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.income after tax
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.