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Tuesday, June 10, 2014

Mehrotra tackles two mysteries in Making the Modern American Fiscal State


Here are two mysteries of United States public finance.  First, how was the 1913 ratification of a Constitutional amendment permitting the imposition of a powerful new federal income tax even possible?  Second, why doesn’t the United States have a value-added tax or other broad-based national consumption tax?  Ajay Mehrohtra grapples with both in his recent book, Making the Modern American Fiscal State.

Ajay calls his approach “neo-progressive,” but “contingent,” and he builds a careful history of American tax law and policy from the 1890s to the 1920s.  The story covers the adoption of the corporate and individual income tax at both federal and state levels and the relative decline of excise taxes and custom duties, as well as efforts to improve the breadth and administration of the property taxes relied on by many municipalities.  It ends before the explosive tax moment of the New Deal and World War II, which saw the institution of Social Security and other payroll taxes and the expansion of the income tax to a “mass tax.” 

The income tax developments form the focal point of this political class warfare story.  

Economists may not have satisfied themselves about the consumer incidence of excise taxes and custom duties, but less-well-off consumers apparently felt it, and demanded a tax based on the sonorous and malleable metric of “ability to pay” – a practical relative of endowment or “faculty” taxation -- rather than the exchange-based concept of “benefits taxation.”  That the 1893 Panic drove a Populist-and-rogue-Democrat passage of the first peacetime income tax in U.S. history is believable.  It is what comes after that generates the mystery.

In class, I used to tell it like this:  In a 5-4 1895 decision in Pollack v. Farmer’s Loan & Trust Co., SCOTUS held the federal income tax unconstitutional because it violated the requirement that “direct” taxes must be “apportioned.”  It reasoned that since property taxes are direct taxes, taxes on income from property must also be treated as direct taxes.  This ridiculously broad interpretation of  “direct tax” was sensibly reversed by the 1913 ratification of the Sixteenth Amendment to the Constitution.

What?  Because of sensible state legislatures, we got a federal income tax?  Plaintiffs who had the resources to persuade a Supreme Court majority just decided to sit down and shut up?   Wasn’t the Republican party dominant nationally?  Were we at war?  Was there some financial crisis?

The story Ajay tells does not have a simple motivating cause.  There are at least three strands.  First, there was a perception of increasingly unequal distribution of wealth and income, highlighted by the growing power of corporations and some rich families and a financial panic in 1906-07.  Second, the states, especially Wisconsin with its individual income tax, successfully experimented, including with the administration of the tax.  Third, academics strongly advocated the view that a federal income tax should not violate the constitution and indeed would make sensible policy.   This view was voiced by Edwin Seligman of Columbia, apparently partly to atone for spinning out hypotheticals to the contrary at the request of the Pollock taxpayer plaintiffs.   Ajay suggests that Seligman’s efforts helped tip the balance in favor of ratification in New York.

The story of this first mystery, the birth of the U.S. national income tax, perhaps partly explains the second mystery – why the United States does not have a value-added or other broad-based consumption tax.  Of course, VAT technology developed later, after World War II.   Nevertheless, Ajay argues that if the framework set up by the Pollock debate continued to dominate in later decades, it helps explain why the U.S. differs from every other OECD nation on the VAT question.

Like other flat-rate consumption taxes, VATs are regressive.  This is often justified outside the U.S. by their capacity to fund broad social welfare programs.   But the U.S. income tax debate at the turn of the century only focused on half the issue:  only on whether certain types of taxpayers should pay more, rather than on how the money was spent.  A focus on how the money was spent could have put income tax advocates back into the excise-tax-dominated benefits-tax box from which they wished to escape. 

So perhaps turn-of-the-century policymakers developed the mental habit of sharply segregating  taxation and public spending in their thinking to permit them to make a coherent argument to reverse Pollock.  But it is striking that we maintain that habit today.  It is a standard underlying feature of much analysis in a standard law school tax class and an explicit assumption of optimal tax theory.  We measure the distribution of tax changes with predictable political skews, but more rarely attempt to say who benefits from changes in public spending.  With Ajay’s book, we understand better why we have this bias.  Whether we have the capacity to expand our view in a disciplined fashion remains an unanswered question.

Posted by Susie Morse on June 10, 2014 at 11:28 AM in Books | Permalink


Matthew -- thanks for the comment. I agree that the move separating taxation from reciprocal benefits does seem to have been highly contextual and instrumental in accomplishing the goal of making a graduated income tax schedule acceptable. It is not as if it has ever been a first-best world!

Posted by: Susie Morse | Jun 11, 2014 12:24:02 PM

I wonder whether the emphasis on path dependency, habits of mind, or “fiscal myopia” (as Ajay puts it) risks underplaying the political-cultural constraints within which the progressive economists and their political allies were operating. I don’t doubt that segregating taxation and public spending (as Susie suggests), or stigmatizing all consumption taxes as hopelessly regressive and defining fiscal fairness exclusively as a matter of reallocating tax burdens according to the ability to pay (as Ajay argues) helped to foreclose serious consideration of a regime of broad-based consumption tax coupled with generous social welfare spending. But shouldn’t we also understand the apparently limited imaginations of American tax theorists as an expression of the very historicism—the sensitivity to social and institutional context—that animated the progressive economists’ initial challenges to British political economy? For all their creativity and innovativeness, the progressive economists were still working within the prevailing liberal-republic idiom of American political culture. Essentially, they argued that, in an era of vast wealth disparities and corporate consolidation, fiscal “equality” now required treating different classes and entities differently. Once the faculty to pay rather than the benefits received became the accepted basis of taxation, even a steeply graduated system of income taxation (Ajay labels it a “soak the rich” regime) thus ceased to read as the “class legislation” that, in one respect, it surely was. That was a signal accomplishment, but it may have been another matter entirely to advocate an explicitly redistributive tax-and-transfer regime; this is an era, after all, in which what counts as legislative even-handedness is highly contested. This is not to dismiss the habits of mind/fiscal myopia thesis, but rather to suggest that, initially at least, tax theorists and policymakers weren’t so much blind to the policy alternatives, as keenly aware of and (perhaps over-) responsive to what they viewed as unalterable constraints of American political culture.

Posted by: Matthew Lindsay | Jun 11, 2014 10:57:07 AM

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