For most of the 100 years of the federal income tax, pass-through business income (that is, income from unincorporated businesses) has been taxed at the same rates whether the income results from the taxpayer’s labor, the taxpayer’s invested capital, or a combination of the two. In a dramatic break with that tradition, the House tax bill would tax pass-through income from capital at a top rate of 25 percent, while continuing to tax pass-through labor income at rates as high as 39.6 percent. The Senate bill’s favoritism for pass-through capital income over labor income is a bit more subtle. While the Senate bill taxes most pass-through business income at an effective top rate of about 29.6 percent, it taxes pass-through income of personal services businesses such as law, accounting, and engineering practices at a top rate of 38.5 percent.
These proposals to tax labor income more heavily than income from capital are strongly reminiscent of income tax policy debates during and after World War I. Almost exactly a century ago, in the autumn of 1917, Congress enacted an excess profits tax. Because the idea of an excess profits tax is to tax above normal returns on invested capital under wartime conditions, ordinarily an excess profits tax does not apply to personal services businesses in which virtually all the income is produced by labor rather than by capital.
Objections to the new tax were immediate, vociferous, and widespread. Many thought that the federal income tax should follow the example of the income tax of the United Kingdom, which taxed labor income produced by the (real or metaphorical) sweat of the brow less heavily than the investment income of the coupon-clipping idle rich. From this perspective, the new tax got things exactly backwards. A New York Times editorial made the point succinctly, deeming it monstrous that Congress should lay a tax penalizing individual toil while exempting from this special levy the receivers of income from dividends, interest, or rent.
Congress’s short-term response to the outcry was its 1918 repeal of all excess profits taxation of individuals. A few years later, however, the short-lived wartime penalty on labor income produced an equal and opposite reaction. Treasury Secretary Andrew Mellon claimed that the fairness of taxing more lightly income from wages, salaries, and professional services than the income from a business or from investment is beyond question, and Congress responded in 1924 by enacting a tax preference for earned income, under which the tax rates on the first $10,000 of earned income were 25 percent lower than the tax rates on investment income. Congress tinkered repeatedly with this earned income preference over the next two decades, before finally eliminating it in 1943 in favor of equal taxation of income streams from labor and from capital.
What lesson should the Congress of today draw from this old story of the fate of legislation taxing labor income more heavily than income from capital? The history suggests that, now as then, such legislation is likely to prove politically unstable. Congress would do well to remember this history, and to avoid repeating it. The obvious way not to repeat it would be not to enact any special favorable rates for non-labor pass-through business income.
Lawrence Zelenak is the Pamela Gann Professor of Law at Duke University and author of the forthcoming book “Figuring Out the Tax: Congress, Treasury, and the Design of the Early Modern Income Tax.”