The Top Federal Tax Rates: Real Perspective

Author: Vale

Historical top tax rates

The main fight of the fiscal cliff was taxes. Obama and the Democrats wanted to raise taxes on those earning more than 200k per year ($250k for families), while Republicans wanted to extend current rates for everyone.

The main argument on the left is that tax rates are historically low and that they should be raised to bring them up to historical standards. Why this should be the prime reason to raise rates is unclear (especially when most of the taxes paid in this country are already on the backs of the highest earners). Firstly, it is naive to assume that because something may have worked out okay in the past that it would work out again in today's economy. Tax rates don't exist in a vacuum as the world has changed a lot through the various decades of the past. World War I and II stimulated economic activity since most of the battling took place overseas, in the 1970s we had the OPEC crisis and stagflation, and in the 1990s, we had the technology internet bubble, for a few examples. Secondly, the federal tax code is a Swiss cheese moving target that seems to change almost every year. It would be a monumental task to pin down what tableIa hypothetical earner's effective tax rate would be, after factoring in all deductions and credits, across different decades since old ones go away and new ones come into existence every few years depending on what lobbyists can get stuffed into bills (for the same reason, you really cannot compare across countries without a plethora of information on deductions being offered across them all). However, what is important is the marginal tax rate because decisions are made on the margin and unless a project comes with additional tax deductions for undertaking it, the marginal tax rate applies to each additional dollar earned. For instance, if one is going to develop a new apartment building, unless building it comes with some new tax deductions that offset the costs, the return on investment is going to be net after the marginal tax rate.

So, back to the point of the article. Most people only seem to focus on the top rate, such as the cartoon pictured above. However, this is an apples-to-oranges comparison because the top rate is only part of the information. I previously mentioned the deductions and credits available in any given year, but there is even a more direct component to the tax rate: what level of income that rate applies to. The way the media commentators talk about it now is akin to telling someone how much their speed just increased while driving. If I tell you your speed just increased 25%, it is only helpful if you know what your speed was before the increase. Similarly, it is only helpful to know what income level a top rate applied to when you are comparing across tax regimes. Also not usually mentioned are the top tax rates that were in effect before the 77% top rate took effect (is discussed below). By omitting both pieces of information, I believe this is the media's attempt to condition their viewers with a narrative about what are acceptable top rates (Although I still find it puzzling that it is acceptable for the government to take as much as they currently do from the producers that earn it, let alone the rates of the past).

Let's walk through a sample of the tax rates since the early 1900s. So, what you will notice in the table to the right is that the top tax rates have been dropping, but so has the tax bracket, so that the top rate has been affecting more and more of America's income. Before 1913, taxes were sporadic and they came and went depending on what war's debt needed to be paid off. At the time, the government collected most of its revenue with tariffs. In 1913, after the 16th Amendment was passed, the top tax rate was 7.0% on income over $500,000. After you adjust that for inflation (CPI) that 7% applied to income over $11,558,081. This is a recurring theme here: those 80% and 90% often touted rates applied to millions of dollars of income.

Taxes became exceptionally high during the inflationary period of the 1970s-1980s. For example, in 1982, that 50% rate applied to $98,417 of inflation adjusted income. The US went through a period of stagnation around this time, and it wouldn't be a surprise to learn that excessively high tax rates played a role here, even though many factors were at play. Luckily, the Tax Reform Act of 1981 added a reform that caused the tax brackets to be indexed to inflation. However, because inflation was so high during the period prior to indexation, the bracket creep was very severe and led to the modern era of high taxes on low dollar amounts. The Tax Reform Act of 1986 attempted to alleviate this problem by dropping the top rate to 38.5% initially and then to 28%, but the damage was done and it has become acceptable to tax away more of each American's earnings since is has become the norm over the last 30 years (and now the government is completely dependent on this revenue).

There are a few odds and ends worth mentioning. Clinton introduced the marriage tax penalty with the tax increases of 1993. No longer did having two married earners mean that their tax brackets were double the single earner brackets. Obama wants to continue this penalty by raising taxes on singles making $200k or more and married families making $250k or more (Update: Fiscal Cliff deal $400k and $450k). Another fact is that over all these different tax regimes and over all these different economies, the tax collected as a percent of GDP has always hovered around 15-20% since 1945. This is known as Hauser's law. You can raise taxes to penalty levels, but all you are going to get is reduced economic activity. Furthermore, a question that needs to be asked is how the definition for being rich started revolving around earnings of $200,000 per year? Take a sample of those earning such salaries and find out they mostly live in New York, Boston, Chicago, San Francisco, Los Angeles and Seattle and other high priced cities where $200,000 a year doesn't go nearly as far as the average city in the US. And finally, don't forget that Clinton's $250k bracket would be worth $379k today after adjusting for inflation, which is what the top rate currently applies to. 

This article is only analysis on the federal income tax and that there are a multitude of other taxes that have been introduced over the last century. Tack on Social Security (where the rate has increased several times since its introduction), Medicare, Medicaid, state, county, city, sales and property taxes [among the various other not so obvious taxes or 'fees' slapped all over our commerce]. At the margin, 40% becomes 60%. Does anyone really think that the government is better at spending 60% of their earnings than they are?


# Gohn Jalt 2013-10-29 14:50
Another factor was that there were so many exclusions, the effective tax rates were quite low by comparison. Total tax revenue as a percentage of GDP wasn't much different from today.

The rates were so high, people simply moved money and activity to take advantage of the exclusions. If you eliminate the exclusions, they just move production and investment to friendlier countries.
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+2 # Z 2013-01-10 11:46
This is good information. It shows that the government has been conditioning people to accept and expect higher taxes. Especially higher taxes on other people.
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