The History of Taxation & Tax Policy in America
Taxes have been around since the beginning of recorded history. The earliest known tax was implemented in the ancient city-state of Lagash in what is now Iraq about 6000 BC. In ancient Egypt residents paid their taxes with grain and livestock. Taxes are a natural consequence of complex social structures with the need for roads, bridges, water & sewage systems, police, social services, and a military to keep the people safe from neighboring communities. Taxation is the price we pay for civilization.
But, while everyone understands the need for taxes, they have always been controversial because of our tendency to believe that we are paying too much and that our leaders squander our tax dollars on things we don't want or need. Surviving hieroglyphic tablets from Egypt tell us that their citizens felt the same way, and the ancient Sumerians had a saying, "you can have a lord, you can have a king, but the man to fear is the tax collector!"
US Tax Policy-Tariffs:
In the United States, taxes have always been about more than raising money to fund the government. There has also been a public policy component and that element increased in the 20th century with the introduction of the income tax.
America's tax history begins with Alexander Hamilton's Report on Manufactures, issued in 1791, during his tenure as Secretary of the Treasury. Hamilton called for the implementation of a national tariff to fund the federal government. Tariffs on imported products were popular because they protected domestic manufacturers and weren't a direct tax on income or property. Moreover, Hamilton believed they would protect America's infant industries until they could compete in the global market and raise revenue to directly support US manufacturers with subsidies. It was an early example of a national industrial strategy that would be copied by other emerging economies in the 20th century.
Tariffs were also popular because they were easy to collect at ports of entry, without the necessity of a large bureaucracy and with little record-keeping or paperwork. They became the largest source of federal revenue from the 1790s to the eve of World War I, when they were surpassed by income taxes.
The United States and other major exporting nations reduced tariffs in the second half of the 20th century in order to expand international trade and increase global economic activity. So, while tariffs once made-up almost 100% of federal revenues, today they contribute just 2%, even after recent tariff increases on Chinese goods.
In the early years, America also funded the federal government with excise taxes on specific products. Like tariffs, excise taxes are mentioned in the Constitution as a funding source, "to pay the debts and provide for the common defense and general welfare of the United States."
Excise taxes are a popular source of government funding at the state and federal level for a variety of reasons. They aren't always obvious to consumers because they are charged to the manufacturer or retailer and then passed along within the price of the product. Additionally, excise taxes are levied to accomplish a specific policy generally recognized by the public. They are often used to discourage a particular behavior [smoking, drinking], or to pay for specific public services like the gas tax to pay for roads and bridges.
The first Congress set fairly minimal excise taxes on such products as whiskey, tobacco, snuff, and refined sugar. The tax on whiskey was deeply unpopular with western farmers, eventually leading to the infamous "Whiskey Rebellion," which President George Washington suppressed with the militia.
For most of our history excise taxes were a fairly insignificant source of federal income, but in the 1930s the United States expanded their use to make up for the reduction in income tax revenue during the Great Depression. And after ratification of the 21st Amendment ending prohibition, Congress passed an excise tax on alcoholic beverages and it provided a substantial portion of federal revenue during the lean years of the Depression.
Today, excise taxes are an established form of federal taxation and we pay them on a wide variety of products like cigarettes, telecommunication products, gasoline, airline tickets, and firearms. They contribute a rather small percentage of federal revenues; 3% in 2019, but there has been quite a bit of discussion in recent years about a substantial increase in the gas tax to fund much needed improvements in America's roads, bridges and other infrastructure needs.
The Income Tax:
Tariffs and excise taxes sufficed to fund the national government until 1861 when Abraham Lincoln signed into law the nation’s first tax on personal income to pay for the Civil War. It taxed individual incomes over $800 at the rate of 3%. In 1862, Congress passed the Internal Revenue Act which created the Bureau of Internal Revenue, the predecessor to our Internal Revenue Service [IRS].
The 1862 Act also created the first progressive income tax which levied a 3% tax on incomes above $600, rising to 5% for incomes above $10,000. Progressivity in the tax code reduces income inequality, especially if some of the tax dollars are used to fund a social safety net and initiatives addressing the education and health of working class families.
At the end of the Civil War, the income tax proved unpopular and was repealed in 1872, but Congress tried again in 1894, establishing a tax of 2% on income over $4,000. However, that legislation was struck down by the Supreme Court in the case of Pollock v. Farmers' Loan & Trust Company in 1895 because it was an unapportioned direct tax, in violation of the Constitution.
In response, Congress passed the 16th Amendment in 1909 and sent it on to the states for ratification. By 1913 it had been approved over the objections of conservatives like Richard Byrd who made an eloquent plea to defeat the amendment in the Virginia House of Delegates. His anti-tax screed has been repeated by conservatives in various forms ever since.
"A hand from Washington will be stretched out and placed upon every man’s business; the eye of the Federal inspector will be in every man’s counting house . . . The law will of necessity have inquisitorial features, it will provide penalties, it will create complicated machinery. Under it men will be hailed into courts distant from their homes. Heavy fines imposed by distant and unfamiliar tribunals will constantly menace the tax payer. An army of Federal inspectors, spies and detectives will descend upon the state." - Delegate Richard Byrd
After ratification of the 16th Amendment, Congress enacted the Revenue Act of 1913, levying a 1% tax on incomes over $3,000, with a 6% surtax on incomes above $500,000. A few years later in 1918, after the United States entered World War I, the top tax bracket was increased to 77% on income over $1,000,000. However, because of progressivity in the tax code and generous personal exemptions, only about 5% of Americans paid any federal income tax in 1918. And, after the war, the top marginal tax rate was reduced to 58% in 1922, 25% in 1925, and finally to 24% in 1929.
In 1932, during the Great Depression, the top marginal tax rate on America's wealthiest taxpayers was increased to 63% to offset falling tax revenue, and when the country entered World War II, it was increased again, reaching 94% in 1944 on income over $200,000 [almost $3 million today, considering inflation]. The tax revisions during WWII also broadened the tax base beyond just the wealthiest Americans. They increased the number of families paying taxes from about 7% of the population in 1940 to 64% by 1944.
However, few taxpayers paid anything close to the top rate. Because of progressivity, deductions, and credits, the poorest 20% of Americans only paid about 1.7% of their income, and 35% of Americans [rich and poor] paid nothing at all in 1945. Moreover, the top 20% of taxpayers only paid 20.7% on average.
The Truman and Eisenhower administrations made few changes to the tax code during the nation's military build-up after WWII and the Korean War, but in the 1960s the top marginal rate was reduced to 70%, then to 50% in 1982, and to 28% for a short time during the 1980s. As federal budget deficits increased in the early 1990s, the top rate was increased to 39.6% and then lowered to 37% most recently.
Because of these rate reductions, deductions, and progressivity in the tax code, the income of an average working American is taxed at an effective rate [the actual percentage of total income] of 14%, while even the wealthiest 1% of Americans pays just 27%. And, total income tax revenue as a percentage of GDP [the measure economists use to gauge the impact taxes have on the economy] has fallen from 9.9% in 2000 to 8.8% today.
As a result, Americans now have one of the lowest tax burdens in the world. The Organisation for Economic Co-operation and Development recently provided new statistics that show that total US tax revenue [state and federal combined] equaled 24.5% of gross domestic product, down from 28.3% in 2000 and almost 9 points below the average rate among developed nations. But, then again, we also have one of the thinnest social safety nets among advanced countries, so it's a trade-off we have consciously made.
The Income Tax Code and Public Policy:
As we mentioned at the outset, taxes are often about more than just raising money to fund the government, and that is especially true of income taxes. Congress has also included many deductions and exclusions into the tax code. Accountants and economists refer to these as "tax expenditures" because they reduce federal tax income and are created to reward selected activities or groups of taxpayers, much like spending programs. These tax breaks are an alternative way for the federal government to intervene in the economy and achieve public policy goals, but they are far more popular than new spending programs. However, like direct spending programs, they benefit one group of taxpayers over others and they must be financed through higher taxes or reduced spending elsewhere in the budget.
The largest "tax expenditure," which will cost about $190 billion in fiscal year 2021, is the exclusion of employers’ contributions to employees’ health insurance premiums. Under the tax code, such contributions are excluded from an employee’s income even though it can represent a net benefit of thousands of dollars annually. And there are many other such "expenditures such as child credits, charitable and mortgage interest deductions, long-term capital gains rate reductions, the earned income tax credit, and a myriad of retirement savings exclusions.
In some cases, Congress has signaled that the activities associated with the deduction [installing solar panels, saving for retirement, buying a home, etc.] should be rewarded. In others, Congress has chosen to benefit some group [investors, parents, homeowners] by providing them a break on their taxes.
Obviously, you can make a good argument for each of these deductions and exclusions, but they now total about $1.5 trillion a year and without tax expenditures, the government could collect 44% more in taxes. Moreover, they seem to continue in perpetuity without much thought about other, possibly better, ways to achieve the original public policy goal. For instance, few politicians today would consider making the employers’ contributions to employees’ health insurance premiums taxable income. Middle and upper class Americans broadly view this tax exclusion as sacrosanct, even those that favor cutting Medicaid benefits to the working poor. And, would the public policy debate on "Medicare for All' be different if the exclusion didn't exist? You bet it would.
Furthermore, these exemptions, credits and deductions primarily benefit the top 20% of households. That’s why tax expenditures have often been referred to as “welfare for the upper middle class.” And that's exactly what conservative legislators in Congress intended, as Syracuse University political scientist Chris Faricy noted in his book “Welfare for the Wealthy.”
Faricy, Washington Post: "I show that Republican control of the federal government has contributed to the rise of income inequality by expanding social welfare tax expenditure programs at the expense of discretionary social spending. This social policy strategy moves federal money to the rich and middle class and away from more vulnerable populations all in the name of economic security."
The Future of Taxation in America:
Looking forward, the most important question about the income tax is whether it will remain a viable method to fund government services. Even before pandemic related expenses in 2020/21, income tax receipts [the largest source of federal revenue] were inadequate to fund the federal government, and the corporate and estate tax cuts of 2017 exacerbated the problem. Moreover, in America's current political environment, tax rate increases for corporations and individuals seem unlikely, and deficit spending isn't infinite.
One tax vehicle that many economists favor, and is widely used in Europe, is a Value Added Tax [VAT]. It's like a retail sales tax, except that it's collected in stages from production to retail sale. It's regressive in that it doesn't differentiate between income levels, but that can be overcome with subsidies and income based rebates to offset the regressive impact. Moreover, It raises a lot of revenue without distorting economic choices like saving and investment, and it can be easier to administer than the retail sales taxes that states employ. And even a small VAT could raise a lot of revenue. The Congressional Budget Office recently estimated that a 5% VAT tax would yield about $3.0 trillion over eight years.
Right now, a VAT tax seems unlikely [it's just so European]. However, if/when America gets serious about fixing our infrastructure, providing additional funding for education, helping American families afford high quality day-care for their children, and reducing the budget deficit, a VAT may seem more palatable then increasing the income tax on businesses and individuals. And there is growing evidence that it could be a smarter way to increase government revenues.
The Estate Tax:
Taxation of the estates of wealthy individuals can be traced all the way back to ancient Egypt and Rome, but the United States didn't employ an estate tax to raise revenue until the 20th century. The Revenue Act of 1916 created the first true estate tax in America and it's been the subject of highly politicized debates ever since.
Opponents call the estate tax the “death tax” and argue that it represents double taxation, first when the money is earned and again upon the taxpayer's death. That's not entirely true, for several reasons. The tax impacts heirs to whom the estate will pass and much of the money was never taxed because it's held in real estate and stocks that aren't taxed until they are sold, even as their value increases. Proponents also argue that the tax reduces income inequality and prevents the accumulation of dynastic wealth. Winston Churchill once argued that estate taxes are "a certain corrective against the development of a race of idle rich".
In 1916, Congress set the maximum tax rate at 10% for estates greater than $5 million, but it was soon increased to 22% for estates valued at between $8 and $10 million, and 25% for estates valued at over $10 million. In 1924, the top rate was increased to 40% for estates over $10 million, and increased again in the Revenue Act of 1941 to 77% on estates valued over $50 million. However, throughout this period smaller estates paid a far lower percentage and many were completely exempted from paying any tax.
More recently, Congress has taken to gutting the estate tax by increasing the exemption so that only a handful of estates pay any tax. In 1997, estates valued at $600,000 and above paid estate taxes, with the top rate set at 55%. By 2017, the exemption had increased to about $5.5 million and the top rate had decreased to 40%. This year only estates valued at $11.5 million or more will pay any estate tax. As a result, only about 2,000 estates are currently liable for the federal tax, and estate tax revenue made up only 0.5% of total federal receipts in 2019.
An interesting and entertaining piece on the history of property taxation: A Brief History of Property Tax By Richard Henry Carlson
Some interesting thoughts about how to reform America's tax system. Efficient and Equitable Ways to Raise Revenue by Various Authors.
Some Favorite Quotes on Taxes:
Franklin Roosevelt: "Taxation according to income is the most effective instrument yet devised to obtain just contribution from those best able to bear it and to avoid placing onerous burdens upon the mass of our people."
David Frum, Conservative Columnist: "The big winners under the American fiscal system are the rich, who pay some of the lowest taxes anywhere in the world; the old, who are the main beneficiaries of the American social service state; farmers, rural people. These are Republican constituencies."
Frederick the Great: "No government can exist without taxation. This money must necessarily be levied on the people; and the grand art consists of levying so as not to oppress."
Leona Helmsley: "We don't pay taxes. Only the little people pay taxes."
Warren Buffett: "If anything, taxes for the lower and middle class and maybe even the upper middle class should even probably be cut further. But I think that people at the high end--people like myself--should be paying a lot more in taxes. We have it better than we've ever had it."
Will Rogers: "The income tax has made more liars out of the American people than golf has."
By: Don Lam & Curated Content