As American taxpayers struggle to prepare their annual federal income tax returns, it’s hard to imagine that as recently as the early 20th century there were NO federal income taxes. The income tax was permanently adopted in 1913, and even then, only the richest one-half of 1 percent of earners paid taxes. Somehow, this simple beginning evolved into the current, complex and bloated U.S. tax code that contains roughly 70,000 pages. Here’s a look at 10 milestones in United States tax history.
10. Colonists Vow “No Taxation Without Representation”
This historic phrase, which actually originated in England, became popular in the 13 colonies in the 1750s and explains why America revolted to gain its independence. Colonists became upset that Great Britain taxed colonial imports and exports, although colonists had no representation in Parliament. This discontent led to the famous Boston Tea Party in 1773, one of the contributing factors to the start of the American Revolution two years later.
9. U.S. Establishes Tariffs to Fund Government
After winning its independence, the new United States needed to fund a federal government. The founding fathers realized that citizens of a country that had just fought a war because of taxation would not accept an income tax, so instead, they adopted a system of tariffs. Imported goods were taxed, typically between 5 and 15 percent, with importers passing the cost along to consumers. The average cost per citizen worked out to around $1 per year. Tariffs proved so successful they served as the primary revenue engine for the U.S. until the Civil War.
8. U.S. Levies First Personal Income Tax To Fund Civil War
In what would be the first, but not the last, great irony on this list, the first Republican president, Abraham Lincoln, proposed the first personal income tax in 1861 to fund the Civil War. The tax rates and income levels seem almost laughable today (tax rates were set at 3 percent of incomes over $800). Congress passed a higher income tax the following year, but the taxes were rescinded a few years after the war.
7. Supreme Court Rules Income Taxes Are Unconstitutional
In 1894, the Democratic majority in Congress succeeded in passing the first peacetime income tax in U.S. history, set at 2 percent for incomes over $4,000, which would affect roughly the top 10 percent of households. A year later, the U.S. Supreme Court struck down the law as unconstitutional. (Here’s a revealing 1894 New York Times story on the debate against the bill, with opponents arguing a tax on the rich would ultimately hurt the poor. Sound familiar?)
6. Sixteenth Amendment Authorizes Personal Income Taxes
More tax irony — a Republican, President William Howard Taft, proposed the Sixteenth Amendment, which authorizes the federal government to levy an income tax. Forty-two of the 48 states ratified the amendment, which states that, “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” Vested with new constitutional power after ratification of the amendment on Feb. 3, 1913, Congress later that year passed the Revenue Act of 1913. Those who earned more than $3,000 a year (roughly $69,000 in 2012 dollars) were subject to a 1 percent tax. The extremely wealthy, those with incomes above $500,000, were taxed at 6 percent. Only the top one-half of 1 percent of citizens were subject to the tax, and Taft argued that only the very wealthy would ever be required to pay income taxes.
5. Revenue Act of 1932 Boosts Taxes
As the Great Depression gripped the U.S. in 1932, the government found itself deficit spending to the tune of $2.5 million per day. To fight the problem, President Herbert Hoover — yes, another Republican — proposed a bill levying the steepest tax increase in U.S. history. The Revenue Act of 1932 increased personal income taxes from 23 to 45 percent, doubled estate taxes, and introduced a sales tax and 1-cent federal excise tax on gasoline. Hoover himself made a surprise visit to the U.S. Senate to lobby for passage of the controversial bill.
4. U.S. Begins Payroll Tax Withholding During WWII
Americans like to complain about paying income tax, but when you think about it, for the most part tax collection is relatively painless, thanks to automatic payroll deductions. In fact, the system is so painless, many Americans have no idea what their current tax rate is, or how much income tax they paid the previous year. The federal government began payroll deductions during World War II, and the system eased tax collection so much that the move became permanent. As noted, it also left many taxpayers essentially clueless about how much they pay. A fact sheet on the U.S. Department of the Treasury website even concedes that automatic deductions, “greatly reduced the taxpayer’s awareness of the amount of tax being collected, i.e. it reduced the transparency of the tax, which made it easier to raise taxes in the future.” How many Americans would be upset about their federal tax rate if they had to send the government a check for $10,000 or $30,000 or more each April? But that’s an argument for another day.
3. President Reagan Slashes Income Tax Rates
Here’s where we move more from the realm of tax history to the politics of taxes. President Ronald Reagan’s Economic Recovery Tax Act of 1981 that slashed tax rates across the board passed Congress with strong bipartisan support. But the fallout from the tax cuts is still debated by scholars and pundits, with — no surprise here — opinion divided along ideological lines. Conservatives say the cuts, along with other Reagan economic initiatives, led to higher government revenues, an expanding U.S. economy and declines in unemployment, interest rates and inflation. Liberal observers believe the prosperity following the cuts resulted from federal deficit spending, and that “Reaganomics” created some of the problems the U.S. faces a generation later. It’s worth mentioning that Reagan was not the first president in modern times to recommend slashing taxes to boost the economy. In his 1963 state of the union speech, John F. Kennedy said, “The most important single thing we can do to stimulate investment in today’s economy is to raise consumption by major reduction of individual income tax rates.”
2. President Bush Cuts Taxes in 2001
Low inflation and interest rates, the technology revolution and other factors led to an economic boon in the 1990s. But by 2001, federal tax revenues as a percentage of the national GDP were higher than at any time since World War II. President George W. Bush proposed changes that most notably lowered the tax rates in each income bracket. The Economic Growth and Tax Relief and Reconciliation Act of 2001 passed with bipartisan support (230-197 in the U.S. House, 62-38 in the Senate.) Some supporters were incredibly optimistic about the bill’s potential impact — the conservative Heritage Foundation even predicted it would “Effectively pay off the federal debt” by 2011, reducing it to 4.7 percent of the national GDP (the national debt as of 2012 was slightly more than 100 percent of the GDP). We have no way of knowing if the optimistic projections would have come true because of a string of events no one could have predicted: 9/11, wars in Afghanistan and Iraq, the burst of the housing bubble, the stock market crash and the Great Recession. Despite calls from many Democrats to let the Bush-era tax cuts expire, President Barack Obama signed a bill in December 2010 to extend the cuts for two more years.
1. Americans Universally Despise Tax Code … But What’s the Solution?
Democrats and Republicans today bitterly disagree on the best way to fund government and boost the economy, but virtually everyone agrees the current U.S. revenue code is a complex, bloated mess that frustrates taxpayers — and tax professionals — and encourages fraud. Even the Internal Revenue Service struggles to manage the code — in its 2010 report to Congress, the IRS’ National Taxpayer Advocate service noted that the tax code included some 3.8 million words, and that 579 changes had been made to the code in 2010 alone, requiring explanations to taxpayers, preparers, new computer programming to process returns, etc.
So while everyone agrees something must be done to simplify the tax laws, there’s little agreement on a solution. Among proposals are a national sales tax, a flat tax, and even a value-added tax, which is common in Europe. Expect more partisan political debate as Republicans and Democrats seek a solution.