As we approach the beginning of a new year, I thought you might enjoy a break from all the numbers (such as percentages, thresholds, tax rates, etc.) that are usually included in my column. Instead, I thought you might enjoy the history of income taxes in America.
Our wonderful country began on July 4, 1776, when the Declaration of Independence was signed by 56 delegates representing all thirteen colonies. After eight years of war with Great Britain, it finally ended when the Treaty of Paris was signed on September 3, 1783. The United States functioned as a nation under the Articles of Confederation until it was replaced by the Constitution, which was signed on September 17, 1787, and ratified on June 21, 1788. The Constitution as adopted prohibited the direct taxation of its citizens. Article 1, Section 9: “No Capitation, or other direct, Tax shall be laid.”
The first personal income tax was passed on August 5, 1861, to raise funds for the Union to fight Confederate forces during the Civil War. (Incidentally, the top tax rate was 5% on income greater than $10,000.) This income tax was allowed to expire in 1873. However, in 1894, Congress passed the first peacetime income tax of 2% on income exceeding $4,000. At the time, less than 10% of the populace were affected by this tax.
The constitutionality of this income tax was challenged by Charles Pollock. The Supreme Court, on April 8, 1895, effectively repealed the 1894 income tax with its decision in Pollock v. Farmers’ Loan Trust Company.
In 1909, Congress proposed a 16th Amendment to the Constitution, which 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.” By February 1913, the amendment was ratified, and Congress passed the Revenue Act of 1913 establishing a national income tax. Income exceeding $3,000 was taxed at 1%, increasing to 7% of income over $500,000. Again, only the wealthiest 10% of Americans were required to file a tax return and pay income taxes. The original 1913 tax return was 3 pages with one page of instructions.
On February 10, 1939, Congress recodified various tax statutes into the “Internal Revenue Code” (IRC). On August 16, 1954, the tax laws were reorganized and expanded in the Internal Revenue Code of 1954. That IRC of 54 taxed income greater than $2,000 at 20% and 24 tax brackets later, taxed income exceeding $200,000 at 91%, which in my opinion is extraordinarily punitive and confiscatory. The 50% tax bracket kicked in at $16,000, allowing citizens to keep only half of their income.
The tax code was overhauled again during the presidency of Ronald Reagan by the Internal Revenue Code of 1986. The initial tax rate was lowered to 11% and the top tax rate to 38.5%. Although many tax code sections were revised, unmodified sections were rolled forward from the 1954 IRC.
The “Tax Cuts and Jobs Act of 2017” (TCJA) was the first major revision of the IRC since 1986. It was signed into law by President Donald Trump. Interestingly, few of the tax law changes were permanent, with most set to expire after 2025. Because the standard deduction amounts nearly doubled, most itemizers now use the standard deduction, which reduced the IRS workload by not having as many Schedules A to review and audit.
Congress often passes laws every year that impact the tax code directly. There are also several thresholds that are adjusted every year for inflation, but many are not. The annual limitation of $3,000 for capital losses is outdated. When that standard was established more than four decades ago in 1978, the median household income was $15,064. (So, $3,000 would have been 20% back then.)
Regarding the history of the IRS, I found it interesting that the first federal agency to be assigned with the collection of “taxes” was the Revenue-Marine. Secretary of the Treasury Alexander Hamilton recommended the establishment of the Revenue-Marine, which Congress legally authorized on August 4, 1790. Back then, our young country needed income, and tariffs on imports were the answer. However, because of low compliance and rampant smuggling, the Revenue-Marine was formed to serve as an armed customs enforcement service. This legislation provided funding for ten cutters (fast ships with a shallow draught) to be constructed and assigned to major ports.
Because the US Navy was mothballed after the War of Independence, the Revenue-Marine cutters were the country’s only armed ships from 1790 to 1798. The purpose of the Revenue-Marine was expanded to include intercepting illegal slave ships after the Slave Trade Act of 1794.
During the wars of 1812, Civil War, and Mexican American War, Revenue Marine cutters served under the US Navy. On July 31, 1894, the service was renamed Revenue Cutter Service. The Coast Guard Act (Jan 28, 1915) combined the US Revenue Cutter Service with the US Life-Saving Service to form the new United States Coast Guard. In summary, the purpose of the Revenue-Marine morphed from the collection of taxes (tariffs) into the US Coast Guard.
During Prohibition (1919), the Volstead Act charged the Commissioner of Internal Revenue with enforcing Prohibition. Al Capone, the notorious gangster, ended up spending 11 years in prison for tax evasion. After Prohibition was repealed in 1933, the IRS started enforcing alcohol and tobacco taxes and later administered the National Firearms Act. In the 1950’s the Bureau of Internal Revenue was renamed Internal Revenue Service.
Hope you enjoyed the history lesson. I don’t think I succeeded in throwing fewer numbers at you.
Aric Schreiner, CPA, PFS, Certified Tax Strategist, helps successful professionals and small business owners strategize to reduce taxes and audit risk.
