How Supply Side Economics of a Low Tax Regime Pushes Down Wages

Henry C.K. Liu
This article appeared in AToL on December 15, 2009 and on NewDeal 2.0 on December 16, 2009


In recent decades, an intuitive myth has been pushed on the unsuspecting public by Supply Side economists that low taxes encourage corporations, employers and entrepreneurs to create high paying jobs. But the counterintuitive historical truth is that a progressive income tax regime with over 90% for top bracket incomes actually encouraged management and employers to raise wages. The principle behind this truth is that it is easier to be generous with the government’s money.
In the past, when top corporate income tax rate was at over 50% and personal income tax rate at over 90%, both management and employers had less incentive to maximize net income by cutting cost in the form of wages. Why give the government the money when it could be better spent keeping employees happy.
The Reagan Revolution, as inspired by voodoo Supply Side economics, started a frenzy of income tax rate reduction that invited employers to keep wages low because cost savings from wages would produce profits that employers could keep instead of having it taxed away by high tax rates.
It follows that the low income tax rate regime leads directly to excess profit from stagnant wages which leads to overinvestment because demand could not keep pace with excess profit due to low wages. Says Law on “supply creating its own demand”, which Supply Side economists lean on as intellectual premise, holds true only under full employment with good wages, a condition that Supply Side economists conveniently ignore.  To keep demand up, workers in a low wage economy are offered easy money in the form of sub-prime debt rather than as paying consumers with living wages, creating more phantom profit for the financial sector at the expense of the manufacturing sector. This dysfunctionality eventually led to the debt bubble that burst in 2007 with global dimensions.    
The State Theory of Money (Chartalism) holds that the acceptance of a currency is based fundamentally on a government’s power to tax. It is the government’s willingness to accept the currency it issues for payment of taxes that gives the issuance currency within a nation. The Chartalist Theory of Money claims that all governments, by virtual of their power to levy taxes payable with government-designated legal tender, do not need external financing and should be able to be the employer of last resort to maintain full employment. The logic of Chartalism reasons that an excessively low tax rate will result in a low demand for the currency and that a chronic budget surplus is economically counterproductive because it drains credit from the economy. The colonial administration in British Africa learned that land taxes were instrumental in inducing the carefree natives into using its currency and engaging in financial productivity.

Thus, according to Chartalist theory, an economy can finance its domestic developmental needs to achieve full employment and sustainable optimum growth with prosperity without any need for foreign loans or investment, and without the penalty of hyperinflation. But Chartalist theory is operative only in closed domestic monetary regimes.
Countries participating in free trade in a globalized system, especially in unregulated global financial and currency markets, cannot operate on Chartalist principles because of the foreign-exchange dilemma. For a country participating in globalized trade, any government printing its own currency to finance domestic needs beyond the size of its foreign-exchange reserves will soon find its currency under attack in the foreign-exchange markets, regardless of whether the currency is pegged to a fixed exchanged rate or is free-floating. The only country exempt from this rule, up to a point, is the US because of dollar hegemony. (Please see my April 11, 2002 AToL article: Dollar Hegemony)
Thus all economies must accumulate dollars before they can attract foreign capital. Even then, foreign capital will only invest in the export sector where dollar revenue can be earned. Thus the dollars that Asian economies accumulate from trade surpluses can only be invested in dollar assets in the United States, depriving local economies of needed capital. This is because in order to spend the dollars from trade surplus, the dollars must first be converted into local currency, which will cause inflation and unemployment because the wealth behind the new local currency has been shipped overseas. The only protection from such exchange rate attacks on currency is to suspend convertibility, which then will keep foreign investment away.
The Income Tax Regime
The United State did not have an income tax for the first 133 years of its existence. Government revenue came from protective tariffs on imports. Corporation income tax was first adopted in 1909 while personal income tax was first adopted in 1913.
Corporate income brackets are not directly comparable over time because the definition of “income” changes over time due to revised tax laws, changing accounting practices, and structural changes in the economy such as globalization of trade and finance, and the corporate taxpayers’ ever-growing sophistication in legal tax avoidance. Thus the calculation of actual tax burdens on the economy or effective tax rates is a highly complex undertaking.
The principle of taxing corporations as legal persons separate from their shareholders was established by the Revenue Act of 1894 in which definitions of taxable income and tax rates were applied to the corporation without regard to the status of its owners. The Civil War era (1861-1865) tax acts had taxed corporate income on the owners through the individual income tax. The 1894 Revenue Act was ruled unconstitutional by the Supreme Court, but the principle survived after a technically constitutional way of taxing corporate income was enacted by Congress in 1909. When the individual income tax was revived in 1913 after the 16th Amendment removed all question of constitutionality, a separate corporation income tax was kept parallel to it. This tax structure has remained to this day.
A rational contradiction exists between the corporation income tax and the individual income tax, because corporations, legal person in the eyes of commercial law, are owned, directly or ultimately indirectly, by real person individuals who immediately or ultimately receive an entitled share of the corporations’ net income. This can result in the same income being double taxed, and various ways of lessening this irrationality have been included in the tax system. And if a corporation is partly owned by other corporations, the question of multiple taxations arises.
The “double taxation” burden are reduced at times by allowing corporations to be pass-through entities that are not taxed, allowing deductions or credits for dividends, and reducing the rates on capital gains separate from income. Different corporate and individual tax rates can also result in opportunities to shelter income from tax through rate and bracket arbitrage, especially if corporate tax rates at a given income bracket are lower than those faced by the owners.
From the beginning of the income tax regime, there were restrictions or compensatory taxes on excessive accumulations of undistributed corporate profits and special rules and rates for individuals who incorporate to avoid high taxes. Another problem with imposing a corporate tax is that the corporate form is used for many different kinds of entities, ranging from ordinary for-profit businesses to religious, charitable, and other nonprofit organizations. Organizations not organized or operated for profit were originally exempt from the corporate tax, and those devoted to religion, charity, education, and other goals deemed socially desirable as specified in Internal Revenue Code section 501(c)(3)) still are. However, by 1950, otherwise exempt organizations were made subject to the ordinary corporate tax rates on business income unrelated to their exempt purposes.
In finance, the line separating mutual and cooperative organizations from for-profit businesses often cannot be clearly drawn. Mutual savings institutions were made taxable in 1951, except credit unions, which are still tax exempt, but paid little tax until their reserve deductions were revised in 1963. Mutual insurance companies have always been subject to tax, but usually under special rules. Even now, mutual property and casualty companies with annual premiums of under $350,000 are tax-exempt, and those with premium income between $350,000 and $1,200,000 are taxed only on investment income. Rural electrical and telephone cooperatives are not taxed on member income; other cooperatives are subject to the regular corporate rates but are allowed to deduct distributions to members which are taxed at individual rates to members. Regulated investment companies such as mutual funds and real estate investment trusts (REIT - pooled real estate investment funds) are subject to the corporation income tax, but are allowed to deduct income allocated to shareholders if they allocate virtually all of their incomes. The most prevalent organization that avoids the corporation income tax, however, is the “S corporation” (named for the subchapter of the Code that defines it).
Since 1958, closely held companies meeting certain other restrictions could avoid paying the corporate tax by electing to allocate all income to the shareholders, who are then taxed on it at individual tax rates. More than half of all corporations now file as S corporations.
The treatment of affiliated groups of corporations has also been a problem. Corporations that own each other or are subject to the same ownership or control (defined in various ways over the years) have been subjected to several different tax regimes. They have variously been required to consolidate their income statements for tax purposes (1917-1921), forbidden to do so except for railroads and a few other companies (1934-1941), allowed the option but required to pay at a higher tax rate (1932-1933, 1942-1963), and allowed the option without penalty (1922-1931, 1964 to the present).
The history of corporate tax rates from 1909 to 2002 as applied to whatever the then-current definition of “taxable income” was so complex in the definition of the income base that a given tax rate from one year is not necessarily comparable to that for another, especially for widely separated years. Initially, the tax was generally imposed on corporate profits as defined under general accounting principles. Tax rules quickly diverged from accounting rules, however, since it was clear that the goals of the two systems were not the same. Accounting rules guard against the temptation to overstate income, while tax rules must guard against the desire to minimize income. The tax law now includes very specific definitions of many items of income and deductions, and many pages specifying when and how to account for the items; and many of these definitions and specifications have changed so dramatically over the years that even experts disagree on proper interpretation.
The deduction for the depletion of oil and gas deposits is an example. It was first included as a tax-defined deduction in 1913 which allowed the producer of any mineral a “reasonable” deduction not to exceed 5% of the value of the deposit. In 1918, as a war measure, a specific deduction for oil and gas deposits was enacted as “discovery value” depletion, which allowed deductions far in excess of the value of the deposit. This was limited to a percentage of net income from the property in 1921 (100%) and 1924 (50%). In 1926, discovery value depletion was replaced by a deduction of a flat percentage of net income from the property (27.5% from 1926 to 1969). In 1969, the percentage was reduced to 22%, and, in 1975, percentage depletion was repealed for all except smaller “independent” producers, for whom the rate was reduced to 15%. The rules were tightened further in 1986 and liberalized again for “marginal” production in the 1990’s. Obviously, attempting to determine the actual tax rate on oil and gas income over the years is a challenging task.
Interpreting the historical tax rates is further complicated by the use of tax credits and the possibility of additions to tax. Credits are direct deductions from the tax figure calculated by the stated rates and are, thus, in reality a reduction in the tax rate. For example, credit for taxes paid to foreign governments has been allowed since 1918. Before that, they could be taken as a deduction in computing taxable income. Credits for various investments and for other policy goals were introduced in the 1960’s and have continued to the present; in 2002, there were more than a dozen credits that could reduce the stated tax rate. Because they interact with one another and with other features of the tax system, it is not even possible to estimate what the tax rates would be if they were taken into account. Finally, there are additional taxes that affect these rates. The general ones, such as the excess profits taxes or the separate tax on capital gains which could have reduced the rates, and the ones applying to significant classes of taxpayers, such as “personal holding companies” or “personal service corporations”.
In the Tax Reform Act of 1986, Congress lowered the top corporate income tax rate from 46% to 34% the largest reduction since the tax was enacted in 1909. The top rate was 53% for income over $25,000 from 1942 to 1949.
Corporate Income Tax Rates from 1993 to 2002:
$15,000,000-$18,333,333 bracket - 38 %
Over $18,333,333 bracket - 35%
Foreign Corporations:
Companies incorporated outside the U.S. are taxed on business income earned in the U.S. at the regular corporate rates, but may be taxed on investment income at special statutory or treaty rates.
US Corporations with Foreign-source Income:
The US taxes the worldwide income of US corporations; however, since 1918, taxes paid to foreign governments on foreign-source income can be credited against the US tax otherwise due on that income. Before 1918, the foreign taxes were allowed as a deduction against worldwide income.
US Possessions Corporations:
Since 1921, corporations earning most of their incomes in a U.S. possession were subject to reduced taxes. From 1921 to 1976, they were taxable only on U.S.-source income; since 1976, they have received a credit for manufacturing income earned in a possession (including Puerto Rico). The credit is now being phased out and is scheduled to end after 2005.
Affiliated groups:
Corporations that are closely affiliated through stock ownership have usually been allowed to consolidate their financial statements for tax purposes and file one return for the group, but there have always been restrictions and, sometimes, they have been charged an additional tax for the privilege. In 1932 and 1933, consolidated returns were subject to an additional tax of .75 percent. In 1934 and 1935, only railroad companies were allowed to file consolidated returns, and the additional tax was 1 percent. From 1936 to 1941, there was no additional tax, but the privilege was restricted to railroads and a few other companies. From 1942 to 1964, most domestic affiliated groups that met the stock ownership and other requirements could file consolidated returns, but the surtax on such a group was increased by 2 percentage points. The additional tax on consolidated returns was repealed, effective December 31, 1963.
The most important type of income to have received special rates was "long-term" capital gains. From 1942 through 1987, the tax rate was capped at a maximum rate lower than the highest corporate rate. Although there is currently no special rate for corporations’ capital gains, long-term capital gains are still treated separately from other income in the tax code. The tax rate on long-term gains was reduced in 2003 to 15%, or to 5% for individuals in the lowest two income tax brackets. Short-term capital gains are taxed at a higher rate: the ordinary income tax rate. The reduced 15% tax rate on eligible dividends and capital gains, previously scheduled to expire in 2008, has been extended through 2010 as a result of the Tax Increase Prevention and Reconciliation Act signed into law by President Bush on May 17, 2006 (P.L. 109-222). In 2011 these reduced tax rates will “sunset,” or revert to the rates in effect before 2003, which were generally 20%. President Obama's budget, announced on February 25, 2009, calls for the Capital Gains Tax to be reverted to the 20% rate before the Sunset date of 2011.

During World War I, the Great Depression, World War II, and the Korean War, additional taxes were imposed on what were called “war profits” or “excess profits.”
Taxes on Undistributed Profit
In addition to taxes based on net income, there have been from time to time taxes based on accumulated earnings that were not distributed to shareholders, designed to limit tax avoidance at the individual stockholder level. Taxes on “undue” accumulations have been imposed (though seldom paid) since the inception of the income tax. These were supplemented, since 1934, by a “personal holding company” tax, equal to the highest individual income tax rate, on the undistributed earnings of closely held companies accumulating investment income. There was also a Depression-era tax on accumulated earnings.
History of Personal Income Tax
When the personal income tax was introduced in 1913, the top bracket was 7% for income over $5,000. By 1918, the top rate had risen to 77% for income over $1,000,000.
In 1921, the administration of Warren Harding lowered the top rate to 58% for income over $200,000. A year earlier, under Woodrow Wilson, income over $200,000 was taxed at 68% while the top rate was 72% for income over $1,000,000. In 1924, the administration of Calvin Coolidge lowered the top rate to 46% for income over $500,000. In 1924, the top rate was dropped sharply to 25% for income over $100,000.  This rate stayed unchanged until to produce the Roaring Twenties of sizzling speculation on margin while wages stagnated that ended in the crash of 1929.
In 1932, the top rate rose back to 63% for income over $1,000,000 and the rate for income over $100,000 was raised to 56%. It was academic because very few people had income of these brackets. In 1936, the top rate was 79% for income over $5,000,000 while the rate for income over $1,000,000 was raised to 77%. But there was no employment and no corporate profit to make a difference until the war started after Pearl Harbor on December 7, 1941. Until the war started people were willing to work just for food so there was no demand for goods to produce corporate profit.
In 1941, the top rate was raised to 81% for income over $5,000,000. In 1942, to help pay for the war, the top rate was raised to 88% for income over $200,000 in a wartime price control regime. In 1944, the top rate was raised to 94% for income over $200,000. In 1946, the top rate was lowered to 91% for income over $200,000. The post war economy took off to produce a new middle class as the majority of the population. There were waiting lines, not at the unemployment offices, but long waiting lists for new cars and houses and television sets.
In 1955, the top rate was 91% for income over $400,000 to adjust for inflation with a median income of $3,358. That rate stayed until 1966 when it was lowered to 77% for income over $400,000 with a median income of $5,306. In 1965, the top rate was lowered 70% for income over $200,000. That rate stayed until 1982 with minor rise in the top bracket to income over $215.400. The period between 1965 and 1982 was the gold years of US economy, with high employment and high consumption, a period when guns and butter was both in ample supply.
In 1982, the top rate was lowered to 50% for income over $85,000 with a median income of $13,950, while the $85,600 bracket was taxed at 59% a year earlier. In 1987, the top rate was lowered to 38.5% for income over $90,000. In 1988, the top rate was lowered to 33% for income over $71,900 and 28% for income over $149.250. In 1991, the top rate was lowered to 31% for income over $32,000 with a median income of $20,469. In 1993, the top rate rose to 39.6% for income over $250,000. In 2003, the top rate fell to 35% for income over income over $311,950.  In 2009, the top rate is 35% for income over $372,950 with a median income of $33,168.

Wages began to stagnate as the tax on top icome bracket fell, while the financial elite was keeping luxury goods maker busy by using the pension fund of worker to move jobs to low wage economies overseas. As American workers marvel at the low price import at Walt Mart, and their pension funds were giddy with high returns, their own jobs at home are disappearing as the wages and benefits ofr those still working fall below living wage levels  

The average American wage earner has very little reason to support a lowering of the top rates in a progressive income tax regime if they understand that employers would rather give tax savings to employees in higher wages than pay high taxes to the government, given the same after-tax net profit.
But the Wall Street Journal or CNBC would never tell workers that basic truth. Rather, workers are told that high taxes lead to high unemployment to scare wage earners into voting for still lower progressive rates that only benefit those who have been oppressing workers with the workers’ own pension money.
December 10, 2009