The U.S. Tax System: How Did We Get Here? Pt. 2, the Middle Years

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This is one of a series of articles for the month of March 2013, 20 Days of Tax Planning Advice for 2013, the third year in which AdvisorOne has focused its content during tax season for advisors and their clients. As part of our month-long focus, advisor Mike Patton in his series of posts traces the development of our current tax system. 

In my last post, we discussed taxation in the U.S. from inception to the late 1700s. Here, we'll focus on the period from 1800 to the modern tax code which began with the 16th amendment in 1913. 

The First Default

During the Revolutionary War, what was the federal government at that time had no taxation powers. Therefore, to pay for our freedom from Britain, the Continental Congress in 1775 issued the first of what were essentially bonds, with additional issuances that year and in 1776. These “Continental dollars” funded the war, but by 1779, when the first issue came due, it was evident that the U.S. did not have the resources to redeem these dollars. So the Continental Congress in 1779 announced a devaluation of 38.5 to 1 on the approximate $241 million outstanding (roughly equivalent to $20.9 billion today) of debt. This was the first of five defaults in our country's history. The Constitution, ratified in 1787, gave the United States to power to levy taxes, though that power itself became hotly debated by the Founding Fathers. Alexander Hamilton was in favor of giving the central government the power to tax individual citizens, but wrote in the Federalist Papers that "It is evident from the state of the country, from the habits of the people, from the experience we have had . . . that it is impractical to raise very considerable funds by direct taxation." 

19th Century: War & Taxes

After the U.S. broke free of Britain's grip there were still many unresolved issues between the two countries. Due to a variety of reasons, the U.S. declared war on Britain and the War of 1812 began. It was during the war that the first direct taxes were imposed on Americans; until that time, the government’s revenue came from borrowing and trade tariffs. 

War is costly, not only in lives, but also in dollars. In 1862, the second year of the Civil War, of the $52 billion federal budget, $49 billion came from taxes on imports. During the war, President Lincoln enacted the most sweeping revenue act in our history up to that time, approving a 3% tax on annual incomes between $600 and $10,000 and a 5% tax on incomes above that level. For the sake of perspective, $600 in 1862 is roughly equivalent to $52,000 today, and $10,000 back then is equal to $868,000 today. Less than 1% of the U.S. population paid income tax during the Civil War. The revenue act also included an inheritance tax, but was repealed in 1872. 

Tax: A Heated Debate

During the 1890s, the U.S. once again became embroiled in a debate over the government’s right to levy an income tax. Proponents of it included farmers, labor and small business groups led by Democrats and Populists. The opposition included business interests led by Republicans who filed lawsuits challenging its constitutionality. A 2% income tax law was passed, but was rejected by the Supreme Court in 1895 as unconstitutional. 

After the turn of the century, progressive Republican senators broke ranks and joined the pro-tax group. In 1908 (his last year in office), Republican President Theodore Roosevelt called for an income tax and an inheritance tax. The following year, newly elected Republican President Taft (although opposed to it) agreed to a constitutional amendment permitting an income tax. Conservatives hoped it would never be ratified by the 36 states needed and thus would fail. However, it was their strategy that failed and less than four years later, the 36th vote for ratification was cast. Hence, the 16th Amendment was added and the federal government was granted the power to tax incomes. 

Summary

The road to our current tax system has been long and contentious. Today, with record debt and deficits, we find ourselves in the middle of perhaps the most hotly contested tax debate in our history. The reach of the federal government was significantly augmented during the Great Depression and income tax rates reached a peak of 94% in 1945 on annual income exceeding $200,000 (roughly $17.3 million today).

Next week, we'll look at some of the ways the federal government uses tax policy to influence behavior.

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