The History of the U.S. Federal Tax System
Federal Taxes on Individuals Then and Now
No one is thrilled to see taxes coming out of their paycheck. In reality, you might not realize that when it comes to federal taxes, many Americans have it pretty easy today, compared to taxpayers even half a century ago. The government has had its hand out for a share of our money in some form of taxation since before the ink dried on the Declaration of Independence, and it’s taken quite a lot from a select few at some points in our history.
Here's an overview of federal taxation throughout American history.
Taxation in Colonial Days
There were no income taxes, and there was no federal government in the beginning—at least not in America—but the colonists still had the British government to contend with.
Individual colonies made ends meet by taxing a variety of things other than income, such as the mere existence of adult males. Men had to pay a “head” tax in some colonies. Excise taxes, real estate taxes, and occupational taxes were all alive and well before the Revolutionary War as well.
As you probably know from your American history lessons, the Revolution was prompted by “taxation without representation.” The English Parliament had first passed the Stamp Act affecting colonists in 1765. Then, a short time later, it began taxing their tea—all without giving them a voice in Parliament. The colonists didn’t take this well, organizing the Sons of Liberty to waylay three ships that were delivering tea to Boston Harbor in 1773.
Britain retaliated, and the rest, as they say, is history. The Boston Tea Party escalated into the Revolutionary War.
America Becomes a Nation
Individual states financed the federal government in the years following the birth of the nation, at least until our Founding Fathers decided that depending on their fiscal generosity put the country in a precarious position. The Constitution was drafted and ratified in 1788, providing that Congress was entitled to “lay and collect taxes, duties, imposts, and excises” so the country could effectively begin supporting itself.
The states were put in charge of collecting those taxes and turning them over to Uncle Sam, but there was no federal tax on income—yet.
Excise taxes—sales taxes on specific goods—were common, however, and it turned out that Americans felt as strongly about their whiskey as they had about their tea in decades past. Alexander Hamilton made the grievous error of trying to impose an excise tax on alcohol in 1791, and it didn't go well. The Whiskey Rebellion followed, forcing President Washington to send federal troops to southwestern Pennsylvania to impose order on a mob of angry and unruly farmers who wanted the federal government to leave their liquor alone.
The federal government proceeded to impose “direct” taxes on Americans after this—individuals were taxed based on the value of things they owned, including slaves and land, but not their incomes. But President Thomas Jefferson pulled the plug on direct taxes in 1802, and the country went back to just collecting excise taxes.
Congress inflated these taxes and introduced new ones to pay for the War of 1812, but even these provisions were repealed five years later, in 1817. The concept of federal taxation eventually fizzled for a time, and the country made ends meet through the sale of public lands and customs duties for the next 44 years until the advent of the Civil War.
The First Income Tax
Wars cost a lot of money, so Congress was forced to go back to the taxation drawing board to raise revenue when the Civil War broke out in 1861. The income tax was officially born, imposed at a rate of 3% on all citizens who earned more than $800 a year. But as it turned out, this wasn’t enough to fund the war. Congress had to breathe new life into excise taxes a year later.
Little was spared from these taxes. They were imposed on everything from feathers to gunpowder and—once again—whiskey. The year-old income tax was adjusted for the first time as well. Instead of just one 3% tax rate, a 5% rate was introduced for all citizens who were lucky enough to earn more than $10,000 a year. The lower threshold was revised as well—anyone with an income of more than $600, not $800, was subject to the tax.
This was also the first time that employers were charged with responsibility for withholding taxes from workers’ pay. What we now know as the Internal Revenue Service came into existence. The office of the Commissioner of Internal Revenue, as it was known back then, was charged with collecting everyone's federal taxes, just as it is today. Individual states were relieved of that duty.
Decades Go by Without an Income Tax
The income tax was repealed 10 years later, and the federal government went back to supporting itself largely by taxing tobacco and liquor after the war ended. This policy lasted another 40 years, except for a brief hiccup in 1894. Congress again attempted to implement a flat-rate income tax in that year, but the U.S. Supreme Court promptly declared that it was unconstitutional—it didn’t take states’ populations into consideration, a practice that was provided for in the Constitution.
The 16th Amendment
Life without income taxes soon became history with the passage of the 16th Amendment in 1913. The amendment struck out the provision in the Constitution that said that taxes had to be levied based on states’ populations, and the income tax was reborn.
This time, however, the lowest rate was only 1% for those with incomes of between $4,000 and $20,000. It increased to 3% for those with incomes of more than $50,000. Very few Americans actually paid any income taxes with the way the new tax law was set up.
Form 1040 came into existence for the first time with the passage of this amendment, so all taxpayers could dutifully roll up their shirtsleeves once a year to figure out what they owed and report it to the IRS. All earners were taxed the same—the amendment didn't provide for filing statuses such as single, married, or head of household.
Tax Rates Skyrocket
Tax rates skyrocketed shortly after the 16th Amendment was passed, because war was looming again. The 1916 Revenue Act was enacted midway through World War I, when the U.S. once again found itself in desperate need of tax dollars. The 1% rate was increased to 2%, and the top rate went up to 13% for taxpayers who enjoyed incomes of more than $1.5 million.
Then, a year later, the War Revenue Act of 1917 increased tax rates yet again. This act also cut back on exemptions that were available to taxpayers. Those with incomes in excess of $1.5 million suddenly found themselves paying taxes at the staggering rate of 63%. Rates were increased yet again with the Revenue Act of 1918, increasing the top rate to 77%.
The Great Depression
The 1920s were an economic seesaw. The economy burgeoned and bloomed after the war, and the federal government found itself standing on steadier financial feet. Congress obligingly slashed those exorbitant tax rates to a range of 1% to 25%.
Then came the Great Depression. The stock market crashed in 1929, and the government found itself scrambling for money yet again. The hike heralded a period during which the top rates were much higher. Rates on the top portion of income rose to 63% in 1932, then increased to 79% in 1936. The lowest tax bracket increased to only 4%.
The Depression also prompted the 1935 Social Security Act to provide for those who were aged, handicapped, or otherwise “needy." This initial version of Social Security was like unemployment insurance for those who had lost their jobs.
The first Social Security tax was set at 2%—1% paid by workers and 1% paid by their employers—on wages up to $3,000 annually. It was first collected in 1937, but benefits weren’t paid out for another three years, by which time the Depression had ended.
The Effect of Another War
Tax rates continued to escalate in the 1940s as the U.S. engaged in World War II and, of course, needed money to fund that war effort. Three new tax laws were passed in 1940 and 1941, raising rates and eliminating exemptions. Those with incomes of $200,000 or more had to give a significant amount of their income to the federal government—the highest tax rate went up to a staggering 94%.
The highest earners didn't pay 94% of their entire income. These tax rates were marginal, as they are today, meaning that they paid progressively more of their income as it passed certain thresholds. Taxpayers paid 94% of any income over $200,000 during World War II.
The number of taxpaying Americans increased by 39 million between 1939 and 1945, although the Individual Income Tax Act gave taxpayers a bit of a break in 1944. It introduced standard deductions on Form 1040 to reduce taxable income for the first time.
Taxes in the Later 20th Century
The IRS really came into its own in the 1950s. Its name was officially changed to the Internal Revenue Service in 1953, and it was reportedly the largest, most powerful accounting and collection agency in the world by the end of the decade.
The IRS got its first toll-free telephone line in 1965, and computers were introduced in the late 1960s, affording IRS agents an easier way to scrutinize returns. By 1992, most taxpayers could file their returns electronically. The Taxpayer Advocate Service was rolled out in 1998 to assist taxpayers who ran afoul of the IRS.
Top tax rates remained high through the 1950s, still set at 91% for the country’s wealthiest taxpayers through 1953, before dropping to 70% in the 1970s.
Medicare officially joined the Social Security tax as part of the Federal Insurance Contributions Act in 1966. These combined taxes increased from the initial 2% Social Security tax to an 8.1% rate by 1980.
The Effect of Reaganomics
Relief came for many high-income taxpayers in 1981 with the passage of the Economic Recovery Tax Act (ERTA). Tax rates fell by about 25%. Ronald Reagan then moved into the White House and spared taxpayers even more. The highest tax rate had been sitting at 50% when he took office—thanks to the ERTA—and Reagan signed the Tax Reform Act of 1986 (TRA), slashing it to 28% beginning with the 1988 tax year.
The TRA compensated by taxing businesses more heavily than individuals. Personal exemptions were increased and indexed for inflation so they would continue to keep pace with the economy, as were standard deductions.
Tax rates began inching up again in the 1990s after Reagan left office. The highest rate eventually reached 39.6%, except for a drop to 35% from 2003 through 2012 under President George W. Bush's Economic Growth and Tax Relief and Reconciliation Act of 2001. That Act dropped the lowest tax rate to 10%, and it also increased the amount of the Child Tax Credit and the Child and Dependent Care Tax Credit.
Most recently, the Tax Cuts and Jobs Act dropped the top tax rate to 37% effective in 2018 under President Donald Trump.