The tax rates are on paper both high and highly graduated. But their effect has been dissipated in two different ways. First, part of their effect has been simply to make the pre-tax distribution more unequal. This is the usual incidence effect of taxation. By discouraging entry into activities highly taxed – in this case activities with large risk and non-pecuniary disadvantages – they raise returns in those activities. Second, they have stimulated both legislative and other provisions to evade the tax – so-called “loopholes” in the law such as percentage depletion, exemption of interest on state and municipal bonds, specially favorable treatment of capital gains, expense accounts, other indirect ways of payment, conversion of ordinary income to capital gains, and so on in bewildering number and kind. The effect has been to make the actual rates imposed far lower than the nominal rates and, perhaps more important, to make the incidence of the taxes capricious and unequal. People at the same economic level pay very different taxes depending on the accident of the source of their income and the opportunities they have to evade the tax, if present rates were made fully effective, the effect on incentives and the like might well be so serious as to cause a radical loss in the productivity of the society. Tax avoidance may therefore have been essential for economic well-being. If so, the gain has been bought at the cost of a great waste of resources, and of the introduction of widespread inequity. A much lower set of nominal rates, plus a more comprehensive base through more equal taxation of all sources of income could be both more progressive in average incidence, more equitable in detail, and less wasteful of resources.
Milton Friedman – Capitalism & Freedom p.172