United States Tax History – Federal Income Tax History in America

100 bill united statesIt’s probably safe to say that Americans rarely find taxes fascinating. In fact, “frustrating,” “nerve-wracking,” and “head-scratching” might be more favored terms for describing the requirement to pay a portion of your money to the Federal Government. However, taxes have played a very important and – in all honesty – fascinating role in U.S. history. Most significantly, the process that would eventually lead to the Revolutionary War and America’s independence was instigated in part by the Stamp Act, Sugar Act, and Tea Act (which incited the Boston Tea Party) – all of which were tax and tariff laws placed by England on the colonies to raise revenue.

Since the Revolution, taxes and national events have continued to influence each other in ways that can not only illuminate, but can help you better understand your tax situation and how everyone benefits from the taxes you pay.

U.S. Tax History

Civil War and the First Income Tax

For many nations throughout history, wars have motivated their governments to collect taxes. U.S. tax history is no different.

During the War of 1812 and the Mexican-American War, the much-smaller-than-today Federal Government got by merely on taxing imports and exports. However, in 1861 the Civil War put a strain on the Union’s coffers. With significant expenses burdening the treasury, the Federal Government enacted a (now modest) tax rate of 3% on incomes above $800, and 5% for incomes above $10,000. (Even the first income tax policies spared the poor.)

However, these measures were short-lived, and the laws were repealed in the middle of Reconstruction, in 1872. American citizens didn’t pay income taxes for the next 20 years.

100 Years of Federal Direct Taxes

While local governments often rely on property taxes for revenue, the U.S. Constitution made it difficult for the Federal Government to directly tax property or income from it (e.g. rental fees) in the states. A federal property tax would have to be evenly divided by states’ populations, making it tough to tax higher-earning states more than lower-income states.

In 1909, Congress tried to overcome this obstacle by proposing the Sixteenth Amendment, which would allow the federal government to collect income taxes directly from individuals. The amendment was ratified in 1913 in the final months of the Taft administration. That year, tax rates were 1% on incomes above $3,000 and 6% above $500,000.

World War I and the Great Depression: Sharp Increases

With the outbreak of World War I, the Federal Government again needed to raise revenue quickly, and in 1918 legislators raised the rates sharply, particularly on high-income citizens: 77% on incomes over $1 million. The marginal tax rate (the percentage of tax applied to your income for each tax bracket in which you qualify) went down slowly over the following 20 years, but it went back up during the Great Depression since fewer people had any taxable income.

The New Deal: Medicare and Social Security

As the nation emerged from the Depression, the New Deal brought new benefits for citizens – and a new type of tax. In 1937, under Franklin Roosevelt’s administration, Congress ratified the Federal Insurance Contributions Act (FICA), creating the oft-maligned line on your paystub. FICA taxes funded the Social Security Administration, and when Medicare passed in 1965 under the Johnson administration, FICA taxes increased to cover that program’s costs.

World War II: Raising Taxes and Adding Withholding

While FICA is a flat tax – a standard percentage that everyone pays up to a set maximum – income taxes are subject to various changes at different income levels. The top marginal tax rate that rode such a steep increase during World War I stayed high all the way through World War II, when it reached 92%. It gone down over the years since to a low of 31% in 1992, and now stands at 39.6%.

During World War II, the tax rate wasn’t the only thing that changed. The new tax policy added a feature that we accept as routine these days: income tax withholding. Before World War II, most people paid their entire tax bill on the tax due date, which put a significant strain on the government’s bank account. To end the feast-or-famine effect on the nation’s coffers, payroll withholding laws have evolved and now require citizens to pay at least 90% of expected taxes due by the end of the year.

A Different Timeline: Estate Taxes

Estate taxes have evolved differently from income taxes, because they began as state taxes in the 1880s – federal estate tax laws were not enacted until the 1920s. Congress didn’t address exemptions for spouses inheriting an estate until 1948. And the current system, by which a spouse may receive an entire estate tax-free, was not approved until 1981. Gift taxes were introduced in 1924 and have remained much the same since.

Final Word

As our history evolves, our tax policies constantly change with it, and new laws are created that affect change to the overall system every year. While everyone may occasionally need to vent about how much Americans pay, it’s even more important to understand exactly why taxes exist and how they came to exist in their current form. Understanding the historical basis of our taxes adds perspective – and perhaps even helps us realize that our tax rates aren’t so bad after all.

Are you a history buff? What key points in American tax history interest you most?

  • http://www.taxes-phd.com LV Tax PhD

    Very nice post. It seems tax rates have gone through trends over time. Wars and new government programs require more money which, in turn, lead to increases. I suspect that, in the near future, we will get new taxes such as taxes on internet purchases and eventually a Value Added Tax. Our budget deficits are too high in relation to tax receipts.

  • Guest

    Why didn’t George W. Bush follow in the successful actions of our past presidents during wartime? What was different about Bush’s war that he felt the need to give tax cuts rather than raise taxes?

    • terry1956

      From 1950 to 1970 Japan cut taxes every year but its tax revenue increased 16 fold but only 5 fold in the US in those 20 years.
      Un employment averaged less than 2% in Japan at the time, around double that in the US.
      Real per capita GDP doubled twice in Japan at the time thus an annual average rate of 7.2% more than double the growth in real per capita GDP of the US at the time. Japan also had a more protectionist policy on imports than the US during those 20 years.
      Japan also balanced its budget until the mid 1960s, some years had to make a second budget in the year to spend surplus revenue because of the balance budget requirement .
      The last time defense caused the USfederal government to run a deficit was in the late 1940s thus if afterwards no deficit spending had occurred on domestic spending thus the debt would have not increased thus the debt could have been paid in full by 1980.

  • David Boone

    Agreed, a valuable history lesson for us tax nerds. It’s a prevailing myth among my community of FairTaxers that the tax initiated by the 16th Amendment was a flat tax, when in fact it had tiers of 1% through 7%. Speaking of the FairTax®, I’d like to see Kira do an article on the next big thing. I would be happy to provide the research.

    • terry1956

      If the Fair tax sales tax is collected through many non corporate stores it would be unconstitutional since it would be a direct tax not based on the census and with the 16th amendment a sales tax would not be based on income either but if it applies to only corporate and LLC stores then it would be a constitutional indirect tax.
      For the same reason a general federal VAT would be unconstitutional.
      Now coupled with a import tax, a tax on corporate and LLC sales to consumers could replace the revenue from the federal individual income tax with a flat rate of 10% or less.
      As the economy grows and or the import tax revenue increases the sales tax rate should be cut and in 40 years it should be 5% or less.
      A flat rate import tax of 10% could replace the revenue from the federal corporate income tax.
      On the other hand to make what Ross Perot called an adjustment at the border for any US higher legal cost I think we should have An American price plus 10% tax on imported goods, imported services and the compensation to non US citizen labor ( employees and contractors) but end the quotas on imported goods and imported services.
      That would tend to decrease the imports from third and second world nations but increase the imports from first world nations except when a first world nation dumps, subsides an export and or devalues it’s currency against US currency since the American price import tax would take care of that.

  • terry1956

    I knew that the federal government normally got most of its revenue before 1860 through custom duties and import imposts as was promised at the state conventions on the US Constitution and in many years we had no internal federal taxes.
    Still I did not know exports was taxed being that article 1 section 9 says no tax or duty( federal) shall be laid on any articles exported from any state.
    Now article 1 section 10 does allow a state to charge a duty on either imports and exports for absolutely necessary inspection expenses and with permission of congress for extra revenue if that extra revenue is turn over to congress.
    In 2012 imported goods and services was a bit over 2.7 trillion, adding import of income payments made the total over 3.5 trillion.
    Even the latter was a higher tax base than C corporate income in 2012 which was under 2.1 trillion with the highly graduated corporate income tax where some pay 0 and others pay over 30% brought in less than 243 billion in 2012.
    So a flat rate of 10% on imports likely would bring in more revenue than the graduated corporate income tax, although maybe not the first year or so since the average across the board rare on imports is less than 2%.
    Exported goods and services in 2012 totaled around 2.2 trillion with exported income payments making the total a bit under 3.1 trillion
    So total imports and exports in 2012 including income payments was around 6.6 trillion dollars and if you look at the 2012 adjusted gross income on individual income it was just 9 trillion or less. The highly graduated worked out to an average of 12% to 13% of adusted gross income.
    In 2012 total wages and salaries was just a bit over 6.9 trillion.
    In 2012 the individual federal income tax brought in 1.132206 trillion.
    Total federal individual and corporate income tax in 2012 brought in a bit under 1.38 trillion.
    a flat rate of 22% on 6.6 trillion ( total imports and exports) would be 1.45 trillion. Maybe not the first year or so since the tax rate on exported goods and services directly is zero, although adding in the corporate income tax, tax on wages, dividends, interest, capital gains and the expense of accounting cost of the graduated system does put federal cost on exports.