The Great Tax Wars by Steven Weisman (2002) is a history of the establishment of the income tax in America. It is very well written, very readable and an excellent component of the development of the progressive political movement.
We take the income tax for granted, but during the period of its enactment it was controversial and a challenge to the core of American values. Our nation was originally financed by tariffs intended to be just high enough to fund the necessary cost of government. As an agrarian nation few worked for salaries and the means to identify and tax income on a national or individual basis was not available. The Constitution also distinguished direct taxes from indirect taxes, requiring direct taxes to be equally proportioned among the citizens of a state, making an income tax very difficult to execute.
As agriculture became centralized into wealthier hands and as the railroads opened up vast new markets for industrial goods, we experienced significant economic growth and a growth in inequality. Tariffs became more than a means of financing the government; it became a means of protecting American industry and farm production. Tariffs were high enough for the national government to run significant surpluses during much of the 19th century even during recurring recessions and panics. Industrialists lobbied for high tariffs claiming to protect American jobs, but it also protected their profits.
The expansion of valuable markets from the railroads and the protection of profits through high tariffs means that the growing wealthy class were paying disproportionately less to the financing of the government than the middle class and poor.
Coming off of Panic of 1857, the Union faced difficulty financing the war in the South. Lincoln implemented our first income tax in 1862; 3% on incomes over $600 a year and 5% on incomes over $10,000. It also taxed inheritances, liquor and tobacco, banks, and it established the Internal Revenue Service. The South also instituted an income tax and found it difficult to apply and collect fairly especially as their currency rapidly depreciated.
The tax was considered a war time necessity and was removed in 1870. For the next twenty years the country grew, and the wealthy grew even more; many from profits generated to finance and supply the war. The rise of populism viewed the tariffs as an issue of social justice; the poor were paying higher prices from the tariffs that made the industrial class wealthy while the wealthy class of the Gilded Age paid relatively little toward the financing of the government.
An income tax bill was passed in 1893, but was declared unconstitutional in 1895 because in the judgment of the court it did not comply with the conditions of a direct tax allowed in the constitution. The opposition in Congress made the push for a graduated income tax about a war on the wealth of the successful and an attack on the American entrepreneurial spirit. Efforts to roll back tariffs fell flat.
The populist sentiment for a more equitable sharing of the cost of government remained and in 1909 Congress passed a proposal for the 16th Amendment to authorize an income tax, which was ratified in 1913. Nelson Aldrich and other opponents voted for the proposal, feeling safe that it would never be ratified.
Once ratified, Woodrow Wilson quickly signed a bill to reduce tariffs and replace the revenue with an income tax. Lower tariffs dramatically dropped the cost of living. The income tax only affected 3% of the populated and was graduated with the highest rate of 7% on income over $500,000. Still the wealthy were outraged on the idea of graduated rate and the assault on private wealth.
By 1920 Wilson had escalated the top rate to 77% to finance the American cost of WW I. In one of the greatest landslides in American history Warren Harding and Calvin Coolidge came into office facing one our worst Depressions in 1920. We recovered in less than two years and Treasury Secretary Andrew Mellon serving under Calvin Coolidge led multiple tax cuts dropping the top rate to 25%. By 1930 only 2% of Americans filed income taxes which provided a third of the revenue. Another third came from corporate taxes and the rest came from tariffs and fees.
Once the graduated income tax was accepted it became inscribed in a tug of war between justice and virtue; how to fairly allocate the cost of government without quelling the animal spirits we need for innovation and economic growth.
Our tax system has become mired in complexity, credits and deductions; often driven more by social engineering than either justice or virtue. The difference between the statutory rates and the actual rates paid can become significant obscuring much of the necessary clarity we need to properly discuss tax policy. Social justice too often descends into class warfare.
A century past the acceptance of the graduated income tax, income and wealth inequality is still a divisive issue although it is measured quite differently; we are more concerned with relative inequality than absolute poverty. The lack of any bipartisan consensus on tax policy means that rates can change dramatically between administrations, diminishing the effectiveness at either raising revenue or stimulating economic growth. Wealth adjusts for political reality rather than effective allocation.
Our biggest challenge is an endless appetite for government spending and an unwillingness and inability to raise taxes enough to support it. The idea that infinite spending can be supported by a small percentage of taxpayers defies basic math and principles of human action. This has caused record deficits and a belief that deficits do not matter and that tradeoffs are no longer required.
No matter how we tax or how much we tax, an unrestrained democracy will find a way to spend more than it takes in and will find rationalizations to both justify and obscure it.