Income Tax: Historical Perspectives

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INCOME TAX: HISTORICAL PERSPECTIVES

A tax consists of a rate and a base. Because income is the base for the income tax, a central question is: What constitutes income? Different theoretical concepts of income exist in economics, accounting, and taxation. The base of income to which the federal income tax rate structure applies is taxable income as constitutionally and statutorily defined. Thus, the concept of taxable income is grounded in theory and modified by political dynamics and administrative concerns.

From its modern introduction in 1913, the rate structure for the individual income tax has been progressive, meaning that tax rates graduate upward as the base of taxable income increases. Different tax rates apply to ranges of income, called brackets. Over time, the number of brackets and tax rates that apply to them have varied greatly. The tax rate applied to the last dollar of taxable income earned by a taxpayer is called the marginal tax rate. Total income tax as a percentage of total taxable income is the average tax rate, whereas total income tax as a percentage of total economic income is the effective tax rate.

ADOPTION AND EARLY IMPLEMENTATION OF FEDERAL INCOME TAX

Until the Civil War, federal revenues came from relatively low tariff rates imposed on a broad base of imported goods and from excise taxes. However, tariffs and excise taxes could not support escalations in government spending caused by the Civil War. Drawing on the example of the British Parliament's adoption of an income tax in

1799 to help finance the Napoleonic Wars, the U.S. Congress adopted the first federal income tax in 1861 to help finance the Civil War. Legislators regarded the war-motivated income tax as an indirect tax because neither real nor personal properties were taxed directly. The constitutionality of the tax was not challenged, and it expired in 1872.

During the post-Civil War years, high tariffs, often established to protect selected industries from foreign competition, and excise taxes were the major sources of revenues. By the early 1890s, tax structure was a political issue, with debate centering on the equity of the tax burden. In 1894, with strong Democratic support, a modest income tax was adopted. The first $4,000 of income was exempt from taxation, and the initial tax rate was 2 percent. The prevailing view was that this tax would apply to high-income taxpayers and corporations without extending to the wages and salaries of working people.

In 1895, the U.S. Supreme Court declared the income tax unconstitutional in the case of Pollock v. Farmers' Loan and Trust Co. on the basis that it was a direct tax. Article I, Section 9 of the U.S. Constitution provided that "No capitation, or other direct tax shall be laid, unless in proportion to the census." After the income tax was declared unconstitutional, Democrats began to introduce constitutional amendments to permit it. By the early 1900s, political support had broadened to include progressive Republicans. The Sixteenth Amendment, which legalized an income tax, was submitted to the states in 1909 and ratified in 1913. At this time, roughly 2 percent of American households paid the new tax.

MODIFICATIONS TO FEDERAL INCOME TAX OVER TIME

Various aspects of the federal income tax have changed since its inception.

World War I and Depression Years

During World War I, the Democrats altered the tax by adopting highly progressive rates and structuring the base to consist of the incomes of corporations and upper-income individuals. Additionally, an excess profits tax was imposed. This was a progressive tax on above-normal profits, and it generated most of the new tax revenue raised during World War I. Together the income tax and excess profits tax became an explicit means for the redistribution of income. To administer these taxes, the Bureau of Internal Revenue reorganized along functional lines, expanded in size, and employed such experts as accountants, lawyers, and economists. In 1916, "reporting at the source" was adopted, which required corporations to report salaries, dividends, and wages to the Treasury Department.

When the Republicans took control of the presidency and Congress in 1921, taxes on corporations and upper-income taxpayers were reduced, the excess profits tax was repealed, and the tax rate structure was adjusted to be less progressive. Many preferences were incorporated into tax law in the form of deductions, and the preferential taxation of capital gains was adopted. A capital gain is a gain that results from the sale of a capital asset, such as shares of stock in a corporation. In 1932 under President Hoover, and in 1935 and 1937 under President Roosevelt, tax rates increased and the tax base expanded. However, the income tax was not a dominant policy focus during the 1930s, partially because the federal government relied heavily on excise taxes and debt to obtain funds to support government activities.

World War II

The most significant impact of World War II on the individual income tax was to transform it to a mass tax that was broadly based and progressive. In 1941, changes were made to both rates and base. Higher tax rates were adopted and lower exemptions were allowed, thus expanding the base. Higher tax rates were adopted again in 1942. With the inclusion of a surtax, tax rates ranged from 13 percent on the first $2,000 of taxable income to 82 percent on taxable income in excess of $200,000. The number of taxpayers increased from 3.9 million in 1939 to 42.6 million in 1945. At the end of the war, 60 percent of households paid the income tax. The efficiency of collection was enhanced by the adoption of payroll withholding in 1943. By 1944, the individual income tax generated about 40 percent of federal revenues.

For corporations, progressive tax rates, also called graduated tax rates, were introduced in 1935, repealed in 1938, so corporations paid a flat tax during World War II. However, wartime corporations were subject to a graduated tax on excess profits, with the maximum rate of 50 percent after an allowance for a substantial credit.

During the World War II years, there was a major shift in the taxing power of the federal government relative to state and local governments. Federal revenues, as a percent of total taxes collected by all levels of government, increased from 16 percent in 1940 to 51 percent in 1950.

With some modifications, the basic structure of the income tax remained in place during the post-World War II years and continued in the early twenty-first century. Individual tax rates were reduced from wartime highs, and the tax base began to narrow with the adoption of exemptions, deductions, and credits. Inflation in the 1960s and 1970s created a condition called bracket creep. Taxpayers whose monetary incomes were increasing because of inflation, but with no equivalent increase in purchasing power, were pushed into higher tax brackets and thus subject to higher marginal tax rates. Because the corporate rate structure was not progressive, bracket creep did not apply to corporations. Although the corporate and individual income taxes had generated roughly the same revenue in 1950, by 1980, partially as a result of bracket creep, the individual income tax generated four times the revenue of the corporate tax.

After World War II

During the post-World War II years, the tax system was used increasingly as a means of financing. A government may deliver services by direct payment or indirectly by subsidy through a reduction in tax. For example, the deduction for home mortgage interest provides a tax subsidy for investing in housing. The term tax expenditure is used to describe subsidies for various purposes achieved by use of exemptions, deductions, and credits. Exempt income is not subject to tax. A deduction reduces the amount of income that is subject to tax, and a credit represents a direct reduction in the amount of tax liability. From 1967 to 1982, tax expenditure increased from 38 percent to 73.5 percent of tax receipts. Tax expenditure provisions complicate the determination of taxable income, the base for the income tax.

The sophisticated study of tax policy, which continued into the twenty-first century, began on a widespread basis during the post-World War II period. Central questions concerned the impact of tax policy on the amount of investment, the movement of capital, and labor-force participation.

From 1980 to 2000

The 1980s began with the adoption of the Economic Recovery Tax Act (ERTA) during President Reagan's term. A key provision of this act was the indexing of tax rates for inflation to eliminate bracket creep. ERTA provided for significant reductions in tax rates and began to reduce the role of the income tax in the nation's revenue system. During the 1980s, interest in tax reform grew, culminating in the passage of the Tax Reform Act of 1986. The goal of this act was to be revenue-neutral, neither increasing nor decreasing revenues. It provided a reduction in tax rates by expanding the tax base through the elimination of some tax expenditures.

After passage of the 1986 Tax Reform Act, attention shifted to the taxation of capital gains and replacement of the income tax. Beginning in 1987, capital gains and ordinary income were taxed in the same manner. Then preferential treatment was reintroduced for capital gains. Commonly proposed alternatives to the income tax include the value-added tax and national sales taxes, two taxes for which the tax base would be consumption rather than income. Another alternative is the flat tax on income. In theory, with one single tax rate—a flat tax—all taxpayers would pay the same proportion of taxable income in taxes. If the base of taxable income were defined as earned income, taxpayers receiving only interest and dividends would be excluded from the payment of taxes. Currently interest and dividends are subject to a double tax. Corporations pay income tax on the earnings from which dividends and interest are paid, and individuals pay income tax on dividend and interest income that they receive. Most flat tax proposals eliminate double taxation.

ADMINISTRATION OF FEDERAL INCOME TAX

The Internal Revenue Service (IRS), which administers the income tax, is part of the U.S. Department of the Treasury. Adapting to changes in technology to achieve the most efficient processing of information is a major challenge for the IRS. For many years the IRS was organized on a geographical basis, but in 1998 it was reorganized into four functional divisions differentiated by type of taxpayer.

For corporate and individual taxpayers that report on a calendar-year basis, annual tax returns are due on or before March 15 and April 15, respectively, following the close of the calendar year. Providing that the tax due is paid, time extensions for filing returns may be obtained. Although the closing dates for the quarters differ, both individuals and corporations are subject to payment of estimated tax in quarterly installments. Taxpayers who fail to file tax returns or fail to pay taxes are subject to monetary penalties, fines, and possible prison sentences.

EXTENSION OF INCOME TAX TO THE STATE LEVEL

Wisconsin was the first state to adopt an income tax in 1911. Massachusetts and New York soon followed by adopting income taxes when faced with problems related to World War I. Most other states adopted the income tax as a response to revenue crises created by the Great Depression. At the state level, definitions of taxable income differ from the federal definition and differ among states. Exemptions, deductions, and rates of taxation vary among states. As of January 2005, Nevada, South Dakota, Washington, and Wyoming did not impose individual or corporate income taxes; Alaska, Florida, and Texas did not impose an individual income tax. Formulas are used to allocate the income of multistate corporations among the states in which they operate.

see also Taxation