The road to a national income tax took some 50 years. It started during the Civil War. The Republicans imposed a 3% tax on income over $800, and during the war it was raised twice. Karl Marx loved the idea of a national income tax. In fact it was one of the ten planks the Communist Party desired in his Communist Manifesto. Many Populists and Democrats advocated a national income tax as far back as the 1890s. Congress passed a 2% tax on all income above $4,000 in 1894, but the Supreme Court struck down the law a year later as unconstitutional. Imagine that.
Enter President Woodrow Wilson, aka Mr. Progressive (at least that is what I call him). He gathered support for the tax on 2 main issues, its simplicity (what?!?) and that it would only affect the wealthiest Americans (sound familiar) at a very low rate. You can see how easy it would be to garner support from the majority of Americans. It also offered a way to avoid the controversy inherent in the tariff system that was being used to fund the majority of the Federal Government’s activities. And so, the national income tax was ratified under the 16
th Amendment to the US Constitution in 1913. Shortly thereafter, the Revenue Act of 1913 was passed. It instituted a maximum rate on people earning $500,000 a year at 7% of income. That doesn’t sound too bad. At the time, lawmakers couldn’t ever foresee the top rate ever climbing above 10%. By 1917, four year later, due to WWI, the top rate had risen to 67%! To be clear, the top rate per the IRS was 6% but they established “surtaxes” which combined with the income tax was 67%. Then in 1918, they pushed even further to 77%. With the war over and through the roaring 20’s, the top rates gradually fell down to a low of 29% in 1929, far above the 7% originally instituted in 1913. With the Great Depression, the Federal Government saw tax revenues plummet. The obvious solution was to raise the tax rates! In 1932, the bottom tax bracket nearly quadrupled, but to be fair, only amounted to 4% of income after the increase, and the top rate skyrocketed from 25% up to 63%.
Enter President Franklin Roosevelt. President Roosevelt pushed a Progressive agenda on this country unlike anything the nation had ever seen. It started with his signature package of economic programs, The New Deal. It is debatable how much these programs truly helped the economy and is beyond the scope of this post. However, specific language began to permeate the New Deal. It came to be known as “soak-the-rich”. Under Roosevelt, the progressivity of the tax was enhanced as well as capital gains rates. Roosevelt also allowed the federal estate tax to swell to 60% on estates above $10 million. In 1939, the Supreme Court determined that Congress had defined taxable income, “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion”. This definition largely holds true today. President Roosevelt gradually raised taxes throughout the decade, but it wasn’t until the US entered WW II that he really hit his stride. Even with all of the tax increases up to the Second World War, less than 7 % of the population had to file tax returns. WW II allowed Roosevelt to turn “the federal income tax from a ‘class’ tax into a ‘mass’ tax”
By 1941, the lowest tax bracket had risen to 10% with the top rate being 81%! With the onset of the war and his New Deal programs needing to be funded, Roosevelt stretched the tax even further. Roosevelt proposed a 99.5% marginal rate on all income over $100,000. When questioned by one of his advisor’s on the tactic, his response was “Why not?”! The proposal was turned down, so instead Roosevelt issued an executive order to tax all income over $25,000 at a 100% rate. (That seems logical.) Congress did not allow this to stand, so instead they allowed the top tax rate to max out at a paltry 94%, the lowest rate to rise to 23% and the reduction of the personal exemption level to $600. This would ensure that now 74% of the population would be filing income tax returns. For the next 20 years, income tax rates would stay around these levels, fluctuating a few percentage points up and down from decade to decade.
By the time President Kennedy was elected, many in government had embraced the economic principles of John Maynard Keynes, in which income tax was a tool that could be used to influence the growth rate of economies. In 1963 President Kennedy pushed an agenda to “reform” the tax code. The reform didn’t exactly take place, but he did cut tax rates dramatically for the top bracket and to a lesser degree, lower brackets. The Revenue Act of 1964 cut the top rate from 91% down to 70% and then reduced the lowest bracket down to 16%. The resulting tax cut of about $10 billion helped grow the economy by roughly $25 billion although, there is some dispute as to the tax cut being solely responsible. More likely it was a combination of the tax cut and the monetary policies of the Fed at the time.
Taxes stayed roughly the same with some legislation and rate changes throughout the remainder of the 60’s and 70’s. President Carter tried a couple of times to make dramatic changes to the income tax code, but was ultimately unsuccessful. The next big thing to affect income taxes was President Ronald Reagan. In 1981, President Reagan managed to lower taxes on upper income owners by 20% and to provide small relief to the lowest earners. After 1981, the upper tax fell to its lowest point in 60 years, down to 50%, while the lowest bracket was at its lowest since 1941, 12%. Then in 1982 with budget deficits looming, taxes were actually increased by expanding the income to include more sources of taxpayer revenue and to decelerate depreciation schedules, however rates did not change. This set the stage for… (feel the tension)
The Tax Reform Act of 1986 (TRA). “TRA has been widely hailed as the most significant tax-reform legislation the history of the federal income tax”. For those of us “in the business”, when it comes to tax rules, there is pre-1986 and post 1986. It slashed the marginal rates dropping the top rate to 28%, made wide-sweeping legislative changes, and simplified the Internal Revenue Code. (Simplified would be a relative term). The change to the Code in 1986 affected every family and business in the nation and was intended to be revenue neutral by lowering individual rates and increasing corporate tax rates.
Presidents Bush “41” and Clinton allowed rates to stay relatively level throughout their terms as President. That is not to stay that there weren’t tax changes. President Bush famously told the public to “read his lips, no new taxes”, but inevitably, there were. There don’t seem to be many years that go by without some tax law changes. The next big tax changes came under President George W. Bush in the form of another major tax cut. The effectiveness of tax cuts on deficits and revenue tends to be a highly debated topic. It is often reported that when the Federal Government cuts taxes, the Treasury generally sees record tax revenues in following years. While that may be true in nominal dollars, things tend to get a bit murky when revenues are adjusted for inflation. One thing that is hard to debate though, is the effect that tax cuts have on economic growth. With each of the last major tax cuts in 1964, 1981, and 2001, the economy has seen excellent periods of growth afterwards. Many things affect economic growth, but it is hard to argue that cutting taxes doesn’t have a substantial influence. President Bush “42” cut tax rates across the board lowering all brackets and doubled the child tax credit. Theses tax cuts helped the economy rebound from the “Dot.com” bubble as well as the tragedies of September 11.
So, what’s coming next? By most accounts, tax increases are coming, particularly on the upper income earners. President Bush’s tax cuts were complicated and many had expiration dates. At the very least, it looks like Congress and President Obama will allow many of them to pass away. While it is not a tax increase in the form of new legislation, by allowing the temporary rate decreases to expire, no one will be able to deny paying more in tax. Congress has also proposed paying for a large part of any health reform package by bringing back surtaxes for upper income earners. Those will start around 1% and move to 5% for the top brackets. One source claimed that “top Democrats are determined to use revenue from a surtax on upper incomers to pay for middle income tax relief”. Here are a few facts from the Tax Foundation (
www.taxfoundation.org). For 2007 (the most current data available) the top 1% of income tax returns earned 22.8% of adjusted gross income but paid 40.4% of the total tax bill. The top 1% of filers actually paid more in tax dollars than the bottom 95%! The top 25% of income earners paid 86% of the tax bill while only earning 68.7% of the nation’s income. I find it ironic that the income tax was sold to the American people on its “simplicity”, and today the US Internal Revenue Code is over 16,845 pages long. “The hardest thing in the world to understand is the income tax” – Albert Einstein.
Sources: Failure of US Tax Policy, Pollack, Sheldon; The Tax Museum; Wikipedia; The Mackinac Center; The Tax Foundation; The Kiplenger Letter; A Patriot’s History of the United States, Schweikart, Larry and Michael Allen.
Thanks for taking the time to read our new blog. Things here won’t always be about tax and they won’t always be as heavy. They certainly won’t all be this long. My goal is to talk about various topics in business and tax, throw in a little humble opinion, and add a little humor. Drop by from time to time and please leave some comments.