cigarette taxes is the criminal activity they create. Large differences in tax rates across jurisdictions present criminals with a profit opportunity: they can purchase cigarettes in low-tax areas and then illegally transport them to high-tax areas where they are sold. Cigarette smuggling is a huge business in the United States and is largely controlled by organized crime syndicates. Most Americans are aware that it takes place but are unaware of its magnitude. Since many states seem intent on raising cigarette taxes to ever-greater heights, this smuggling problem will not only persist, it will worsen.
The third case is the U.S. minimum wage law. Minimum wage laws first appeared at the state level in the early 1900s and were advocated as a method of raising the cost of employing women and children so that employers would replace them with adult men. Several additional arguments were used to justify these laws, such as ensuring that workers earned enough to afford a decent standard of living (i.e., a “living wage”) and encouraging children to attend school instead of working. The federal minimum wage law was enacted in the 1930s and has existed ever since.
The problem with a minimum wage law is that it can artificially raise the wage rate of marginal workers above the value they create while working for an hour. If that occurs, businesses will employ fewer of these low-skill workers, replacing some of them with machines, or altering business practices to save labor. So at a basic level, the minimum wage is about a choice: (1) a smaller number of workers earning a higher legally mandated minimum wage or (2) a larger number of workers earning a lower market-determined wage. Most economists would argue in favor of the latter, yet society chooses the former. One major reason that this law has survived is that the beneficiaries of minimum wage laws tend to be adults, while the losers are often teenagers. Another consideration is that the losers (those who are unemployed because of the law) are harder to identify than the winners (which include those with jobs at the minimum wage).
The final case is alcohol Prohibition, which existed from 1920 to 1933. The unintended negative consequences of Prohibition were so obvious and enormous that the policy was eventually abandoned. The intent was to reduce alcohol consumption, which the Prohibition laws accomplished, although by nowhere nearly as much as the proponents originally predicted. The basic problem was that the law’s intent was easily bypassed through both legal and illegal means. Illegal alcohol was the main factor in causing Prohibition’s undoing, as criminal gangs became major players in the U.S. alcoholic beverage industry. They produced and sold so much poisoned booze that tens of thousands of Americans died and many more were sickened. Prohibition also led to soaring levels of corruption by public officials and caused a major crime wave that filled America’s courts and prisons to capacity and beyond. After experiencing these problems for several years, Americans finally said “enough” and ended Prohibition.
The moral of these stories is that whenever you hear about a new government policy being considered, give thought to potential unintended consequences. Policies created for one set of purposes almost always create an additional set of results that were not part of the original plan. Very often these unintended consequences are seriously adverse.
2. Federal Income Taxes: Funding the Welfare State
The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
—Sixteenth Amendment to the U.S. Constitution, ratified February 3, 1913
The seeds of today’s big-government welfare state were sown during the post–Civil War industrial boom in the United States. Industrialization caused the gap between America’s rich and working-class families to widen, and that growing income disparity was instrumental in creating popular support for a federal income tax. Motivated by a sense of social justice, many Americans, especially western and southern farmers, hammered by the effects of financial crises and deflation during the late 1800s, came to believe that the government should tax the income and wealth of the upper class. A small number of business-owning families had become phenomenally wealthy after the Civil War, and the public resented their political influence, as well as their anti-competitive business behavior, which was viewed as being responsible for the high prices U.S. consumers paid for finished goods. In addition, the financial manipulations of these business tycoons were considered a primary cause of the periodic financial crises that plagued the nation.
The U.S. tax system in place at the time allowed the super-rich to accumulate and retain their fortunes while avoiding major tax burdens. State and local governments relied primarily on property taxes for their revenue, and most wealthy industrialists were not large landowners. The federal government collected the bulk of its revenue from taxes on imported goods (called tariffs, or customs duties), along with excise taxes on tobacco and alcohol. Although upper-class Americans paid those taxes, they did so in amounts that were nowhere nearly as large a proportion of their incomes as was the case for ordinary Americans. Wealthy capitalists earned their incomes as profits from businesses they owned, and that income was not taxed. Another important source of their income was interest earned on bank accounts and bonds, and that wasn’t taxed either. So the super-rich families of the era were able to earn essentially tax-free incomes that middle- and lower-class Americans believed were being earned at their expense. It was a situation rife for creating resentment.
Americans vented their frustration with this state of affairs by supporting a federal tax on personal incomes and corporate profits. That tax came about in 1894 when Congress imposed a 2 percent tax on incomes above $4,000, a very high income at that time. However, in 1895 the U.S. Supreme Court declared the tax unconstitutional on the grounds that it was a “direct tax” that, according to the U.S. Constitution, had to be apportioned among the individual states based on their populations. Thus, the 1894 income tax suffered a quick death and by doing so made its supporters realize that a permanent income tax would require a constitutional amendment. The effort to bring that about took place during the early 1900s and eventually resulted in the Sixteenth Amendment, which was ratified in 1913.
The great irony of the U.S. federal income tax is that the original supporters apparently gave little thought to what to do with the revenue it would generate other than to use it to reduce the federal government’s dependence on tariffs and excise taxes as funding sources. This lack of foresight likely occurred because income tax advocates had no idea how much revenue the tax would actually bring in. In fact, what happened was the income tax—originally created to shift the tax burden away from the middle and lower classes and toward the upper-class capitalists—turned out to be the mother of all cash cows. It brought in unprecedented amounts of revenue, and by doing so had the unintended consequence of allowing the enormous expansion of the federal government. The income tax was instrumental in helping create the huge federal bureaucracy that many Americans complain about today.
Rise of the Super-rich
In 1789, the upper strata of American society consisted of landowners in the South and merchants who were primarily located in the North. For example, Virginians George Washington and Thomas Jefferson were wealthy because they owned large amounts of property in the form of land and slaves, and they earned their incomes primarily from selling crops produced by that property. Wealthy landowners paid property taxes, and those taxes were the major source of revenue to state governments at the time.1
The merchants earned their incomes from exporting goods produced in North America, such as tobacco and rum, and importing finished goods and slaves. These merchants paid tariffs, or customs duties, on imported goods, and that revenue was the primary source of funds for the federal government. The government collected tariffs from the merchants, but consumers actually paid the tariffs in the form of higher prices for the imported goods.
This system of taxation was essentially unchanged until the Civil War (1861–1865). When the conflict erupted, the government
