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Chapter 1
A Brief History of Federal Income Taxation
As every schoolchild knows, following the American Revolution, the Articles of Confederation governed the United States from 1781 to 1789. But the government established by the Articles proved to have a fatal weakness in the area of taxation. The federal government depended on the states to provide it with revenue, and like all taxpayers, the states didn’t much enjoy paying taxes to Washington. The federal government soon had a financial crisis. It lacked the revenue to function adequately, and so a constitutional convention was assembled to write a new basic law for the nation.
The Constitution, which replaced the Articles, gave the federal government independent taxing power so that it was no longer dependent on the states for revenue. The precise terms of the government’s taxing power are surprisingly vague. It is free to tax what it likes, subject to just two constraints: exports may not be taxed, and the federal government is prohibited from levying a direct tax unless it is proportionate to the population. The main purpose of the latter clause was to limit the federal government’s ability to tax slaves—one of the many compromises made by the Founding Fathers to accommodate the South’s “peculiar institution.”
Initially there was resistance to federal taxation, especially the whiskey tax, which led to a rebellion in 1794. But after Treasury Secretary Alexander Hamilton had the federal government assume state debts from the war, state taxes fell. On balance, the tax burden declined.
THE TARIFF
From the beginning, the federal government’s primary revenue source was the tariff. This led to continuing tensions between the northern states, where manufacturing was the dominant industry—manufacturers favored high, protective tariffs—and the southern states, where agriculture was the dominant industry and tariffs were thus unpopular. Interestingly, one argument for raising revenue through tariffs was that it was a progressive form of taxation, one that takes more, proportionately, from the rich than the poor. As Thomas Jefferson wrote in 1811 in a letter to Thaddeus Kociuszko, “The rich alone use imported articles, and on these alone the whole taxes of the General Government are levied. The poor man, who uses nothing but what is made in his own farm or family, or within his own country, pays not a farthing of tax to the General Government.”
Until the Civil War, tariffs constituted about 90 percent of all federal revenues. The balance came mainly from sales of federal lands. On the eve of the war, total federal revenues were $53.5 million, of which $49.6 million came from customs duties. Federal revenues consumed about 1.2 percent of the gross domestic product (GDP); they have averaged 18.5 percent of GDP since World War II.
The war increased the need for revenue. By 1866 federal revenues were ten times greater than they had been before the war. An important innovation was the creation of the first federal income tax in 1861. As the war progressed, the government’s revenue needs increased, and it raised the income tax. By 1866 income taxes constituted 55 percent of federal revenues. But even at the end of the war, the top rate was just 10 percent on incomes over $10,000 (equivalent to $142,000 today).
The unpopularity of the income tax led to its expiration in 1872. To replace the lost revenue, the federal government expanded the taxation of alcohol and tobacco. By 1900 these taxes constituted 43 percent of federal revenue. Customs duties raised 41 percent.
In 1894, Democrats attempted to revive the income tax in order to finance a reduction in tariffs, which fell heavily on the farmers and workers who constituted their base. A 2 percent flat-rate income tax was enacted on incomes over $4,000 (about $105,000 today). However, the following year the Supreme Court found it to be unconstitutional in the case of Pollock v. Farmers’ Loan and Trust Co. (1895), even though the Civil War income tax had been found to be constitutional in Springer v. United States (1880). The Court found that the income tax was a direct tax and not apportioned uniformly.
Although it was widely believed among legal scholars that the Supreme Court erred in the Pollock decision, this ruling nevertheless effectively foreclosed any further legislative efforts regarding an income tax without a change in the Constitution.
Growth of the Progressive movement and continuing agitation for tariff cuts kept up the pressure for an income tax. In 1909 President William Howard Taft, a Republican, endorsed a constitutional amendment to permit one. In part it was a delaying tactic to fend off increasing support for tariff cuts, which would have angered the GOP’s base among manufacturers.
SIXTEENTH AMENDMENT
The proposed Sixteenth Amendment passed both the House and the Senate surprisingly easily, but ratification by the states was slow. The last state, Delaware, didn’t ratify it until 1913, just days before Woodrow Wilson became only the second Democratic president since before the Civil War.
Wilson brought with him a Democratic Congress, which quickly enacted legislation reducing tariffs and creating a permanent income tax. The 1913 act imposed a 1 percent tax rate on all those with incomes above a personal exemption of $3,000 (about $66,000 today) and a top rate of 7 percent on those with incomes above $500,000 (about $11 million today). Consequently, few people paid substantial income taxes. But that changed with the outbreak of World War I. Anticipating U.S. involvement, the government raised tax rates in 1914 and 1916. The United States’ formal entry into the war in 1917 led to a further rise.
By 1918 the lowest rate of taxation was up to 6 percent on incomes over $1,000 (about $14,000 today), and the top rate was 77 percent on incomes over $1 million (about $14 million today). Although taxes were quickly reduced after the war, they were not lowered to their prewar level. By 1920 the bottom rate was down only to 4 percent, and the top rate fell to 73 percent. The thresholds were unchanged, but there was considerable inflation, which lowered the real income levels at which tax rates became effective.
The desire for significant income tax cuts helped Republican Warren Harding win the White House in 1920. He appointed the financier Andrew Mellon as his Treasury secretary, and Mellon began a decade-long effort to bring down the wartime tax rates. Kept on in his position by Calvin Coolidge, Mellon succeeded in getting the bottom tax rate down to just 0.375 percent in 1929 and the top rate down to 24 percent. However, in the process the threshold for the top rate was reduced to $100,000 (about $1.3 million today).
The Great Depression decimated federal finances. Revenues fell more than half between 1930 and 1932, while relief measures caused spending to rise 40 percent. In 1932 Herbert Hoover asked Congress to raise taxes to reduce the deficit. The bottom rate went back up to 4 percent and the top rate increased to 63 percent. In dollar terms, however, the largest increases were for excise taxes on a wide variety of goods and services, including gasoline, telephones, tires, and many others.
Franklin D. Roosevelt’s first major contribution to tax policy came in 1935, when he asked Congress to raise taxes on the rich. This move was driven less by revenue needs than by fairness. In a message to Congress on June 19, he said, “People know that vast personal incomes come not only through the effort or ability or luck of those who receive them, but also because of the opportunities for advantage which government itself contributes. Therefore, the duty rests upon the government to restrict such incomes by very high taxes.”
SOAKING THE RICH
Privately Roosevelt worried about the growing political support for socialist and crackpot schemes. To keep them in check, he had to increase the perception of fairness in the capitalist system. “I want to save our system, the capitalistic system,” he told an emissary of the archconservative newspaper publisher William Randolph Hearst. To do so, Roosevelt said, “it may be necessary to throw to the wolves the forty-six men who are reported to have incomes in excess of one million dollars a year.”
The 1935 tax bill raised the top rate to 79 percent, but also raised the income threshold at which the top rate applied, from $1 million to $5 million (about $78 million in today’s dollars). It was reported that only one person in America, John D. Rockefeller Jr., paid taxes at the top income tax rate.
The institution of Social Security that same year also had a major impact on taxation. Roosevelt insisted that it be financed conservatively to impress upon people that it was an earned benefit, not a giveaway welfare program. People had to pay into Social Security to get benefits; it was financed with a flat-rate tax of 2 percent; and revenues went into a trust fund, not unlike a private pension fund.
Social Security taxes began being collected in 1937, but the first benefits weren’t paid out until 1940. The payroll tax constituted a significant tax increase on the working population, most of whom paid no federal income taxes. Many economists believe that this increase was a major contributor to the recession of 1937–38 after several years of double-digit real growth in the economy. For three years the payroll tax took money out of the economy before benefit payments started putting it back in again.
World War II led to a drastic expansion of federal taxation. With the top rate already at virtually a confiscatory level after 1935, there was limited scope for raising significant additional revenues from the rich. The tax base had to expand to include the middle and working classes previously exempt from income taxes. On the eve of war only about 3 percent of Americans paid any income taxes. By the end of the war the rate was up to 30 percent. There were fewer than 4 million taxable returns in 1939. By 1943 this figure was up to more than 40 million.
During the war the bottom tax rate rose from 4 percent to 23 percent on incomes over $500 (about $6,000 today). The top rate increased from 79 percent to 94 percent on incomes above $200,000 (about $2.4 million today). Although tax rates were reduced after the war, the reduction was modest due to growth in the national debt and fears of inflation, which prohibited a large cut in federal revenues that would have increased the budget deficit. By 1949 the bottom income tax rate was down to just 16.6 percent and the top rate fell to 82.1 percent.
Concerns about Soviet expansionism prevented the sort of demobilization and cuts in military spending that accompanied previous major wars. Moreover, by 1950 the United States was again involved in a shooting war, this time in Korea. Consequently there was little scope for tax reduction throughout the 1950s, reinforced by Dwight Eisenhower’s opposition to deficit spending. The bottom tax rate stayed at 20 percent throughout the 1950s, while the top rate remained above 90 percent.
KENNEDY TAX CUT
By 1960 there was general agreement among economists that the economy needed a boost. Keynesian economists, who increasingly dominated economic discussions, wanted the federal government to increase federal spending and the budget deficit to increase aggregate demand and raise growth. While John F. Kennedy was sympathetic to the Keynesian argument, he worried about inflation and the precarious position of the dollar. He therefore resisted the recommendations of his economic advisers.
House Ways and Means Committee Chairman Wilbur Mills convinced Kennedy that a fiscal stimulus could just as well be done on the tax side as the spending side. A big cut in tax rates could serve the dual purpose of stimulating the supply and demand sides of the economy. It was also less likely to upset financial markets and was easier to enact, politically, than an equivalent increase in spending.
In 1963 Kennedy asked Congress to reduce the top income tax rate to 65 from 91 percent, and the bottom rate to 14 from 20 percent. Unfortunately he was assassinated before congressional action could be completed. Lyndon Johnson finished the job in 1964. The final bill was close to Kennedy’s proposal, except that the top rate was reduced only to 70 percent.
By the end of the 1960s inflation was becoming the nation’s number one economic problem. Keynesian economics recommended a tax increase to reduce aggregate demand. Reluctantly Johnson supported a surtax in 1968 that temporarily raised everyone’s income taxes by 10 percent. The impact on inflation was modest and due largely to a recession that began in December 1969.
Although more and more economists concluded that the Federal Reserve’s monetary policy was primarily responsible for inflation, the Keynesians had enough influence to prevent any permanent tax cuts during the 1970s. They believed that budget deficits were primarily responsible for inflation. Tax cuts would make it worse.
However, one of the most important ways that inflation harms the economy is by pushing people into higher tax brackets. This is the main reason federal revenues rose from 17.3 percent of GDP in 1971 to 19 percent in 1980. Marginal tax rates also increased for the same reason. According to the Treasury Department, for a four-person family with the median income, the marginal income tax rate—the tax on each additional dollar earned—rose from 19 to 24 percent over the same period. The marginal rate on a family with twice the median income went from 28 to 43 percent.
REAGAN TAX CUT
In the 1980 presidential campaign Ronald Reagan promised to replicate the Kennedy tax cut and reduce rates across the board. He supported the tax proposal sponsored by Rep. Jack Kemp of New York and Sen. Bill Roth of Delaware. As a member of Kemp’s staff, I had a key role in developing this legislation.
Reagan’s tax cut, enacted in 1981, reduced the top rate from 70 to 50 percent and the bottom rate from 14 to 11 percent. Reagan also supported the Tax Reform Act of 1986, which raised the bottom rate to 15 percent but reduced the top rate to just 28 percent. His successor, George H. W. Bush, agreed to a budget deal in 1990 that raised the top rate to 31 percent. Not only did this action undermine his conservative support in 1992, but it also poisoned the well for future tax reforms. The 1986 act was a deal in which the wealthy gave up their tax preferences in return for a lower top rate, but when the top rate was increased in 1990, the preferences were not restored.
Having broken the deal that underlay the 1986 reform, Bush made it easier for Bill Clinton to go back to the same well and raise the top rate to 39.6 percent in 1993. However, it is seldom noted that Clinton raised the threshold for the top rate from $86,500 to $250,000 ($500,000 for couples), equivalent to $375,000 ($750,000 for couples) today.
Although Republicans predicted an economic apocalypse from the 1993 tax increase, the opposite occurred, and a period of exceptionally rapid growth followed. Also, contrary to Republican predictions that the new revenue would be spent and not reduce the deficit, spending and the deficit both fell. Federal outlays fell from 22.1 percent of GDP in 1992 to 18.2 percent of GDP in Clinton’s last year in office; revenues rose from 17.5 percent of GDP to 20.6 percent of GDP. The deficit went from 4.7 percent of GDP to a surplus of 2.4 percent of GDP over the same period, a remarkable improvement of 7.1 percent of GDP. Thus, ironically, a liberal Democrat turned out to be America’s most fiscally conservative president since Calvin Coolidge.
In the 2000 election Republican George W. Bush campaigned on the idea that the budget surplus was dangerous because Congress might spend it. It was better, he said, to dissipate the surplus through tax cuts. True to his word, Bush supported tax cuts that caused the budget surplus to evaporate into a deficit of 3.2 percent of GDP by his last year in office, a fiscal reversal of 5.6 percent of GDP. And contrary to Republican promises that tax cuts would stimulate the economy, economic growth was sluggish throughout the early 2000s, culminating in the second worst economic slump in American history.
Barack Obama’s principal contribution to tax policy was to insist that the Bush tax cuts be allowed to expire on schedule at the end of 2010—exactly as Republicans had written the legislation in the first place—for those with incomes above $250,000. At the last minute, however, he agreed to extend the Bush tax cuts for another two years without change. They are scheduled to expire at the end of 2012 and will, undoubtedly, be a major issue in the presidential campaign that year.
FURTHER READINGS
Ackerman, Bruce. “Taxation and the Constitution.” Columbia Law Review (Jan. 1999): 1–58.
Baack, Bennett D., and Edward John Ray. “Special Interests and the Adoption of the Income Tax in the United States.” Journal of Economic History (Sept. 1985): 607–25.
Bank, Steven A. “Origins of a Flat Tax.” Denver University Law Review (1996): 329–402.
Bank, Steven A., Kirk J. Stark, and Joseph J. Thorndike. War and Taxes. Urban Institute, 2008.
Bartlett, Bruce. The New American Economy. Palgrave Macmillan, 2009.
Bartlett, Bruce. Reaganomics: Supply-Side Economics in Action. Arlington House, 1981.
Blakey, Roy G., and Gladys C. Blakey. “The Revenue Act of 1932.” American Economic Review (Dec. 1932): 620–40.
Blakey, Roy G., and Gladys C. Blakey. “The Revenue Act of 1935.” American Economic Review (Dec. 1935): 673–90.
Brown, Roger H. Redeeming the Republic: Federalists, Taxation, and the Origins of the Constitution. Johns Hopkins University Press, 1993.
Brownlee, W. Elliot. Federal Taxation in America: A Short History. Cambridge University Press, 1996.
Edling, Max M., and Mark D. Kaplanoff. “Alexander Hamilton’s Fiscal Reform: Transforming the Structure of Taxation in the Early Republic.” William and Mary Quarterly (Oct. 2004): 714–44.
Einhorn, Robin L. American Taxation, American Slavery. University of Chicago Press, 2006.
Ekirch, Arthur A. “The Sixteenth Amendment: The Historical Background.” Cato Journal (Spring 1981): 161–82.
Evans, Michael W. “Foundations of the Tax Legislative Process: The Confederation, Constitutional Convention, and the First Revenue Law.” Tax Notes (Jan. 21, 1991): 283–93.
Flaherty, Jane. The Revenue Imperative. Pickering & Chatto, 2009.
Jones, Carolyn C. “Class Tax to Mass Tax: The Role of Propaganda in the Expansion of the Income Tax during World War II.” Buffalo Law Review (Fall 1988–89): 685–737.
Joseph, Richard J. The Origin of the American Income Tax: The Revenue Act of 1894 and Its Aftermath. Syracuse University Press, 2004.
Leff, Mark H. “Taxing the ‘Forgotten Man’: The Politics of Social Security Finance in the New Deal.” Journal of American History (Sept. 1983): 359–81.
McMahon, Stephanie. “A Law with a Life of Its Own: The Development of the Federal Income Tax Statutes through World War I.” Pittsburgh Tax Review (Fall 2009): 1–41.
Mehrotra, Ajay K. “Lawyers, Guns, and Public Moneys: The U.S. Treasury, World War I, and the Administration of the Modern Fiscal State.” Law and History Review (2010): 173–225.
Mehrotra, Ajay K. “‘More Mighty Than the Waves of the Sea’: Toilers, Tariffs, and the Income Tax Movement, 1880–1913.” Labor History (May 2004): 165–98.
Slaughter, Thomas P. “The Tax Man Cometh: Ideological Opposition to Internal Taxes, 1760–1790.” William and Mary Quarterly (Oct. 1984): 566–91.
Slaughter, Thomas P. The Whiskey Rebellion. Oxford University Press, 1986.
Stanley, Robert. Dimensions of Law in the Service of Order: Origins of the Federal Income Tax, 1861–1913. Oxford University Press, 1993.
Thorndike, Joseph J. “An Army of Officials: The Civil War Bureau of Internal Revenue.” Tax Notes (Dec. 24, 2001): 1739–60.
Thorndike, Joseph J. “Four Things That Everyone Should Know about New Deal Taxation.” Tax Notes (Nov. 24, 2008): 973–75.
Thorndike, Joseph J. “The Limited Lessons of 1937.” Tax Notes (Jan. 25, 2010): 429–32.
Weisman, Steven. The Great Tax Wars: Lincoln to Wilson—The Fierce Battles over Money and Power That Transformed the Nation. Simon & Schuster, 2002.
Witte, John F. The Politics and Development of the Federal Income Tax. University of Wisconsin Press, 1985.
Zelizer, Julian E. Taxing America: Wilbur D. Mills, Congress, and the State, 1945–1975. Cambridge University Press, 1998.
Copyright © 2012 by Bruce Bartlett
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