Americans don't mind taxes -- they hate tax loopholes

By Joseph J. Thorndike
Sunday, September 12, 2010; B03

Americans hate taxes, right?

We vote for candidates who promise to cut them and punish candidates who pledge to raise them. We tell pollsters we don't want to pay them. And we teach our children that the nation was founded to resist them. From the Boston Tea Party to Shays's Rebellion to California's Proposition 13, we are a nation of tax revolters. Hand us a pitchfork, and we'll march on Washington -- just witness the "9/12 Taxpayer March" on Sunday on the Mall.

This is the history underlying today's battle over the Bush tax cuts, the economy and President Obama's complicated call for new business tax breaks even as the nation faces crippling budget deficits. Yet it's a history that doesn't quite meet the test of, well, history. Oliver Wendell Holmes once observed that "taxes are what we pay for civilized society," and for more than 200 years, Americans have been remarkably willing to pony up. It's not that we hate the financial inconvenience of paying taxes -- we hate the injustice of an unfair tax code. We've long agreed to pay the price for civilization. We just can't tolerate anyone looking for civilization on the cheap.

Consider the Boston Tea Party, the creation myth for today's anti-tax activists. It was a protest not against taxes but against tax loopholes. The colonists who dumped tea into Boston Harbor were objecting to a special tax exemption that Parliament had granted to the East India Company, a well-connected enterprise that in the early 1770s happened to be in dire need of a government bailout.

In the centuries since, national crises have periodically transformed our fiscal infrastructure. Wars have usually been the catalysts, establishing the need for new revenue and exposing the inadequacy of existing taxes. Economic collapse has also triggered change, particularly during the Great Depression, when President Franklin Roosevelt gave the federal tax system a distinctly progressive cast.

But if crises have sparked change, they have not shaped the details. Deep popular worries over fiscal unfairness -- and over tax loopholes in particular -- have been central to the overhauls, with presidents from Abraham Lincoln to Woodrow Wilson to Barack Obama struggling to reconcile fiscal imperatives with prevailing norms of social justice.

Since at least World War II, when our current tax system took shape, the federal revenue structure has been undergirded by an implicit bargain. Middle-class Americans have agreed to shoulder much of the burden, through income and payroll taxes. In return, they have insisted that rich Americans pay higher rates -- sometimes much higher.

Such progressive taxation has sometimes been proposed as a means to make society more egalitarian. In 1935, for instance, Roosevelt defended his plans for tax reform by highlighting the failures of the existing system. "Our revenue laws have operated in many ways to the unfair advantage of the few," he declared, "and they have done little to prevent an unjust concentration of wealth and economic power."

More often, however, progressive taxation has been advanced as a means to redistribute the tax burden more fairly. Rep. Cordell Hull of Tennessee, a champion of the income tax during the 1910s, repeatedly stressed the need to reallocate fiscal responsibilities, not overall wealth or economic power. "I have no disposition to tax wealth unnecessarily or unjustly," he said, "but I do believe that the wealth of the country should bear its just share of the burden of taxation and that it should not be permitted to shirk that duty."

But here's the problem with progressive taxation, especially when it features high rates on the very rich: Carried to an extreme, it can prove its own undoing. When faced with high marginal rates, wealthy taxpayers always seek loopholes. Such tax avoidance costs money, but even worse, it undermines the legitimacy of the tax system itself, eroding what economists call "tax morale." Commentators who bemoan the decline of Americans' trust in government need look no further than the public suspicion that the tax system is not fair -- that some people are shirking their fiscal duties through legal tax avoidance or illegal tax evasion, with the help of lawyers, campaign contributions and lobbyists.

President Ronald Reagan understood the political dangers and opportunities presented by this fact. "The American people are always willing, even eager, to do their duty," he observed during his campaign to reform the tax system in 1985. "But you quite naturally resent it when you see others shirking theirs. It rankles to know that your tax rates are so high because others who can afford high-priced lawyers and tax consultants are able to manipulate the system to avoid paying their fair share."

Populist resentments have often been used to justify even higher rates for the rich. As President John F. Kennedy pointed out in 1961, "Whenever one taxpayer is permitted to pay less, someone else must be asked to pay more. The uniform distribution of the tax burden is thereby disturbed and higher rates are made necessary by the narrowing of the tax base."

But as Kennedy, Reagan and other presidents have understood, the effort to offset tax avoidance with higher rates is self-defeating. Wealthy taxpayers will redouble their efforts to identify and win tax preferences, lawyers will rake in more money advising their clients on how to do it, and tax cynicism will grow among the populace. In an arms race between tax collectors and tax avoiders, the latter usually win. With ample means and motivation, they will never abandon the fight.

Twenty-four years ago, a recognition of this reality helped produce the Tax Reform Act of 1986, the greatest peacetime tax reform in U.S. history. Lawmakers eliminated many tax preferences, expanding the size of the tax base dramatically. The broader base allowed them to cut marginal rates, reducing the incentive for aggressive tax avoidance.

It was a good bargain -- but not a durable one. In the two decades since Reagan shepherded tax reform into reality, pernicious dynamics have returned in full force. As economist C. Eugene Steuerle, an architect of the 1986 reform, has observed, "Helped by pollsters skilled at making private greed appear like public need, even the White House, Treasury, and tax-writing committees have increasingly used the tax code to serve special interests instead of the common good."

Today, once again, the resentment is evident around us. The "tea party" movement, in particular, draws sustenance from a deep-rooted suspicion that politicians serve the interest of a well-connected minority, not a long-suffering majority. For many tea partiers, the loophole-ridden tax code is Exhibit No. 1 in their indictment of American government.

In recent days, Obama seems to have rediscovered his populist voice, so evident in the 2008 campaign but largely absent during much of his presidency. His insistence on ending the Bush-era breaks for the nation's wealthiest taxpayers seems calibrated to appeal to angry voters, who continue to tell pollsters that they support higher taxes on the rich.

"I believe we ought to make the tax cuts for the middle class permanent," Obama said in Ohio on Wednesday. "These families are the ones who saw their wages and incomes flatline over the last decade -- you deserve a break." The president also decried Republicans' plans to "cut more taxes for millionaires and cut more rules for corporations."

Obama would do well to remember that soak-the-rich taxation, while politically appealing and perhaps even morally justified, carries its own risks. Sure, voters need to believe that the wealthy are paying their fair share. But the best way to provide that assurance is by closing loopholes and keeping them closed. By deepening the incentives for tax avoidance, high rates on the rich by themselves pose a long-term threat to the nation's tax system.

Real tax reform -- the kind we need to solve the nation's long-term fiscal crisis -- will involve sacrifice from everyone, not just the fortunate few.

Joseph J. Thorndike is the director of the Tax History Project at Tax Analysts in Falls Church and the author of "Their Fair Share: Why Americans Tax the Rich," forthcoming in 2011.

For recent Outlook coverage of taxes, see "Five myths about the Bush tax cuts" by William G. Gale.

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