Two Awful Anniversaries: Income Tax and Federal Reserve

Two Awful Anniversaries: Income Tax and Federal Reserve
This story appears in the March 4, 2013 issue of Forbes.






This year marks the 100th anniversary of the federal income tax (February) and the Federal Reserve System (December), both of which today are doing immeasurable harm. And, thankfully, both will be undergoing enormous changes.
Income taxes punish the very things we want more of: productive work, risk-taking and success. We can’t say this enough: A tax on income is the price you pay for working; a tax on profits, the price you pay for success; and a tax on capital gains, the price you pay for taking risks that work out.
In times past when the income tax burden has been eased–that is, rates have been lowered–our economy prospered because people weren’t hindered or punished for engaging in more productive activities. The 1920s, 1960s and 1980s were all marked by fantastic innovation, greater economic growth and a gratifying rise in the standard of living. Even during 2003–08, when the income tax burden was eased, the economy did better (as we’ll discuss, the Federal Reserve undid this prosperity).
Some cite the period from the end of WWII through the 1950s as demonstrating that our economy could blossom under high income tax rates. They overlook the enactment of joint filing after WWII, which effectively cut a family’s tax burden in half. We grew in the 1950s because tax thresholds were high. There were also countless tax shelters that eased the bite of high rates. But those high rates took their toll as the U.S. was beset by a number of recessions, and the economy’s average growth rate in the 1950s was subpar.
Today federal income taxes are crushing us again. The fiscal cliff deal not only raised top rates but also reduced the deductions of higher-income people. Add in the Medicare tax–now 3.8% for upper-income earners–and the effective marginal federal rate is 44%. And President Obama wants to boost these levies even more. He envies France, which is putting in a 75% tax rate on the “rich.” Even more destructive, France is also hiking capital gains levels to that catastrophic height.
So why is there hope for major change?
For one thing–and this is critical in the war of ideas–the justifications for punitive rates have been demolished. The literature undercutting the rationales for absurd levels–that they produce more government “investment,” that they don’t hurt economic activity–continues to grow. The truth is that on the national level those higher taxes are slowing down an already sluggish economy. The recessions in western European countries are deepening. Japan, the world’s third-largest economy, is also mired in recession.
But here at home the state level is where the income tax battle is taking an astonishing turn. One of the virtues of our federal system is that states are laboratories for public policies. Starting in the 1980s, for example, Wisconsin, followed by others, demonstrated that radical welfare reform was feasible, and their successes enabled significant federal reform in 1996 (which the Obama Administration is undermining).
Research by Art Laffer and other economists has demonstrated that over time states that have no income tax perform better than states with high income taxes. New Jersey, for instance, traditionally outperformed the national economy. Then it not only enacted a state income tax but also subsequently raised it to nosebleed levels. Today New Jersey’s economy is a shadow of its former self and lags the nation. The same thing has happened in Connecticut.
Before the enactment of the 16th Amendment, which permitted Washington to impose an income tax, states were in the vanguard of putting taxes on income. Today they are doing just the opposite. Governor Sam Brownback of Kansas has been unrelenting in pushing for lower income tax levies. When certain members of his own party balked, he supported their challengers in the primaries. Brownback triumphed and is now putting Kansas on the path to eliminating this exaction altogether. Governor Dave Heineman of Nebraska wants to do the same thing, as does Governor Bobby Jindal of Louisiana. Other governors are pushing to reduce rates sharply, including Governors Pat McCrory of North Carolina, Mary Fallin of Oklahoma and John Kasich of Ohio.
And look at what’s happening in Massachusetts: Governor Deval Patrick, taking cues from his close friend Barack Obama, proposed raising Massachusetts’ 5.25% income tax to 6.25%, as well as boosting other levies. Despite virtually no Republican representation in the state legislature–Democrats have 36 of 40 seats in the Senate and 129 of 160 in the House–Patrick’s scheme looks to be crashing and burning. White House fantasies to the contrary, most people are in no mood to pay more to Big Government.
States with taxaholic governors, such as Illinois, California, Maryland and Connecticut, are being hit hard. Jerry Brown claims his massive retroactive tax increase on upper-income Californians is balancing his budget. Not for long. Businesses and individuals are fleeing the once Golden State.
Golfer Phil Mickelson was trashed by liberals and the liberal media when he dared voice his disgust with having most of his earnings go to government bureaucracies. But shouting critics won’t alter reality. Is it a coincidence that such athletes as Tiger Woods, Derek Jeter and countless others have official residences in places like no-state-income-tax Florida? Or that numerous Californians have their official residences just across the border in no-state-income-tax Nevada?