Income tax history

While a number of states and municipalities experimented with an income tax throughout the 18th and 19th centuries, the first federal income tax in the United States was not instituted until the Civil War, as a direct response to the national war emergency. A low flat rate of 3 percent on incomes above $800 was established in 1861; subsequent amendments to the tax laws during the war years reduced the exemption level and introduced modestly graduated rates, with a maximum rate of 10 percent on incomes above $10,000 established in 1864.

Although the Civil War income tax generated significant federal revenue, financing nearly 20 percent of Union Army costs, it affected only a small percentage of affluent Americans. Since the tax was instituted under the guise of a war emergency, nationalistic sentiment ensured relatively high rates of individual compliance. By the end of the war, 10 percent of all Union households had paid some form of income tax. But once the wartime and Reconstruction emergencies were over, many of the constituents affected by the income tax lobbied to have it removed. By 1872, America’s first experiment with a federal income tax came to an end when Congress allowed the existing tax legislation to expire without renewal.

Throughout the 1870s and 1880s, federal policy makers neglected the income tax and returned to a regime of high indirect consumption taxes that included the tariff and sales taxes on items such as tobacco and alcohol. During the depression of the early 1890s, however, criticism of the regressive nature of the high tariff regime began to mount. The rise of corporate consolidation, together with the economic downturn, led Populists and disciples of Henry George’s “single tax” to call for a more equal distribution of the burdens of financing a modern, regulatory state. Organized political parties such as the Greenbacks and the Populists inserted calls for a graduated income tax in their platforms, and federal politicians from the South and West introduced numerous income tax bills.

Congressional Democrats responding to this clamor for tariff reform reinstituted the income tax in the 1894 Wilson-Gorman Tariff Bill. Like the Civil War income tax, the 1894 law affected only a small percentage of the population, taxing all incomes above the exemption level of $4,000 at the modest rate of 2 percent. Nevertheless, the 1894 income tax law was a poignant symbol of the federal government’s attempt to address the growing disparity of wealth and power in a modern industrial society. Instituted during peacetime, the 1894 law demonstrated that the income tax was not simply a tool for raising revenue, but could also be a viable vehicle of social justice.

The 1894 income tax did not last long, however. One year later the U.S. Supreme Court, in a controversial 5 to 4 decision in Pollock v. Farmers’ Loan & Trust Co., declared the new law unconstitutional. Many commentators at the time viewed the Court’s decision as an example of judicial adherence to laissez-faire constitutionalism. But the Pollock decision helped galvanize the forces in favor of an income tax. In an effort to overcome the Court’s decision, a movement for a constitutional amendment legalizing a federal income tax soon gained momentum, and by 1913 the Sixteenth Amendment made the income tax a permanent part of the U.S. tax system. Even with a constitutional amendment political leaders proceeded cautiously in passing an income tax law in 1913. Enacted as part of the Underwood-Simmons Tariff Act, the new income tax was even more moderate than its Civil War predecessor. It taxed incomes above $3,000 at 1 percent and had a graduated rate reaching up to 6 percent for incomes above $20,000.

The income tax may have remained anemic had it not been for the national emergencies created by the two world wars and the Great Depression. During the First World War, the demand for government revenues combined with nationalistic sentiment not only to create a tax system that had steeply progressive rates reaching as high as 77 percent, but also to institute an “excess-profits” tax on corporate income. The first corporate income tax had been instituted in 1909, preceding the Sixteenth Amendment and the 1913 tax law, but it remained insignificant until the war emergencies.

After World War I, the income tax, like other aspects of economic policy making, returned to a period of normalcy. With the economic prosperity of the 1920s, income tax rates returned to their more modest prewar levels, and new sets of exemptions and deductions were introduced benefiting wealthy and corporate taxpayers. This philosophy of limiting tax rates and creating particular loopholes continued for the most part through the Hoover administration and the early phases of Roosevelt’s NEW DEAL.

In 1935, as the Great Depression continued to drag on, the Roosevelt administration sought to change the course of federal tax policy. Treasury Secretary Henry Morgenthau worked with the Democratic leadership in Congress to enact a “soak the rich” tax law in 1935 that included a graduated corporation tax ranging from 12.5 to 15 percent; an intercorporate dividends tax that inhibited popular tax avoidance schemes; an increased estate and gift tax; and a surtax on incomes more than $50,000 that had a top rate of 75 percent on all incomes more than $500,000. The 1935 law did not reach many taxpayers, but the symbolism was significant, especially considering that FDR and the New Deal were coming under increased attack from the political left by such figures as Senator Huey Long of Louisiana and his radical “Share the Wealth” tax program.

With the onset of World War II federal income tax underwent dramatic change. The fiscal demands of war mobilization transformed a class-based income tax that affected only the wealthy few into a mass-based tax that touched a significant portion of the U.S. population. Whereas in 1939 only 4 million Americans were required to pay an income tax, that number had escalated to approximately 43 million by 1945. The collection of these revenues was facilitated by the introduction of a withholding system of taxation in 1943. The World War II tax regime also raised the marginal tax rates to a new high of 91 percent, allowing the federal government to collect an unprecedented amount of revenue. In fact, personal income tax revenues, which had never exceeded 2 percent of GDP between 1913 and 1940, had by the end of the war increased dramatically, reaching roughly 8 percent of GDP. Federal personal income tax revenues have remained close to 8 percent of GDP ever since World War II.

The postwar period ushered in a new era of public finance, whereby relatively high rates of taxation remained, but the aim of tax policies was focused more on economic growth rather than progressive equity. Keynesianism had convinced leaders on both the political right and left that countercyclical government policies were the key to economic stability, and this entailed tax cuts during economic downturns and tax increases during times of prosperity.

Postwar tax policy remained relatively stable until the “Reagan Revolution” of the 1980s. As the stagflation of the late 1970s continued to plague the country, Ronald Reagan embarked upon the presidency with an ideology and policy known as “supply-side economics.” A key component of this economic thinking was a massive set of tax cuts instituted by the passage of the Economic Recovery Act of 1981. With this law, and the subsequent enactment of the TAX REFORM ACT of 1986, the American system of public finance dramatically diminished the role of the income tax, as both individual and corporate rates were severely slashed. Although succeeding political leaders have altered the tax structure at the margins, the fundamental concept of Reagan’s low rates and relatively abundant deductions and exemptions remains a part of today’s U.S. tax system. Indeed, despite political rhetoric to the contrary, the income tax appears to be a permanent part of the U.S. system of taxation.

Further reading

• Brownlee, W. Elliot. Federal Taxation in America: A Short History. New York: Cambridge University Press, 1996. 
• Stein, Herbert. The Fiscal Revolution in America. Chicago: University of Chicago Press, 1969. 
• Weisman, Steven R. The Great Tax Wars: Lincoln to Wilson: The Fierce Battles over Money and Power That Transformed the Nation. New York: Simon & Schuster, 2002. 
• Witte, John F. The Politics and Development of the Income Tax. Madison: University of Wisconsin Press, 1985. 

Ajay K. Mehrotra