A Brief History of the Income Tax

History of the Income Tax by Bob Green

Bob Green is a licensed CPA in New York State and also happens to be the father of the TJT IT Director, Drew Green.  Bob allowed us to share an article he wrote recently on the history of income tax.

Income taxes are a key factor to consider in investing and retirement planning, so this column provides a brief primer on the origins of revenue efforts from a variety of  governments.

Income taxation has a two thousand year history. In 10 AD, an emperor in China imposed a 10% income tax for profits on professionals and skilled labor. He was later overthrown and one of the causalities was his tax plan. In England Henry II instituted an income tax in the late 12th century to fund the Third Crusade. A more contemporary type of income tax was introduced in England in 1799 to fund the war against the French forces under Napoleon. It was meant as a temporary funding source at 10% on total income over sixty British pounds, equivalent to about $6,600 today.

In the United States income taxes were first introduced after the Civil War began in 1861, intended to make up for the shortfall in tariffs, duties and other federal revenue sources which had largely disappeared from many southern ports. Individuals earning between $600 and $10,000 a year paid taxes at the rate of 3%, after a $600 personal exemption. (This $600 is equivalent to about $16,000 in today’s purchasing power. See http://www.measuringworth.com/ppowerus/ for a sample chart.) At that time the maximum tax on interest income earned from U.S. Government securities was capped at 1 ½%, so more than 150 years ago there was a distinction between earned and unearned income. Moreover, in 1862 residential rent payments made by individuals or families could be deducted from taxable income and U.S. government employees were exempt from the tax.

Sales, excise taxes and estate taxes were eventually introduced, so by 1866, federal internal revenue collections exceeded $300 million, equal to about $4.6 billion in today’s dollars; still a pittance compared to what the IRS collects now, roughly $1.7 trillion a year.

After the Civil War, Congress repealed the income tax. It was reinstated in 1894 until the Supreme Court ruled it to be unconstitutional the next year. In the 20th century Congress enacted the 16th Amendment and it was ratified in 1913, essentially establishing the current system. (The 1913 three-page tax form and its one-page instruction sheet are about the same length as that used in 1862.) Failure to submit the form by March 1 subjected the taxpayer to a fine of between $20 and $1,000 (nearly $24,000 is today’s purchasing power). Guess what the form was called in 1913? Yes, it was Form 1040 (because there already was a 1039 for some other purpose)!

That 1913 tax return provided an exemption of $3,000 for single filers and $4,000 for a married couple. After the personal exemption, the normal tax rate was 1% up to $50,000 (equivalent to about $1.2 million today); over $500,000 the maximum rate was six percent. Permitted business deductions included “necessary” business expenses such as interest paid. A depreciation deduction was allowed, artfully called, “… a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business…”

During World War I an excess profits tax was enacted, with rates from 20 to 60 percent on the profits of all businesses in excess of prewar earnings. In 1918 rates were increased, ranging up to 80 percent. However, a major tax reduction followed the Republican victory in 1920, repealing the wartime excess profits tax. The top marginal rate on individuals fell from 73 to 58 percent and preferential treatment for capital gains began at 12.5 percent, well below the tax rates on ordinary income. Of course, this preferential capital gains treatment continues today. Overall, capital gains tax revenues have been a fairly modest portion of government revenue. Since 1954, revenue from the capital gains tax as a share of total tax revenue has averaged about 5.2%, but it reached a peak of 12.8% in 1986. Why was it so high that year?

In the name of tax fairness, the Tax Reform Act of 1986 raised the maximum long-term capital gains rate to 28 percent from 20 percent at the same time reducing the maximum rate on ordinary income to 28 percent from 50 percent. Many analysts expected investors sitting on long-term unrealized profits to recognize those gains before the 28% gains rate took effect and they did just that. Capital gains tax revenues in 1986 were double the level of 1985, the largest increase on record.  That 28 percent rate makes today’s maximum capital gains rate of 20% seem fairly manageable by comparison.

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