John Steele Gordon: A Short History of the Income Tax

Great piece in today’s WSJ: A Short History of the Income Tax by John Steele Gordon.

Distilled into bullet points:

• After the Civil War, the government relied mostly on the tariff for revenues, which was basically a consumption tax that hit the poor much harder than the rich.

• An income tax on the “rich” was attempted in 1894. The income tax was to be 2% on incomes above $4,000 (less than 1% of the households at the time). It was challenged and eventually struck down 5-4 by the Supreme Court.

• President Taft “…proposed a constitutional ammendment to legalize a personal income tax, while meanwhile imposing a tax on corporate profilts.”

• The 16th Amendment was ratified in 1913 and the income tax was created.

• The new tax was 1% on income above $3,000 and reached 7% on incomes over $500,000.

• There were many deductions, which drastically reduced effect income tax rates.

The author closes out the piece with a couple of interesting points:

Unfortunately the corporate income tax, originally intended as only a stopgap measure, was left in place unchanged. As a result, for the last 98 years we have had two completely separate and uncoordinated income taxes. It’s a bit as if corporations were owned by Martians, otherwise untaxed, instead of by their very earthly—and taxed—stockholders.

This has had two deeply pernicious effects. One, it allowed the very rich to avoid taxes by playing the two systems against each other. When the top personal income tax rate soared to 75% in World War I, for instance, thousands of the rich simply incorporated their holdings in order to pay the much lower corporate tax rate.

There has since been a sort of evolutionary arms race, as tax lawyers and accountants came up with ever new ways to game the system, and Congress endlessly added to the tax code to forbid or regulate the new strategies. The income tax act of 1913 had been 14 pages long. The Revenue Act of 1942 was 208 pages long, 78% of them devoted to closing or defining loopholes. It has only gotten worse.

Finally, he closes with this, which I totally agree with:

The other pernicious consequence of the separate corporate and personal income taxes has been a field day for demagogues and the misguided to claim that the rich are not paying their “fair share.” Warren Buffett recently claimed that he had paid only $6.9 million in taxes last year. But Berkshire Hathaway, of which Mr. Buffett owns 30%, paid $5.6 billion in corporate income taxes. Were Berkshire Hathaway a Subchapter S corporation and exempt from corporate income taxes, Mr. Buffett’s personal tax bill would have been 231 times higher, at $1.6 billion.

34 thoughts on “John Steele Gordon: A Short History of the Income Tax”

  1. Berkshire doesn’t pay dividends, so I am really confused why the author would even look at Buffett’s personal and Berkshire’s corporate tax rates.

    They are separate entities, and since Berkshire pays NO DIVIDEND, they are not even comparable…

  2. Jack) It is separate when it comes to taxation, because there is no ‘taxable-event’. 95% of Buffett’s wealth is in the form of Berkshire stock — but since that corporation has never paid a dividend, there has NEVER been a transaction for the government to tax.

    If the author wanted to get to the brass tacks, he would look at Buffett’s DIVIDEND paying holdings, which contribute to his $46million/year income, and also THOSE companies corporate rates (GE and EXXON — known to not pay ANY federal taxes are among Buffetts top holdings). That would be much more informative.

    Buffett is a smart guy, and he has positioned himself to have a ridiculously low tax rate (legally) — he also has devised an ingenious way (that only a billionaire could) to avoid the AMT altogether. The AMT was specifically designed to tax the Buffetts of the world, and Buffett has managed to not be subject to the AMT.

    Jon) I agree, the Buffett rule (as currently defined) won’t work. What we need is a flat-tax with the primary purpose of closing all these loop-holes permanently (no deductions allowed, period). The one flat-tax should replace the income, corporate, employment, capital gains, estate, dividend, and whatever other taxes we have. Basically just scrap the entire tax-code and start over.

  3. @BG,

    I agree, although I don’t believe there should be any involuntary tax, if we are going to have one, it should be simple and fair. But, I don’t see that ever happening because it is against human nature. As long as you give a certain group of people power to control others they will use that power to make those others do as they will. If that group of people decide to punish other people, or even give incentives, it then introduces corruption and people follow the money. Hence the super wealthy will always find ways out of high taxes, whether it is through buying off politicians to create loop holes or find already existing loop holes to put their money. I say good for them and whomever else minimizes their tax burden. Really, the only solution, is freedom and liberty, AKA, less statism. People will try and do their best to retain their property.

  4. > It is separate when it comes to taxation,
    > because there is no ‘taxable-event’.

    Berkshire Hathaway was taxed to the tune of $5.6B. Since Buffet owns 30% and BH, and thus 30% of the profits. The government took $16.8B of Buffet’s profits.

  5. So you are making the claim that Warren Buffett earned $46 million, and paid $1600 million in taxes? Why are you counting the taxes paid by Berkshire (and attributing them to Buffett) yet not attributing Berkshires profits to Buffet?

  6. OK…and those numbers are?

    Nobody is arguing that Buffett doesn’t pay taxes, or even that he doesn’t pay A LOT of taxes in raw dollar amounts.

    The issue is whether he has a lower effective tax-rate than his secretary: because if so, that would be the ‘unfair’ part and the reason for the ‘Buffett Rule’ tax proposal.

  7. > and those numbers are?

    Which year do you want numbers for?

    > The issue is whether he has a lower effective
    > tax-rate than his secretary…

    Then ALL of his income, and ALL of his taxes — including those paid by the companies he owns — must be taken into consideration.

    This goes back to my argument that corporate income should not be taxed. Tax the individuals when they get the money. Even better, tax the spending.

    > that would be the ‘unfair’

    Define “fair” — in general. (I’m not asking for a definition regarding taxes, money, or anything else in particular, but for “fair” as a general definition.)

  8. “This goes back to my argument that corporate income should not be taxed. Tax the individuals when they get the money…”

    So you are saying that Berkshire should not have paid that $5.6 billion tax bill, and also continue not paying ANY dividends, so the ‘shareholders’ (Buffett) would pay nothing in taxes?

    “… Even better, tax the spending.”

    Sure, as long as that ‘spending’ includes the purchase of stocks, and hence is ALSO subject to the tax.

    “Define “fair””

    adverb: Without cheating or trying to achieve unjust advantage
    adjective: Just or appropriate in the circumstances

  9. Jack) According to your link, Berkshire paid $4,546 million in taxes to the federal government last year.

    The tool that wrote the WSJ article is including Berkshire’s state and foreign taxes to get to that $5.6 billion number. (See Berkshires 2010 SEC filing, page 86). Berkshire paid $4,546 million in taxes on $19,051 taxable earnings: so an effective federal tax rate of 23.8%.

    Which is, wait for it…..LOWER than his friggin secretary!

    You argument is leaking like a sieve.

  10. Wow, he has as VERY expensive secretary.

    Tax rates for individuals in 2010 were…
    10% up to $8,375 (max $837.50)
    15% up to $34,000 (max $837.50 + .15*(34000-8375) = $4681.25)
    25% up to $82,400 (max 4681.25 + .25(82400-34000) = $16,781.25
    28% up to $171,850

    Now, 16,781.25/82,400 = 20.4%. So she must make more than that. Let’s see how much.

    At $150,000, she would have paid $16,781.25 + .28*(150,000-82400) = $35,709.25.
    $35,709.25/$150,000 = 23.8%

    Wow, $150k of TAXABLE income. That’s pretty damned good for a secretary! With the personal exemption, mortgage interest deduction, charitable deductions, etc., she’s probably pushing $200k.

  11. Sorry, BG, but we’re talking about federal income taxes, not payroll taxes. If you want to include the payroll taxes paid by the secretary, then you must include the payroll taxes paid by Berkshire Hathaway, and you must also deduct from the secretary’s taxes the present value of the benefits she will receive from those programs.

    Go for it.

  12. So you are saying Buffet is wrong to include the payroll taxes in his figure of 17.7% after I bent and allowed you to include Berkshires (corporate) taxes on Buffetts PERSONAL taxes. I was wrong about the original author being a ‘tool’, instead you are the tool.

  13. > So you are saying Buffet is wrong to include the
    > payroll taxes in his figure of 17.7%…?

    Since payroll taxes are not paid on dividends and capital gains, and he gets a $100k salary (considerably less than his secretary), he paid about $7650 in payroll taxes. If that were included not included in his $6.5M (17.7%) figure, those numbers would have been $6.5M and 17.7%.

    > [You] are the tool.

    When one’s arguments are shot down, resort to personal attacks. Right out of the playbook.

  14. Yes Buffett included the payroll taxes in his 17.7% figure. Why are you afraid to include the same in your calculations? Thats right, because it will prove that me (and Buffetts assertion) correct.

  15. I did. Put in his payroll taxes, and his taxes change from $6.5M to $6.5M.

    The payroll taxes are tied to particular programs — and one’s estimated benefits from those programs are tied to the taxes paid. So for a fair comparison, the present value of those estimated benefits must be factored in.

    If the taxes are in, the direct personal benefits of those taxes must also be in.

  16. “I did. Put in his payroll taxes, and his taxes change from $6.5M to $6.5M.”

    Now do the same for his secretary, and tell me their effective tax rates for different income levels.

    “The payroll taxes are tied to particular programs…”

    BS — they are a general tax. Already settled by the Supreme Court.

  17. Then why are benefits computed according to taxes paid?

    Put in the present value of their expected benefits, and you have a reasonable comparison.

  18. Benefits are not based on taxes paid. They are based on ‘ credits earned’. I’m in my mid-thirties and already maxed out my credits years ago. Technically, I an just paying a tax now, and will continue for the next thirty years without any increase in ‘promised’ benefits (as if I expect to get a single penny out of the system anyway).

    Anyhow, all that is besides the point. The people with the highest effective tax rates are not ‘the rich’, it is the middle class. Even poor people who pay nothing in income taxes, have effective federal tax rates of about 15%, just from the employment taxes. This is a fact and I am getting tired of the misinformation.

    Do I want the rich to pay more? No, I want their low effective tax rates for everyone.

  19. > [Benefits] are based on ‘ credits earned’.

    Which are directly proportional to taxes paid.

    > I’m in my mid-thirties and already maxed out my
    > credits years ago.

    Most impressive. You’ve been working since you were born, and maxed out your contributions every year!

    > The people with the highest effective tax rates
    > are not ‘the rich’, it is the middle class.

    The Congressional Budget Office disagrees with you.

    The top quintile has an effective rate of 25.8%, and the middle quintile 14.2%. The bottom quintile is at about 4.3%.

    The top 1% have an effective federal tax rate of 31.2%.

  20. “..The Congressional Budget Office disagrees with you…”

    Assume a married couple earning $100k in 2008. They paid $12,4000 in SS taxes on income of $106,200, plus $2,900 in Medicare taxes, plus $16,966 in income taxes on AGI of $82,100 (AGI reflects Standard Deduction and Personal Exemptions for two).

    Total tax of $32,266.25 on income of $106,200 == 30.4% effective tax rate.

    I’d really like to see the raw data behind those CBO graphs, because:

    1) you can’t even tell which quintile my example falls in, and

    2) I don’t trust their numbers when they show ANY group with effective tax rates less than the employment tax rates, except for MAYBE the lowest quintile that is able to have a negative income tax rate which would offset (somewhat) the 15.3% in employment taxes.

  21. Your income tax calculation is incorrect. The married rate at that AGI was $8,970 plus 25% of excess over $65,150. That would be $13,207.50.

    Total taxes paid: $13,207.50 + $12,4000 + $2,900 = $28507.50. That would be 26.8%.

    Your estimates also do not include employer-paid health insurance and 401(k) contributions (which those w/ $50k incomes generally have).

    Even assuming that the couple had neither of those, they would still be in the top quintile. So the CBO number for the top quintile — 25.8% — is right in the ballpark.

  22. Good catch, I used the ‘Single’ marginal rates accidentally. The correct numbers are:

    Married effective rate: 26.8% (your math)
    Single effective rate: 32.7% (lower SD and only one PE)

    Point still stands though: both are higher than Buffett’s rates (even if you do include the Berkshire corporate taxes in Buffett’s personal effective rate).

    So WHY are Buffett’s rates so much lower than everyone else in that top quintile? It is because his charitable contributions allow him to avoid AMT and also because he is ‘donating’ Berkshire shares that have tremendous amounts of ‘un-taxed’ capital gains in them — which he uses to offset his taxes even more.

    Buffett is doing everything ‘legally’: the question is should we have these loop-holes in the tax code? As you know every tax-break for one group is paid for by everyone else NOT in that group. People may argue morality and that charitable contribution is ‘good’ and hence should be (un)taxed favorably — hence allowing the government to socially engineer and manipulate people into doing what the government wants you to do/not do.

    I say: forget all that. Tax everyone (rich and poor) at the exact same tax rates with absolutely no deductions. The government needs to get out of the pandering business. Morality shouldn’t be codified in the tax-code. If Buffett wants to be ‘noble’, then he should continue his charitable giving and also NOT claim the deductions, which just causes you/me/everyone else to subsidize HIS charity.

    Also, for the SS benefits discussion:

    “During your lifetime, you probably will earn more credits than the minimum number you need to be eligible for benefits. These extra credits do not increase your benefit amount.”

    (click on How Credits are Earned from your link)

  23. All of those things just point out what a hypocrite Buffet is. If he really believed in big government solutions, he would be donating to the government, not to NPO’s.

    I do not really care whether charitable contributions are deductible or not. That is one reason that I favor a national sales tax — if you give money to a charity, and that charity buys stuff with your contribution, it gets taxed at that point.

    I really do NOT like the governments’ knowing what charities I choose to contribute to, or how much. It is none of their business.

    > Also, for the SS benefits discussion:

    > “During your lifetime, you probably will earn
    > more credits than the minimum number you need
    > to be eligible for benefits. These extra
    > credits do not increase your benefit amount.”

    That is correct, but also irrelevant. CREDITS do not affect your benefit amount, only whether you are eligible for benefits at all. What affects your benefits is how much you have paid in FICA taxes.

  24. Jack) I don’t think Buffett is a hypocrite, simply because he broadcasts that this is what he is doing, to effect change.

    He literally saying: TAX ME (and my kind) MORE!

    Then people come out of the wood-work to defend his low rates. People who are paying a higher rate than him, defend him.

    BTW: I’m really stating to like Herman Cain’s 9-9-9 plan. Even though I think it will eventually be a 15-15-15 plan — it is still much better than what we have today.

  25. Then there would be no example for us to discuss and nobody would realize we have an issue in the tax code allowing billionaires to pay a lower effective tax rate than his secretary.

    If Buffett thinks there are unfair loopholes in the tax code, then he should use them, and every year publish his numbers until everyone, collectively, says we know your rates are lower and that is fine. Or we change the tax code to ‘ fix’ the Buffett problem with a law aimed directly at him (and his kind). We could even call the law the ‘ buffet rule’


  26. “Then there would be no example for us to discuss…”

    Nonsense. He would just not be a hypocrite, but a good example to his fellow billionaires, and maybe more would give to the government. He would then have a little moral authority behind him, not hypocrisy.

    “…and every year publish his numbers….”

    But he doesn’t. He has made claims, but neither his tax returns nor those of his secretary have been made public.

  27. “But he doesn’t. [publish his numbers]”

    And he doesn’t need to either — just like Obama didn’t need to publish his “long” birth certificate (which isn’t even a legal document) to appease the birthers (after Obama already published the short/legal certificate).

    However, he did bring his tax return with him for an interview with Charlie Rose (see for the video interview).

    Buffett is just one of _thousands_ that have found ingenious loop-holes to avoid taxes. There is an entire class of people (Buffett included) that are WAY outside the average when it comes to effective-tax rates for THEIR income brackets — and this crosses ALL income brackets.


    “Here’s how to read this: 40 percent of taxpayers with incomes between 30K and 40K pay more than 12.9 percent of their income in income and payroll taxes; meanwhile, 25 percent of people with incomes OVER $1M pay less than 12.6 percent of their income in these taxes. This suggests that there are a lot of very-high-income guys paying a lower tax rate than their secretaries.”

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