Releasing the Kraken Part 2   6 comments

The question is: how did we get from a modest 1% income tax on fairly wealthy people to the current system?

It’s easy to say — well, it’s been a century, but actually it took a lot less time than that. Within the space of seven years, the income tax had grown beyond its modest beginnings to become something close to what it is now.

In 1913, newly elected President Woodrow Wilson included a call for tariff reform in his inaugural address, then reiterated the need for revenue reform in that joint session of Congress, with a particular emphasis on lower import duties. House Ways and Means Chairman Oscar W. Underwood (D-Va.) introduced a bill to lower tariff rates from an average of 40% to roughly 29%. To compensate for lost revenue, the bill also included an income tax. The House passed the legislation in May and the Senate four months later. When Wilson signed the bill in October, it included an income tax of 1% on individual income over $3,000 ($4,000 for married couples). It also featured a progressive surtax ranging from 1 to 6%, depending on income.

The Bureau of Internal Revenue established a Personal Income Tax Division to collect the new tax, including a Correspondence Unit of 30 employees dedicated solely to answering questions about the new levy. The four-page-long Form 1040 was considered by many congressmen to be too complicated.

That sounds sort of familiar, doesn’t it? Here we see a professional bureaucracy created to deal with a crisis it created. It’s still going on 100 years later. The solution might be to make the form less complicated, but that wouldn’t employ thousands of IRS agents, so ….

Of course, the administrative state never lets a crisis – even one not of its manufacturing – go to waste. World War I brought a sharp decline in international trade, further affecting tariff revenue, causing President Wilson to call for emergency revenue legislation, which featured a whole new slate of excise taxes. These consumption taxes were lucrative, but proved unable to close the fiscal gap, so Wilson joined Democrats in Congress to support a steeper, more productive income tax. 

The Revenue Act of 1916 set out to raise $205 million in new revenue, more than half coming from the income tax. The “normal” income tax rate rose from 1 to 2% on net incomes over $3, 000 ($4,000 for married couples). Surtax rates also rose from 6 to a maximum of 13% on incomes over $2 million. To avoid widespread protests, the changes made the personal income tax steeper, but left its base quite narrow as the levy still applied only to the nation’s richest taxpayers. Corporation income tax also increased from 1 to 2% and a new federal estate tax was introduced with an exemption of $50,000 and rates ranging from 1 to 10%. The law also included a novel munitions tax designed to appease opponents of American involvement in the war; levied on manufacturers of military equipment, it was advertised to prevent war profiteering. Finally, the law featured a host of excise taxes, as well as a capital stock tax on corporations. Because of widespread voter objections, the 1916 revenue law repealed the “collection at source” provisions of the 1913 tax. Instead, the law now required simply that income sources provide information to the government on the amount of income paid out to recipients.

In March 1917, Congress introduced a corporate excess profits tax, a major innovation to the federal tax system. This levy taxed any profits above a “reasonable” rate of return, which was originally set at 8% profit; if owners made more than that, then they paid taxes according to a steep rate schedule.

Supporters defended the new tax on equity grounds, but it also turned out to be the biggest money maker among new wartime taxes. It attracted bitter opposition from business groups, who considered the tax a threat to managerial prerogatives. They were certainly justified in their suspicion, since both Wilson and his allies in Congress considered the levy a legitimate means of business regulation that many hoped to retain it after the war ended.

The excess profits tax applied to individuals as well as businesses. Individuals were taxed at 8% on incomes over $6,000. This innovation applied mostly to professionals and other highly educated workers, prompting critics to call it a “brain tax”.

Additionally, regular income taxes now applied to incomes over $1000 ($2000 for married couples), imposing a 2% rate, with graduated surtaxes as high as 63% of income.

Federal revenue grew dramatically. From 1900 to 1915, the average annual revenue collection was $281 million. From 1915 to 1926, the average collection was $2.78 BILLION.  

That enabled the administrative state, naturally. Every new type of tax required new administrative machinery to interpret and administer the law and the resultant rates. The Bureau of Internal Revenue had 524 headquarters staff and 4,529 field staff in 1917. By 1920, it employed about 12,000 staff nationwide.

Rates were raised in 1919. Corporations were allowed to exempt the first $2000, but rates were raised to 12% on net taxable income and large income individual payers were forking over 77% of their income. Still, it remained a narrow levy. In 1920, only 5.5 million returns showed any tax due.

In May 1919, lame-duck President Wilson made his famous “politics is adjourned” speech, urging higher taxes on income, estates and excess profits and the Bureau of Internal Revenue began a massive recruitment campaign to reduce its personnel shortage.

There existed a broad consensus that the steep wartime tax rates were unsustainable, driven home by a mid-term election that ushered the Democrats out and the Republicans in. Even Wilson’s own Treasury secretaries, Carter Glass and David Houston, suggested cuts. Wilson himself even suggested reducing taxes in his 1919 State of the Union Address. Still, many Democrats and progressive Republicans were unwilling to roll back wartime tax reforms. They liked the newly progressive cast of federal revenue policy, especially the excess profits tax, which they saw as a blow for egalitarian ideals. They argued that it would shift the fiscal burden to the individuals and corporations whose wealth posed a threat to American society.

Voters disagreed, however.

6 responses to “Releasing the Kraken Part 2

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  1. “The four-page-long Form 1040 was considered by many congressmen to be too complicated.”

    Makes one wonder how complicated it will be in another 50 years.


  2. Like the article – love the title.


  3. There nothing as certain in life as death and taxes.


  4. There is nothing as certain in life as death and taxes.


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