Retirement and Social Security Reform
Revisiting 'Scientific Tax Reform': How To
Tax Smarter, Not Heavier
Investor's Business Daily
April 12, 2005
By Ernest S. Christian
The task before President Bush and his Tax Reform
Advisory Panel is similar to the one faced by the Treasury
Department in 1920 shortly after enactment of the first federal
income tax: how to raise the requisite amount of tax revenues
while interfering the least with the ability of the economy
In other words, taxing smarter instead of heavier.
Today, tax reform is focused primarily on correctly defining
income and assuring that it is taxed only once. In 1920, Treasury's
experts were searching for an optimal tax rate. They called
their project "Scientific Taxation" in the belief
that it is possible to determine the precise point at which
economic growth and tax revenues are in perfect harmony.
Their more immediate task, however, was to lower high World
War I tax rates that were about to kill the emerging industrial
At the same time, they had to keep rates sufficiently high
to satisfy Republicans who wanted to pay off the debt from
WWI. They also had to satisfy the ideological demands of the
Progressives who wanted to tax savings and investment as heavily
Ultimately, Treasury Secretary Andrew Mellon succeeded in
getting the wartime tax rates lowered enough to permit the
economy to grow. (The British, in contrast, nearly destroyed
their economy by continuing wartime tax rates unabated.)
A new study by Susan Murnane at Case Western Reserve credits
the Treasury's efforts to sell its modest tax cuts in the
1920s with having begun the process of educating the public
and politicians about the workings of modern capitalism and
the interaction between it and the newly enacted federal income
Taxed Like A Capitalist
Since in those early days the income tax applied only to
big corporations and the wealthy, the Treasury had the task
of explaining that because high taxes on capital harmed the
economy (costing jobs and reducing productivity), they were,
in reality, taxes on the "working man."
Sounds simple and obvious, but it was not obvious at the time.
To many politicians, the economics of taxation remained a
mystery for many more decades.
The anti-capital attitudes of the Progressives continued to
be the dominant characteristic of the income tax - which soon
became nearly universal, applying to the working man as well
as to the capitalist.
Even though the average American was taxed like a capitalist,
the tax code made it very hard for him to become one. High
tax rates in combination with double taxation of savings kept
millions of Americans from accumulating wealth of their own.
Grossly inadequate depreciation allowances for the cost of
capital equipment made it difficult for small-business entrepreneurs
to expand. Nevertheless, the number of capitalists did increase
substantially and, as that occurred, the economic class distinctions
upon which the tax code's anti-capital bias depended began
Scientific tax reform reasserted itself in 1960, this time
with strong popular political support.
In an attempt to rescue the economy from 91% tax rates and
a dangerous decline in business capital investment, President
Kennedy increased depreciation deductions, got Congress to
enact an investment tax credit and promised across-the-board
tax cuts. He explained the economics of taxation in a way
that sounded much like Andrew Mellon in the 1920s: "The
tax deterrents to private initiatives have too long held economic
activity in check."
By the time of President Reagan's "supply-side"
revolution in 1981, scientific taxation had changed from being
an effort to save the economy from decline and became a calculated
effort to achieve higher levels of economic growth by lowering
tax rates and removing the anti-capital biases that had characterized
the tax code from the beginning.
Overall, up through the tax cuts in Bush's first term, tax
rates have been reduced to 35% from 91%, capital gains tax
rates have been reduced to 15% from 28% and corporate tax
rates have been reduced to 35% from 52%.
In addition, depreciation allowances for capital equipment
have been improved four times, to the point that first-year
expensing is within reach.
Indeed, starting in 2001, partial first-year expensing was
allowed for a temporary period during which time business
capital investment increased at an phenomenal rate. So did
corporate profits and tax collections, proving yet again the
advantages of taxing smarter instead of heavier.
Low marginal rates of tax and first-year expensing are now
fundamental components of nearly all tax-reform proposals.
Bush and his advisory panel have a historic opportunity to
complete the growth-oriented tax reform legacy of Reagan.
Bush can also create his own tax reform legacy by taking the
third critical step in the long march of tax reform - removing
the double tax on saving.
More personal saving will promote economic growth and help
create the "ownership society" he envisions.
Even after the income tax was expanded to reach the working
man as well as the rich, the anti-capital bias that permeated
the early tax code led to the deliberate double taxation of
Not Free To Save
The first small measure of relief from double taxation did
not occur until the 1950s and was strictly limited to savings
through highly regulated employer-sponsored pension and profit-sharing
In the 1970s, relief from double taxation was expanded to
include savings in IRAs, Section 401(k) plans and other similar
arrangements, although always highly limited in amount and
restricted to retirement savings. Most recently, Congress
has also granted relief for small amounts of savings to pay
for education and medical costs.
But Americans have never been allowed the freedom to save,
without tax penalty, for whatever purpose they wish, in whatever
amounts they wish and for however long (or short) a time they
And the country has never been allowed to experience the burst
of economic growth that such freedom can spawn.
Once again, as in the 1920s, it is time for the administration
to launch a public educational campaign to explain to the
American people how they themselves will benefit from tax
Fortunately, the educational task should be much easier than
it was in the 1920s. As a result of the proliferation of IRAs
and 401(k) plans, large segments of the U.S. population have
had personal experience with savings that are free of double-taxation
and will understand how the freedom to save for any purpose
without tax penalty can boost their personal wealth.
Moreover, 54% of American households own stocks, directly
or through pension funds, and thus have a personal stake in
the fortunes of business corporations - many of which will
be able to operate more productively after tax reform allows
first-year expensing for new capital equipment.
Finally, a new generation of upwardly mobile younger Americans
- better educated than prior generations and more comfortable
with the concept of themselves as budding capitalists - should
be particularly receptive to tax reform that promises them
the chance to participate in a new era of economic growth.
With broad public support, Bush can achieve what tax reformers
have sought for three-quarters of a century - a tax code that
promotes, rather than retards, economic activity.
Christian, a former Treasury tax official, is director of
the Center For Strategic Tax Reform in Washington. The
first five parts of this series appeared on Feb. 1, Feb.
15, March 1, March 15 and March 28.