FINANCIAL LIFE | WINTER 2011/2012 EFFECT

Individual Income Tax: A Little History

by Chris Hesse and Nick Houle

The income tax was first used to raise revenues for the United States government during the Civil War, and it was repealed soon after. In 1894, with President Grover Cleveland in the White House and both houses of Congress controlled by Democrats, the income tax was re-instituted, imposing tax at the rate of 2 percent on incomes above $4,000^[1]. In a Wall Street Journal article (September 27, 2011), writer John Steele Gordon comments that at the time less than 1 percent of the households were subject to the tax, and the next year it was ruled unconstitutional.

Taxing decisions

So went the early years of experimentation with taxes. How taxes were applied and which items were taxed reflected the relative power of the various groups lobbying the government. As the country grew and the government’s role changed both nationally and internationally, taxes became the source of funding for its evolving obligations.

President Theodore Roosevelt was sympathetic to the idea of an income tax, and ultimately his successor, William Howard Taft, proposed a constitutional amendment to allow for the collection of a personal income tax. Both were Republicans. The amendment was adopted as Taft was leaving office; President Woodrow Wilson and a Democratic Congress inherited the task of implementation. The amendment allows a tax to be collected on “income,” but it does not define “income.” Consequently, Congress was obligated to provide the definition, and its attempts have yielded the sprawling Internal Revenue Code we have today.

When first implemented in 1913, the income tax applied to incomes above $3,000 at the rate of 1 percent, increasing to 7 percent on incomes over $500,000. The effective rates were less because of the many deductions and exemptions. The legislation was only 14 pages long. Using 2011 dollars, the tax code in 1913 effectively exempted the first $68,650 of income, and the 7 percent rate would apply to income above $11.3 million.

U.S. Income Tax Rates, 1913 to Present
Year	Lowest Rate	Up to Income of	Up to Inflation Adjusted Income	Highest Rate	Above Income of	Above Inflation Adjusted Income	Income at Which 50% Imposed
1913	1%	$20,000	$453,292	7%	$500,000	$11,332,304
1916	2%	$20,000	$411,706	15%	$2,000,000	$41,170,573
1917	2%	$2,000	$35,059	67%	$2,000,000	$35,059,316	$5,258,897
1918	6%	$4,000	$59,438	77%	$1,000,000	$14,859,578	$1,159,047
1919	4%	$4,000	$51,880	73%	$1,000,000	$12,969,920	$1,115,413
1922	4%	$4,000	$53,424	58%	$200,000	$2,671,186	$1,175,322
1924	2%	$4,000	$52,486	46%	$500,000	$6,560,808
1925	1.5%	$4,000	$51,287	25%	$100,000	$1,282,169
1932	4%	$4,000	$69,040	63%	$1,000,000	$17,259,971	$1,441,271
1936	4%	$4,000	$64,570	79%	$5,000,000	$80,712,095	$1,194,539
1941	10%	$2,000	$30,528	81%	$5,000,000	$76,319,600	$396,862
1942	19%	$2,000	$27,531	88%	$200,000	$2,753,124	$247,781
1944	23%	$2,000	$25,498	94%	$200,000	$2,549,768	$178,484
1946	20%	$2,000	$23,013	91%	$200,000	$2,301,329	$184,106
1964	16%	$1,000	$7,238	77%	$400,000	$2,895,221	$289,522
1965	14%	$1,000	$7,123	70%	$200,000	$1,424,633	$313,419
1982	12%	$5,500	$12,788	50%	$85,600	$199,035	$199,035
1988	15%	$29,750	$56,427	28%	$29,750	$56,427
1993	15%	$36,900	$57,298	39.6%	$250,000	$388,200
2003	10%	$14,000	$17,072	35%	$311,950	$380,409
2011	10%	$17,000	$17,000	35%	$379,150	$379,150

Source: U.S. Federal Individual Income Tax Rates History, 1913-2011 (Nominal and Inflation-Adjusted Brackets), Tax Foundation

Balancing the budget with taxes

It didn’t take long for rates to increase. The United States entered World War I in 1917, the tax rates rose to fund the war, and never decreased to pre-war levels. The tax debate continued. After the war, Treasury Secretary Andrew Mellon pushed for reductions, stating in his book Taxation: The People’s Business (Macmillan, 1924), “The history of taxation shows that taxes which are inherently excessive are not paid.” Though President Calvin Coolidge supported this perspective, the stock market crashed in 1929, dramatically changing the economic landscape.

After three years of deficit spending, President Herbert Hoover encouraged increasing the tax rates to balance the budget. New tax brackets were created, rising to the 63 percent bracket. By 1936, President Franklin Delano Roosevelt raised the highest rate to 79 percent. As we entered the next decade, the threat of world war was looming, and in 1942, with the United States fully engaged, the rate was further increased.

The highest rates peaked in 1944 at 94 percent, dropped slightly in 1946, and then remained essentially unchanged for nearly two decades. The tax funds previously dedicated to war production were effectively diverted to fund both domestic and foreign priorities.

Cutting taxes

President John F. Kennedy proposed an across-the-board reduction in taxes, lowering the top rate to 70 percent. In an address to the Economic Club of New York on December 14, 1962, he commented, “[A]n economy hampered by restrictive tax rates will never produce enough revenues to balance our budget just as it will never produce enough jobs or enough profits.”

The Revenue Act of 1964 dropped the top bracket to 70 percent where it would stay until President Ronald Reagan’s Economic Recovery Tax Act of 1981 lowered it to 50 percent. Reagan would later spearhead the Tax Reform Act of 1986, expanding the tax base and creating a rate structure of two brackets: 15 percent and 28 percent, with no special tax rate for capital gains.

Reagan’s 1986 changes lowered the marginal rate to a point it hadn’t been since 1931. As a “permanent” change (as permanent as tax laws can be), taxpayers could understand that they could keep 72 cents for each additional dollar earned. In this respect, the lower marginal rate on everyone is a “hands off” approach from government when compared to a higher marginal rate, offset by “incentive” tax credits granted to favored industries.

The rates were increased to 39.6 percent in 1993 but without the credits and deductions previously enjoyed. In order to increase tax revenue without raising the rates, Congress also reduced deductions as income increased. Although tax rates have decreased since 2000, the decreases are temporary, and each year leaders debate their extension. Tax rates for 2013 remain uncertain.

Uncertainty

Uncertainty inhibits growth—uncertainty about taxes, regulations, or the future. Will the government deny me the ability to charge a fee for a service provided? Are the current tax proposals reducing uncertainty? If permanently imposed, will they raise revenue? Or are reductions in government spending and regulation the answer to the economy lifting itself from stagnation? You decide. Unfortunately, the only thing that we can be certain about is that the government will continue to tinker: with monetary policy, “stimulus” spending, tax provisions, and regulations—historically, it’s what the government has done.

[1] The Decline of the Income Tax, by Michael J. Graetz, W.W. Norton & Co., Inc., 1997, page 15.

 

One should not rely on this information for the primary basis of investment, tax or financial planning. General market information does not take into account such factors as an individual’s goals, objectives, risk tolerance, tax situation, age, or time frame. We believe the information obtained from third-party sources to be reliable, but neither LarsonAllen Financial, LLC, member FINRA & SIPC, nor its affiliates guarantee its accuracy, timeliness, or completeness. The views, opinions, and estimates herein are subject to change without notice at any time in reaction to shifting market conditions. Tax laws change and investments in the stock market entail risk and potential loss of principal. This material may not be republished in any format without prior consent.