The History Of Income Taxes

1913 celebrates the 16th Amendment to the constitution of the United States marking the beginning of income taxes. The tax code is more complicated than anyone can imagine and a look at the major events over the past 100 years might help you understand how we got to where we are today.

In researching for this article, I kept looking for a single word or phrase that could easily describe the “History of Taxes”. The only thought that kept popping into my head was… “Schizophrenia”. Defined by Webster: schiz·o·phre·ni·a Noun; 1) A long-term mental disorder of a type involving a breakdown in the relation between thought, emotion, and behavior, leading to faulty… 2) A mentality or approach characterized by inconsistent or contradictory elements.

Today’s tax code is made up of perhaps the most complex assembly of contradictory rules, regulations, and laws on earth. For the sake of this article, I’m only going to touch on the key factors and point out how to make your way through this maze. Even the most respected authorities on the topic of taxes are confused by the nearly 10,000 pages of tax code.

There were many taxes before the 16th Amendment. To help fund the War of 1812 there was a tax on gold, silver, jewelry, and watches. Once the debts from the war were completely settled, the taxes were halted in 1817. Revenue to operate the government was adequate with tariffs and fees on traded goods until the Civil War. In 1862 Congress enacted the first income tax law to support the costs of the Civil War. The tax rate was at 3% and higher on some luxury items. Then in 1868 Congress enacted a new tax on tobacco and distilled spirits. This is the first sign of a ‘parallel’ tax along with an income tax. Revenue was the highest ever achieved at $310 million and quickly settled all debts of the country, so in 1872 Congress eliminated the income tax.

Following the Civil War, America experienced a great economic boom with the ‘Reconstruction Era’. In the years from 1870-1900 the benefits from the Industrial Revolution were put into action. Chicago hosted the World’s Fair in 1893, celebrating the 400th anniversary of Columbus’ arrival in the new world in 1492. In 1894, Congress revived the income tax law and looked to aggressively grow revenue. Just one year later on May 21st 1895 the Supreme Court Ruled that income taxes were ‘unconstitutional’. The 5/4 decision stated that a direct tax on the income of real and personal property was unconstitutional and void. In the years that followed this Supreme Court decision the economy once again grew rapidly. The very wealthy became wealthier and there were jobs for everyone. The good life in America was celebrated with growing immigration from Europe bringing tradesmen looking for a better life. In 1904, Saint Louis hosted the World’s Fair celebrating 100 years of the 1803 Louisiana Purchase. This event showed the world how abundant every aspect of life was in America.

In 1907, only three short years later, America faced a huge crisis. The economy of America fell to a point where the average family income fell by 40%. A panic set in because many banks closed and people lost trust and hope. Times were difficult for average families. When banks closed, hardworking people lost their savings. President Taft addressed Congress in 1909 proposing a 2% federal income tax on corporations (for the privilege of doing business). On July 12, 1909, Congress passed a resolution proposing the 16th Amendment. This amendment to the constitution allows Congress to levy an income tax. Federal Income tax is not required to be distributed or apportioned to states nor have any connection to Census results. It was written to avoid being a ‘direct tax’ and avoid conflict with the Supreme Court ruling in 1895. With 48 states in the union, 36 states were needed to ratify before it could be passed as an amendment.

Then in 1910 a secret meeting was held on secluded Jekyll Island with the most powerful bankers and financial decision makers of the time. This event really requires much more discussion and entire books have been written about this meeting. What is important to take from this is the fact that this meeting was the start of what we know today as the Federal Reserve Bank. Few people even today understand the impact of this meeting.

It is interesting to note that since the proposed 16th amendment in 1909; only 31 states ratified it through 1911. The US presidential election of 1912 was a rare four way contest. Incumbent President William H. Taft ran along with former President Theodore Roosevelt and Woodrow Wilson (finally nominated by his party on the 46th ballot) and Eugene Debs from the Socialist Party. Throughout the 1912 presidential campaign (typically a 2 month event), the 16th Amendment was a ‘hot topic’. At the time of the election in November only two more states were needed to ratify the 16th amendment. Woodrow Wilson was elected and the 16th Amendment to the US Constitution was ratified on February 3, 1913.

With the Congress’ windfall of revenue it was time to jump on the roller coaster of cash. World War I came along and in 1918 Congress set the taxes at a rate of 77% for those with income over $ 1,000,000. That’s a 2012 equivalent of $15 million annual income, so most people didn’t even care that there was an income tax. With this first major income tax in 1918, our US annual revenue surpassed one billion dollars for the first time ever. That’s a “one” as in single and “B” for Billion. Then just two years later, in 1920 the US annual internal revenue grew to $5.4 billion. This represents a 500% increase in just 24 months.

A lot of other history was being made over the years from 1920 to 1940 and the tax front was relatively quiet. The economy grew at a rapid pace during the 20’s, hence the name ‘Roaring Twenties’. Then in October of 1929 the “What goes up must come down” effect took place. The stock market crashed and brought with it a depression. Like many events in history, the government’s intervention slowed the normal recovery and this era is now known as the “Great Depression”.

When people talk about the ‘highest tax rate’ they often see a number that is reserved for the very rich. What gets overlooked in addition to that highest rate is the income ‘threshold’ which determines the number of people impacted by that rate. In 1941 the highest income tax rate was 81.1% for those making over $5,000,000. That certainly limited this high rate to a minimal number of people. Then in 1942 (the very next year), the highest rate was raised to 88%. In itself, this does not seem too bad until you consider that the threshold was lowered to those making over $200,000. Lowering the threshold from $5 million to $200,000 meant that many more people would be paying that new higher rate. In 1942, World War II created a huge increase in employment and stimulation of the economy (compared to the years of the depression). With this spike in employment there was also a spike in tax revenue and the US revenue exceeded $7.3 billion in collections.

Up to this point in time the collection of taxes were voluntarily paid by taxpayers. People filed their tax reports and made payment of their taxes. In 1943, Congress adopted ‘Mandatory Federal Income Tax Withholding’ requiring employers to pull out taxes from employee’s pay and forward it to the US Treasury. This measure increased the number of taxpayers to over 60 million (estimated increase of 30+% in number of taxpayers). After WWII ended in 1945, Congress increased that top rate to 94% and kept the threshold at $200,000. Congress/IRS closed some loopholes on the ‘tax withholding’ bill and included more complications on who had to pay quarterly tax payments. The annual internal revenue in 1945 surpassed $43 billion, up nearly 50% each year for 15 years.

The end of WWII marked a period of substantial growth, both the economy and the birthrate. We entered a new era in America with tremendous growth and individual responsibility. Families were living the American Dream. Congress and the Internal Revenue Service continued to ‘tinker’ with the tax codes after WWII. At the end of 1969, Congress enacted the “Tax Reform Act of 1969” which established the Alternate Minimum Tax (AMT). This was a new totally separate tax system for some Americans. The number of Americans who were required to pay the AMT in 1970 was around 19,000 and the amount collected was $122 Million.

Years go by with an obvious abundance of income for the Federal Government. Budgets are set to automatically increase, regardless of the actual amounts needed or spent. In 1981 Congress enacted the largest tax cut in US History by cutting $750 Billion over 6 years from revenue. Then in 1982, yes just the very next year, Congress passes a tax act to INCREASE revenue. The increase wasn’t enough, so in 1984, Congress passed another tax act increasing revenue. Between the 1982 and 1984 tax acts, the total revenue was around $265 Billion. This is about 1/3 of the revenue cuts passed in 1981, which were to take place over 6 years.

On October 22, 1986, President Ronald Reagan signed the “Tax Reform Act of 1986” which dropped the top tax bracket from 50% to 28%. This represents a significant drop in the top rate, the lowest top rate since 1916. Another part of the 1986 Act was a change in the AMT to expand and include many homeowners. Congress got into a bad habit of making their “Tax Act” an annual event with more changes in 1987, 88, and 89.

On November 5, 1990 the “Revenue Reconciliation Act of 1990” was signed into law. This was just a fancy name for “Tax Act” and had most of the same tinkering with our income taxes. This Act primarily focused on raising taxes on wealthy Americans. The economy was growing and inflation rates were recovering from the 80’s. When President Clinton signed the “Reconciliation Act of 1993”, the purpose was to reduce the federal deficit by $496 Billion. Revenue to the Federal government was still greater than what was required to operate and surpluses existed. In 1997, President Clinton signed the tax Act cutting taxes by $152 Billion. This bill brought down the capital gains tax, provided a $500 per child tax credit, and had tax incentives for education.

In 2001, President Bush signed the “Economic Growth and Tax Relief Reconciliation Act of 2001”. This contained the 3rd largest tax cut since WWII, set to cut $1.3 Trillion over 10 years. With such a long name and such a huge tax cut, you would hope that maybe this would be enough to last 10 years. Well that makes too much sense. In 2003, President Bush signed the “Jobs and Growth Tax Relief Act of 2003” accelerating the rate cuts of 2001.

While not a law, in 2004 the ‘World Trade Organization’ ruled that the US Corporate tax provision was illegal. This did have an impact on how corporations planned their business and tax strategies. This also indicates the foreign influence and encouragement for American corporations to be more like European business models. In 2005 the favorable rates on capital gain and dividends were extended. The exemption levels for the Alternative Minimum Tax were raised in 2006.

Remember a few paragraphs ago when we looked at that Alternative Minimum Tax? Established in 1969, the AMT was established as an entirely separate tax system to the income taxes. While most Americans were not aware that this tax even existed, the changes made to the AMT affected nearly 5 Million taxpayers in 2011. In 1970 the AMT accounted for $122 Million in revenue and in 2011 the AMT revenue exceeded $40 Billion. This is nearly 260 times more than 1970.

Through the years since our founding, America has been on a path of rapid government growth. Taxes are the price we pay to live in a civilized society providing basic services and caring for those unable to care for themselves. If the government showed a history of being good stewards with our tax dollars, more Americans would proudly pay taxes without complaining. However, the layers upon layers of tax regulation have brought us to a point of dependency for many who rely on our complicated tax system. The kind of changes that are needed will require a major overhaul. Most politicians and special interest groups today will not allow the drastic measures needed to establish a new fair tax system. This means that anyone looking to the future would have sense enough to figure that future taxes will most likely be much higher than they are today.

People need to be careful how much money they accumulate that is considered ‘tax-deferred’. I try not to use the term ‘deferred’ when talking about taxes because they really are ‘tax-postponed’. Think of it as the government providing you with a loan. They tell you that you can keep this money until a later date. If a bank did this, the first thing you would ask would be; how much is the interest and when do I need to pay you back. Well, ‘tax-deferred’ savings is like this except that the government says, you keep the money and when we need it, we’ll ask for it back and tell you the interest rate at that time. OK, so maybe this example is harsh, but we don’t know what the future taxes will be on ‘tax-postpones’ savings and investments.

References:

1) http://www.taxpolicycenter.org/

2) http://www.loc.gov/

If you needed the money and someone offered you a loan, what would you want to know? If someone offered you the money and told you that you could have the money right now and since they didn’t need the money immediately they simply said, you can repay me later on when I need the money and I’ll set the interest rate at that later time. Would you take that deal? Probably not. When you think of this example it really is the same thing that the government is doing with tax-deferred retirement savings. You don’t really know when you are going to withdraw the money creating a taxable event. Also, you don’t know what the future tax rate will be. So, one thing that is evident from this article is that taxes will not remain the same in the future. A smart look would have one conclude that future taxes WILL BE HIGHER.

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