The United States, having been born in part from a tax revolution, was slow to implement any form of taxation. Over 90% of the early federal government was financed by tariffs. The first use an excise tax on whiskey had resulted in a military action in 1794 to enforce it known as the Whiskey Rebellion. The government did expand sales and excise taxes to finance the War of 1812, only to have all of these repealed in 1817. Congress was considering an income tax for the War of 1812 when it ended. From 1817 to 1861, the United States was funded by tariffs on incoming goods and to a small part excise taxes. The Civil War, however, required huge expenditures by the federal government. The Revenue Act of 1861 imposed an income tax on all incomes over $600. The tax rate was 3 percent graduated up to 5 percent for the very few that earned over $10,000 a year. This income tax targeted the very wealthiest of Americans and accounted for only a fifth of the necessary income for the war. This tax was repealed in 1872. During the 1880s, many states passed inheritance taxes, which had popular support. Surprisingly, the inheritance tax and a luxury had the support of wealthy industrialists such as Andrew Carnegie and John Rockefeller.
In 1894, Democrats in Congress were able to pass first peacetime income tax as part of the Wilson-Gorman Tariff. The Democrats reduced tariffs at the same time to help farmers, who complained of the high price of sugar and household products. Tariffs were considered a “tax” on the average consumer who paid more for imported products. This income tax was 2 percent on incomes over $10,000, which addressed less than 10 percent of households. In 1895, the United States Supreme Court, in its ruling Pollock v. Farmers’ Loan and Trust Company, held such an income tax as unconstitutional. The court ruled the income tax a direct tax, which was inhibited by the constitution under Article I, Section 9 that “No capitation, or other direct tax shall be laid, unless in proportion to the census.” With tariff incomes rising in the late 1890s, Congress decided not to challenge the court decision with a new tax initiative. The reduction of tariff rates in the early 1900s and a rising public awareness of the wealthy excesses created pressure again for an income tax. This was consistent with the progressive movement of the time in both political parties. Congress first passed a corporate income tax of 1 percent of income over $5,000 (about $110,000 today). In 1913, there was a clear demand to reduce tariffs and impose an income tax. The Underwood Tariff Act of 1913 ended the protectionist tariffs that had existed since the earliest days of the United States. With popular support, Congress moved to have the 16th Amendment passed by the states.
The 16th Amendment stated: “The Congress shall have 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.” Politicians sold the amendment saying it would result on a tax only on America’s wealthiest (a pledge quickly forgotten once the power was given to tax). The 16th Amendment was ratified in 1913 and Congress passed the Revenue Act of 1913. This act levied a 1 percent tax on incomes above $3,000 with a surtax of 6 percent on those with incomes above $500,000. This meant a top rate of 7 percent. At the time roughly 2 percent of the population paid the income tax. The 1916 Supreme Court decision Brushaber v. Union Pacific actually expanded the meaning to profit and gain from any source. The needs of the government to finance World War One quickly caused the top rate to increase to 77 percent. Democrats created an excess profit tax for corporations as well to finance the war. Total tax revenues increased to over a billion dollars in 1918. Popular support eroded as the government began to expand taxation on all fronts for the war, but the genie was out of the bottle.
The government became a series of hundreds of bills over the years to adjust the tax for various groups and types of ‘income.” The first of these created progressive steps of income to be taxed at increasing marginal rates. The top marginal rate was cut to 58% in 1922. From 1913 to 1921, capital gains were taxed as ordinary income. Many argued that this treatment took away the incentive to invest in American stocks. The Revenue Act of 1921 allowed for assets held for two years to be taxed at 12.5 percent instead of top rates of 77 percent. Capital gain taxes were adjusted and excluded with various laws until the present day. These treatments became very complex as economic models used taxes as incentives for government economic intervention. These economic uses of taxes to control behavior were popular with followers of John Maynard Keynes. The 1930s brought more taxation by the federal government, including a progressive tax on business profits.
Major changes came during World War Two when the income tax expanded to the middle class. Franklin Roosevelt also increased the top marginal to 91 percent. The system was still very disorganized and full of tax fraud. Roosevelt increased enforcement as a means to increase revenue. The passage of the Revenue Act of 1942 was considered the most expansive in our history. Congress also enacted payroll withholding with the Current Tax Payment Act of 1943. Congress also increased the base and rates with a “surtax.” Rates ranged from 13 percent on the first $2,000 of income to 81 percent on $200,000 up to a maximum of 91 percent. The withholding tax, while extremely unpopular, greatly increased revenue. It was sold a patriotic sacrifice during World War II. Taxpayers went from 3.9 million in 1939 to 42.6 million in 1945 or 60 percent of households paid an income tax. For the same period collections went from $3.2 billion to $35.1 billion. Politicians wisely called this broad expansion of taxing and rate as a “defense tax.” Corporate taxes were also increased to 50 percent.
Taxes have become a political issue with the tax code used to affect the economy and control consumer behavior. The 1940s saw the expansion of a tax code of exemptions, deductions, and credits making the collection and maintenance of the system complex. With this complexity came business opportunities such as H&R Block to help taxpayers. Today the income tax (Internal Revenue Service) falls under the Department of the Treasury. It represents one of the government’s largest bureaucracies. Today because of the huge government expenditures of maintaining, managing, and enforcing some politicians are arguing for a flat tax on sales. This had actually been considered during the debate over the Revenue Act of 1942.
