From the September 2014 issue of Research Magazine • Subscribe!

The Shriveling of America's Tax Base

The low-tax route to global economic crisis

Historians say that in Europe, the 20th century really began with the outbreak of World War I in August 1914, and that in many ways we still live in the shadow of that conflict. The centennials of various events leading to the war have been marked in recent months, and now battles, military campaigns and other milestones will have their 100th anniversaries in the next four years.

In the United States, the 20th century arguably began almost a year before, in October 1913, with a much less bloody event—when following the adoption of the 16th Amendment, Congress passed a law introducing permanent peacetime income tax. The tax centennial wasn't widely celebrated. When it was mentioned at all, it was in order to complain of the depredations of the IRS. Nevertheless, the introduction of the income tax was when the American Century came into being, with vast global repercussions.

Funding Global Power

The income tax was introduced just in time to finance America's entry into the European conflict in 1917, which helped decide its outcome. Later, it provided resources to fight World War II in Europe and on the Pacific. In the early postwar decades, the income tax helped repay the federal debt, which in 1945 stood at over 100% of GDP, and, more important, it funded the creation of the global economic system based on the dollar and American financial infrastructure, with the Federal Reserve serving as linchpin.

Washington also devised rules of international commerce, spearheading—and largely funding—a slew of institutions needed to expand it. It promoted free trade, free movement of people and ideas and various other aspects of economic integration. At the same time, it supplied the military muscle needed to keep peace. Even today, we see that few conflicts around the world are resolved without active U.S. involvement.

None of it would have been possible if the U.S. had not had the financial wherewithal to be the world leader.

The U.S.-dominated global system first encompassed Western Europe and Japan, which had to be rebuilt after the war. Gradually, over the years, it was joined by countries in the developing world and, after the collapse of the Berlin Wall, by former Communist nations and China. The system proved flexible, accommodating new entrants and bringing unprecedented prosperity to most of them.

Of course it was not done for altruistic motives. The U.S. and its multinationals have been the greatest beneficiaries of the global economic system. The dollar being the only reserve currency, this country is able to pay for its exports in domestic currency, and most commodities, including oil, are priced and traded in dollars. The U.S. can borrow in dollars and run up its current account and budget deficits seemingly without end, allowing Americans to consume much more than they produce, for decades. No other nation can do this with impunity, without running the risk of a massive default.

American companies have benefited from the international economic system by expanding around the globe. The vast majority of most valuable global brands are based in America. The U.S.-led international economic system also has fostered U.S. technological primacy, since most innovative projects around the world are tied to Silicon Valley and U.S.-based funds and markets.

Global economic integration also has been a source of soft power. Since Russia annexed Crimea and began stirring trouble in eastern Ukraine, Washington has been slowly tightening the noose around the Russian financial system with sanctions. Russia faces financial strangulation and economic collapse because it has taken on the U.S. in a Cold War-style confrontation. Meanwhile, China has refrained from acting on its territorial claims against its neighbors, notably Japan, in part because it fears being targeted by similar sanctions by Uncle Sam.

During Europe's mercantilist era in the 16th to 18th centuries, the wealth of nations was measured by the amount of gold they held in their vaults. During the industrial era, it was the tonnage of coal and steel and the quantities of machines they produced. Today, countries become wealthy or poor depending on their ability to produce what the rest of the world wants and to sell it in international markets. National wealth is directly correlated to the openness of a country's economy.

If the global economic system crumbles, the world will be plunged into economic collapse. This will be a near-certainty if the U.S. stops playing an active role on the international scene.

The Tax Revolt

And yet, the withdrawal into its own shell by the U.S. is not such a fanciful notion because the government in Washington, quite simply, is starting to run out of money. The tax revolt, which began innocuously enough in 1978 with the passage of Proposition 13 in California, putting a strict limit on property taxes in the state, spread to the national level with the election two years later of Ronald Reagan, who criticized the “tax and spend” government, and then George H.W. Bush with his famous “read my lips: no new taxes” pledge. While the 16th Amendment remains in place, the tax revolt is returning the U.S. to a semblance of the situation that prevailed before the introduction of income tax.

Over time, the tax revolt has brought about a fundamental change in the way federal operations are financed. Even as a new super-rich class emerged, the top income tax rate, which in the prosperous post-World War II decades stood at 70–80%, dropped into the 30% range. The actual rate is often even smaller: Billionaire Warren Buffett admitted a couple of years ago that he legally pays only 17.5% of his huge income in taxes. His was the lower rate than any of the salaried employees of his firm had to pay. Mitt Romney, multimillionaire presidential candidate, paid just 14%.

Meanwhile, the middle class has been steadily losing ground on the income front. The Commerce Department reported that in 2013 wages and salaries of Americans amounted to 42.5% of GDP, the lowest level since measurements began. As a result, the middle class can't afford to pay enough taxes to sustain the government, shifting the burden of taxation onto higher income brackets. Not surprisingly, the rich feel they are being unfairly targeted and spend their considerable resources to lobby Congress to cut their tax burden.

Corporate profits measured 10% of GDP last year, the highest percentage ever recorded. But businesses paid only 1.6% of GDP in taxes, compared to close to 5% in the 1950s and around 4% in the 1960s. Fortune magazine, a business publication, recently ran a cover story titled “Positively Un-American,” revealing a number of tax dodges used by U.S. corporations to minimize taxes they pay to Uncle Sam. It seems that many multinationals are giving up on the U.S. and so have little interest in funding the U.S. government.

The overall tax take in the U.S., including federal, state and local taxes, amounts to some 25% of GDP, well below comparable levels of other rich industrial nations, despite the fact that America's international commitments and military budget are the world's largest.

Initially, despite being squeezed for revenues, Washington attempted to provide the same level of services to citizens at home while continuing to engage abroad. Budget deficits grew, and the debt burden exploded. Congress began to worry about debt, but has resisted the idea of raising revenues. The result has been sequestration—a 10% across-the-board cut in federal spending, begun March 2013. The Congressional Budget Office now estimates that in the fiscal year ending October 2014, aside from Social Security, health care and interest payments, federal outlays in relation to GDP will be the lowest since it started keeping records in 1940.

In the foreseeable future, this seems to spell doom for America's engagement with the world. Signs of it are everywhere, but the most obvious is the disdain with which Washington is now held everywhere, from Asia to Europe to the Middle East. This is happening at a time when a number of international players are working to undermine the global economic system. If the U.S. fails to hold back the tide, every member of the international community will suffer severe economic damage—but none will be hurt as much as the U.S. economy.

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