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United States Tax History – Federal Income Tax History in America

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It’s safe to say that few Americans find taxes fascinating. In fact, “frustrating,” “nerve-wracking,” and “bewildering” might be more commonly applied terms when describing the requirement to pay a portion of your income to the federal government.

Nevertheless, taxes play a critical and even 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 enacted by England on the colonies to raise revenue.

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Since the Revolution, national events have had a major influence on tax rates. Understanding how those events contributed to the rates we pay can help you better understand your tax situation and how everyone benefits from the taxes you pay.

U.S. Tax History

The U.S. government imposed very few taxes during its early history. The federal government’s revenue came mostly from customs duties and land sales. That all changed as soon as the country went to war.

The War of 1812

The high cost of the War of 1812 and the Mexican-American War meant the country needed money. The government began imposing a sales tax on gold, silverware, jewelry, and watches.

In 1813, Congress consented to a series of direct taxes on land, property, and products, including carriages, spirits, and refined sugar.

The Civil War & The First Income Tax

Strapped for cash to fund the Civil War, President Lincoln and Congress agreed to impose the country’s first income tax. It amounted to a 3% tax on incomes above $800 and 5% for incomes above $10,000.

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 The income tax was repealed in 1872 in the middle of Reconstruction.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

Decades 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 the rental income that came from it in the states.

In 1895, the Supreme Court ruled that it was unconstitutional for the federal government to levy an income tax without dividing it evenly between the states based on population. That made 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 & The Great Depression: Taxes Increase

With the outbreak of World War I, the federal government again needed to raise revenue quickly. In 1918, legislators raised tax rates sharply, particularly on high-income citizens – 77% on incomes over $1 million.

The marginal tax rate – the percentage of tax applied to an individual’s income for each tax bracket in which they 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 & Social Security

As the nation emerged from the Great Depression, the New Deal brought new benefits for citizens – and with them, a new type of tax. In 1937, under Franklin D. Roosevelt’s administration, Congress ratified the Federal Insurance Contributions Act (FICA), creating the oft-maligned deduction on your pay stub.

FICA taxes funded the Social Security Administration, and when Medicare passed in 1965 under the Johnson administration, FICA taxes increased to cover the program’s costs.

World War II: Raising Taxes & Adding Withholding

While FICA is a flat tax – meaning the same percentage applies to all taxpayers up to a set maximum – income taxes are progressive, meaning they’re tiered rates that charge higher-income individuals a higher percentage of their income. 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 94%. It has gone up and down over the years, reaching a low of 28% from 1988 through 1990. It now stands at 37%.

During World War II, the tax rate wasn’t the only thing that changed. The new tax policy added a feature that we now accept as routine: 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. In order to end the feast-or-famine effect on the nation’s coffers, payroll withholding laws have evolved. It’s now a “pay as you go” system, requiring taxpayers to pay at least 90% of their expected tax liability by the end of the year or in quarterly installments.

1960s to Today: Tax Reform

President John F. Kennedy was the first president to push for tax cuts aggressively. When he spoke about tax reform to the Economic Club of New York in 1962, the highest marginal tax rate was a whopping 91%. In 1964, shortly after Kennedy’s death, tax cuts went into effect, dropping the top marginal tax rate to 77%.

Since Kennedy, there have been significant tax cuts every couple of decades. President Ronald Regan’s tax cuts had the biggest impact. His 1986 tax reform bill cut the highest marginal tax rate from 50% to 38.5%, consolidated tax brackets, and simplified the tax code.

While tax rates have ebbed and flowed since Regan, his was the last significant tax reform package until the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA impacts virtually every individual and corporate taxpayer in the United States by lowering income tax rates, providing a new tax deduction for owners of pass-through businesses, making major changes to the taxation of foreign income, and eliminating or limiting many tax breaks.

However, many provisions of the TCJA are set to expire after 2025. It remains to be seen whether we’ll revert to the pre-TCJA rates and rules in 2026, whether Congress will extend its provisions for a few more years, or whether we’ll see another upheaval of the tax code in the next decade.

Gift & Estate Taxes: A Different Timeline

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 the history of our nation evolves, our tax policies change with it, and new laws are created every year that modify the overall system. We may occasionally become frustrated with how much of our income goes toward things like payroll taxes, federal and state income taxes, and sales taxes each year.

However, it’s important to understand why taxes exist and how they reached their present form. Understanding the historical basis of our taxes can give us a fresh perspective on their importance – and perhaps even help us realize that our tax rates aren’t so bad. After all, if not for taxes, we might still be living under British rule or dealing with far worse outcomes from World Wars I and II. When you look at it from that perspective, paying taxes is as American as apple pie and baseball.

Can you imagine paying 94% of your income toward federal taxes, as the wealthiest citizens did during World War II? How do you think that compares to today’s highest marginal rate of 37%?

Janet Berry-Johnson
Janet Berry-Johnson is a Certified Public Accountant. Before leaving the accounting world to focus on freelance writing, she specialized in income tax consulting and compliance for individuals and small businesses. She lives in Omaha, Nebraska with her husband and son and their rescue dog, Dexter.

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