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Tax History: McKinley’s Tariff Gave Us Income Tax; Will Trump’s Lead to VAT?

Posted on Sep. 2, 2019

The 20th-century income tax emerged from failures of 19th-century tariffs, including the highly protectionist McKinley Tariff of 1890. The regressive burden of post-Civil War import duties helped fuel the fires of political reform, resulting first in the ephemeral income tax of 1894 and later in the permanent tax of 1913.

Which raises a question: Will the Trump tariffs produce a similar overhaul of the federal revenue system? If Americans sour on President Trump’s pugnacious approach to international trade, will that open the door to meaningful tax reform? Might it pave the way for something like the VAT?

As always, the smart money is on “maybe.” But there are reasons to think that tariffs might play a role in driving fundamental tax reform.

Some Caveats

Whether tariffs will again serve as a catalyst for fiscal reform depends on a few problematic assumptions, starting with the validity of the comparison itself. Turn-of-the-century lawmakers used progressive income taxes to compensate for regressive tariffs. Our hypothetical question, by contrast, presumes that Congress might respond to a regressive tariff by enacting a regressive consumption tax. How does that make sense?

Fair enough. But the comparison works better if we treat both the income tax and the VAT not simply as tools for redistributing the tax burden, but also as policy responses to political discontent.

In this view, it’s the discontent that matters most, not the solution used to defuse it. My question is whether discontent (and in this case, discontent with tariffs) might play a catalytic role, shaking loose the ossified structures of an entrenched revenue regime.

Catalysts are crucial to tax reform, given the reality of fiscal inertia. And they’re also rare. Historically, wars have typically played the role, both in the United States and elsewhere; pressed for money to support armed conflict, nation-states have deployed new revenue tools in rapid bursts of fiscal innovation.

That process, however, seems unlikely to recur, at least anytime soon. By and large, wars aren’t fought the way they used to be; although still expensive, they are less expensive (in terms of money) than they were 75 years ago. World War II was the last conflict to test seriously the revenue capacity of the federal tax system. Since then, policymakers have managed to fight a series of major conflicts without significantly changing the tax system.

If a war-driven revenue shortfall seems unlikely to prompt a fiscal watershed in modern America, that doesn’t mean change is impossible. Other crises might prompt radical restructuring of the tax system, including a major economic downturn. Arguably, that has already happened once; historian W. Elliot Brownlee has contended that the Great Depression actually served as a fiscal catalyst, upending the tax regime that had dominated American politics from the start of World War I through the beginning of the New Deal. Again, it was a fiscal imbalance that prompted change, but that time it was driven by a drop in tax revenue rather than a war-induced surge in spending.

Downturns, however, aren’t the catalyst they once were. The Great Recession of 2007-2009 prompted no especially durable or significant tax reforms. In large part, that’s probably because policymakers (and the economists who advise them) no longer reach for tax hikes when confronted by a recession-induced budget deficit. As Richard Nixon reportedly said, “we are all Keynesians now,” and in a Keynesian world, it seems unlikely that recessions will precipitate meaningful tax reform.

The Power of Discontent

If wars and economic crises are unlikely to reprise their roles as fiscal catalysts, what other factors might prompt change? One possibility is popular discontent with the existing revenue structure.

After all, political pressure proved crucial to the creation of the modern income tax. Typically, we view the income tax as a product of World War I: Pressed for new revenue to fight the war in Europe, Congress transformed the nascent income tax into a revenue workhorse. That story is correct, but it glides past decades of political turmoil surrounding both the income tax and the fiscal instrument that preceded it: the protective tariff.

In fact, unhappiness with the tariff was a crucial factor in the rise of the income tax. During the last 30 years of the 19th century, the tariff developed a long list of political enemies, most of whom objected to its regressive incidence.

In his 2013 book Making the Modern American Fiscal State: Law, Politics, and the Rise of Progressive Taxation, 1877-1929, legal historian Ajay K. Mehrotra quotes the 1883 testimony of Conrad Carl, a New York City tailor, before a Senate committee investigating “the labor question.” Asked how lawmakers might help the working class, Carl pointed to the tariff (and the small handful of excise taxes raising significant revenue, including those on alcohol and tobacco). “So long as legislation is unjust to the poor, to tax the poor who have nothing but their daily earnings, to tax them by indirect taxes, there is no way to better the condition of the workingman,” Carl said.

“The indirect taxes are a fraud and a crime against the workingmen, and society will have its punishment sooner or later for it,” Carl continued. “When there lies so great a wrong on the bottom of society as to tax the laboring man by indirect taxes, there grows wrong after wrong, and it will grow as high as Babylon’s tower if we do not go against it.”

Economists of the era were uncertain about the incidence of 19th-century tariffs. Carl and other working-class Americans, however, were not. “Regardless of what the experts might have thought, most late-nineteenth-century Americans believed that the tariff insidiously fell upon end users, that it was a hidden levy passed along to the quotidian consumers of most ordinary products,” Mehrotra writes.

That belief played a key part in prompting fiscal reform. It wasn’t a catalyst, in the sense of something that precipitates action in a short period. But it eventually prompted lawmakers to experiment with fiscal reform. In 1894 Congress enacted the nation’s first peacetime income tax, while also modestly reducing tariff rates. That early income tax didn’t last long, of course, thanks to a hostile Supreme Court. But it bears notice that Congress responded to popular outrage at the tariff by introducing a new and potentially important revenue device.

The Limits of Discontent

Still, it’s important not to overstate the case. Popular hostility to the tariff was widespread and powerful in the late 19th century. But it wasn’t overwhelming, thanks in part to the skillful maneuvering of tariff defenders. Republican protectionists managed to link the tariff to various popular spending programs, including pensions for Civil War veterans. They framed it as a tool for protecting not just capitalists, but workers, too.

“While customs duties may have hurt workers as consumers, the tariff also appeared to benefit laborers in protected industries,” Mehrotra writes. “Not only did the tariff shelter domestic manufacturers and thus create and preserve jobs that might not have otherwise existed in the face of foreign competition, it also supposedly led to higher wages — a point that high-tariff Republicans frequently raised during congressional debates.”

Ultimately, while tariff discontent was widespread and powerful, it was also hard to mobilize in the service of specific reforms. “Despite the frustrations with the status quo, the opposition to the late-nineteenth-century fiscal order remained fractured and distracted,” Mehrotra concludes.

Indeed, the power of discontent doesn’t seem to obviate the need for a catalyst. The 1894 income tax, while enacted during peacetime, was still the product of crisis, specifically the Depression of 1893. Precipitating events still seem crucial, if only to help mobilize the “fractured and distracted” critics of existing tax structures.

Still Lacking a Catalyst

Which brings us back to the original question: Might tariffs again play an important role in shaping fiscal reform? History doesn’t support the idea that unhappiness with tariff policy will precipitate change; we still need some sort of discrete catalyst to activate otherwise inchoate unhappiness. Necessity is still the parent of fundamental tax reform.

But if tariff discontent is unlikely to precipitate change, it might still contribute to it. In the late 19th and early 20th century, that discontent was a necessary but not sufficient factor driving fiscal reform. Other factors, which Mehrotra describes expertly throughout his book, included rising inequality, surging creativity among economic thinkers, and a confusing, sometimes chaotic transformation of the American economy.

The nation’s changing fiscal outlook was also important. Champions of the high tariff regime of the late 19th century defended it as a way to pay down the country’s accumulated Civil War debt. As that debt shrunk over the decades, high tariffs became harder to defend.

Today, similar factors are at play, although some (including the fiscal outlook) are moving in the opposite direction. But one obvious commonality — discontent with the existing revenue structure — seems very similar indeed.

Of course, current discontent is probably focused more on non-tariff elements of the revenue structure, including the income tax (the erstwhile solution having become a problem in its own right). What makes tariffs different, however, is their relative novelty. Before Trump, they were all but invisible. Now, while still almost insignificant in revenue terms, they have assumed an outsize importance in political discourse. Whether the political salience of tariffs continues to grow probably depends on two factors: (1) the trajectory of the economy and (2) the extent to which tariffs get the blame for any coming recession.

In tax politics, appearances matter. In Grover Cleveland’s day, economists were uncertain about who actually shouldered the burden of the protective tariff; tax incidence was still a guessing game (even more than it is today). But as Mehrotra makes clear, plenty of people thought they knew who was paying the tariff. And that thought was politically potent, at least when activated by a crisis. However, it’s still a challenge to conceive of a modern-day crisis that might precipitate tax reform. But I can see at least one possibility.

It’s plausible that an economic crisis might prompt a two-pronged approach to fundamental tax reform: tax cuts focused on lower- and middle-income individuals, combined with new taxes on the rich and corporations. The lower-end tax cuts might focus not simply on income taxes (paid by only about half of Americans) but on payroll taxes, too. Reductions in those taxes might be defended as a way to stimulate the economy, especially using “propensity to spend” arguments.

Meanwhile, tax hikes on rich individuals and corporations could be defended as a matter of fairness. Buttressed by complaints about rising inequality and stagnant wages, the roster of reforms might include higher marginal income tax rates on the nation’s most fortunate few, as well as some sort of individual wealth tax. Corporate tax rates also seem a likely target, assuming a progressive wave in American politics.

There are a lot of imponderables underlying that scenario, including that last assumption about progressive politics. But tariffs seem likely to be in the mix, one way or another, given their high profile in current political discourse. That profile might be unjustified by the numbers, but it doesn’t have to be: Perceptions can be powerful, even when they’re debatable.

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