Watts: Book Review
‘Taxes Have Consequences: An Income Tax History of the United States’ by Arthur Laffer, Brian Domitrovic and Jeanne Cairns
by Tyler Watts, Ph.D.
“Taxes Have Consequences” (THC) is a masterful survey of income taxation in the United States since the ratification of the 16th amendment in 1913. The authors make a com pelling case that high income tax rates are bad economic medicine that routinely fail progressives’ stated goal of reducing income inequality, while the implementation of lower tax rates has routinely led to both higher economic growth and increased federal revenue. THC is solid economics, applying the principles of opportunity costs and incentives to the history and impact of perhaps the most important economic policy lever the government can wield. THC demonstrates that taxes matter; getting taxes wrong has devastating consequences for everyone, and even seemingly small downward adjustments can have a huge positive impact on growth, incomes, and employment. THC’s narrative style and chronological structure make it palatable to the economic layman, yet it’s packed with enough empirical data and fascinating episodic analyses to be of great use to trained economists.
THC’s authors make it clear that earning and reporting income is a choice driven by costs and benefits at the margin. Those with the highest incomes — and hence the most to lose through high tax rates—have strong incentives to reduce reported income and/or shelter income from taxation. THC’s well-crafted historical narrative recounts how tax sheltering and avoidance tactics emerged over time, beginning amid the imposition of ultra-high marginal tax rates during World War I. THC provides a trove of insights from contemporary observers of the tax scene, such as Pennsylvania financier Andrew Mellon, who observed that “an income tax is the price which the Government charges for the privilege of having taxable income” (p. 70). Mellon realized that as the “price” of income rose, people would “buy” less of it, partly by working and investing less, but largely by moving their capital into tax shelters. THC dedicates an early chapter to outlining these tactics and tools, such as municipal bonds, deduction of lavish business expenses, “in-kind” compensation by way of well-appointed offices, income splitting, and many more. THC also documents in detail the tug-of-war between Congress and corporate lobbyists, whose interactions gave rise to the byzantine system of deductions, exemptions, and credits with which we’re all familiar.
The accretion of multitudinous tax-code tweaks and favors, resulting from decades of lobbying efforts and Congress enacting social policies via the tax code, has made America’s tax system outrageously arcane and expensive. Laffer cites his earlier study indicating that federal income tax compliance costs amount to upwards of $431 billion annually (Laffer et al., 2011).
With a firm awareness of tax incentives and the availability of tax shelters, it is easy to see that the reported income of the rich will ebb and flow in response to changes in top marginal tax rates. As the authors note, “[i]ncome at the top is the most variable of all income because the people earning it do not desperately need it” (p. 16). This negative elasticity of reported income with respect to tax rates leads directly to the well-established logic known to modern economics as the Laffer Curve. Tax revenues at first rise with higher rates, but at some rate the disincentive effect over comes the revenue effect, bending the revenue curve backwards. At any point in this “prohibitive range” of the curve, government revenue will rise with a reduction in the tax rate. Laffer gets naming rights for (re)popularizing this basic economic logic in the 1970s, but Laffer readily acknowledges that economists were well aware of these tax dynamics from early on1. THC marshals quotations evincing a thorough understanding of the incentive effects of taxation from multiple sources. Perhaps most surprising is this gem from progressive stalwart Woodrow Wilson, who stated in December 1919:
Congress might well consider whether the higher rates of income and profits taxes can in peace times be effectively productive of revenue, and whether they may not, on the contrary, be destructive of business activity and productive of waste and inefficiency. There is a point at which in peace times high rates of income and profits taxes discourage energy, remove the incentive to new enterprise, encourage extravagant expenditures and produce industrial stagnation with consequent unemployment and other attendant evils (p. 110).
Wilson’s awareness of counterproductive tax policy did not translate into reform, however. Laffer et al. contend that the ultra-high World War I era tax rates drove the US economy into a sharp recession in 1920, helping sweep Republicans into power that fall. Newly elected President Harding installed Andrew Mellon as Trea
sury Secretary, and Mellon set himself the task of undertaking the largest tax-cutting movement in US history. Echoing Wilson and presaging Art Laffer, Mellon made the evergreen case for supply-side tax cuts in his 1924 book, Taxation: The People’s Business: “These taxpayers are withdrawing their capital from productive business
and investing it instead in tax-exempt securities and adopting other lawful methods of [tax avoidance]. The result is to stop business transactions… and to discourage men of wealth from taking the risks which are incidental to the development of new business… the only way to save the situation is to put the taxes on a reasonable basis that will permit business to go on and industry to develop” (Mellon, 1924, p. 56).
Following up on their discourse regarding the underlying economics of taxation, the authors next dig deeply into the data to recount the impact of taxes on US economic performance over time. The US income tax regime oscillated between high and (relatively) low marginal personal and corporate tax rates, giving economists a rich natural experiment to peruse. The authors document no less than five distinct episodes of significant tax cutting, from Mellon’s aggressive 1920s rate cuts, to the 2017 Tax Cuts and Jobs Act, which Art Laffer himself promoted as an advisor to the Trump Administration. Each tax cut generated an economic boom with above-trend GDP growth and (eventual) increases in federal income tax revenue.
Fans of supply-side economics are probably aware of the Mellon tax cuts, the JFK LBJ tax cuts, the Reagan tax cuts, and most recently the Trump tax cut, and their posi tive economic impact. THC provides a riveting, detailed accounting of these stories, as well as lesser-known but also fascinating and important episodes from the annals of taxation. Take for instance the little-known tax reforms of the late 1940s, among which Congress first allowed married couples to jointly file their tax returns, claiming one spouse’s income divided equally between them. This reform was prompted by a movement amongst the states in the 1940s to switch from “common law” to “com munity property” legal regimes, primarily for the benefit of their taxpayers. Community property systems treat all assets and income of a married couple as belonging equally to the husband and wife, which allowed high income earners to significantly shave their tax bills. THC explains how this worked:
“A male high earner making, for example, $50,000 in 1941 (about $925,000 today) faced a marginal tax rate of 59 percent, with a great part of this income taxed at rates above 40 percent. However, if this male earner filed for only $25,000, with his wife filing for the other $25,000, the top rate for each filer was 48 percent, with the bulk of the income taxed at rates around 30 percent. In this case, total federal tax liability from the two filing separately was a third less than if the husband filed on behalf of the household” (p. 250).
THC notes that postwar tax reforms, involving both rate reductions and the formal ization of income splitting into the federal tax code amounted in practice to a substan tial tax cut, which helped spur the rapid and robust recovery from wartime austerity. THC is chock full of such fascinating tidbits of tax history, all of which illuminate the book’s clear theme: when taxes are too high, “[i]ncome earners… will spend less, earn less, and search for ways to avoid paying the tax” (p. 2). Wise policymakers will realize this and set tax rates appropriately, and when they do the economy will perform well.
No 400-plus page book is perfect. I found an inordinate number of typos in the text, perhaps indicative of lax editing. Academics and researchers will be frustrated by the absence of an index. I also noted a few inconsistencies in terminology — for instance, are taxes the “price” of income, or it’s “cost”? (p. 26). The authors pay very little attention to other elements of the “policy mix” in promoting growth, particularly the role of monetary policy. Though the book admittedly is laser-focused on the consequences of taxes, it would have been nice to see a greater integration of mon etary and regulatory policy into the analysis of taxes. All in all, these flaws are minor and do not detract from the reading experience. Editing can be tightened and an index added in future editions; my quibbles about content are easily forgiven in light of the overall excellence and depth of this book.
Adam Smith is often quoted declaring that “[l]ittle else is required to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things” (1980, p. 322). What Smith knew 250 years ago, America has spent a full century re-learning, sometimes through very painful tax-induced down turns. With this book, Art Laffer — ever the happy warrior for incentives-based economic policy — and his crew equip today’s economists with ample evidence that the ancient economic wisdom regarding taxation holds true. Anyone who reads this book and still favors high tax rates is either living in proud ignorance of economic logic and facts, or is aware of the consequences of high taxes, but cares more about punishing “the rich” than about growing the economy or funding the government. In either case, THC may well prove a useful remedy. For the rest of us, the book will stand as an important contribution to sound economics, a valuable teaching and research tool, and another powerful example of the economist’s creed, “incentives matter.”
Tyler Watts, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation formerly with Ball State University, is professor of economics at Ferris State University. A version of this review originally appeared in The Review of Austrian Economics.
References
Smith, A. (1980). Essays on philosophical subjects. New York: Oxford University Press. Laffer, A. B., Winegarden, W. H., & Childs, J. (2011). The economic burden caused by tax code complex ity. Austin: The Laffer Center.
Mellon, A. W. (1924). Taxation: the people’s business. New York: Macmillan.
Roberts, P. C. (2020). What is supply-side economics? Four decades later Wikipedia and academic econo mists still don’t know. The Independent Review: A Journal of Political Economy, 25(3), 467–470.
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