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 needed additional revenue to finance the U.S. military effort. So Congress passed several tax laws that raised tariffs; increased excise taxes on many products, including alcohol and tobacco; and imposed the nation’s first federal income tax. The public was amenable to these taxes because they supported the war. But when the war ended, the taxes were no longer viewed as necessary, so Congress eliminated many of them, including the income tax. It retained the higher tariffs on imports and the excise taxes on alcohol and tobacco. The federal government was once again largely dependent on import tariffs and excise taxes on alcohol and tobacco for revenue. States continued to rely on property taxes.
The rise of the capitalists during the post–Civil War era changed the composition of America’s elite by replacing landowners and merchants with business owners, such as Andrew Carnegie (steel), John D. Rockefeller (oil), J. P. Morgan (banking), and Philip Armour (meat packing). These capitalists owned land and paid property taxes, but those taxes were not a major consideration to them. Tariffs were not a burden either; in fact, many industrialists benefited enormously from import taxes because they offered protection from foreign import competition. So the capitalist business tycoons had an incredible deal: they were able to accumulate unprecedented amounts of income and wealth, largely free of taxes, and were made even richer by the protective tariff that was primarily paid by the middle class.
Vast fortunes allowed the upper class to enjoy lifestyles that were mind-boggling by the standards of the day: multiple mansions, scores of servants, yachts, private railcars, fabulous collections of art and jewelry, grand tours of Europe. A social observer of the era reports that “in the mansion of the genteel captain of industry there must be five or six servants to receive you, as well as a butler. The butler and three servants in livery served you dinner. . . . To serve a cup of tea two servants were necessary” (Josephson 1934, 334). Many of the United States’ so-called 400