Financial History 141 Spring 2022 - Page 36

Library of Congress
Cartoon titled “ No Income Tax !” published in Puck magazine .
“ psychologically prepared to pay ” or some other reason , it is clear they acted quickly . Consider that these high rates became law in October 1917 , and within only a few months over half of the top earners of 1916 simply disappeared from the rolls of top earners of 1918 .
This drop in very high-income returns did not reflect illegal tax evasion ; rather , these very wealthy citizens were engaged in the legal process of tax avoidance . The decline in the number of such returns is also impossible to place at the foot of the economy : The years 1916 – 1918 saw the number of people filing returns and reporting higher wage incomes escalate dramatically , and it was a time when progressives accused rich industrialists of “ war-profiteering .”
A popular method of legal tax avoidance , one familiar to many readers of this magazine , is redirection of investment capital into state or municipal bonds , the income from which is free of federal tax .
The extremely wealthy and / or their advisors clearly figured this out very quickly in 1917 . There was a sharp stock market decline in the fourth quarter of 1917 following passage of the Revenue Act of 1917 with those dramatically higher rates — a drop perhaps traceable to the selling of shares to raise money to pay a big tax bill and the re-direction of capital towards municipal bonds .
The popularity of this method of tax avoidance was such that three years later it dominated the debates over the Revenue Act of 1921 , debates that concerned not whether , but how much , to reduce these high marginal rates . These debates witnessed US senators reviewing calculations aimed at pinpointing exactly how much these top marginal rates would have to decline to reduce the incentive for wealthy taxpayers to invest in “ Munis .” Senator Reed Smoot of Utah approached the question using “ a mathematical calculation ” and arrived at a maximum marginal tax rate of 32 %.
“ The reason ,” he explained , “ is because 32 % is the difference between the income from a tax-exempt security and one that is taxable on the basis of today ’ s money market .” Taxation expert Blakey , in commenting on these 1921 debates , conceded that “ no one paying 73 % or even 58 %… will invest in 6 % or even 10 % taxable railroad or industrial securities so long as 5 % state and municipal tax-exempt bonds may be purchased at par or thereabouts .”
The “ rhyme ” in this fact pattern is that these same calculations are done exactly this way today , albeit with different bond interest and marginal tax rates . According to Investopedia , “ Muni bonds are often a good investment for people with high incomes living in states with high income taxes , such as California .” Tax advisors have also formulated other methods of tax avoidance in response to other tax law changes . The 80 +% marginal rates of the mid-20th century instituted to try to pay for World War II inspired a veritable cottage industry of other “ rhyming ” schemes : passive loss real estate investments , hobby farms , etc . The modern-day tax advisor is not lazy .
A defense of these high rates on high incomes was raised a century ago , just as it is today . A century ago , the argument was made that although collections on income above $ 300,000 had declined , total tax receipts from the wealthy had
34 FINANCIAL HISTORY | Spring 2022 | www . MoAF . org