Don’t Substitute Tariffs for Income Taxes: You’ll Get Both

In his inaugural address, President Trump repeated his call for an External Revenue Service. At other times, he has talked about replacing personal income taxes with high tariffs on imports. Besides the fact that U.S. tariffs on imports are collected from U.S. importers, not external exporters, this idea would not work and would likely result in a higher tax burden for Americans.

Current income tax revenues are about $2.5 trillion per year. Goods imports are just over $3 trillion per year. So replacing individual income taxes would imply an 83 percent tariff rate. But that’s true only if raising tariff rates by over 2,500 percent (from under 3 percent to 83 percent) would have no effect on the level of imports. Because people would buy fewer imports if they had to pay that tax, the tariff rate would have to be substantially higher or the income tax system would have to be retained.

The modern federal income tax originated as part of a now-obscure tariff statute, which provided most of the federal government’s revenue at the time. President William Howard Taft called on Congress to modernize the tariff schedule in 1909. Instead, legislators produced the Payne-Aldrich Tariff—a protectionist boondoggle in which lobbyists secured preferential rates for politically connected industries. American consumers took it on the chin, with dual punches of import taxes and higher prices on domestic goods, effectively subsidizing the industrial Northeast.

After decades of trying and failing to divorce the tariff schedule from protectionist lobbying, oppon ents of the Payne-Aldrich Tariff tried to execute a tax swap. They wanted to replace the tariff’s revenue stream with income taxation and banish the special interests who had captured the tariff schedule revision.

Despite initial setbacks in 1909, the tax-swap advocates succeeded in ratifying the 16th Amendment in 1913. They passed a tax system overhaul that year, cutting the average tariff rate from 43 percent under Payne-Aldrich in 1909 to just 16 percent by 1920. The new income tax had a top marginal rate of only 7 percent. The lowest bracket of 1 percent kicked in only for incomes above $3,000, or roughly $100,000 today.

For a brief moment, the tax swap worked. The new income tax became a “club to beat down the tariff,” as its supporters argued, and the replacement system extracted only a modest fee from the wealthiest earners.

Within a decade, however, both elements of the tax-swap bargain collapsed. Congress quickly discovered that income taxes yielded far more revenue than the old tariff system they replaced. To pay for U.S. entry into World War I, they jacked the top marginal rate up to 77 percent in 1918. Attempts to bring the income tax under control succeeded briefly in the 1920s, but President Hoover raised the top rate to 63 percent and Franklin Roosevelt raised it to 79 percent. Under FDR, Congress also reduced the exemption threshold for lower-income earners. What started as a low “class tax”—a tax on only very high-income earners in 1913—became, by 1942, a “mass tax,” a broad-based tax on most American families.

When Congress flipped back to the protectionist-dominated Republican Party in 1920, it restored the average tariff rate to 38 percent. In 1930, Congress again opened its doors to industries seeking government protection from the stock market crash. Its intended “stimulus” became the notorious Smoot-Hawley Tariff, which jacked average rates up to 59 percent and instigated a global trade war.

The damages from the collapse of this original tax swap took decades to disentangle. Congress recognized its error and ceded its trade policy oversight to the State Department in 1934 as an emergency measure to bypass the tariff system. The liberalization of the global economy since World War II came about through treaties and trade agreements. These measures remain fragile, and they depend on an executive branch that continues to honor international agreements. If Trump abandons our free trade obligations with other countries, the Smoot-Hawley schedule still remains on the books.

Exorbitant top income tax rates remained in place until Ronald Reagan’s tax reforms finally brought them down to earth. Congress became addicted to deficit spending in the meantime, and now any tax reform discussions must contend with a national debt of $36 trillion.

In both cases, the hard-fought battles to rein in the federal tax collectors trace their genesis to the mistakes of the last tax swap in 1913. President Trump is playing with fire. In the long run, the most likely effect of his swap of the income tax with high tariffs would be high tariffs and only somewhat lower income taxes.