- Individual income taxes are the largest source of revenue for the government
- The 16th Amendment gave Congress “the power to lay and collect taxes on incomes”
- History has shown that tax revenues increase when rates are cut
Taxes have been part of our country’s history from the very beginning – No Taxation Without Representation! Some have said that the only two constants in life are death and taxes. Will Rogers once clarified that statement when he said “the only difference between death and taxes is that death doesn’t get worse every time Congress meets.” Today, different taxes (individual, corporate, partnership, state and local, estate, generation-skipping, sales, value-added, etc.) have become so complex, that you could spend as much time as you wanted buried in resources and still have more to learn. When most people think of taxes, they’re probably thinking of the individual income tax.
The individual income tax is the largest source of revenue for the federal government, accounting for close to half of the tax revenue each year. Side note: you may be surprised to learn that corporate income taxes account for only about 10% of the federal revenue. So, rather than dive into a specific technical area of the tax code, we are instead going to revisit the history of the individual income tax in our country.
In 1862, President Lincoln signed a bill into law that created a Commissioner of Internal Revenue and instituted our nation’s first income tax. Incomes between $600 and $10,000 were taxed at three percent, while incomes over $10,000 were taxed at five percent. This did not last long as ten years later in 1872, the income tax was repealed. For the next 40+ years, the government collected 90% of its revenue from taxes on liquor, beer, wine, and tobacco.
In 1913, the 16th Amendment gave Congress “the power to lay and collect taxes on incomes, from whatever source derived.” The first ever Form 1040 was created, and Congress adopted a tax of one percent on net personal income over $3,000 and six percent on incomes over $500,000. Five years later in 1918, Congress instituted a progressive income-tax rate structure similar to what we still have today. One major difference, however, was that the highest tax rate back then was 77%.
Twenty-four years later, Congress passed the Revenue Act of 1942. The Act increased taxes and increased the number of Americans subject to the income tax. In a win for taxpayers, this Act also created deductions for medical and investment expenses. Our existing tax payment system was forever shaped by the Current Tax Payment Act. Passed in 1943, this Act required employers to withhold taxes from employees’ wages and pay them in to the government on a quarterly basis.
Taxpayers got another win in 1944 when the Individual Income Tax Act created the standard deductions on Form 1040. Ten years later in 1954, the deadline for filing individual tax returns was changed from March 15 to April 15. In 1986, President Reagan signed the Tax Reform Act which was the most significant piece of tax legislation in 30 years. This Act formally codified the federal tax laws for only the third time since the Revenue Act of 1918.
Most recently, in 2017 (you may have heard) President Trump signed the Tax Cuts and Jobs Act into law. This was the most significant piece of tax legislation since the 1986 Act, and it made several substantial changes to the individual income tax. Among those changes were reforms to the alternative minimum tax, nearly doubling the standard deduction, and lower marginal rates across the tax brackets.
Tax Rates and Revenues Collected
Throughout our history, individual income tax rates have been all over the board. Between the mid-1920s to early 1930s, the rates were lower than almost any other time in our history with a lowest marginal rate of 1.5% and a top rate of 25%. Perhaps the all-time high was in 1944-45 where the lowest marginal rate was 23% and the top rate was 94%.
With the recent tax cuts, many arguments have been made on both sides about what the lower tax rates will mean for us as taxpayers and for our country as a whole. In years to come, when all the data is in, we will be able to accurately analyze the true effects of the Tax Cuts and Jobs Act of 2017. However, with regard to arguments about overall revenue collection and whether or not the high-income earners are paying enough taxes, we can look to several examples from history. We all understand that the past does not predict the future, but we have seen at least three examples of dramatic tax cuts that each led to similar outcomes.
In the 1920s, rates were cut drastically from top rates of 70% to top rates of 25%. Perhaps counterintuitively, revenue from individual income tax increased roughly 62%. Specifically, revenue rose from $719 million in 1921 to $1.164 billion in 1928. The share of taxes paid by high-income earners (over $50,000 per year back then) increased similarly. High-income earners accounted for 44.2% of the revenue in 1921, compared to 78.4% in 1928.
Tax rates increased again, eventually to a top rate of over 90%, and remained high until rate cuts proposed by President Kennedy were enacted. The reductions lowered the top rate from 91% to 70%. Similar to the outcome some forty years earlier, tax revenues increased from $94 billion in 1961 to $153 billion in 1968. The share of the tax burden borne by high-income earners also increased. Between 1963 and 1968, revenue collected from people earning over $50,000 per year increased by 57%.
Time passed, and thanks in large part to inflation, many taxpayers found themselves in higher tax-brackets – even though their inflation-adjusted incomes were not rising. To combat this, President Reagan proposed sweeping tax cuts. As a result, overall tax revenues increased by 99.4% during the 1980s. Focusing on individual income tax, between 1983 and 1989, revenues increased by more than 54% (still 28% after inflation). Similar again to prior examples, the share of taxes paid by the top 10% of income earners increased from 48% in 1981 to 57.2% in 1988. During the same timeframe, the top 1% of income earners’ share increased from 17.6% to 27.5%.
At the end of the day, whether you agree with them or not, taxes are here to stay. Today, taxes are both lower and higher than they have been at various times in our past, and you can be certain that taxes will be both lower and higher at various times in our future. With the tax situation the way it is at any given point in time, the best we as advisors can do for our clients is help them understand their tax picture as a whole and create a plan that follows the tax code as efficiently as possible. As Judge Learned Hand wrote in Gregory v. Helvering:
Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.
Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934)
Center on Budged and Policy Priorities; Policy Basics: Where Do Federal Tax Revenues Come From?; updated December 6, 2018; https://www.cbpp.org/research/federal-tax/policy-basics-where-do-federal-tax-revenues-come-from
eFile.com; US Income Tax History, Taxucation;
Internal Revenue Service; Historical Highlights of the IRS; March 22, 2019
Mitchell, Daniel; The Historical Lessons of Lower Tax Rates; August 13, 2003; https://www.heritage.org/taxes/report/the-historical-lessons-lower-tax-rates
York, Erica and Alex Muresianu; The Tax Foundation; The Tax Cuts and Jobs Act Simplified the Tax Filing Process for Millions of Households; August 7, 2018; https://taxfoundation.org/the-tax-cuts-and-jobs-act-simplified-the-tax-filing-process-for-millions-of-americans/