Schansberg: We ‘Celebrate’ the Income Tax Centennial

April 10, 2013

by Eric Schansberg, Ph.D.

This year, we celebrate the 100th anniversary of the 16th Amendment’s income tax, passed in the last days of the Taft Administration in February 1913. It was the first change in the Constitution since 1870, giving Congress “the power to lay and collect taxes on incomes, from whatever sources derived.”

In 1913, there were only seven tax brackets with marginal tax rates ranging up to 7 percent on income earned about $500,000 (about $10 million in today’s dollars). Initially, only about 15 percent of households paid any income tax.

During World War I, the number of brackets increased dramatically and the top marginal tax rate rose to 77 percent, but the threshold to be in the top tax bracket rose to $1 million (about $16 million today). In the 1920s, marginal tax rates decreased four times, bottoming out at 24 percent, but with a much lower threshold of $100,000.

During the Great Depression, the government increased income taxes four times — up to 79 percent in the top bracket. It doesn’t take a Ph.D. in economics to see this as one of the many boneheaded policies that lengthened the Depression. (On top of that, 1937 featured the new payroll tax on income — a key reason for the jump to 19 percent unemployment in the sixth year of the “New Deal.”) Top tax rates increased further in World War II — as high as 94 percent.

In the 1960s, JFK’s “supply-side” tax policy dropped the top rate from 91 percent to 70 percent. And under Reagan, the top rate fell to 28 percent, with only two tax brackets. Since then, our elected officials have added a few more tax brackets. And the top rate has bounced up and down in a relatively narrow range — up a few percentage points under Bush I, Clinton and Obama; and down a few percentage points under Bush II. Today, the top rate stands at 35 percent with proposals to increase it to 39.6 percent.

Over time, taxes have become immensely more complicated. The tax code debuted at 400 pages in 1913; today’s version weighs in at more than 70,000 pages. The first tax form and instructions were four pages long in total; today, many segments of the 1040 are longer than that. In its first year, relatively few people filled out simple forms efficiently; today, we spend billions of hours in tax preparation — another tax on our well-being.

A connection between wartime and dramatic increases in government spending and tax rates is not particularly surprising. Debt, inflation, lotteries and excise taxes financed the Revolutionary War. The first income tax was suggested during the War of 1812. And the first income tax was imposed during the Civil War.

There are three options to pay for more government spending: higher tax revenues, higher debt (and thus, future taxes) and higher inflation taxes (printing money to pay for spending). Some or all of these typically increase during times of war, but most of them disappear afterward. (Robert Higgs talks about the ratchet effect of wars on government budgets in his classic book, Crisis and Leviathan.)

The new, permanent, peacetime income tax changed this. (Before the 16th Amendment, the first peacetime income tax was passed in 1894 but was sacked by the Supreme Court the next year.) Before then, the federal government was financed by tariffs on international goods, excise taxes on domestic goods and the sale of land in the West.

Good news: Moving from taxes on consumption to taxes on income is progressive rather than regressive. Bad news: This new and largely open-ended pot of money allowed a fundamentally different approach to government spending and revenues. As a result, despite rapidly increasing standards of living, we’ve seen massive growth in government over the last 100 years.

Our version of “income-tax withholding” began in World War II — in which taxes are simply removed from your paycheck, making the cost of government far more subtle. This is a problem when costs are already inherently subtle (since they’re spread thinly per person), and interest groups have powerful incentives to use government to benefit themselves. Instead, imagine that you had to make payments to the government — quarterly.

And for all of the excitement about income taxes, most wage-earners lose far more to the 15.3 percent payroll taxes on all income earned up to a cap of $110,100 — also withheld quietly from our paychecks.

Someday, the complicated, progressive income tax and the simple, regressive payroll taxes on income may be replaced by a “flat tax” on income or a “fair tax” on consumption. Until then, take a closer look at what you pay — in both types of income tax — and imagine a simpler, less taxing world.

D. Eric Schansberg, Ph.D., an adjunct scholar with the Indiana Policy Review Foundation, is a professor of economics at Indiana University Southeast.

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