Income taxes and Opinion and Economic Analysis and Government

The tax system has fluctuated throughout the ages

April 13, 2009

It is tax season again, and my accountant friends are all aglow with anticipation. While their next few days are full of deductions and credits, it might do the rest of us well to reflect on the origins of the current income tax system.

For just about the first 150 years of the Republic, our tax system was a mess. States and local governments, largely wielding the property tax, were relied upon to field armies and build roads. So desperate was the situation that the Navy relied upon a system of privateers—licensed pirates—who had to share their treasure with the government.

The most famous of these was John Paul Jones. In the Civil War, men could buy themselves out of the draft. Indeed, it was considered patriotic to do so for older men, and President Lincoln paid the $300 bounty as an example to others.

In a period of sweeping government reforms, the nation imposed the first permanent income tax in 1913 (along with the Federal Reserve System). Taxes were levied on a sliding scale of 1 percent to 7 percent. With World War I came a top tax bracket of 73 percent. The top tax bracket fluctuated from 24 percent to 94 percent with wars and depression. Highly progressive taxes (with the rich paying a higher percentage than the poor) became the American standard.

With the tax system came loopholes (a great gift to the accounting and legal professions). A whole industry of tax avoidance has sprung forth. It makes much money, but is of dubious social value.

The bottom tax rates had slowly crept from 1 percent to 22 percent and again down to 15 percent by 2000. These were loaded with exemptions for families, such as home mortgages, charitable donations and, my favorite, the dependent-child deduction. The economic effect of these is huge.

During the Kennedy and Reagan administrations, there were substantial changes to income taxes, making them less progressive and altogether lower. President George H.W. Bush raised taxes on the highest income levels, making the tax more progressive. This enabled the Clinton administration to do the same, and the top rates rose from 28 percent to over 39 percent.

Interestingly, the much-maligned Bush tax cuts of the past eight years made the tax system far more progressive by lowering the rate on lower-income earners by two thirds. Today, just over half of all American households actually pay income taxes, and about one in seven households actually receives a payment—or negative income tax—as a tool for poor relief.

The economic effects of altering tax rates are significant for households and businesses. Raising or lowering rates changes who pays the taxes, but doesn't much affect the total revenue share, which has been at just under 20 percent over the past 60 years.

Not many folks, save for the aforementioned accountants and lawyers, like the tax code. But until we can get the Navy to pirate some of those oil tankers, we are stuck with it.
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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu. 

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