A Century Later, Big Questions about the Income Tax and the Fed

This year we celebrate—if that’s the word for it—the 100th anniversary of the federal income tax and the founding of the Federal Reserve system.

They were born in 1913 through the 16th Amendment to the Constitution and an act of Congress, respectively, during the first year of Woodrow Wilson’s presidency. These two acts were central to the U.S.’s emergence as a great economic and military power in the American Century.

But as their power has grown, both institutions have become unaccountable to the American people.  

The IRS’s political profiling of Tea Party groups’ applications for tax-exempt status shows how unwieldy the tax code has gotten and how out of touch the people who enforce it have become.

And the Fed’s  vast manipulation of interest rates under Fed chairman Alan Greenspan created several bubbles that decimated the U.S. economy, while the massive experiment in cheap money unleashed by his successor, Ben Bernanke, has taken us into uncharted territory.

Former Federal Reserve chairman Alan Greenspan speaks at the Aspen Institute in 2010. Photo: Flickr/Aspeninsitute.

Former Federal Reserve chairman Alan Greenspan speaks at the Aspen Institute in 2010. Photo: Flickr/Aspeninsitute.

Before 1913, tariffs and excise taxes were the principal sources of federal revenue. Originally proposed by socialists and Democratic populists like William Jennings Bryan, the federal income tax became a rallying cry for progressive Republicans like Teddy Roosevelt:

These Republicans were  driven mainly by a fear of the increasingly large and sophisticated military forces of Japan, Britain and the European powers [and] their own imperial ambitions…[and] were… convinced that central governments could play a positive role in national economies. A bigger government and a bigger military, of course, required a correspondingly larger and steadier source of revenue to support it.

Over the decades, the tax system  became more convoluted, including deductions, exemptions, the alternative minimum tax, truly byzantine corporate tax laws, and special goodies for politically powerful constituencies. It also gave rise, in 1953, to the Internal Revenue Service, whose unenviable job it is to administer this mess.

In the recent scandal, the IRS has proved to be out of its depth, and Fareed Zakaria laid out the broader implications:

The U.S. tax code is at the heart of a system of institutionalized, legal corruption. The code is so vast because companies, industries and lobbying groups receive special preferences in return for campaign contributions, a cash-for-favors scheme that Washington would denounce as crony capitalism in any Third World country.

The Fed was formed after a series of financial panics in the late 19th and early 20th centuries. Several powerful Wall Street bankers, led by Senator Nelson Aldrich, convened in secret on Jekyll Island, Ga., and drafted a plan which became, despite much opposition, the outlines of the current system.

The central bank helped finance America’s efforts in World War I, but its history has been marked more by failure than by success: easy money during  the speculative stock bubble of the 1920s  and tight money  in the early days of the Great Depression; the Arthur Burns Nixonian inflation of the 1970s, and Greenspan and Bernanke’s “Great Moderation,” which proved to be anything but.

William McChesney Martin’s steady-as-she-goes leadership in the 1950s and 1960s and Paul Volcker’s heroic defeat of the inflation monster in the 1980s were rare exceptions.

As David Stockman wrote in his new book, “The Great Deformation”:

…Since October 1987 the nation’s central bank has destroyed the free market in interest rates. Once the Fed embraced easy money and prosperity management through the Wall Street-based wealth effect…, rates became a bureaucratically administered value emanating from the [Federal Open Market Committee], not a market-clearing price representing the true supply and demand for money and debt capital.

Simply put, the 100-year histoy of the income tax and the Federal Reserve shows how difficult it is for institutions to give up power once they accumulate it. That certainly wasn’t what their creators envisioned a century ago, but you know what they say about good intentions and the road to hell.

2 Responses to A Century Later, Big Questions about the Income Tax and the Fed