The Lesson of Wealthy Americans’ Rich History of Dodging Super High Income Tax Rates

MIAMI, FL - APRIL 15:  Armando La Rosa directs people to the Liberty Tax Service office as the deadline to file taxes looms on April 15, 2016 in Miami, Florida.  The Internal Revenue Service moved the deadline from April 15th to Monday the 18th due to the Emancipation Day holiday in Washington, D.C.  (Photo by Joe Raedle/Getty Images)
For relaxing times, make it…tax time? Joe Raedle/Getty Images

As you’ve probably been reminded umpteen times this month (grazie, AOC), the top U.S. income tax rate used to be vastly higher than today’s. It maxed out at around 90 percent during the Eisenhower years and later hovered at 70 percent until Ronald Reagan came around started slashing. Now, it’s a measly 37 percent.

You might also have heard once or twice that the rich rarely paid those astronomical mid-century rates, because the tax code was pocked with large and reasonably easy to exploit loopholes. Many high earners got away with passing off their income as long-term capital gains, for instance, which were taxed at substantially lower rates than wages and salaries. In today’s Wall Street Journal, Laura Saunders offers some fun celebrity examples of such exploits. Donald Trump, it turns out, was not the first president to appreciate creative tax accounting.

The rules defining gains were looser then. In 1948, when CBS offered Jack Benny more than $2 million to bring his radio show to the network, he was able to treat it as capital gain, reducing the tax rate to 25% and saving him perhaps $800,000.

Gen. Dwight Eisenhower also successfully argued that $635,000 he earned from his 1948 memoir, “Crusade in Europe,” should be treated as a capital gain, saving him as much as $400,000 of tax, says Joseph Thorndike, a historian with Tax Notes magazine.

Conservatives often present this history as evidence that there isn’t much to be learned from the eye-popping rates of the 1950s, 60s, and 70s, because the Himalaya-high numbers that appeared in statute were just a mirage. If anything, the argument goes, our mid-century tax system is a cautionary tale that proves high rates lead to tax avoidance. This was one of the animating insights of tax reform during the Reagan years—which was ultimately designed to “lower the rates and broaden the base,” meaning that politicians wanted to bring down the official tax rates while eliminating all of those loopholes and exceptions that had long allowed Americans to avoid actually paying them. (When economists talk about the “tax base,” they’re talking about all the types of income and activity subject to taxation). And to some extent, that’s what happened. From 1980 to 1990, the top federal income tax rate fell from 70 percent to 28 percent. But the average rate that the top 1 percent of earners actually paid on all of their income—including income, sales, payroll, property, corporate, and estate taxes—only fell from 38.5 percent to 34.6 percent, according to historical data produced by economists Thomas Piketty, Emmanuel Saez, and Gabriel Zucman.

I think there’s another way to look at this story, however. The main lesson is not that confiscatory tax rates are a doomed idea guaranteed to produce little but accounting contortions (and, in fact, the very, very rich did pay substantially more of their income to the IRS than they do now). Rather, it’s that in order to make high taxes work, the government needs to plug loopholes that let high earners worm their way around them. In other words, if Democrats ever do get around to their own version of tax reform, they’ll need to raise the rates and broaden the base.

This is really just tax economics 101. When Saez and MIT’s Peter Diamond published their famous 2011 paper showing the optimal tax rate on top earners would be 73 percent, it was meant to apply to what was then the current tax base. (This is something many conservatives have gotten wrong). But they also ran models showing that, depending on the breadth of the tax base, and the extent to which you assume the rich would attempt to avoid taxes in response to higher rates, the optimal number could be anywhere from 54 percent to 80 percent. Raw tax rates tends to dominate headlines. But closing off opportunities for avoidance also matters. Thankfully, tax wonks in Washington are perfectly aware of this. Nobody is looking to create a new generation of Jack Bennys and Dwight Eisenhowers.