The History of Taxes

When you raise the subject of taxes, you are likely to get a very strong reaction from most people. It’s a very personal subject and, depending on your political view, could be one that pushes many of your “hot buttons.”

The next time you are at a party – if you’re brave enough – ask if anyone knows when taxation in the United States first began. You’re likely to get a variety of answers.

Many people think it was the cause of the Revolutionary War and the birth of our nation. Others might say that it’s a recent invention that’s only been around since the 20th century. Some might laugh and tell you that taxes are as old as the world.

The truth is … they’re all right.

Taxes have been around since the dawn of recorded history. You can find references to taxes in Greek and Roman civilizations. Throughout history, taxes and wars seem inextricably linked. Taxation, it seems, is a convenient way to pay for the high cost of going to war.

Although the concept of taxes has been around for since the dawn of time, let’s keep our focus on the issue of taxation in the United States.

Taxation in the United States has a long and interesting history. Our tax system has undergone many changes – both subtle and significant – since it first began. Each change is in response to changes in our society, the role of government in the lives of the citizens and the changing landscape of politics and the economy.

Colonial America

Prior to the Revolutionary War, there wasn’t a strong Colonial government like there is today. Colonies had more influence in the lives of the colonists and a larger role in the government of the country. This meant that individual colonies had a greater need for revenue.

Each colony instituted their own taxes and a complicated hodgepodge system of excise taxes, tariffs, and customs duties thrived with no Federal oversight.

By the second half of the 18th century, England was engaged in a bitter and expensive war with France. To finance the war efforts, it turned to its colonies.

American colonists were already feeling the weight of the Sugar and Molasses Act, which taxed the molasses needed to make rum – a valuable commodity in the New World.

In 1764 the English Parliament amended the Molasses Act to include taxes on cloth, wine, and other commodities. While it reduced the overall tax rate on these items, it allowed for strict enforcement and seizure of commodities in certain cases. The new act became known as the Sugar Act.

The Sugar Act did not bring in the revenue Parliament had hoped. In 1765 they passed the Stamp Act which taxed documents – permits, legal documents, contracts, newspapers, and pamphlets. Stamps had to be purchased and affixed to all of these documents.

The Stamp Act met with great resistance. It was a tax on the American colonies that directly benefited England, unlike previous taxes which were used mostly to pay for costs associated with the commerce system – something that benefited the colonies.
Colonists were angry with Parliament and threatened Colonial tax collectors with tar and feathering. Fearing their lives, many tax collectors never bothered to enforce the tax. The Stamp Act was repealed less than a year later.

The Revolutionary rallying cry that “taxation without representation” was tyranny became popular because colonists were forced to pay taxes without any representation in the British Parliament.

Colonists realized that they could not change or nullify Acts of Parliament in any peaceful way. Growing dissent with England lead to greater protests which eventually ignited into the Revolutionary War.

The Post Revolutionary War Era

After the Revolutionary War, a new country had to be created. The Founding Fathers made critical decisions regarding the form and structure of a new government. Perhaps their strong feelings about taxation and their fear of a strong central government led the Continental Congress to craft the Articles of Confederation which keep the balance of power in favor of the states.

The national government of the time had very little power and they relied on donations from individual states as a source of revenue. Each state maintained the right to levy taxes in any manner the state legislature desired.

By the time the Constitution was written, the Founding Fathers realized that a government could not function if it relied solely on its states for its revenue. Congress was given the power to collect taxes:

“The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States.” (Constitution, Section VII.1)

Congress soon levied excise taxes on consumer items such as distilled spirits, tobacco, and refined sugar to help create economic stability and pay off its tremendous war debt.

Americans now had taxation with representation in Congress, that didn’t eliminate the uniquely American desire to complain about government taxes.

Many citizens were very vocal about taxes they viewed as unfair. The Congressional tax on the sale of whiskey caused considerable outrage. Farmers in Pennsylvania saw the tax as a threat to their livelihood. They also realized that the tax was not applied consistently and fairly. They led a protest against tax collectors now known as the Whiskey Rebellion.
President Washing sent in Federal soldiers to suppress the farmers. Two protestors were arrested for treason and later pardoned by President Washington.

Although President Washington faced severe criticism for sending out the militia, he defended his actions. He wanted to send a strong message that this new government was determined to carry out – by force, if necessary – the law of the land.

Until the late 1790’s, all taxes imposed were excise taxes – taxes paid on the sale and consumption of certain items. At this time, Congress created the first direct tax on the owners of land, houses, and slaves. Direct taxes were recurring taxes levied on the basis of the value of the item being taxed. This tax was enacted to pay for the expansion of the Army and Navy.

In an event that became knows as the “Fries Rebellion”, John Fries organized an armed group of about 400 men to oppose the tax. They intimidated tax assessors and encouraged others to resists paying taxes. The militia was called out and Fries was arrested and tried for treason. He was later pardoned by President Adams in 1800.

The issue of direct taxes was controversial, at best, and when Thomas Jefferson was elected to the White House in 1802, all direct taxes were abolished. Only excise taxes remained.

By 1812, the United States was again involved in war. To raise money, Congress imposed additional excise taxes, raised customs duties, and issued Treasury notes. This new tax was based on the British Tax Act of 1798. This revenue strategy worked and by 1817 Congress had repealed these laws. For the next 44 years, the government collected its revenue from customs duties and through the sale of public land.

Civil War Era

During the Civil War, Abraham Lincoln and Congress were desperate to raise funds to pay for the war efforts.

The Revenue Act of 1861 proposed that “there shall be levied, collected, and paid, upon annual income of every person residing in the U.S. whether derived from any kind of property, or from any professional trade, employment, or vocation carried on in the United States or elsewhere, or from any source whatever.”

This act never took effect, partly due to glaring problems with the law and the tax collection system.

In 1862, Abraham Lincoln signed The Revenue Act of 1862 into law. This act was the first Federal income tax law and created the Bureau of Internal Revenue as well as the nation’s first Commissioner of Internal Revenue.

The tax was levied on personal incomes between $800 and $10,000 which were taxed at a 3% rate. Higher income was taxed at a 5% rate. This ensured that the tax was based on the person’s ability to pay.

(Note: $800 today, adjusted for inflation, would be the equivalent of over $15,000.)

The Revenue Act of 1862 had many other similarities to the tax system we know today. These included:

• A progressive system with rates increases with higher incomes
• A standard deduction of $600
• A variety of deductions were permitted
• Taxes were “withheld at the source” by employers to ensure timely collection
• A voluntary compliance system

“The people of this country,” the Commissioner of Revenue stated, “have accepted it with cheerfulness, to meet a temporary exigency, and it has excited no serious complaint in its administration.”

People may have cheerfully accepted the tax, but that doesn’t mean they paid them. Records from the time indicate that in 1870, when the country’s population exceeded 38 million people, only 276,661 tax returns were filed.

In addition to the personal income tax, new excises taxes were passed. These taxes were placed on items such as playing cards, gun powder, telegrams, leather, drugs, patent medicines, whiskey, and billiard tables. Legal documents were taxed and license fees were collected from various professions.

The Revenue Act of 1862 underwent many changes after the war and was finally repealed in 1872. In 1895 the Supreme Court declared it to be unconstitutional because it was considered an illegal direct tax.

The 16th Amendment

The 16th Amendment was passed by Congress in 1913. It allowed the government to collect tax on income from any source:

“The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” (Constitution, 16th Amendment)

Congress levied a 1% tax on personal incomes above $3,000 and a 6% tax on incomes of more than $500,000.

That same year, the first Form 1040 appeared. Even though it has changed considerably over the years, it has remained the main form for the collection and reporting of taxes.

In 1916 Congress amended the tax code to deal with a growing problem. Until this time, the tax system imposed a tax only on “lawful” income. The definition of “lawful” was being pushed to the limit and tested significantly. Congress acted by deleting the word “lawful” thus making all income subject to taxation – even if earned through illegal methods.

This change became the friend of government prosecutors who could not convict bootleggers and Capone-era mobsters through any other means except on income tax evasion charges.

Another important change happened for taxpayers in 1916. Before the income tax, the government had little need to know the intimate details of citizens’ private financial lives. Taxes were not based on income and the government could collect revenue without worrying about people’s financial situations.

With an income tax, the government suddenly had the need and the right to delve into the lives of every taxpayer. To deal with the invasiveness of the new income tax, Congress required that information obtained from tax returns be kept confidential.
The income tax system continued to respond to changes in the first half of the 20th century, including two World Wars and the Great Depression.

The Social Security Tax

President Roosevelt initiated many economic and social programs to combat the failing economy during the Great Depression. It was in 1935 that Congress enacted the Social Security Act.

This law provided, among other things, for “unemployment compensation” – payments to workers who lost their jobs. It also gave public aid to those in need, including the handicapped, certain minors, and the elderly.

All of these programs were funded by a 2% tax, half of which came directly from an employee’s paycheck and the other half of which came from the employer on the employee’s behalf. The tax was levied only on the first $3,000 of the employee’s annual wages.

Modern Times

After World War II, Congress changed the method for collecting taxes closer the way it had been during Lincoln’s administration. Taxes were again withheld from employee’s paychecks. This made it easier to collect taxes.

Unfortunately, it decreased the awareness of the tax rates for the taxpayer. Taxpayers had taxes taken out of their paychecks automatically and didn’t necessarily realize what tax rates were in effect.

An unintended benefit for the government was that this change made it easier to raise tax rates in the future.

By the 1950’s the Bureau of Internal Revenue was reorganized. It was now known as the Internal Revenue Service and it became a professional government organization. The name was chosen to reflect the organization’s new service-oriented vision.

The Commission of Revenue was replaced by the Internal Revenue Service Commissioner now appointed by the President and confirmed by the Senate.

By 1959, the IRS had become overwhelmed with accounting and processing tax forms. It introduced computers in order to automate and streamline processes. By 1967 all business and personal tax returns were processed by computer systems.
With computer automation came every taxpayer’s nightmare. The same computers that could process and handle millions of tax returns each year could also automatically select tax returns to be audited.

Despite the apparent efficiency by which the IRS could now come after taxpayers, the system did make the auditing process more fair and equitable. Complex computer programs could evaluate millions of tax returns and compare them against national averages. Those tax returns that could potentially contain errors or problems could now be identified easily and without the need to auditors to examine many unnecessary returns.

Over the years, Congress and the Presidents have made both small and significant changes to the tax laws in response to many difference factors – politics, the economy, inflation, and market factors. Our tax system will continue to change and evolve in the future.

It is this evolutionary process that makes it important for tax professionals to stay current with their education and keep up with the latest trends and changes.