The Federal Tax System Is Broken -- Fix It, Don’t Cut Out Its Heart

Various presidents have overseen major reforms of the progressive income tax, but according to news accounts the Bush administration contemplates its virtual abandonment.

One possible route it has suggested would be to shrink the tax base to just wages, salaries and pensions (thereby exempting investment income such as interest, dividends and profits) and replace progressive rates -- rates that increase as income rises -- with a single “flat� rate.

This would be an immense break from the past. Before proceeding, the administration ought to consider the history and success of progressive taxation, and the case for reforming it rather than scrapping it.

The enactment of a progressive federal income tax, in 1913 under President Wilson, culminated a long and often bitterly contested reform movement. The reformers believed that individuals ought to be taxed according to their ability to pay, and that individual taxes ought to be based on a person’s total income -- investment income as well as wages and salaries. They lamented the fact that state and local property taxes applied only to real estate, leaving such property as stocks and bonds untaxed, as remains the case today. A federal income tax, they thought, would help compensate for this.

The reformers also regarded the existing tax system, which relied heavily on tariffs and other consumption taxes at the federal level and on real estate taxes at the state and local levels, as too regressive. Such a system hits low-income families harder than the rich. The adoption of progressive taxes at the federal level -- with some rates aimed at the very wealthy -- was expected to help correct for the regressive elements elsewhere in the system.

The progressive tax got much more progressive during World War I and World War II. It reached deep into the middle class in World War II, but it hit the wealthiest as well: The top “marginal� rate rose to 94% by the war’s end. (This rate was not as onerous as it sounds. A person would pay the 94% only on the dollars earned in excess of $200,000, a huge income in 1945.) The tax was seen as helping to equalize wartime sacrifice.

Continuing high marginal rates, however, created two major problems. First, the rates created economic disincentives for wealthy Americans to save and invest, and to work. Ronald Reagan made this point by complaining that the 90% marginal rate of the 1940s led him to choose more leisure over making additional movies.

Second, these rates ultimately undermined the goal of broadening the economic base for taxation -- they created incentives for taxpayers to seek lucrative loopholes in the form of special deductions and exemptions. The loopholes in turn created economic distortions (by favoring one form of income or industry over another), made the tax code mind-numbingly complex and weakened the public’s faith in the fairness of the income tax.

These problems prompted major reforms over the years, many focused on reducing the highest marginal rates. None of these reforms, however, challenged the fundamental progressiveness of the rate structure. In 1986, for example, the Reagan administration coupled rate reductions at the top with significant cuts for low-income Americans. One reason for keeping progressivity was that the administration recognized the need to offset the regressiveness of the payroll taxes that funded Social Security and Medicare. Other reforms focused on tax simplification, particularly through the closing of loopholes. The 1986 reforms under Reagan were the most comprehensive and successful.

President Bush has continued Reagan’s program of reducing the top marginal rates, but the president -- like his predecessors since Reagan -- has failed to follow through on the loophole-closing reforms of 1986. The tax code may now be even more complex than it was before those changes. As a consequence, another major reform measure is overdue.

The success of the 1986 reforms in making the income tax economically sounder, fiscally stronger and more equitable ought to encourage the president to stay on that path and reject scrapping the progressive income tax.