Ask most people what should be done to reform the tax system, especially the income tax, and probably the most popular answer will be, "Get rid of it." What many people don't understand, however, is that the income tax was instituted with strong popular support. It was a solid plank of the Populist political platform in the late 19th century, along with cheap money in the form of "free silver." Taxing income was considered much more democratic than tariffs, property taxes, or other forms of taxation that, in many cases, were simply passed on as added costs to consumers.
What made the income tax popular in the early days was the fact that it specifically targeted the rich. It did not become regressive until the mid-1930s when the parallel Social Security and Medicare income tax system was instituted, levied only on wage incomes with no exemptions or deductions. In contrast, the first income taxes in the United States set the amount of income on which the tax was levied so high that paying the tax was almost regarded as a privilege, a sign that the taxpayer was in the upper financial and social stratum of society.
Like the national debt, the income tax received its greatest impetus as a result of the Civil War. There has, of course, always been a national debt. Before the 1860s, however, the debt was limited to the tens of millions. It was not until the Civil War and Treasury Secretary Salmon P. Chase's decision — for which Lincoln, as president, was ultimately responsible — to finance the Union war effort by printing money instead of by raising taxes that the national debt first managed to get into the billions of dollars. When it became clear that the country could not easily bear such a burden, Chase (who had presidential aspirations) finally switched from the politically popular but inflationary and financially ruinous debt financing, to the politically unpopular but fiscally sound taxation. The damage, however, had already been done, and the country saddled with a colossal debt and an inflated currency.
Printing money as a first resort and only having recourse to taxation later put the country in a very shaky financial position. Authorities concur that had Chase minimized borrowing from the beginning and relied primarily on taxation, not only would the national debt have remained relatively low, but the total cost of the war would have decreased dramatically. (Charles Conant, A History of Modern Banks of Issue. New York: G. P. Putnam's Sons, 1927, 403-404; cf. Harold G. Moulton, Money and Banking. Chicago, Illinois: The University of Chicago Press, 1916, 162-174.) Further, without Chase's "success" in financing the Civil War out of debt to provide an example and set a precedent, the First and Second World Wars might not have caused the massive increases in the national debt — in the latter case over the protests of John Maynard Keynes, otherwise a proponent of government debt. (See John Maynard Keynes, How to Pay for the War. Toronto, Canada: Macmillan and Co., 1940.)
Nevertheless, so great was the financial strain of the war effort that even before Chase finally saw the light, the first income tax was introduced via the Revenue Act of 1861. This was a flat rate of 3% on income above $800. This sounds oppressive until we realize that $1 a day ($6 per week, or roughly $312 per year) was very good pay until the late 19th century. The Revenue Act of 1862 changed the flat rate to a progressive rate on income above $600. This was still almost twice a good rate of pay for an average wage worker, roughly analogous to approximately $100,000 in today's terms when the median national income is over $50,000. The tax included a sunset date of 1866.
Calls for a permanent income tax increased in the late 19th century. In 1887, probably inspired by The Communist Manifesto, the Socialist Labor Party called for a progressive income tax, while the Populist Party started agitating for a progressive income tax as part of its platform in the 1892 election. The passage of the Wilson-Gorman Tariff Act of 1894 included a provision for a federal income tax of 2% on incomes over $4,000. Led by William Jennings Bryan, the Democratic Party endorsed Wilson-Gorman.
The tax was challenged in Pollock v. Farmers' Loan & Trust Co. (157 U.S. 429), 158 U.S. 601 (1895)). Before Pollock, income taxes had been construed as "indirect" taxes. This meant they could be imposed uniformly on everyone, regardless of state or territory. In Pollock, however, the U.S. Supreme Court decided that an income tax is a "direct" tax. As a direct tax, the income tax had to be apportioned among the states according to population, not on the basis of individual income. In 1908 the Democratic Party again included an income tax in its platform. Following the Panic of 1907 and the findings of the Pujo Committee, the 16th Amendment was enacted in 1913, permitting a direct tax to be imposed without apportionment.
Conspiracy theory to the contrary, the 16th Amendment did not illegally give Congress the power to tax incomes. Congress has had the power to levy a tax on income since 1789 with the ratification of the U.S. Constitution. What the 16th Amendment did was allow the imposition of a tax on incomes without apportionment. This removed the problem resulting from the Supreme Court's reinterpretation of the indirect versus direct nature of an income tax. As the United States Court of Appeals for the Third Circuit explained in Penn Mutual Indemnity Co. v. Commissioner, 32 T.C. 653 at 659 (1959),
It did not take a constitutional amendment to entitle the United States to impose an income tax. Pollock . . . only held that a tax on the income derived from real or personal property was so close to a tax on that property that it could not be imposed without apportionment. The Sixteenth Amendment removed that barrier. Indeed, the requirement for apportionment is pretty strictly limited to taxes on real and personal property and capitation taxes.Detailed Tax Reforms for Implementing Capital Homesteading
It is not necessary to uphold the validity of the tax imposed by the United States that the tax itself bear an accurate label. Indeed, the tax upon the distillation of spirits, imposed very early by federal authority, now reads and has read in terms of a tax upon the spirits themselves, yet the validity of this imposition has been upheld for a very great many years.
It could well be argued that the tax involved here [the income tax] is an "excise tax" based upon the receipt of money by the taxpayer. It certainly is not a tax on property and it certainly is not a capitation tax; therefore, it need not be apportioned. We do not think it profitable, however, to make the label as precise as that required under the Food and Drug Act. Congress has the power to impose taxes generally, and if the particular imposition does not run afoul of any constitutional restrictions then the tax is lawful, call it what you will.
Sound tax policy recognizes that government does not produce wealth. Every government subsidy originates with those whose productive labor and capital actually produce marketable goods and services. Sound tax policy also recognizes that wealth is produced most efficiently when competing privately owned enterprises vie to satisfy private consumer demand, with every buyer voting with his or her money to reflect a choice among available goods and services.
How then could the tax system be restructured to achieve responsible, sustainable and fair fiscal policy, while encouraging the objectives of Capital Homesteading?
One, replace the graduated tax on personal income above the poverty level with a single rate on income from all sources, "earned" and "unearned." This includes employment and property incomes, interest, dividends, inflation-indexed gains from sales and exchanges of property, unemployment compensation and welfare, social security and pension incomes, winnings from gambling, gifts and bequests, any of which that are not reinvested or exempted by the "Capital Homestead Exemption" described below, and so on.
Note the radical departure of this "poor man's single tax proposal" from the flat tax proposals of Steve Forbes, Jack Kemp, and others. Their "make the rich richer" flat tax would exempt from taxation capital gains, dividends, interest, inheritances, and gifts. The tax would insulate the rich from contributing from their property incomes to the regressive, pay-as-you-go Social Security and Medicare systems. Under our single rate tax, the poverty level worker and his employer would pay no Social Security or Medicare taxes, because all revenues to meet Social Security and Medicare promises would come from the single rate tax.
Two, exempt all household incomes of the genuinely poor by excluding from taxation all incomes below $30,000 per adult household member and $20,000 per dependent child. This would allow the "typical" family of four with two adults and two dependents a tax-free income of $100,000 with which to meet common domestic needs.
Three, eliminate all existing deductions and tax credits to businesses and individuals, except 1) Ordinary and necessary business expenses. This would include full and immediate deductions for current expenses as well as full debt service payments to replace existing productive assets and otherwise to protect the property rights of current owners. 2) All incomes channeled by businesses or individuals into dividend and patronage distributions or into the financing of business growth or transfers of equity ownership in ways that broaden the base of capital ownership.
These might include Employee Stock Ownership Plans (ESOPs), Capital Homestead Accounts (CHAs), Citizens Land Cooperatives (CLCs), Land and Natural Resource "Banks," pension plans, Keogh plans, and other IRS-qualified expanded ownership investment vehicles. In no case, however, would a deferral or deduction be allowed where such amounts would cause the accumulations of individual beneficiaries to exceed the "Capital Homestead Exemption," described below. These "savings" could be treated as tax deductible by either the businesses or individuals that make them.
Formerly we held that charitable contributions would be legitimate deductions. We advocated imposing appropriate limitations to encourage expanded capital ownership and discourage monopolistic accumulations and control over productive assets. Now, however, we believe that further discussion is required on this point.
Four, eliminate a number of features that complicate the tax code and insert unfairness. These would include the tax penalty on married couples, tax credits, tax-free interest on public-sector financing, tariffs and duties on imported goods (except when used selectively to encourage just market competition), tax shelters (especially for speculative and non-productive investment, and all indirect taxes in any form not based on consumption incomes.
Five, allow the full deduction of the purchase price or the current mortgage payment (principal as well as interest) for the purchase of a taxpayer's principal home if purchased through a Homeowners Equity Corporation. This would provide tax neutrality between renters and homeowners, as renters would be "renting to buy," but without the need to qualify personally for a mortgage or come up with a down payment. Previously we favored providing tax neutrality by adding the "imputed rent" of each dwelling of a taxpayer to his annual taxable earnings, but this would require cash payment of taxes for a non-cash income item.
Six, convert Individual Retirement Accounts (IRAs) into Capital Homestead Accounts (CHAs) as a mechanism for enabling all individuals to accumulate income-producing assets on a tax-deferred and/or exempt basis. The IRA/CHA could then be "supersized" by adding a provision, such as the one permitted ESOPs, to be used to acquire corporate shares on credit secured with capital credit insurance and reinsurance and repaid with dividends deductible at the corporate level. Gifts or bequests to CHAs, ESOPs, and other ownership-expanding vehicles could be made tax-deductible for income and estate tax purposes, as they are today for tax-free foundations.
Seven, tax all dividends and interest income at the personal level without exclusions to the extent the taxpayer's total income from all sources exceeds the exemption levels for the poor.
Eight, only allow exemption of capital gains from taxable personal income, to the extent that the taxpayer's spendable gains are equal to or less than the inflation-adjusted value of the assets during the period over which the assets were held before being sold; and the gains are reinvested within 60 days (or 18 months for a home) into income-generating investments held within an IRS-qualified capital accumulation mechanism (e.g., CHA, ESOP, etc.) but not exceeding the "Capital Homestead Exemption" (below).
Nine, avoid double and triple taxation by maintaining a tax on corporate net earnings but allowing corporations to avoid taxes on earnings 1) paid out as dividends, cash productivity bonuses, ESOP and profit sharing contributions, purchases or debt service payments on replacement assets, patronage refunds, etc. 2) Expended on research and development.
Previously we added, "used for working capital," but cash used as working capital is as fully a productive asset as any other capital. As such, if additional working capital is needed for anything exceeding the short-term (for which borrowing from the money market should suffice to cover temporary shortfalls), a new issue of shares should be made to obtain the cash; cash-as-profits should not be reinvested in cash-as-asset. If a permanent or long-term reduction in working capital is desired, then shares should be bought back or, better, the cash used to make debt service payments for long-term capital, or (best of all, assuming any earnings have been retained) paid out as dividends.
Ten, allow ordinary business expenses, like wages, to remain deductible at the corporate level as under present laws, while encouraging ownership expansion by allowing for tax deductibility of profits paid out to owners. First, of course, this will enable Capital Homesteaders to use the stream of dividends to make debt service payments on their capital. Previously we said that there should also be full deductibility of debt service payments, both principal and interest, on loans used to acquire replacement assets, but the usual provision for depreciation will continue to allow the effective depreciation of the principal, while interest costs will continue to be a deductible expense. While tax deductibility of dividends is directed primarily at Capital Homesteaders, workers through ESOPs, and other shareholders through CHAs, CSOPs, CICs, etc., could use these tax-deductible dividends to repay loans for the acquisition of larger blocks of stock on a leveraged basis.
Tax-favored payout of corporate dividends should not be labeled "tax subsidies," any more than deductible wage costs are "subsidies" to employers. Tax-deductible profit distributions under Capital Homesteading represent structural reform of the tax system. These tax deductions are designed to eliminate the unjust "double tax" penalty on corporate profits, by integrating the corporate income tax with the personal income tax, while exempting reasonable property accumulations to meet the Nation's income security goals.
Finally, the ceiling should be lifted on tax-deductible contributions to a leveraged ESOP for financing new equity issuances representing growth capital of the company. This would effectively allow the current expensing of annual debt service payments for financing growth through the company's ESOP.
Eleven, liberalize depreciation rules by allowing full first-year deductions on all purchases of replacement assets. This will help maintain existing levels of capital productiveness, profits and property rights of existing owners.
Twelve, allow the tax advantages of a leveraged ESOP to be extended to all taxpayers through IRS-qualified Capital Homestead Accounts (CHAs), to utility customers under consumer stock ownership plans (CSOPs), and to citizen-shareholders of State and local Citizens Land Cooperatives (CLCs) for developing local land and natural resources.
Thirteen, integrate with the Social Security System a tax-deferred "Capital Homestead Exemption" to encourage every man, woman, and child to accumulate a personal life-time estate of wealth-producing assets through Capital Homestead Accounts, ESOP rollovers, Keogh Plans, IRAs, gifts, bequests, savings, etc. Presently we recommend that taxes be deferred on capital accumulations up to $1 million, excluding any equity in a primary residence, whether directly held or owned through shares in a Homeowners Equity Corporation (HEC). This reform would be targeted to provide all Americans with growing property incomes and direct ownership participation in the competitive free enterprise system. Such an estate would provide the same degree of income self-sufficiency and economic security for a family as the 160 acres of productive farmland granted under the original Homestead Acts.
Fourteen, eliminate all contribution limits on "savings" through CHAs, ESOPs, IRAs, Keogh Plans, etc., until individual accumulations exceed the proposed Capital Homestead Exemption of $1 million.
Fifteen, provide an existing owner with a tax-deferred rollover of the proceeds from the sale to an ESOP of shares or assets of any enterprise, including shares trading in the open market, as long as the proceeds are reinvested by the seller in other productive assets within 18 months. This would encourage employee participation in ownership as well as provide a new source of equity financing for new and growing businesses. (This expands the present rollover provision for sale of shares to an ESOP to shareholders of publicly traded companies.)
Sixteen, permit an ESOP, CHA, CIC, or other ownership-expanding mechanism to be treated as a charitable organization for income, gift, and estate tax purposes provided the donated stock is not allocated to the donor, family members of the donor or "25% shareholders."
Seventeen, amend the Internal Revenue Code (following the precedent in the former Subchapter U for General Stock Ownership Corporations) to allow the use of Citizens Land Cooperatives (CLCs) for land planning, acquisition and development of "super empowerment zones" so as to encourage comprehensive, large-scale development of designated urban and rural areas combined with widespread participation among residents in the ownership, profits, and appreciated real estate values that would otherwise flow exclusively to outside land speculators.
Eighteen, absorb the annual cost of the Social Security System entirely within the single rate income tax imposed on all incomes above the poverty level. As expanded growth and expanded ownership provide non-inflationary property incomes for retiring Americans, Social Security benefits can become stabilized and perhaps eventually reduced as they are replaced by Capital Homesteading incomes.