income tax — July 02, 2014

A Brief History of Income Tax in America 2

by Bob Williams

A New Kind of Tax Part 2: 1776–1900

Slave of Liberty With the winning of the Revolution, the American colonies became the United States – and taxation became a much more local issue. But to this point, taxation – whether British or home-grown – was pretty straightforward. Taxes were levied on sales of products or on property. The tariff, a tax on imports or exports – became a popular vehicle. Taxing income, though, was still years away.

The fledgling Congress struggled with running a new nation; just paying the bills was a work in progress in those early days. Meanwhile, the British were developing a nasty habit of stopping American ships and kidnapping our sailors to help them fight Napoleon. Eventually, it boiled over into war. The year was 1812.

In 1815, Secretary of the Treasury Alexander Dallas thought up the first American income tax. He needed to raise more money for the war effort. Britain had adopted an income tax during the Napoleonic wars, and Dallas thought it could work during wartime here. The big hitch in the U.S. was that the law said that any direct tax had to be apportioned according to each state’s population.  Dallas thought the income tax got around this provision because it was indirect, not direct taxation. But he never got the chance to try it. The War of 1812 ended before the income tax could be enacted.

In the ensuing years, the issue of slavery became the undercurrent that drove most federal policy. While administrations continued to tweak tariffs and other trade-related measures, a North-South tug of war was slowly developing in economic and social terms. By 1860 that tug of war would quickly morph into the real thing.

The Unthinkable Becomes Reality

Between 1861 and 1865, American fought American in one of the most gruesome military campaigns on the planet. We’ll leave the political dynamics to the real historians. Suffice to say the American Civil War pitted the industrialized North against a largely agrarian South. Both sides needed to raise more money to finance their military aims – a contest clearly won by the Union. They sold war bonds to aid the war effort, with sales over $3 billion. But they needed more.

Enter the income tax. It was passed in 1861 to help assure the financial community that the Union would have the money to pay interest on the war bonds it sold. The Constitution demanded that any direct tax be apportioned among states according to population. That meant the tax would be regressive; lower-density states and poor states could face a bigger burden than highly populated states.

The first income tax was simple: A 3 percent tax on annual incomes over $800. Most wage earners of the time were exempted. The income tax was expanded and graduated in 1862, exempting the first $600, setting a 3 percent rate on income between $600 and $10,000, and placing a 5 percent tax rate on income over $10,000.

The rising cost of the war – even for the Union – led Congress to expand the income tax again in 1864. By the end of the war, the North had raised over 20 percent of its war revenue through taxation; the South had managed just 5 percent. And with the end of hostilities, the first American income tax faded into history in 1872.

By 1894, an income tax was back on the table. This time it was packaged in the Wilson-Gorman Tariff bill and it was pretty straightforward, putting a 2 percent tax rate on incomes over $4,000. But just one year later, it was struck down by the Supreme Court. The Court ruled that a tax on the income derived from land – such as rent or real estate sales – constituted a direct tax on that land, and therefore should be apportioned. They also said the income from state or municipal bonds couldn’t be taxed – a matter of state powers vs. the federal government.

The Court’s decision silenced the issue of an income tax for the remainder of the 19th century. But the 20th century was about to dawn, and that would carry with it the beginnings of a new American tax structure.

Next time: Tax As We Know It

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