You may remember, a few months ago, that I listed the problems of a tax code riddled with loopholes, also known as “tax expenditures”:
The biggest problem with tax expenditures, though, is that they are most valuable to the people who pay the most taxes. Not only are they huge and hidden, but they’re skewed to the people who already have the most money. The biggest tax expenditures bestow between one-third and two-thirds of all their money on the six-figure incomes that make up the richest 15 percent of the population. Rather than reducing inequality, they increase it. The U.S. may not have the smallest welfare state in the world, but it has one of the least progressive.
This was not the original intent of the federal tax code. When it was first created, in fact, the federal income tax did the converse: It exempted everyone but the rich.
The year was 1862. The country was running out of money. Abraham Lincoln pleaded with the banks, but they were reluctant to lend. How, they wanted to know, would the government raise enough money to pay them back? The Civil War had already cost over $500 million, and it was on its way to a total bill of $5 billion. No American government had ever collected that much tax revenue.
Until this point in American history, the federal government had raised almost all its money from tariffs.
The very first Treasury secretary, Alexander Hamilton, had set in motion a program of taxing imported goods to make them more expensive than domestic manufactures, in order to give American firms an advantage against foreign competitors. The program had worked. By the 1860s, the United States had developed a strong manufacturing sector.
But it came at a cost. The poor and the middle class spent more of their income on imported goods than the rich, and so they paid a higher percentage of their income in taxes. Tariffs were extremely regressive.
Now, faced with the need to raise more revenue, President Lincoln was discovering a second drawback: Imports never accounted for more than a small fraction of the nation’s income. Even at very high tax rates, there simply wasn’t enough money there for the government to take.
But tariffs actually had a deeper problem. They didn’t just tax the wrong things. They taxed the wrong people. They couldn’t raise enough money from the poor and the middle class because they didn’t have it.
Back in Hamilton’s day, they had a much bigger piece of the pie. By some measures, colonial America had the most equitable income distribution in the world. With industrialization, however, came increasing inequality. Income and wealth concentrated among the few who owned the factories and the plantations. By the 1850s, the richest 5 percent of Americans held the majority of the country’s wealth.
If they wanted to pay their bills, Lincoln and his Treasury secretary, Salmon P. Chase, had to go where the money was.
On July 1, 1862, Abraham Lincoln signed into law the first federal income tax in U.S. history. It set the tax rates at 3 percent on incomes above $600 and 5 percent above $10,000. It allowed taxpayers to “deduct” state and local taxes — and later, business expenses including interest payments — or subtract them from their income, so they did not have to pay taxes on that amount. And it created the Internal Revenue Bureau to collect the taxes.
It wasn’t enough. The costs of the war were escalating, and tax revenues weren’t keeping up. Meanwhile, the inequality gap continued to widen. The poor and the middle class were fighting in the war, while the rich were reaping profits selling war materiel. Then, they were lending those profits to the government to fund the war, and they were getting paid back with considerable interest. Since the majority of tax revenue still came from tariffs, the government was basically taking from the poor and giving to the rich.
So, in 1865, they raised the income tax to 5 percent on incomes above $600 and 10 per cent above $5,000. At long last, Lincoln could declare that the government was generating enough revenue to “maintain the contest indefinitely.”
The income tax lasted for another six years before it was phased out, having fulfilled its task in the eyes of Congress. But the remarkable thing about this decade-long experiment, looking back from our modern perspective, is how progressive it was. Because all incomes under $600 were exempt, the only people who paid the first federal income tax were the richest 10 percent of households. Everyone else paid nothing — because, in all other respects, they were paying so much.
With the income tax gone, the government went back to its regressive ways. In 1889, the famous litigator Thomas Shearman published an analysis showing that the poor bore the majority of the federal tax burden — and quite a burden it was, taking 75 to 80 percent of their savings, while for the rich it was less than 10 percent. Year after year, battles raged in Congress between populists decrying the plight of the American consumer and protectionists warning that American businesses wouldn’t be able to compete without tariffs.
Finally, in 1894, Congress agreed to lower tariffs slightly and reinstate an income tax to make up the lost revenue. This second attempt was even more progressive than the first. With the 2 percent tax kicking in at an income of $4,000, it only applied to the richest 2 percent of Americans.
Alas, it was not to be. The Supreme Court declared it unconstitutional in 1895, and Congress raised tariffs back to their old levels in 1897.
The third time Congress passed an income tax, it finally stuck. In 1909, they began taxing corporate profits, again deducting business expenses like interest payments. While the Supreme Court upheld this “corporate income tax” on a technicality, Congress passed an initiative to extend their taxing power to all incomes. The deciding state ratified the Sixteenth Amendment on February 3, 1913, and President Woodrow Wilson signed the first permanent federal income tax exactly eight months later. This time, the tax started at incomes above $3,000 for individuals and $4,000 for married couples — that is, the richest 3 percent of the population.
The original intent of the federal income tax was unambiguously to tax the rich.
And it became more so in short order. The United States entered World War I in 1917, and the federal government grew 20 times bigger. Woodrow Wilson, like Abraham Lincoln before him, had to go where the money was.
Since the 1860s, inequality had only gotten worse. Instead of the richest 5 percent of Americans holding the majority of wealth, now it was held by the richest 2 percent. Only high rates could extract enough revenue from so few people. And so, Wilson signed the War Revenue Act, raising rates as high as 63 percent on incomes over $1 million and 67 percent over $2 million.
“Never before, in the annals of civilization, has an attempt been made to take as much as two thirds of a man’s income by taxation,” marveled the great tax economist Edwin Seligman.
Below those levels, the rates varied from 20 to 60 percent, increasing with income. The law taxed inherited estates, as well as luxury goods and companies’ “excess profits.”
It was, in Seligman’s estimation, “the most gigantic fiscal enactment in history.”
And yet, for 95 percent of Americans, it cost nothing. It was entirely paid by the richest 5 percent.
The costs of World War I lingered long after the Treaty of Versailles. The federal government downsized from its wartime peak, but it would never return to its pre-war level. It still had a debt of $25 billion to pay off, plus another $2.25 billion that Congress allocated in bonuses for veterans over the next 20 years. The new Treasury secretary, Andrew Mellon, worked hard to bring the top tax rates down to a more moderate level, but even he had to admit they couldn’t go back to the regressive system of the past.
Regardless, the respite he bought them was temporary. The Great Depression and World War II increased the size of government permanently, and the top tax rates rose accordingly. The progressive income tax was here to stay.
The extent of its progressivity, however, was not.
This is the fourth in a series of Substack posts that will show how the United States can raise trillions of dollars in revenues to reduce inequality. Come back next week for Part 5…