Steven A. Bank
Although the modern income tax emerged in 1913, it pales in comparison to the Internal Revenue Code in effect at the beginning of the twenty-first century. Because of a generous $3,000 exemption, plus an additional $1,000 exemption for married couples, the tax applied to fewer than four percent of the population. Even for those it affected, the impact was relatively mild. The act levied a tax of one percent on all incomes above the exemption with additional surtax rates imposed for progressively higher incomes. Those surtax rates started at one percent for those making $20,000 or more and topped out at a mere six percent on incomes in excess of $500,000. Given such a limited taxpayer base and low rates, it is not surprising that the income tax had only a minor role in the federal revenue system during its infancy. In its first year in operation, it was responsible for raising less than 10 percent of federal revenues. By contrast, the income tax accounted for 45 percent of federal revenues in 1950 and nearly 73 percent in 1985. The 1913 version of the income tax did not even merit its own act; rather, it was adopted as part of the Underwood/Simmons Tariff Act of 1913. Despite the income tax's relatively minor role, even contemporary observers recognized its larger significance. It marked the beginning of a transformation from taxation based upon the need to consume to taxation based upon the ability to pay. It also provided the vehicle for a rapid expansion of the federal government over the next thirty years.
EARLY HISTORY OF THE INCOME TAX
In the nineteenth and early twentieth centuries, the United States relied primarily on taxes levied on products manufactured in the United States (excise taxes) or imported into the country from elsewhere (tariffs) for the bulk of federal revenues. Two notable problems resulted from this heavy reliance on what are called consumption taxes. First, the revenue from tariffs was easily disrupted when trade fell. Second, both types of taxes were typically passed on to consumers in the form of higher prices, and this disproportionately impacted the poor. Both of these problems with the consumption-based tax system led to consideration of an income tax during the nineteenth century.
When the War of 1812 began, the federal government doubled the customs duties it had been using to raise the majority of its revenues. As a drop in trade caused these sums to dwindle and the national debt to increase, Alexander Dallas, Thomas Jefferson's Secretary of the Treasury, sought alternative sources of revenue. Dallas turned first to internal revenues from excise and property taxes before deciding to push forward with proposals for income and inheritance taxes. Although these latter proposals were raised too late to secure passage, the war had exposed the vulnerability of a tariff-based system.
During the Civil War (18615), Congress could no longer avoid the income tax. Imports were on the decline in part because of a drop in demand after the Panic of 1857, a severe recession that began with the discovery of a Wall Street embezzlement scheme and an ensuing run on the banks. Moreover, Abraham Lincoln assumed the presidency in March of 1861 with a pre-war debt of almost $75 million. The onset of war, with its accompanying naval blockades and other economic dislocation, only exacerbated this situation. Thus, in 1862 Congress adopted an income tax. Not only was it the country's first income tax, but it was the first use of graduated rates, or rates that increased progressively with the rise in a taxpayer's income. Some contend that the progressive rates were intended merely to raise more revenue, rather than to redistribute wealth, but it is enough to say that they helped shift some of the revenue-raising burden from the poor to the rich. After the war ended, the economy began to improve, prices fell, and budget surpluses replaced deficits. In the face of growing opposition to what the New York Tribune called "the most odious, vexatious, inquisitorial, and unequal of all of our taxes," the income tax was repealed in 1872.
A CONSTITUTIONAL CHALLENGE TO THE INCOME TAX
The income tax issue continued to simmer during the 1870s and 1880s, but a number of influences converged to make it a reality in 1894. Great fortunes were amassed during the high prosperity and protectionism of the 1880s. This focused attention back to the inequities of the tariff system during the election of Democrat Grover Cleveland in 1892. Coupled with the popular and economic unrest resulting from the Panic of 1893 depression in which the stock market collapsedhousands of businesses went bankrupt, million of people were left jobless, and the national income dropped ten percent. Congress once again adopted an income tax as part of the Tariff Act of 1894. Although the rates were flat rather than graduated as in the Civil War version, the goal was more clearly to redress inequity than in the early experiment with an income tax.
The 1894 income tax was never actually implemented because of a judicial challenge. Although the Supreme Court had upheld the Civil War version in Springer v. United States (1880), two shareholder suits were soon filed to prevent their respective corporations from paying the 1894 act's income tax. In the case that followed, Pollock v. Farmers' Loan and Trust Co. (1895), the Supreme Court struck down the income tax as unconstitutional. According to the Court, the income tax was a direct tax under Article I, Section 9 of the Constitution, and therefore must be levied "in proportion to the Census or Enumeration." Since the income tax would be collected at a uniform national rate on the basis of income rather than population, the Court found it to be an unapportioned direct tax.
THE SIXTEENTH AMENDMENT
With the Court's decision to strike down the income tax as unconstitutional, Congress once again turned to the tariff. Republicans had blamed the Panic of 1893 on Cleveland's tariff reform efforts. They regained control of both houses of Congress during the midterm elections of 1894 and the presidency in 1896 with the election of William McKinley on a platform of protectionism. Armed with this mandate, Republicans passed the highly protective Dingley Tariff Act in 1897.
The Republicans' push for high tariff rates came back to haunt them when prices rose over the next decade. While there is only mixed evidence that the tariff was responsible for this inflation, Democrats took advantage of the public's perception of a link between tariffs and high prices in order to bolster their anti-tariff, pro-income tax stance. The Panic of 1907, with its ensuing economic instability, furthered this cause. By the 1908 elections, both parties pledged their support for tariff reform. Presidential candidates William Jennings Bryan and William Howard Taft each expressed their support for an income tax; Taft, the eventual winner, declared in his acceptance speech that it was both constitutionally permissible and potentially desirable to have an income tax under circumstances of dire need.
On March 4, 1909, Taft formally called a special session of Congress to discuss the issue of tariff reform. This contentious session illustrated the political breakdown that had developed over the subject. While Republicans ostensibly dominated both houses of Congress, a rift was growing in their ranks. Regular Republicans adhered to the traditional party dogma of protectionism. A small but significant group of Republicans, however, were straying from this stance. Known as "Insurgents," this group of primarily western representatives and senators were opposed to favoritism toward big business. They sought a scientifically drawn tariff, which would provide protection for certain deserving industries, supplemented by an income tax designed to add a measure of tax equity. Given this changing political landscape, Republicans had to take seriously calls for an income tax during the 1909 special session.
In an attempt to forestall income tax proposals supported by a coalition of Democrats and Insurgents, regular Republicans, led by Senator Nelson Aldrich and Representative Sereno Payne, both of New York, managed to secure a compromise. They agreed to submit a constitutional amendment to the states that would allow Congress to levy a tax upon incomes. At the same time, they enacted an excise tax on corporate income in part to offset revenue lost through tariff revision. The resulting Payne-Aldrich Tariff Act, enacted on August 5, 1909, delayed the income tax, but fell far short of the fundamental reform of the tariff system that had led to the special session.
This failure of tariff reform helped fuel efforts toward ratification of the constitutional amendment for an income tax. Prior to 1910, two-thirds of the states had not even considered the proposed amendment. During the 1910 elections, however, Democrats and Insurgents rode a wave of anti-tariff sentiment to victories at both the state and federal levels. The following year, income tax supporters secured passage of the constitutional amendment in all but eight of the states necessary for ratification. Although there was a subsequent delay because most state legislatures only met every other year, ratification was achieved when Delaware voted to accept the amendment on February 3, 1913. Under what became the Sixteenth Amendment to the U.S. Constitution, "[T]he Congress shall have the power to lay and collect taxes on income, from whatever source derived, without apportionment among the several states, and without regard to any Census or Enumeration."
INCOME TAX OF 1913
In his inaugural address in March 1913, newly elected Democratic President Woodrow Wilson quickly took advantage of the new amendment by calling for tariff reduction and the adoption of an income tax. Within a month, during an emergency session of Congress, House Ways and Means Chair Oscar Underwood, a Democrat from Alabama, introduced a tariff reform bill that provided for an income tax with progressive rates. Underwood and the income tax section's principal drafter, Representative Cordell Hull of Tennessee, had originally sought to introduce a flat rate income tax to ensure judicial approval, but pressure from other Democrats, including future Vice-President John Nance Garner of Texas, led them to opt for the graduated rates.
The ensuing debates over the income tax primarily centered on the rate and exemption amount for an income tax, rather than the propriety of the income tax itself. Regular Republicans pushed for flatter rates and lower exemptions. Since they did not concede that the tariff was itself a tax, they viewed any exemption to the income tax to be class legislation and, in the words of Michigan Senator Charles E. Townsend, a "danger to the Republic." When combined with progressive rates, Senator Henry Cabot Lodge of Massachusetts argued, the exemption would "set a class apart and say they are to be pillaged, their property is to be confiscated."
Insurgents and members of the newer Progressive party saw the income tax very differently from regular Republicans. They advocated steeply progressive rates as a method of redistributing wealth. In the most extreme example, Representative Ira Copley proposed an income tax with a top marginal rate of 68 percent on incomes exceeding one million dollars. Others, such as Senator Robert La Follette of Wisconsin, proposed rates as high as 11 percent to reach what he called the "menace" of "great accumulation of wealth."
Standing between these two extremes were the Democrats, who proposed a more mild progression of rates to offset the burden of tariff taxes on the poor. Senator John Sharp Williams from Mississippi, one of the Democratic caucus's spokesmen in the Senate, rebuked the Insurgent and Progressive position by stating "[n]o honest man can make war upon great fortunes per se.... I am not going to make this tariff bill a great panacea for all the inequalities of fortune existing in this country." Nevertheless, he recognized that a modicum of progressivity, accompanied by a high exemption, was necessary as long as tariff taxes remained in place. According to Williams, the regular Republicans' plea for flat rates and low exemptions should be left for "when the good day comeshe golden dayhen there will be no taxes upon consumption at all."
The Democrats' position carried the day. The Underwood/Simmons Tariff Act, which went into effect on October 3, 1913, levied an income tax that imposed mildly progressive rates and was accompanied by a healthy exemption. The graduated rate feature was later challenged, but the Supreme Court
Although the income tax act of 1913 instituted only mild progressivity and raised a relatively small amount, it was still a monumental development. It began the process of converting the tax system from a regressive consumption-based system to a system that levied taxes based on the ability to pay. Moreover, it offered the vehicle for a rapid expansion of the tax system during World War I (1914918) when consumption taxes proved inadequate. It was not until World War II (19395), however, when Congress permitted payroll deduction and a significant cut in the exemption, that the income tax truly became a tax for all people. Nevertheless, it was in the income tax act of 1913 that the seeds were planted for this development.
See also: CORPORATE INCOME TAX ACT OF 1909; ESTATE AND GIFT TAXATION; TAX REFORM ACT OF 1986; TAXPAYER BILL OF RIGHTS III.
Brownlee, W. Elliot. Federal Taxation in America: A Short History. New York: Woodrow Wilson Center Press and University of Cambridge Press, 1996.
Buenker, John D. The Income Tax and the Progressive Era. New York: Garland, 1985.
Ratner, Sidney. Taxation and Democracy in America. New York: W.W. Norton, 1967.
Roberts, Paul C., and Lawrence M. Stratton, "The Roots of the Income Tax." National Review (April 17, 1995): 42.
Stanley, Robert. Dimensions of Law in the Service of Order: Origins of the Federal Income Tax 1861-1913. New York: Oxford University Press, 1993.
Waltman, Jerold L. Political Origins of the U.S. Income Tax. Jackson: University Press of Mississippi, 1985.
Weisman, Steven R. The Great Tax Wars. New York: Simon & Schuster, 2002.
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