This post first appeared on Harvard Business Review's blog, and is posted in conjunction with the publication of the October 2014 issue of the magazine's feature article, "The Rise (and Likely Fall) of the Talent Economy," which can be read in full here.
The changing attitudes toward and laws around income taxes has been a major driver of the rise of America's modern talent-based, knowledge economy.
Two things strike me as I study the history. First, it is hard to see the historical development of US income taxation as a gradual evolution. Rather, it is characterized by major swings. Second, it is interesting to see a very consistent cycle in the tax treatment of the super-rich. I think that today we are approaching an inflection point. Unless we do something about the current set up, the tax system may end up as a major factor in the fall of that talent economy.
As I see it, the tax system has moved through four distinct eras over the last century and a half. During each era, government and society subscribed to a theory about what taxes were for, which was eventually replaced by another theory, flipping us into another era. Let's look at how the pendulum has swung and how the treatment of the super-rich has changed. All the data is from the very handy Tax Foundation website. I have inflated all the incomes to 2013 dollars to make comparisons more easily understood.
The First Era: 1862-1915
From its inception in 1862 and up to 1915, personal income tax was not unlike a modern-day state sales tax: a percent or two of income, with richer folks paying a slightly higher level. For example, in 1915 a $1 million earner paid income tax at a 2% rate. Like a sales tax, income tax was seen primarily as a revenue earner and not as a tool for influencing behavior. It was only mildly progressive: the rate was 1% on incomes up to about $450,000. In this era, the rich (e.g., $1 million earners) were taxed exactly the same as the super-rich (e.g., $10 million earners).
The Second Era: 1916-1931
In 1917, with the First World War at its height, Congress passed the War Revenues Tax Act, which changed thinking about personal income taxation dramatically. The new theory was that personal income tax could fund the war effort. And within that funding, rich people could and should pay more -- and the super-rich much, much more.
Under the new Act, rates skyrocketed: a $1 million earner paid a 16% rate and the top marginal rate, which kicked in at $36 million, was a hitherto unimaginable 67%. A year later the rates went up still further: 43% for the $1 million earner and a 77% top rate kicking in at a $15 million income level.
After the war ended, rates drifted back down (the top rate went down to 25% in 1925) though the prewar rates were gone forever. But interestingly, the level at which the top rate kicked in fell all the way to $1.3 million by 1925. So although there had been a meaningful distinction between the rich and super-rich during the height of the war, after the war, they were all lumped together and the $36 million earner, who in 1918 had paid at a rate over four times that of the $1 million earner, was paying at the same rate in 1925-1931.
The Third Era: 1932-1981
The Great Depression precipitated the next big swing. The rate for $1 million earners shot up from 22% to 35% in one year between 1931 and 1932 and the top rate from 25% to 63%. Within just a dozen more years (1944) those rates were 84% and 94% respectively, with the top rate kicking in at only $2.6 million. At those rates, the average present-day mid-level investment banker would be giving the federal government all but 6 cents of his/her last dollar earned, which would seem to us to be a huge disincentive.
But in the third tax era, income of that scale was not typically assumed to something you could earn by working; it was something you derived by virtue of owning a particular asset, and earning from that asset what the economists call a "rent." According to the theory, most rich people were basically rentiers and their income from owned assets could -- and should -- be taxed at very high rates with no adverse impact on their behavior or the economy.
Financing WWII could have been used as an excuse for these highly confiscatory rates, but rather than dropping after the end of war, they continued to rise. By 1963, the $1 million earner was paying 89%. So in the mid-1960s, anybody in America that would be considered reasonably rich was keeping a mere 10% of marginal earnings -- and that is before paying all state, municipal and indirect taxes; with all of those added in, they probably kept less than 5 cents on the extra dollar.
From about 1960, however, the economy began to change, as I describe in this HBR article, with an increasing proportion of earnings and wealth being tied to value created by way of the exercise of talent through work. With this change there came a growing awareness that 90% personal income taxation had a disincentive effect. Between 1963 and 1981, therefore, the rate on a $1 million earner slid from 89% to 70%. But, somewhat paradoxically and echoing the 1920s, the level at which the top rate kicked in plummeted to $272,000 -- meaning that by 1981 virtually everyone who was upper-middle class or above paid the top marginal rate. There was no longer a distinction of any meaningful kind between rich and super-rich.
The Fourth Era: 1982-Present
It was not until the 1980s, by which time the idea that the economy was knowledge driven had firmly taken hold, that our lawmakers finally abandoned the prewar assumption that all rich people were rentiers and recognized that at the prevailing rates talented people were being put off work. Instead, the new theory was basically that all income should be considered to be the product of exercising talent and that people should be taxed less so that they had a motive to work.
But with the abandonment of the rich-as-rentier concept, lawmakers no longer drew a distinction between the rich and other folks, making it easier to justify reducing tax thresholds to compensate for falling rates. This is exactly what happened: in 1982 the top rate dropped to 50% but kicked in at $101,000. By 1988, it had fallen to 28% and kicked in at $29,000, which meant that America effectively had a flat tax of 28% (the 15% rate for incomes below $29,000 would have applied to very few fully employed Americans). Since then the top rate has drifted up to 39.6%, kicking in at $220,000. But the progressivity of the system is still extremely modest.
Towards a Fifth Era?
A quick look at this brief history dispels a common misperception among American Baby Boomers, Generation X's, and Millennials who all think the current system is "the way America taxes" because it is the only thing they have ever known. It is actually a modern phenomenon -- a product of the most recent theory change, in this case from a rentier theory, in which economic growth is seen as the product of exploiting assets, to a talent theory in which growth is driven by the exercise of talent and the application of knowledge.
The history also demonstrates that the current system of equal treatment of the rich and the super-rich (and in this case also of the same as the upper-middle class) is not typical or normal. Rather, it happens to be at one of the two poles across which the system has oscillated over history.
So will the current system endure? I think not. In times of crisis, America has shown that it asks the super-rich to pay a lot more than the rich and I think this will happen based on the feeling that it is a time of economic crisis in America. Also, although applying a rich-as-rentier theory (implying tax rates in the 70% plus range for high incomes) isn't really fit for purpose in a talent-driven economy, it's also not justifiable to have a maximum rate that doesn't distinguish between a mid-level executive and a hedge fund manager.
My bet is that the Fifth Era will look a lot like the early Third Era -- after the height of the Great Depression but before the inception of WWII. That is, $10 million earners paying in the 75% range, $1 million earners in the 50% range and $500,000 earners in the 35% range.
How high or low the rates of the Fifth Era structure will be will depend, I think, on whether talent is seen as engaging primarily in trading value or primarily in creating value for their fellow citizens (in terms of better products and services and more jobs). If it is the former, they will be taxed more highly as unworthy rentiers and there will be little concern for incentive effects. If the latter, they will be taxed as important economic assets whose incentives must not be dampened. Right now, sentiment is trending more in the former direction than in the latter -- a perception that the talented people on the Forbes 400 list have done little to dispel.
To read "The Rise (and Likely Fall) of the Talent Economy," click here.