TCS Daily

19th Century Taxes in the 21st Century Economy

By Kevin Hassett - August 22, 2005 12:00 AM

Over the past few decades, economists have spent a great deal of effort understanding the optimal design of the tax code. One undisputed result is that the government should try not to play favorites, taxing one activity much heavier than other. Even that simple maxim is absent from current law, however, because policies enacted many decades ago have acquired a life of their own.

The importance of neutral taxation was not always universally recognized. Back in the Great Depression, for example, Herbert Hoover signed the Revenue Act of 1932 to boost federal revenue. Included in the Act was a series of excise taxes, designed to raise revenue in the short term, many of which were set to expire in 1934. The IRS collected excise duties on a host of goods including chewing gum, soda fountain syrup, and refrigerators. Taxable goods that were regarded as luxuries, opera glasses for example, were subject to higher taxes than goods more commonly regarded as necessities, with the notion that the poor wouldn't have to bear the brunt of government's new fundraising exercise. Cheap paper matches in books, for example were taxed at a rate of 0.5 cents per 1,000, while those who insisted on lighting their candles with "fancy wooden matches" would have to consider the 5 cents per 1000 matches rate at which these luxury matches were taxed.

For the federal government to enact taxes to raise emergency funds for wars or the Depression is not without precedent, but these taxes typically come off the books when the immediacy of the revenue crunch subsides. Consumers can now buy opera glasses and matches without facing depression era excise taxes. Unfortunately, the federal government is not always so ready to scrap such tax code anachronisms.

Perhaps, the most ludicrous example of this phenomenon is the federal telephone excise tax, which currently imposes a 3 percent tax on local and long distance telephone service. The tax was first enacted in 1898 to help fund the Spanish American war effort, in an era when telephones were regarded as luxuries. Unlike taxes on opera glasses and fancy matches however, this tax is still in effect, long after the battle of San Juan Hill, and long after telephone service was considered a luxury.

Not only is the tax the product of a 19th century war, it is also the product of a 19th century economy.

While telephone use may have been regarded as a luxury in 1898, and the original imposition of the tax could have been viewed as progressive, times have changed in the last 100 years. The tax today is regressive, unduly burdening the poor. According to the Tax Foundation, in 2001, the poorest quintile of the population bore the highest burden as a percentage of income of the telephone excise tax. This finding is consistent with a recent paper I co-wrote with Anne Moore which shows that the poor are increasingly responsible for the nation's sales and excise taxes.

But it gets worse. As written, the federal telephone excise tax imposes a surcharge on local and long distance service charges based on time and distance. The applicability of the telephone tax as such, is now in question as many service providers charge on the basis of price or distance, or by charging a single, flat rate. Many taxpayers are challenging the tax in the U.S. court system. They do so for a good reason. The clear meaning of the law excludes many current telecom bundles from taxation.

With a string of legal victories against the IRS (there are currently no rulings in favor of the IRS), most recently in the 11th Circuit Court of Appeals, taxpayers may succeed in shelving this antiquated tax. Unfortunately, the IRS continues to litigate these cases, despite its losing record, and despite the fact that a targeted tax on a specific activity is against everything we know about efficient tax design.

The fight may have to be taken to the Supreme Court before a final judgment is rendered, a long and expensive process. As an IRS spokesman recently told the Tampa Tribune, "It can happen that, in spite of what different courts rule, we're not bound by those rulings, unless it's a [U.S.] Supreme Court ruling.

"Unless the statute is changed," he continued, "we have to continue to collect the tax." He has it exactly wrong. Given that the statute has not changed, they must stop collecting the tax

The ongoing legal battle notwithstanding, some encouragement can be found on Capitol Hill. Two bills currently making their way through Congress, one in the House Ways and Means committee and one in the Senate Finance committee, call for a repeal of the tax. Before the legal morass draws on any further, and businesses and taxpayers continue to pay taxes that the courts have repeatedly rejected, Congress should work to repeal the federal telephone excise tax, which belongs in history books, like the Spanish American War.

Dr. Kevin Hassett is the director of the economic policy studies group and a resident scholar at the American Enterprise Institute. Before arriving at AEI, Dr. Hassett was a senior economist at the Board of Governors of the Federal Reserve System and associate professor of economics and finance at the Graduate School of Business of Columbia University.



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