The fundamental structure of the American tax system emerged from the extended political crisis that led to the formation of the U.S. Constitution. Its architects struggled with the problems of how to finance the Revolutionary War debts and establish the nation's credit in international financial markets. Consequently, the Constitution gave the new government clear fiscal authority to establish its sovereignty. In the words of Article I, Section 8, Congress had the general power “to lay and collect taxes, duties, imposts, and excises.”
The one tax that the new federal government could not enact was a property tax. Property taxation had been the mainstay of local government in the Colonial Era, and after 1775 the newly independent states employed it extensively and worried that the proposed national government might preempt its use. Accordingly, Article I, Section 9 required that Congress allocate direct taxes, like property taxes, to the states in proportion to their population, rather than to the value of their property.
Taxation in the Early National Era.
The financial program of Alexander Hamilton, the first secretary of the treasury, established tariffs, set at low rates, as the major source of the federal government's revenue. Tariff revenues paid off the Revolutionary War debts and financed the Quasi-War with France in the late 1790s and President Thomas Jefferson's war against the Barbary pirates. Tariff revenues, in combination with borrowing and land sales, funded the Louisiana Purchase and allowed presidents from Jefferson through John Quincy Adams to implement an ambitious program of internal improvements. By 1836, tariff revenues had enabled the federal government to retire its debt, and in 1837 customs duties also enabled President Martin Van Buren to distribute surplus revenues to the states for internal improvements.
Before the Civil War, the nation's leaders rarely broke from a reliance on low tariffs. One exception occurred in the early 1790s, when Congress followed the recommendation of President George Washington and Secretary Hamilton and enacted the nation's first excise taxes. These applied to distilled spirits and touched off the Whiskey Rebellion of 1794. The revolt ended significant use of excise taxation until the Civil War.
Congress also experimented with high tariffs from the 1820s until the early 1830s. Protective tariffs were imposed to promote industrialization and to shelter America's high-wage workers and high-cost industries from British competition. But American industries quickly become competitive, and southern planters and western farmers resisted tariffs that increased the price of manufactured goods. Southern politicians, especially in South Carolina, denounced the 1828 tariff legislation as the “Tariff of Abominations” and vowed to overturn it. During the Nullification Crisis of 1832–1833, high tariffs came to symbolize federal power for South Carolinians worried about the future of slavery.
Consequently, Congress in 1833 reduced tariffs and in 1846 passed the low Walker Tariff, which paralleled Britain's repeal of the Corn Laws in the same year, another defeat for protectionism. These actions heralded the adoption of free trade throughout the Anglo-American world.
Meanwhile, state and local governments developed revenue systems that relied heavily on property taxes. As the Industrial Revolution gathered force during the 1820s and 1830s, Jacksonian reformers extended property taxation, trying to tax all forms of wealth. By the Civil War, most states had a general property tax designed to reach not only real estate, tools, equipment, and furnishings, but also intangible personal property such as cash, credits, notes, stocks, bonds, and mortgages.
Civil War to World War I.
The financial system of the early republic might have remained adequate for at least another generation had not the Civil War created such enormous requirements for capital that Washington had to adopt emergency taxes unprecedented in scale and scope.
The wartime government placed excise taxes on virtually all consumer goods, license taxes on a wide variety of activities (including every profession except the ministry), special taxes on corporations, stamp taxes on legal documents, and taxes on inheritances. Each wartime Congress also raised the tariffs on foreign goods. And, for the first time, the government levied a federal income tax—a graduated tax reaching a maximum rate of 10 percent.
Republican Congresses phased out most of the excise taxes after the war and in 1872 allowed the income tax to expire. Republicans, however, maintained the consumption basis of the federal tax system by retaining two elements of the Civil War tax system. First, they kept high tariffs. Until the Underwood-Simmons Tariff of 1913 significantly reduced the Civil War rates, the tariff on dutiable goods often approached 50 percent of their value. By 1872, the tariff again supplied most federal revenues. The high-tariff system of the Civil War Era came to be justified as a means of creating a national market and protecting American industries and their workers. Second, Republicans retained the taxes on alcohol and tobacco products. A buoyant demand for both meant that revenues from these levies produced at least one-third of all federal tax revenues. These taxes appealed to moralists as discouragements to, and punishments for, the consumption of commodities they stigmatized as sinful and threatening to a virtuous social order.
Between the Civil War and World War I, however, the class and sectional tensions created by industrialization increased political pressure for reform of the federal tax system. One result was the enactment in 1894 of a progressive income tax (i.e., rates rose as incomes increased). But in 1895 the Supreme Court, in Pollock v. Farmers' Loan and Trust Co., declared this measure unconstitutional because it was a direct tax not assessed in proportion to population. Popular support for progressive income taxation grew, however, and in 1909 congressional reformers from both parties sent the Sixteenth Amendment, legalizing a federal income tax, to the states for ratification. It prevailed in 1913, and Congress forthwith passed a modest income tax.
State and local governments, too, gradually transformed their tax systems. With urbanization, the rising demands for parks, schools, hospitals, transit systems, waterworks, and sewers overwhelmed the long-established system of general property taxation. Traditional self-reporting of property holdings proved especially inadequate for assessing the value of “intangible” property such as stocks and bonds. Accordingly, most local governments focused property taxation on real estate, which they believed could be assessed accurately at relatively low cost. States gradually abandoned property taxation altogether and adopted special taxes to replace the lost revenues. In 1911, Wisconsin adopted the first modern income tax.
World War I expanded the use of income taxation by the federal government. Mobilization required enormous revenue, and President Woodrow Wilson and other Democratic leaders strongly favored progressive income taxes and opposed the regressive general sales taxes preferred by the Republican party. To persuade Americans to make financial and human sacrifices for World War I, President Wilson and Congress introduced significant progressive income taxation.
The World War I income tax, enacted in 1916 as a preparedness measure, was an explicit “soak-the-rich” levy. Rejecting an approach that would have fallen most heavily on wages and salaries, it imposed the first significant taxation of corporate profits and personal incomes, and placed a graduated tax on all business profits above a “normal” rate of return. This “excess-profits” tax actually raised most of the federal government's wartime tax revenues.
During the 1920s three successive Republican administrations granted substantial tax reductions to corporations and the wealthiest individuals. Secretary of the Treasury Andrew Mellon (1855–1937) argued that the tax cuts would promote economic productivity and expansion. In 1921 Republicans abolished the excess-profits tax, dashing Democratic hopes that the tax would become permanent. In addition, Congress made the nominal rate structure of the income tax less burdensome on the wealthy and introduced a wide range of special tax exemptions and deductions, including the preferential taxation of capital gains and oil- and gas-depletion allowances.
Nonetheless, the tax system retained most of its “soak-the-rich” character. Indeed, Secretary Mellon struggled within the Republican party to defend income taxation against those who wanted to replace it with a national sales tax. He helped persuade corporations and the wealthiest individuals to accept some progressive income taxation and the principle of “ability to pay.” This approach, Mellon told them, would defuse radical attacks on capitalists.
During the 1920s, state governments faced growing expenses for schools, highways and other needs but were reluctant to compete with the federal government for income-tax revenues. Instead, they expanded their use of sales taxes and of various levies such as vehicle-registration fees, license fees, and gasoline taxes designed to make vehicle users pay the cost of highways. During the 1930s, state governments further increased the scope and rates of their sales taxes until, in 1940, they were raising most of their funds by this means.
The Depression of the 1930s produced a new “soak-the-rich” tax system. Beginning in 1935, President Franklin Delano Roosevelt and the Democratic Congress responded to threats from the left, particularly Huey Long's “Share Our Wealth” movement, by increasing the taxes on the wealthiest individuals and corporations while adopting payroll taxes to fund the new Social Security system. In 1936, Roosevelt and Congress took the radical step of enacting an undistributed-profits tax—a progressive tax on the profits that corporations did not distribute to their stockholders. This innovation, more than any other New Deal measure, aroused fear and hostility among large corporations. Business seized the political opening created by the recession of 1937–1938 and Roosevelt's faltering political power, and in 1938 and 1939 a congressional coalition of Republicans and conservative Democrats eliminated the undistributed-profits tax and halted New Deal tax reform.
World War II and Beyond.
During the mobilization for World War II, Roosevelt sought to finance the war with substantial taxes on corporations and upper-income groups, but opposition to radical war-tax proposals proved too strong. One source of opposition came from a diverse group of military planners, foreign policy strategists, financial leaders, and economists. To mobilize greater resources than during World War I, and to do so more predictably while also reducing inflationary pressures, they favored a general sales tax or an income tax that would produce most of its revenue from wages and salaries. The second source of opposition to Roosevelt's radical wartime tax proposals came from Democrats in Congress and the administration. They worried that anticorporate taxation could cause a postwar slump and even another major depression.
In October 1942, Roosevelt and Congress finally reached a compromise. They dropped a general sales tax, which Roosevelt opposed, and adopted an income tax that was progressive, although not as progressive as Roosevelt wanted. The act substantially reduced personal exemptions, establishing the means for the federal government to acquire huge revenues from the taxation of middle-class wages and salaries. To make the new individual income tax work, the administration and Congress relied on payroll withholding, deductions that sweetened the tax system for the middle class, a progressive rate structure, and the popularity of the war effort.
Under the new tax system, the number of individual taxpayers soared from 3.9 million in 1939 to 42.6 million in 1945, and federal income-tax collections over the period leaped from $2.2 billion to $35.1 billion. Mass taxation had become more important than class taxation.
Victory in World War II and postwar prosperity produced a popular, bipartisan consensus for maintaining the wartime tax regime. This consensus meant that Republicans accepted levels of taxation on large incomes and corporate profits that were substantially higher than the prewar rates. Democrats, in turn, largely abandoned taxation as an instrument to mobilize class interests. Instead, adopting the principles of Keynesianism, they used taxation as a means of stabilizing the economy, often giving Keynesian arguments a conservative twist. Presidents John F. Kennedy and Lyndon B. Johnson won bipartisan support for major tax cuts, enacted in 1964, by hawking the same growth-promoting, “supply-side” benefits that Andrew Mellon had urged during the 1920s.
The tax system of World War II endured for the rest of the twentieth century. Until the late 1970s, inflation and economic growth extended the system's life by pushing people into higher tax brackets (a process known as “bracket creep”) and enlarging the tax base. The federal government could cut taxes while still funding national defense and creating new domestic programs. In the late 1970s, however, a stagnant economy eroded the system's basis. Also, a powerful antigovernment movement emerged. California voters in 1978 passed Proposition 13, which slashed property taxes, encouraging President Ronald Reagan and Congress to make deep cuts in the federal income tax in 1981. The federal government subsequently ran huge budget deficits until the mid-1990s, when economic revival once again produced abundant income-tax revenues.
Taking a leaf from Ronald Reagan's playbook, George W. Bush in the 2000 presidential campaign called for major tax cuts, since the federal budget was showing a comfortable surplus. After Bush took office the economy turned sour and tax revenues declined, but he continued to push for tax cuts, now as a stimulus to economic recovery. The Republican Congress responded in 2001 with a $1.35 trillion tax cut spread over ten years, particularly favoring taxpayers in the upper income brackets (though less so than in Bush's original proposal). The economy did slowly revive, in part through the tax-cut stimulus; but as tax revenues declined and government expenses soared, owing in part to the Iraq War of 2003 and homeland-security costs, massive federal deficits resulted, as they had after the Reagan tax cuts.
As a new century dawned, antigovernment reformers proposed replacing the World War II system with more regressive taxes, such as a national sales tax. To succeed, they would have to persuade Americans to abandon their historic commitment to the progressive principle of taxation according to the “ability to pay.”
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