The limits of taxing the rich

By Amity Shlaes

The general assumption is that tax-rate increases for the rich will be the new norm. The main reason for this is said to be democracy itself.

We have reached the point where just about half of all taxpayers - the lower-earning households - pay almost no income tax. Voters have no reason to endorse a tax cut that's not for them. And the group that pays high rates represents an electoral minority.

In other words, America has passed its tipping point on taxes. There's something un-civic and creepy about this. Everybody should pay some tax, just as everybody should vote.

As recent history shows, an untaxed majority is unlikely to reduce taxes for the taxed minority. In the 1970s and '80s, tax-rate cuts were possible only because inflation pushed many lower-earning taxpayers into higher brackets. Then these lower earners endorsed cuts. Politicians prevented a repeat of that by indexing brackets.

Capital strike

Look further back, and you'll find there is a case of the majority helping the minority. In 1917, the tax schedule was highly progressive, topping out at 66 percent of income. But the income-tax schedule commenced with earners who made more than $2,000 a year. That was double the wage of the average unskilled worker and well above what skilled workers made.

So how did the rich get their cut? Not easily. A 1918 law, passed during Woodrow Wilson's administration, actually pushed the top rate up farther, to 77 percent.

But tax authorities, and with them many politicians, gradually came to see that the high rates weren't necessarily productive. The spread between the yield of earnings subject to the top income-tax rate and earnings from tax-free municipal bonds was so attractive that estates poured their cash into bonds. By 1923, almost $4 in $10 of estates was invested in municipal bonds, compared with less than $1 in 1917. Millionaires went on "capital strike," as the newspapers called it. Revenue to Washington generally came in below forecasts.

The waste disgusted Warren Harding's treasury secretary, Andrew Mellon, who treated the U.S. government as just another business to manage. Mellon posited that lower income-tax rates might bring in more revenue, just as lower freight taxes sometimes created more trains. He found support first from Harding and then from Calvin Coolidge. Mellon and Coolidge plotted an elaborate propaganda campaign for lower rates. In the tax lexicon of the day, they wanted to reduce not merely the "normal" (base) rate, but also the surtax schedule that sat atop it.

Such a plan took chutzpah. Mellon was one of the wealthiest men in the nation, almost a parody of a plutocrat. And he was publishing articles and even a book on the merits of lower rates, from which fortunes like his would benefit. He even titled his antitax book Taxation: The People's Business at a time when "the people" paid no income tax at all. This made him a perfect target for Western progressives such as Sen. James Couzens of Michigan and "Fighting Bob" La Follette of Wisconsin.

The first effort to cut top rates misfired dramatically when Congress opted to emphasize cuts for lower earners. Victory for Mellon and Coolidge came only in the fourth tax cut of the period, in 1926, when they managed to get the top rate down to 25 percent.

Why did Mellon, Harding, and Coolidge succeed? First, the administrations' tenacious publicity work revealed the extent of the cash flowing into municipal bonds, which turned out to disgust the average citizen as well. Second, federal revenues increased after each rate cut. Third, Harding, Mellon, and Coolidge slashed the budget year after year, building confidence that the tax cuts could be permanent.

Forgotten experiment

The prosperity resulting from this small-government policy also did its part. Under Coolidge, the U.S. economy grew at an average rate of more than 4 percent a year. Unemployment stayed below 6 percent and often below 4 percent. Wages rose slightly in real terms, and automobile prices dropped.

The spread between municipal and other kinds of bonds narrowed in tandem with the tax reductions. By decade's end, the very wealthiest were paying a greater share of income taxes than they had before.

The outcome surprised many, even among the administration's own people. A secretary of Coolidge's wrote after the 1926 cut that "it was greeted with joy by his opponent because it was felt that here was an issue between the rich and poor where popular feeling could be but one way."

That the entire experiment has been forgotten matters less than the fact that it happened. Look back far enough, and there's the evidence: Even a tipped nation can untip.