Page 1 of 2 The supply-side tax con By Henry CK Liu
In recent decades, an intuitive myth has been pushed on the unsuspecting public
by supply-side economists - that low taxes encourage corporations, employers
and entrepreneurs to create high-paying jobs. The counterintuitive historical
truth is that a progressive income tax regime with over 90% for top-bracket
incomes actually encourages management and employers to raise wages. The
principle behind this truth is that it is easier to be generous with the
In the past, when the top corporate income tax rate was over 50% and the
personal income tax rate at over 90%, both management and employers had less
incentive to maximize net income by cutting costs in the form of wages. Why
give the government the money when it could be better spent keeping employees
The Reagan "revolution", as inspired by voodoo supply-side economics, started a
frenzy of income tax rate reduction that
invited employers to keep wages low because cost savings from wages would
produce profits that employers could keep instead of having it taxed away by
high tax rates.
It follows that the low income tax rate regime leads directly to excess profit
from stagnant wages, which leads to over-investment because demand could not
keep pace with excess profit due to low wages. Say's Law  on "supply
creating its own demand", which supply-side economists lean on as intellectual
premise, holds true only under full employment with good wages, a condition
that supply-side economists conveniently ignore.
To keep demand up, workers in a low-wage economy are offered easy money in the
form of subprime debt rather than paying consumers with living wages, thus
creating more phantom profit for the financial sector at the expense of the
manufacturing sector. This dysfunctionality eventually led to the debt bubble
that burst in 2007 with global dimensions.
The State Theory of Money (Chartalism) holds that the acceptance of a currency
is based fundamentally on a government's power to tax. It is the government's
willingness to accept the currency it issues for payment of taxes that gives
the issuance currency within a nation. The Chartalist Theory of Money claims
that all governments, by virtue of their power to levy taxes payable with
government-designated legal tender, do not need external financing and should
be able to be the employer of last resort to maintain full employment.
The logic of Chartalism reasons that an excessively low tax rate will result in
a low demand for the currency and that a chronic budget surplus is economically
counterproductive because it drains credit from the economy. The colonial
administration in British Africa learned that land taxes were instrumental in
inducing the carefree natives into using its currency and engaging in financial
Thus, according to Chartalist theory, an economy can finance its domestic
developmental needs to achieve full employment and sustainable optimum growth
with prosperity without any need for foreign loans or investment, and without
the penalty of hyperinflation. But Chartalist theory is operative only in
closed domestic monetary regimes.
Countries participating in free trade in a globalized system, especially in
unregulated global financial and currency markets, cannot operate on Chartalist
principles because of the foreign-exchange dilemma. For a country participating
in globalized trade, any government printing its own currency to finance
domestic needs beyond the size of its foreign-exchange reserves will soon find
its currency under attack in the foreign-exchange markets, regardless of
whether the currency is pegged to a fixed exchanged rate or is free-floating.
The only country exempt from this rule, up to a point, is the United States
because of dollar hegemony.
Thus, all economies must accumulate dollars before they can attract foreign
capital. Even then, foreign capital will invest in the export sector only where
dollar revenue can be earned. Thus the dollars that Asian economies accumulate
from trade surpluses can only be invested in dollar assets in the United
States, depriving local economies of needed capital. This is because in order
to spend the dollars from trade surplus, the dollars must first be converted
into local currency, which will cause unemployment because the wealth behind
the new local currency has been shipped overseas. The only protection from such
exchange rate attacks on currency is to suspend convertibility, which then will
keep foreign investment away.
The income tax regime
The United State did not have an income tax for the first 133 years of its
existence. Government revenue came from protective tariffs on imports.
Corporation income tax was first adopted in 1909 while personal income tax was
first adopted in 1913.
Corporate income brackets are not directly comparable over time because the
definition of "income" changes over time due to revised tax laws, changing
accounting practices, and structural changes in the economy such as
globalization of trade and finance, and the corporate taxpayers' ever-growing
sophistication in legal tax avoidance. Thus the calculation of actual tax
burdens on the economy or effective tax rates is a highly complex undertaking.
The principle of taxing corporations as legal persons separate from their
shareholders was established by the Revenue Act of 1894 in which definitions of
taxable income and tax rates were applied to the corporation without regard to
the status of its owners. The Civil War era tax acts had taxed corporate income
to the owners through the individual income tax. The 1894 Act was ruled
unconstitutional by the Supreme Court, but the principle survived after a
technically constitutional way of taxing corporate income was enacted by
Congress in 1909.
When the individual income tax was revived in 1913 after the 16th Amendment
removed all question of constitutionality, a separate corporation income tax
was kept parallel to it. This tax structure has remained to this day.
A rational contradiction exits between the corporation income tax and the
individual income tax, because corporations, legal person in the eyes of
commercial law, are owned, directly or ultimately indirectly, by real person
individuals who immediately or ultimately receive an entitled share of the
corporations' net income. This can result in the same income being double
taxed, and various ways of lessening this irrationality have been included in
the tax system. If a corporation is partly owned by other corporations, the
question of multiple taxations arises.
The "double taxation" burden is reduced at times by allowing corporations to be
pass-through entities that are not taxed, allowing deductions or credits for
dividends, and reducing the rates on capital gains separate from income.
Different corporate and individual tax rates can also result in opportunities
to shelter income from tax through rate and bracket arbitrage, especially if
corporate tax rates at a given income bracket are lower than those faced by the
From the beginning of the income tax regime, there were restrictions or
compensatory taxes on excessive accumulations of undistributed corporate
profits and special rules and rates for individuals who incorporate to avoid
Another problem with imposing a corporate tax is that the corporate form is
used for many different kinds of entities, ranging from ordinary for-profit
businesses to religious, charitable, and other nonprofit organizations.
Organizations not organized or operated for profit were originally exempt from
the corporate tax, and those devoted to religion, charity, education, and other
goals deemed socially desirable as specified in Internal Revenue Code section
501(c)(3)) still are. However, by 1950, otherwise exempt organizations were
made subject to the ordinary corporate tax rates on business income unrelated
to their exempt purposes.
In finance, the line separating mutual and cooperative organizations from
for-profit businesses often cannot be clearly drawn. Mutual savings
institutions were made taxable in 1951, except credit unions, which are still
tax exempt, but paid little tax until their reserve deductions were revised in
1963. Mutual insurance companies have always been subject to tax, but usually
under special rules. Even now, mutual property and casualty companies with
annual premiums of under US$350,000 are tax-exempt, and those with premium
income between $350,000 and $1,200,000 are taxed only on investment income.
Rural electrical and telephone cooperatives are not taxed on member income;
other cooperatives are subject to the regular corporate rates but are allowed
to deduct distributions to members which are taxed at individual rates to
members. Regulated investment companies such as mutual funds and real estate
investment trusts (REITs - pooled real estate investment funds) are subject to
the corporation income tax but are allowed to deduct income allocated to
shareholders if they allocate virtually all of their incomes. The most
prevalent organization that avoids the corporation income tax, however, is the
"S corporation" (named for the subchapter of the code that defines it).
Since 1958, closely held companies meeting certain other restrictions could
avoid paying the corporate tax by electing to allocate all income to the
shareholders, who are then taxed on it at individual tax rates. More than half
of all corporations now file as S corporations.
The treatment of affiliated groups of corporations has also been a problem.
Corporations that own each other or are subject to the same ownership or
control (defined in various ways over the years) have been subjected to several
different tax regimes. They have variously been required to consolidate their
income statements for tax purposes (1917-1921), forbidden to do so except for
railroads and a few other companies (1934-1941), allowed the option but
required to pay at a higher tax rate (1932-1933, 1942-1963), and allowed the
option without penalty (1922-1931, 1964 to the present).
The history of corporate tax rates from 1909 to 2002 as applied to whatever was
the then-current definition of "taxable income" was so complex in the
definition of the income base that a given tax rate from one year is not
necessarily comparable to that for another, especially for widely separated
years. Initially, the tax was generally imposed on corporate profits as defined
under general accounting principles. Tax rules quickly diverged from accounting
rules, however, since it was clear that the goals of the two systems were not
Accounting rules guard against the temptation to overstate income, while tax
rules must guard against the desire to minimize income. The tax law now
includes very specific definitions of many items of income and deductions and
many pages specifying when and how to account for the items; many of these
definitions and specifications have changed so dramatically over the years that
even experts disagree on proper interpretation.
The deduction for the depletion of oil and gas deposits is an example. It was
first included as a tax-defined deduction in 1913 which allowed the producer of
any mineral a "reasonable" deduction not to exceed 5% of the value of the
deposit. In 1918, as a war measure, a specific deduction for oil and gas
deposits was enacted as "discovery value" depletion, which allowed deductions
far in excess of the value of the deposit. This was limited to a percentage of
net income from the property in 1921 (100%) and 1924 (50%). In 1926, discovery
value depletion was replaced by a deduction of a flat percentage of net income
from the property (27.5% from 1926 to 1969).