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There is no certainty about the Death of Taxes

The personal Federal income tax turned 100 last year.  Like many things that have been around for 100 years, it is full of stories and changes and “fun facts”.  Some of these facts may be interesting and others may be downright scary just like the stories of a 100 year old relative. One thing seems to be clear, though; nobody expects the income tax to flat-line anytime soon.

 

The first federal income tax was passed by the first Republican President.

The first U.S. Federal income tax was passed in 1861 and signed into law by Abraham Lincoln.  As the Federal Government faced the threat of secession and war, and a financial strain due to a difficulty in borrowing, the Revenue Act of 1861 was passed which included a three-pronged tax structure; an import tariff on sugar, tea and other trade items, a property tax on real estate and the first income tax.  The income tax was a flat 3% of annual income over $800. (About $20,000 in today’s dollars)

Perhaps setting the stage for annual tax bills for decades to come, the first income tax had several practical flaws and was immediately repealed and replaced with the Revenue Act of 1862 before any taxes were collected under the first act.  The 1862 Act established the first progressive tax and established the Commissioner of Internal Revenue which remains today as the Internal Revenue Service.   This tax in turn was revised by the Revenue Act of 1864 which was challenged in the Supreme Court and upheld as constitutional.  It was fully repealed in 1872 as it had been primarily considered a war-time tax.

Beyond War-Time Taxes

In 1894, Grover Cleveland signed the first peacetime income tax.  The new tax imposed a 2% tax on incomes above $4,000. (About $105,000 in today’s dollars).  This tax, primarily on the rich was different from the Civil War income tax, which had exempted only the poor.  In 1894, less than 1% of the population earned enough to be subject to the tax.

As with the 1864 tax, the tax was challenged in 1895 in a court case called Pollack v. Farmers' Loan & Trust.  The case hinged on the Constitutional requirement that taxes be apportioned equally among the states according to population, which is not achievable with an income tax.

With one member of the court, Justice Howell Jackson of Tennessee absent because of illness, the court split 4-4 as to whether the new income tax was constitutional.  However, due to enormous public attention, the court agreed to reargue it and Justice Jackson, a known proponent of the income tax, rose from his deathbed to hear it.  It was assumed that with Jackson’s vote, the tax would now be upheld 5-4. But one of the other justices switched his vote and it was defeated 5-4.  Justice Jackson would die just three months later.

The Sixteenth Amendment

Although the decision in the Pollack case did not deem an Income Tax unconstitutional per se, it was generally seen as limiting the scope of an income tax in that it made it difficult to tax the wealthy through taxes on interest and dividends which the Pollack decision prohibited.  In 1909, members of Congress let by Senator Norris Brown of Nebraska and Nelson Aldrich of Rhode Island passed a constitutional amendment which was submitted to the states for ratification.  The full text of the amendment read:

“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.”

With 48 states existing at the time, 36 states were needed for ratification.  On February 3, 1913, ratification of the Sixteenth Amendment was completed with the ratification by Delaware. Six other states subsequently ratified the amendment, but six of the existing 48 states have never ratified the amendment, Connecticut, Rhode Island, Utah, Virginia, Florida and Pennsylvania. 

Income Tax in its early form

Once the amendment was ratified, Congress quickly passed and President Woodrow Wilson signed a new personal income tax.   The new progressive income tax started at 1% on income above $3,000 (approximately $70,000 in today’s dollars) and reached a top rate of 7% on incomes over $500,000 (over $11 Million in today’s dollars).  This income tax however, allowed for many deductions which could bring the actual tax rate down significantly, a feature of the income tax that is still with us today.

Within a few short years, freed of the constitutional barrier, the income tax proved itself to be a viable source of new revenue which the Congress and the President could change with relative ease.  This freedom to tax, combined with the onset of World War I would soon result in a top tax rate of 67% and increased the percentage of federal revenues from the income tax from 16% to 58%.

Following World War I and during the “roaring twenties” there was a brief relaxation of these high wartime top tax brackets.  But with the Great Depression and more war in Europe, Korea and Vietnam, high top marginal rates returned and became the norm for the next five decades.  From 1932 until 1982, the top rate rose from 58% to 92% and fell back slightly to 70%. 

Institution of Social Security Tax

 Also during the years of the great depression, President Franklin Roosevelt passed the Social Security Act as part of his “New Deal” in an effort to combat old age, poverty and unemployment.  Social Security, although promising benefits and being proposed as a “social insurance” program was eventually upheld by the Supreme Court as constitutional as an exercise of Congress’s taxation powers including those granted by the sixteenth amendment. 

Ida Mae Fuller was the first American to receive a monthly benefit from the new Social Security Program.  She paid into the Social Security System for three years from the time it was implemented in 1937 until she retired in 1939.  During those three years she paid in a total of $24.75.  Ida Mae lived to be 100 years old and collected Social Security until she died in 1975, collecting nearly $23,000.

As is the nature of taxes, the Social Security tax rates and earnings caps have steadily increased over the years.   What started out as a 2% tax on the first $3,000 of earnings has now risen to a 12.4% tax on $113,700. 

Below are the rate changes over the year.

The following table reflects how the earnings cap for Social Security has changed over the years.

The following table reflects the combined Social Security and Medicare tax cost on the Social Security earnings cap.  Beginning in 1994 the earnings cap for Medicare taxes was removed. 

Income Tax in its modern form

The exceedingly high marginal tax rates were heavily criticized as an obstacle to productivity claiming that beyond a certain point it was “not worth” working to earn more when such a large portion of it would be paid in taxes.  In addition, many high income taxpayers felt that the high tax rates were unjust and tax avoidance and tax evasion became common.

Between 1981 and 1986, President Ronald Reagan slashed the top tax rates from 70% to 28%.  Reagan’s tax reforms cut tax rates across the board, but increased tax revenues for the government by closing loopholes, making it tougher to evade taxes and broadening the base of those paying taxes.

After Reagan’s tax major reforms, President’s George H.W. Bush and Bill Clinton increased the top rates bringing them to 31% and eventually 39.6%.  This is where the top rates have remained for the last 20 years except for the temporary cuts under President George W. Bush.

While the top rates seem to have stabilized in the 30-40% range, there is still much, if not more tinkering done with the tax code from year to year.  While it is unlikely that we will see top marginal rates as high as 50% or more anytime soon, there are still many ways congress has found to increase taxes on wealthier individuals.  Beginning this year, a new surtax on investment income and a separate new Medicare surtax on earnings will be imposed on high income individuals who exceed certain thresholds.  (Click here to learn more about these new taxes beginning in 2013)

 The individual income tax has changed much in its 100 year history since passage of the sixteenth amendment.  Many would say it has changed for the better and many say for the worse.  Some people even say it has grown past its time and needs to be replaced altogether.  Benjamin Franklin opined, “"'In this world nothing can be said to be certain, except death and taxes" but while it is quite likely that the income tax is here to say, there is nothing certain about the form it will take even in the near future.