taxed, for if so evaded it would, of course, be worse than no tax at all; as the least desirable of all taxes is the tax which bears heavily upon the honest as compared with the dishonest man. Nevertheless, a graduated income tax of the proper type would be a desirable feature of Federal taxation, and it is to be hoped that one may be devised which the Supreme Court will declare constitutional.”

The inheritance tax was even more desirable, Roosevelt continued. Not only did it serve the cause of social justice, but it also enjoyed the Supreme Court's constitutional imprimatur:

“The inheritance tax, however, is both a far better method of taxation, and far more important for the purpose of having the fortunes of the country bear in proportion to their increase in size a corresponding increase and burden of taxation. The Government has the absolute right to decide as to the terms upon which a man shall receive a bequest or devise from another, and this point in the devolution of property is especially appropriate for the imposition of a tax. Laws imposing such taxes have repeatedly been placed upon the National statute books and as repeatedly declared constitutional by the courts; and these laws contained the progressive principle, that is, after a certain amount is reached the bequest or gift, in life or death, is increasingly burdened and the rate of taxation is increased in proportion to the remoteness of blood of the man receiving the bequest.”

Roosevelt rejected arguments that an estate tax would penalize thrift:

“A heavy progressive tax upon a very large fortune is in no way such a tax upon thrift or industry as a like would be on a small fortune. No advantage comes either to the country as a whole or to the individuals inheriting the money by permitting the transmission in their entirety of the enormous fortunes which would be affected by such a tax; and as an incident to its function of revenue raising, such a tax would help to preserve a measurable equality of opportunity for the people of the generations growing to manhood. We have not the slightest sympathy with that socialistic idea which would try to put laziness, thriftlessness and inefficiency on a par with industry, thrift and efficiency; which would strive to break up not merely private property, but what is far more important, the home, the chief prop upon which our whole civilization stands. Such a theory, if ever adopted, would mean the ruin of the entire country--a ruin which would bear heaviest upon the weakest, upon those least able to shift for themselves. But proposals for legislation such as this herein advocated are directly opposed to this class of socialistic theories. Our aim is to recognize what Lincoln pointed out: The fact that there are some respects in which men are obviously not equal; but also to insist that there should be an equality of self-respect and of mutual respect, an equality of rights before the law, and at least an approximate equality in the conditions under which each man obtains the chance to show the stuff that is in him when compared to hi fellows.”

1908: William Howard Taft won the presidential election to succeedWhtaft Roosevelt. Handpicked by his predecessor, Taft was considered fairly liberal within his party, but he presented a less threatening image to party regulars. While supporting certain reformist ideas, including the possibility of limited taxes on income and estates, he moved cautiously in advancing such ideas.

1908: William Howard Taft won the presidential election to succeed Roosevelt. Handpicked by his predecessor, Taft was considered fairly liberal within his party, but he presented a less threatening image to party regulars. While supporting certain reformist ideas, including the possibility of limited taxes on income and estates, he moved cautiously in advancing such ideas.

1909: An uneasy coalition of Democrats and western Republicans joined to support passage of an individual income tax. The specter of a hostile Supreme Court haunted the debate. Some observers believed the justices would invalidate an income tax, just as they had in 1895. Others, however, thought the Court had changed to reflect growing bipartisan — and popular — support for the levy. A few income tax supporters wanted to press the issue regardless of the Court's likely response, eager to make the case for progressive taxation. In any case, the income tax coalition developed a moderate proposal and sought to attach it to tariff legislation in the Senate.

GOP leaders were alarmed by rebellion in their own ranks, with numerous Republican progressives indicating their support for a new income tax. Senate Finance Committee Chairman Nelson Aldrich (R-R.I.) tried to fend off300px-NelsonWAldrich the income tax proposal, but pro-tax forces enjoyed considerable momentum. Worried that Aldrich would lose the battle, President Taft convinced the senator that a modest tax on corporate income would siphon off support for general income taxation. In doing so, it would deny victory to the congressional income tax coalition, preserving GOP unity.

Taft — who had earlier indicated some openness to income taxation anyway — orchestrated passage of a 1 percent tax on net corporate income. Framed as an excise tax on the privilege of doing business as a corporation, the levy was carefully designed to sidestep constitutional issues surrounding the income tax.

As Taft had predicted, the corporation tax successfully deflated the larger income tax movement — at least for the time being.

The corporation tax included a publicity requirement that all returns be open to public inspection. As with publicity provisions during the Civil War, this requirement proved unpopular, especially among small business owners unaccustomed to releasing information. Taft argued, however, that publicity would enhance federal oversight of corporations, aiding lawmakers, administration officials, and investors. In fact, the publicity feature was key to Progressive support for the law, helping convince many lawmakers to accept the corporate excise tax in lieu of a broader income tax that included individuals.

1910: In response to taxpayer complaints, the Appropriations Act of 1910 tightened disclosure regulations for Taft's corporation excise tax. Henceforth, tax returns would be open to inspection "only upon the order of the President." It was a blow to progressives in both parties, who had hoped the tax would serve as a means to regulate private corporations by fostering the availability of accurate financial information.

1913: As part of his 1909 tax compromise, Taft had agreed to support a constitutional amendment authorizing federal income taxes. Not only would an amendment settle constitutional questions once and for all, it would also delay substantive action on the income tax, at least until ratification was complete. And since ratification was far from certain anyway, the amendment might defuse the income tax issue indefinitely, allowing it to simply fade away in the state legislatures.

In making his case for the amendment to wary Republican legislators, Taft stressed the importance of avoiding a confrontation with the Supreme Court. Such a fight, he warned, would diminish public confidence in the Court and threaten one of the pillars of American government. Congress agreed, and lawmakers soon approved the amendment and sent it to the states.

While opponents couldn’t stop the 16th Amendment, they argued long and hard against it. Richard E. Byrd, speaker of the Virginia House of Delegates made a particularly impassioned plea to reject the amendment, offering a potent rhetorical blend of state rights, limited government, and anti-tax convictions. Ratification, he warned, would open a new and dangerous chapter in American government:

“A hand from Washington will be stretched out and placed upon every man’s business; the eye of the Federal inspector will be in every man’s counting house. The law will of necessity have inquisitorial features, it will provide penalties, it will create complicated machinery. Under it men will be hailed into courts distant from their homes. Heavy fines imposed by distant and unfamiliar tribunals will constantly menace the tax payer. An army of Federal inspectors, spies and detectives will descend upon the state. Who of us who have had knowledge of the doings of the Federal officials in the Internal Revenue service can be blind to what will follow? I do not hesitate to say that the adoption of this amendment will be such surrender to imperialism that has not been since the Northern states in their blindness forced the fourteenth and fifteenth amendments upon the entire sisterhood of the Commonwealth.”

Opposition from Byrd and like-minded conservatives couldn't stop the amendment. To the surprise of many, the states ratified the amendment in relatively short order, and in February 1913 it became the Sixteenth Amendment to the Constitution.

Meanwhile, newly elected President Woodrow Wilson included a call for tariff reform in his inaugural address. On April 8, he reiterated the need for revenue reform, with a particular emphasis on lower import duties. Four days later, House Ways and Means Chairman Oscar W. Underwood (D-VA.) introduced a bill to lower tariff rates from an average of 40 percent to roughly 29 percent. To compensate for lost revenue, the bill also included an income tax. The House passed the legislation on May 8, and the Senate followed suit four months later. When Wilson signed the bill in October, it included an income tax of 1 percent on individual income over $3,000 ($4,000 for married couples). It also featured a progressive surtax ranging from 1 percent to 6 percent, depending on income.

Returns for the new tax were to be kept secret, reflecting the unhappy fate of corporate publicity features in the 1909 revenue law. The new income tax also provided for collection at source, meaning that some kinds of income would be taxed before it reached the taxpayer, as with the modern system of tax withholding.

The Bureau of Internal Revenue established a Personal Income Tax Division to collect the new tax. It included a Correspondence Unit of 30 employees dedicated solely to answering questions about the new levy. In a 2004 press release the IRS stated they have around 116,675 full time employees. The Internal Revenue Service has a budget of $11.1 billion to hire additional workers be it part time or full time employees.

1914-1915: In 1914, the BIR unveiled its form for the new income tax. Four pages long, it was dubbed Form 1040 as part of the agency’s normal sequential numbering process. No money was collected during the first year. Instead, taxpayers returned just a completed form, which was then checked by field agents for accuracy.

In 1915, several congressmen complained that income tax forms are too complicated. The House Sergeant at Arms offered lawmakers assistance in preparing their own returns. As one congressman explained the complexity: "I write a law. You drill a hole in it. I plug the whole. You drill a hole in my plug.

1916: Once again, war brought a steep decline in international trade. In 1914, President Woodrow Wilson had asked Congress for emergency revenue legislation, and lawmakers responded with the War Revenue Act of 1914. Featuring a slew of new excise taxes, the law tried to compensate for slumping customs revenue — a byproduct of the damper that war put on international trade. While lucrative, these consumption taxes proved unable to close the fiscal gap. Wilson soon joined Democrats in Congress to support a steeper, more productive income tax.

Rep. Claude Kitchin, D-NC, led a group of congressional insurgents pushing for steeper income taxes. While barely two years old, the income tax had already proven itself a viable source of new revenue. Kitchin and his allies — all comfortably to Wilson’s left — wanted to make better use of the tax, redistributing tax burdens up the income scale.

Congress approved a new income tax as part of the Revenue Act of 1916. The law set out to raise $205 million in new revenue, with more than half coming from the income tax. Lawmakers boosted the "normal" income tax rate from 1 percent to 2 percent on net incomes over $3,000 ($4,000 for married couples). They also raised surtax rates, moving them from a maximum of 6 percent on incomes over half a million dollars to a maximum of 13 percent on incomes over $2 million. The changes made the income tax steeper, but left its base quite narrow; the levy still applied only to the nation’s richest taxpayers.

The 1916 law also raised the corporation income tax from 1 percent to 2 percent, and introduced a new federal estate tax with an exemption of $50,000 and rates ranging from 1 percent to 10 percent. The law included a novel munitions tax designed to appease opponents of American involvement in the war; levied on manufacturers of military equipment, it was designed to prevent war profiteering. Finally, the law featured a host of excise taxes, as well as a capital stock tax on corporations.

In response to administrative concerns, the 1916 revenue law repealed the "collection at source" provisions of the 1913 tax. Instead, the law now required simply that income sources provide information to the government on the amount of income paid out to recipients.

1917: In March 1917, Congress introduced a major innovation to the federal tax system: a corporate excess profits tax. This levy taxed any profits above a "reasonable" rate of return. Initially, this rate was set at 8 percent; if owners made more than that, then they paid taxes according to a steep rate schedule.

Supporters defended the new tax on equity grounds, but it also turned out to be the biggest money maker among new wartime taxes. It attracted bitter opposition from business groups, who considered the tax a threat to managerial prerogatives. They were certainly justified in their suspicion, since both Wilson and his allies in Congress considered the levy a legitimate means of business regulation. Many supporters hoped to retain it after the war ended.

The excess profits tax applied to individual as well as businesses, taxing the former at 8 percent on incomes over $6,000. This last innovation prompted critics to label it a “tax on brains,” since it generally only applied to professionals and other highly educated workers.

In addition to the new excess profits tax, 1917 brought hikes in the regular income tax as well. The War Revenue Act of 1917 imposed a 2 percent tax on incomes over $1,000 ($2,000 for married couples). It featured graduated surtaxes reaching as high as 63 percent. It also added an additional tax of 4 percent to the existing corporate income tax.

The Bureau of Internal Revenue struggled to cope with the massive tax changes. Federal revenues grew dramatically. The average collection for each year in the twelve years preceding 1915 was $281 million. For the twelve years between 1915 and 1926, the average was $2.78 billion. As one congressional report later summarized the change: “An organization which had collected slightly over a quarter of a billion dollars yearly suddenly was required to collect annually nearly ten times that amount.”

The estate, munitions, and capital stock taxes all required new administrative machinery. The agency added staff in all these areas to interpret and administer the taxes. The real work, however, came from the expansion of the individual and corporate income taxes, as well as the introduction of the corporate excess profits tax. To cope, the bureau expanded dramatically. In 1917, as the agency began to gear up for war taxation, it employed 524 headquarters staff and 4,529 field staff. By 1918, total staff had grown to 9,600, and it rose further to roughly 14,000, 18,000, 20,000, and 21,000 in each of the subsequent years.

The task almost proved too much for the agency. The expanded income tax deluged the agency in paper. When returns for 1918 began to arrive, those from 1916 had not been audited, let alone ones from 1917. The number of returns filed in 1918 was five times greater than the number from 1917. Subsequent increases only added to the burden. All told, the number of returns increased more than 1,000 percent between 1916 and 1921, giving the BIR an impossible problem. “The enormous increase in the revenue,” one BIR commissioner complained, “the overwhelming increase in the number of returns filed and increase in the work to be performed as a consequence thereof went by leaps and bounds. No one did or could foresee it, or prepare for it.”

1918-1919: The Revenue Act of 1918, actually passed in early 1919, made relatively few major changes in the tax structure, but it did raise rates on individual and corporate income, corporate excess profits, and estates. The law provided for normal and surtax rates that rose to the dizzying level of 77 percent on the biggest incomes. Corporations were given an exemption of $2,000, but rates were raised to 12 percent on net taxable income. The law also rectified numerous mistakes in earlier revenue laws, most of which had been enacted in great haste.

The income tax now occupied a central place in the federal revenue system. In 1916, income taxes had been providing 16 percent of federal revenue. From 1917 to 1920, that percentage ranged as high as 58 percent. The tax was now a pillar of federal finance. Still, however, it remained a narrow levy. In 1920, only 5.5. million returns showed any tax due.

May 27: Wilson makes his famous "politics is adjourned" speech to urge higher taxes, including levies on income, estates, and excess profits.

Meanwhile, the BIR began a massive recruitment campaign to help redress its chronic personnel shortage. More than 1,000 auditors were hired in the first six months of 1919. The agency still struggled to keep up, however; delays in the printing of tax forms and instructions prompted an extension of the filing deadline from March 1 to April 1.

October 27: Volstead Act, providing for enforcement of the new Prohibition Amendment, passed over Wilson's veto. BIR commissioner was charged with enforcing the act. A new Prohibition Unit was created on December 22, allowed a budget of 2 million under the Volstead Act. (This Amendment was repealed with the passage of 21st Amendment in 1933)

1920: A broad consensus held that steep wartime tax rates were unsustainable. Two of Woodrow Wilson’s Treasury secretaries, Carter Glass and David Houston, suggested cuts. Even Wilson himself — the architect of the progressive wartime tax system — seemed to agree. In his 1919 State of the Union Address, he had suggested the possibility of reducing taxes.

Still, many Democrats and progressive Republicans were unwilling to roll back wartime tax reforms. Pleased with the newly progressive cast of federal revenue policy, they sought to retain some of its more progressive elements, including the excess profits tax.

Supporters believed that the profits tax — which imposed a graduated levy on business profits above a pre-determined “normal” rate of return on capital — to be a blow for egalitarian ideals. Rep. Claude Kitchin led the campaign to retain the tax. As chairman of the House Ways and Means Committee in the years leading up to World War I, he had helped craft the highly progressive wartime tax system. Now in the minority, he insisted that the tax should be made permanent, arguing that it would shift the fiscal burden to the individuals and corporations whose wealth posed a threat to American society.

Kitchin and his allies were not destined to succeed. Republican lawmakers joined with a series of GOP presidents to engineer tax cuts in 1921, 1924, 1926, and 1928. Andrew Mellon — who moved into his Treasury office in 1921 and stayed there until 1932 — was the principal architect of these reforms. As one wag remarked, “three presidents served under Mellon,” and when it came to taxes, he was certainly correct.

1921: The series of Mellon tax cuts began in 1921, as legislators from both parties set about revising the wartime tax system. On April 30, Mellon asked Congress for a variety of tax changes, including elimination of the excess profits tax, a modest increase in the corporate income tax, a reduction in personal income tax rates, and the retention of most wartime excise levies.

Repeal of the excess profits tax was almost a foregone conclusion, enjoying broad, bipartisan support. In 1919, President Wilson had told Congress in 1919 that the levy “should be made the basis of a permanent tax system which will reach undue profits without discouraging the enterprise and activity of our business men.” But fiscal experts had since begun to question the tax.

Thomas S. Adams was arguably the most important tax policy expert of his day, a trusted adviser to both Democratic and Republican administrations. He was also one of the original champions of excess profits taxation. In 1920, however, he dealt the levy a heavy blow, calling for its repeal. Having once defended the tax as a means to “allay hostility to big business,” Adams now derided it as burdensome, complicated, and inequitable. Business leaders, he warned, understandably resented its “intricacy and capricious inequalities.” Government officials, moreover, had found the levy hard to administer.

1924: Mellon took another run at tax reduction in 1924. He urged lawmakers to further cut income tax rates, arguing — as he had in 1921 — that lower rates would actually raise revenue. Existing taxes were simply too high, he told the chairman of the House Ways and Means Committee. “Ways will always be found to avoid taxes so destructive in their nature, and the only way to save the situation is to put the taxes on a reasonable basis that will permit business to go on and industry to develop,” he wrote. “The alternative is a gradual breakdown in the system and a perversion of industry that stifles our progress as a nation.”

The secretary proposed a top rate of 25 percent, insisting that lower rates would stem tax avoidance. He also proposed his special tax break for earned income, amounting to a 25 percent reduction for wage and salary income. Finally, he supported reductions in estate taxes, which Mellon considered a “levy upon capital,” since it allowed lawmakers to extract capital from accumulated fortunes and use it for current operating expenses.

Mellon met stiff resistance on Capitol Hill. With a smaller congressional majority than they had enjoyed in 1921, Republicans had less room to maneuver. Rep. John Nance Garner, D-Tex., seized the opportunity to launch a Democratic attack, contending that the Mellon plan cut rates too much. “This is the time to determine the policy of who is going to pay the taxes,” he told one observer. “The crux of the fight is the surtax. The Mellon 25 percent maximum is at least 10 or 15 per cent too low.”

Republican stalwarts attacked Garner's substitute bill as a mishmash of bad economics. “You have heard of great musicians sitting down at a piano and improvising a tune,” declared Rep. Ogden Mills, (R-N.Y). “Mr. Garner sits down at a table in this chamber and improvises a tax bill.” But Garner was gaining ground, securing the votes of virtually all Democrats and even some progressive Republicans. Within three weeks, Republican leaders were ready to capitulate. Speaker Nicholas Longworth, R-Ohio, agreed to accept higher income tax rates, and even swallowed a hike in estate tax rates.

In the Senate, Republican leaders knew they had a weak hand, and they offered only limited resistance to the Democratic onslaught. President Calvin Coolidge reluctantly signed the 1924 act, complaining that Congress had ignored his recommendations. The law granted an immediate 25 percent rebate on taxes paid for 1923 income. It also reduced the top marginal income tax rate to 40 percent — a substantial cut but, again, much less than Mellon had sought. The secretary got his 25 percent earned income credit, but he also had to swallow a hike in estate tax rates from 25 percent to 40 percent.

1928: The tax cut parade was not quite over. In 1928, Mellon took another run at reduction, again suggesting estate tax repeal, as well cuts in the corporate income tax. Lawmakers agreed with the latter but not the former. It was the last time for a long while that legislators would have a free hand in cutting taxes.

As Mellon surveyed his seven years in office, he must have been pleased.AWMellon The income tax had grown more central to the federal revenue system; Prohibition had dried up alcohol excise revenue, making the income tax even more important than it had been at the end of World War I. But rates had declined dramatically since 1921. And while Mellon never succeeded in his quest to eliminate the estate tax, he did manage to keep its rates relatively modest. All in all, taxes were less burdensome for many Americans, particularly those in the upper strata of society. These were happy years for tax policymakers of both parties. They had the pleasant task of choosing among various tax cuts, their deliberations buoyed by a fat and happy Treasury. As Franklin Roosevelt later pointed out, “it was all very merry while it lasted.” But in 1929, the party came to a crashing end.

1929-1932: The Great Depression wreaked havoc on the federal budget; as one observer recalled, “The sun was sinking in a cloudy western sky.” By 1930, Andrew Mellon was warning Congress that declining revenues would produce a deficit of $200 million. His projection proved optimistic, and lawmakers watched fiscal gap soar to more $900 million that year. Despite the prospect of even larger deficits to come, Mellon and President Herbert Hoover continued to resist tax increases. But with national income falling from $87.8 billion to $42.5 billion between 1929 and 1932 — and tax revenues falling at an even faster rate, thanks to the progressive rate structure of the individual income tax — such intransigence could not last.

Early in 1932, Mellon appeared before the House Ways and Means Committee to ask for a tax hike. It was a painful request for this inveterate tax cutter, but one dictated by fiscal orthodoxy. In a sign of things to come, Mellon asked Undersecretary of the Treasury Ogden Mills to read his statement; within a month, Mellon would be eased out of the Treasury building, dispatched to London as an ambassador. This towering figure of the 1920s was being put out to pasture.

Ogden Mills took the reins at Treasury, offering the Hoover Administration both his financial expertise and his political acumen. An upper-class New York Republican of generally orthodox fiscal inclinations, he had served on the Ways and Means Committee during the early 1920s. “Little Oggie,” as he was known in the liberal press, enjoyed a reputation as a tax expert.

In presenting the administration's proposals, Mills warned that the deficit was soaring above $2 billion. Excessive expenditures, coupled with falling tax revenues, had opened a huge hole in the budget. The decline in revenue was particularly dramatic. Corporate income taxes, which had yielded $1.1 billion in fiscal 1930, were likely to raise only $550 million in 1932. Individual income tax rates were plummeting even more dramatically, from just over $1 billion in 1930 to $370 million in 1932. The only relatively bright spot was excise revenue, which Mills expected to decline from $628 million to $544 million over the same period; the moderate decline, he pointed out, was due largely to the stable revenues of the federal tobacco tax.

Altogether, the revenue shortfalls were nothing short of cataclysmic. The problem, Mills declared, was inherent in the revenue structure. “The truth of the matter is that our revenue system rests on a comparatively narrow base,” he explained, “and that our tax receipts are susceptible to the widest variations in accordance with variations in business conditions. This is particularly true of current individual income-tax collections.” The progressive nature of the income tax made the problem worse, he said. Large incomes were the first to rise in good times and the first to fall in bad times. The graduated rate structure ensured that revenues would rise faster than overall income when the economy was doing well. But it also guaranteed that when depression struck, revenues would fall faster than incomes.

Given this reality, Mills counseled against steep increases in the rate structure, predicting that they would not raise adequate revenue. While acknowledging that rates must necessarily rise, especially on the richest Americans, he emphasized the need for an increase in the number of people paying income taxes in the first place. Congress must recognize, he said, that “the weakness in our revenue system is, as I have already stated, the narrowness of the base on which it rests.” Broadening that base was crucial to securing adequate, and dependable, revenue. It was also, he said, manifestly fair. “Many not now taxed are very definitely in a position to make some contribution to the support of Government,” he declared. “They should be asked to do so, taking into consideration ability to pay.”

To close the budget gap, Mills suggested a package of tax hikes that would together raise about $920 million. First and foremost, he asked legislators to restore income tax rates to their 1924 levels. Surtax rates, he said, should increase across the board, topping out at 40 percent — twice their existing level. Even more important, Congress should reduce exemptions to $1,000 for individuals and $2,500 for married couples. These reductions would broaden the tax base, bringing 1.7 million new taxpayers into the system. The tax, Mills emphasized, would still be confined to a narrow slice of American society. “There would be only some 3,600,000 Federal taxpayers in a Nation of 120,000,000 people, and of this number less than 300,000 would contribute 90 percent of the tax.” Indeed, Mill's plan would still have left the tax much narrower than it had been before the 1926 exemption hike.

Ultimately, leaders of the new democratic Congress refused to adopt the lower exemptions that Mills suggested. Instead, they chose to embrace a new federal sales tax. This was a striking departure, given the party's traditional opposition to sales taxes.

A rebellion among rank and file Democrats forced party leaders to backtrack. Abandoning the sales tax, they resorted to a slew of narrow excise taxes, as well as higher rates on incomes and estates.

As ultimately passed by Congress, the Revenue Act of 1932 was predicted to raise $1.1 billion in new revenue. A substantial chunk of this revenue — some $178 million—was expected to come from a combination of steeper rates and lower exemptions in the personal income tax. But fully $457 million was expected from new or increased excise taxes. The list of consumption levies was long, including taxes on lubricating oil, malt syrup, brewer's wort, tires, toilet articles, furs, jewelry, automobiles, trucks, radio and phonograph equipment, refrigerators, sporting goods, cameras, firearms, matches, candy, chewing gum, soft drinks, and electricity.

Taxed goods were disparate, their selection dependent on a variety of factors, including the political influence — or lack thereof — associated with an industry. Most important, however, was a preference for articles of wide consumption, with a secondary concern for their relative necessity. Lawmakers preferred to tax items that people had some choice about consuming, rather than, say, table salt or flour. Some levies, however, were selected because they clearly seemed to indicate a capacity to pay — hence the luxury tax on jewelry, for instance. But others, like the car tax, were selected at least as much for the revenue they promised. Long the target of progressive tax reformers, the car tax survived the legislative battle because it promised to raise money.

Indeed, revenue was the name of the game in 1932. All other concerns were secondary. The pitched battle over the sales reflected not so much an argument about whether to increase taxes — that was never in doubt — but exactly how. The rank and file Democrats who shaped the debate made clear their preference for isolated excise taxes, strongly preferring them to more general sales levies. In large part, this preference reflected a conviction that people could choose whether to consume taxed goods. Under a general sales tax, no such choice was possible.

Of course, the excise taxes were highly regressive. But regressivity was only one measure of fairness, and in the face of a gaping deficit, it was not the most important one. Democrats made consumer choice a central aspect in their definition of fair taxation.

Just five months after the 1932 revenue act was signed into law, Franklin Roosevelt won his campaign for the presidency. When he took the oath of office in 1933, he inherited a tax system largely defined by this last revenue bill of the Hoover Administration. It was, in almost every respect, consistent with the revenue policy advanced by the GOP Treasury of Andrew Mellon and later Ogden Mills. It represented a triumph for fiscal orthodoxy, even at the expense of tax fairness. The Republican era of tax policymaking would have long-lasting effects, if not quite the ones that Mellon had originally hoped to define. The low taxes of the 1920s were a distant memory, as was any hope of eliminating such progressive taxes as the estate and gift levies. But the tax system of 1933 was certainly nothing like the progressive revenue structure emerging from World War I. Republicans had managed to limit the scope of progressive taxation, keeping the income tax reasonably limited and placing much of the tax burden on consumption. While sales tax proponents had reason to be disappointed, the federal revenue system was increasingly dependent on narrow sales taxes of one sort or another. That structure, moreover, was not imposed by Republicans on their unwilling Democratic colleagues. Indeed, Roosevelt‘s party had crafted this system in close cooperation with the Hoover Administration. Regressive taxation was a bipartisan achievement.

As you can see from this long and detailed history of our current tax system the American people have been subjected to a slow but constant intrusion of Congress and the IRS into their lives through a coercive and overburdening tax system.

As I stated above the IRS not only has he ability to pick your pocket it also has a tremendous amount of power to regulate your behavior. In the past 50 years both Democratic and Republican administrations have used the power of the IRS to silence their critics. This list includes Kennedy, Johnson, Nixon, Clinton, and now Obama — with Obama being the worst offenders.

The only way to curtail the abuses of the IRS is to abolish it. Now is the time for a serious debate to begin on the either a FairTax or a Flat Tax.

The FairTax is a national sales tax that treats every person equally and allows American businesses to thrive, while generating the same tax revenue as the current four-million-word-plus word tax code. Under the Fair Tax, every person living in the United States pays a sales tax on purchases of new goods and services, excluding necessities due to the prebate. The FairTax rate after necessities is 23% and equal to the lowest current income tax bracket (15%) combined with employee payroll taxes (7.65%), both of which will be eliminated.

Under the FairTax, all Americans consume what they see as their necessities of life free of tax. While permitting no exemptions, the FairTax (HR25 / S122) provides a monthly, universal prebate to ensure that each family unit can consume tax-free up to the poverty level, with the overall effect of making the FairTax progressive in application. This is not an entitlement, but a rebate (in advance) of taxes paid — thus the term prebate. Everyone pays taxes at the cash register. Although everyone pays the same tax rate at the cash register, the chart below shows that the effect of the prebate is to increase the actual tax rate (annual taxes paid as a percentage of annual spending) as the level of spending increases, a progressive tax rate structure. For example, a person spending at the poverty level ($31,020 for a family of four) has a 0% effective tax rate because the annual prebate of $7,135 refunds all of the taxes they paid in their annual spending of $31,020. Whereas someone spending at twice the poverty level has an effective tax rate of 11.5%, and so on. Annual spending would have to be in excess of $14 million per year to reach the statutory rate of 23%.

A flat tax (short for flat tax rate) is a tax system with a constant marginal rate, usually applied to individual or corporate income. A flat tax falls under proportional tax as they allow certain deductions. There are various tax systems that are labeled "flat tax" even though they are significantly different.

The negative income tax (NIT), which Milton Friedman proposed in his 1962 book Capitalism and Freedom, is a type of flat tax. The basic idea is the same as a flat tax with personal deductions, except that when deductions exceed income, the taxable income is allowed to become negative rather than being set to zero. The flat tax rate is then applied to the resulting "negative income," resulting in a "negative income tax" the government owes the household, unlike the usual "positive" income tax, which the household owes the government.

For example, let the flat rate be 20%, and let the deductions be $20,000 per adult and $7,000 per dependent. Under such a system, a family of four making $54,000 a year would owe no tax. A family of four making $74,000 a year would owe tax amounting to 0.20 × (74,000 − 54,000) = $4,000, as under a flat tax with deductions. But families of four earning less than $54,000 per year would owe a "negative" amount of tax (that is, it would receive money from the government). For example, if it earned $34,000 a year, it would receive a check for $4,000. The NIT is intended to replace not just the USA's income tax, but also many benefits low income American households receive, such as food stamps and Medicaid. The NIT is designed to avoid the welfare trap — effective high marginal tax rates arising from the rules reducing benefits as market income rises. An objection to the NIT is that it is welfare without a work requirement. Those who would owe negative tax would be receiving a form of welfare without having to make an effort to obtain employment. Another objection is that the NIT subsidizes industries employing low cost labor, but this objection can also be made against current systems of benefits for the working poor.

Either system would abolish the IRS and the thousands of pages of tax code. The forms would be simple one or two page documents and you would not need H&R Block to assist you. As the GEICO commercial once stated: “even a caveman could do it.”

With either system the power and abuses of the IRS would be eliminated. There would be no 501c4 tax exempt status or deductions for race horses. There would be no home mortgage or equipment depreciation. There would be no deductions for medical or business expenses. There also would be no need for 116,000 IRS employees. All that would be needed is just one simple form with one simple rate. Also it would be next to impossible for any administration to use the IRS for political purposes.

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