On April 14, 1864, a third bill was introduced. This one changed the rate to 5 percent (from 3 percent) on incomes over $600. Rep. Augustus Frank, Republican of New York, set off the first debate on progressivity by offering an amendment to add a 7.5 percent bracket for incomes between $10,000 and $25,000 and a 10 percent bracket for incomes over $25,000. “I offer the amendment,” Frank said, “because I think it is just, right, and proper that those having a larger amount of income shall pay a larger amount of tax.” (Frank was most sloppy: as we saw in chapter 2, the rich pay a larger amount under a flat rate and could even pay a larger amount with a regressive rate structure. Ten percent of $100,000 is more than 25 percent of $10,000.) But the Ways and Means Committee report said the “principle [of progressivity] was a vicious one.” Stevens said he could “see no reason why a man should be punished in this way because he is rich.” Sen. Justin Morrill of Vermont said unequal taxation amounted to confiscation.7
Frank’s amendment was nevertheless adopted by the Ways and Means Committee. The Senate Finance Committee struck the 10 percent bracket. The full Senate applied the 7.5 percent rate to income over $5,000 (instead of $10,000). Another motion set a 10 percent rate for incomes over $15,000.
The conference committee lowered the threshold for the 10 percent rate from $15,000 to $10,000 and raised the rate on dividends and interest from 3 percent to 5 percent. Holders of government securities no longer paid a lower rate. The rental deduction was extended to owners.8
For the first time, tax returns had to be sworn, and government assessors could challenge returns. The penalty for late filing was doubled to 10 percent.
In addition, the Congress passed a special 5 percent tax on incomes over $600 for 1863 to pay for an army incentive program under which anyone who provided an acceptable recruit would be paid $2 and any person enlisting for three years would get the first month’s pay in advance.9
The income tax by now was raising money. From a slow start of $2.7 million in 1862–63, it brought in $20.2 million the next year. The taste of that much money was apparently sweet to those who collected it. Treasury Secretary William P. Fessenden called for repeal of the exemption so that the tax would begin with dollar one. When he was a senator he expressed no opinion about progressivity. But as head of the Treasury he defended progressivity on the grounds that “the ability to pay increases in much more than arithmetical proportion as the amount of income exceeds the limit of reasonable necessity.” The historian Harry Edwin Smith observed, “Many other men in public life seem to have gone through a similar experience in their attitude toward progressive rates.”10
But before the latest act could take effect, a fourth bill was passed. Out of a belief that too many large-income earners were escaping the tax, Congress applied the 10 percent rate to incomes over $5,000. Government assessors were given the authority to increase the estimates of people’s income. Penalties were increased: there was a 25 percent fine for neglecting or refusing to file. And the tax was to be doubled for a fraudulent return.11
None of the income-tax legislation prohibited making people’s returns public, and when newspapers began asking for the returns the government agreed in order that “the amplest opportunity may be given for the detection of any fraudulent returns that may have been made.” This naturally created antagonism toward the tax among those whose returns were of the greatest interest. In 1870 public release was outlawed.12
It should be noted that the government of the Confederacy also passed a progressive income tax. It also passed a tax in kind, which authorized government officials to seize the fruits of production directly.13
Postbellum America
When the Civil War ended, the income tax continued in order to pay the interest on the Union’s debt and to establish a sinking fund for the principal. But the attack on progressivity picked up again. Morrill argued that progressivity “can only be defended on the same ground that the highwayman defends his acts.”14 His opponents insisted that progressivity remain a feature of the tax until the regressive consumption taxes were removed. Some even called for increasing the top rate to 25 percent. There was also talk about raising the exemption because of the Civil War inflation.
In 1867 America’s experiment with a progressive income tax ended. A tax bill was passed that eliminated the progressive rate structure and raised the exemption: a uniform rate of 5 percent would now be applied to all incomes over $1,000. The lessening demand for revenue seems to explain the loss of support for progressivity. The penalty for refusal to file was raised to 50 percent, but the penalty for failing to pay the tax when due dropped from 10 percent to 5 percent. The date for payment was moved from June 30 to April 30.15
In 1868 no more than 250,000 out of a population of 39.5 million paid the tax. This was down from nearly half a million in 1866.16
As the April 30, 1870, expiration date neared, there began a move to retain the income tax, led by the revenue department. Special Commissioner David Wells called for lowering the rate to 3 percent, arguing that revenues would hardly drop because people would be more truthful about their incomes.17
Three arguments, from various perspectives, were made against the tax at this time. First, Populists said that the tax was unjust because it did not distinguish between “earned” and “unearned” income. Second, outright income-tax opponents said it fostered fraud and evasion because the rates were so high. Third, those opponents also said it was inquisitorial, because government officials inquired into the affairs of citizens.18 Defenders of the tax responded that the government needed the money and that the opposition came from rich, elite city dwellers.19
Congress approved a 2.5 percent rate and a $2,000 exemption. The tax expired in 1872 and for the first time since the Civil War, the United States had no income tax. By this time the federal government was running a surplus and many believed the tax was superfluous.
America’s first experiment with income taxation was instructive. The tax quickly became an important revenue raiser. At its height in 1866 it raised 30 percent of internal revenues — $73 million — and nearly 19 percent of the net ordinary receipts of the federal government.20
Nearly two-thirds of that money was raised in three states. About one-third of the tax came from New York, with almost another one-third coming from Massachusetts and Pennsylvania. The area’s heavy concentration of population and economic activity made this inevitable, and it was not missed by the people in the South and Midwest. It would become a big issue over the following twenty years.
The United States experienced great economic growth after the Civil War. Along with the boom came a great increase in duty-paying imports. That brought large surpluses to the U.S. Treasury for thirty years. The federal government kept the surplus down by paying pensions to Union veterans of the Civil War and their relatives. The pension program was arguably the first American welfare-state venture.
Although the surpluses hurt the case of those wishing to reinstate the income tax, sixty-eight bills were nevertheless introduced in Congress between 1874 and 1894. The tax was endorsed by the Greenback Party, the Farmers’ Alliances, and the Populists, who saw it as a way to reduce the regressive tariff. Since the income tax would be paid by the rich and could relieve the poor from the tariff, it had the makings of an excellent political issue. The great fortunes being amassed by a small number of industrialists and businessmen made the issue ripe.
The Income Tax of 1894
As Grover Cleveland was resuming the presidency in 1893, a depression following a stock and bank panic hit the country and lasted until 1896. Unemployment reached 18 percent in 1894, with the figure for nonagricultural workers as high as 30 percent.21 The budget surplus shrank.22 The hardship created social unrest and protest. The economic upheaval worried the Democrats, for they feared they would lose ground to the Populists in the West and South. They also saw an opportunity to attack what they hated: the McKinley Tariff passed by the Republicans in 1890.
The result of the
se twin considerations was an income-tax amendment. The South and Midwest led the effort for the tax, with the main opposition coming from the East.23 The vote in the House was: 196 Democrats and 8 Populists for the bill; 122 Republicans, 17 Democrats, and 1 Populist against. In the Senate, only 2 votes from the Northeast were cast for the bill.24 President Cleveland objected, but allowed it to become law without his signature.
The 1894 bill established a 2 percent flat tax on incomes from all sources, including wages and salaries, above $4,000 (about $50,000 today). It exempted interest on federal bonds issued with a prior exemption from taxes and the salaries of state and local officials, federal judges, and the president. Again, the tax hit very few people.
The argument for the tax once more centered on the belief that large incomes were untouched by the tax gatherers. Opponents predicted economic ruin and condemned the tax as “inquisitorial.” Democrat Sen. David Hill of New York said, “It may be impracticable that our distinctively American experiment of individual freedom should go on.”25
The Supreme Court Speaks
The U.S. Supreme Court would have the last word in the matter after hearing the case of Pollock v. Farmers Loan and Trust Co. in 1895. It took two hearings before the matter was resolved. In the first instance, the Court ruled that the bill’s tax on rents and other income from property was a direct tax and hence was invalid because, contrary to the U.S. Constitution, it was not levied proportionally on the states. The tax as applied to state and municipal bonds was also struck down. But the Court divided 4–4 (one justice was out sick) on the question of whether the tax on general income was unconstitutional.26
Because of the importance of the issue, the Court agreed to rehear the case when it was back to full strength. In a 5–4 vote, the Court stuck to its ruling on real estate and broadened it to include personal property. The fatal provisions sank the whole scheme. (The Pollock case partially reversed the 1881 Springer case, which had upheld the Civil War tax and ruled that all income taxes are indirect taxes.)
At this point something must be said about the distinction between direct and indirect taxes. The Constitution, in Article I, Sections 8 and 9, apparently draws the distinction by declaring that direct taxes, such as a “capitation” (or head or poll) tax, must be apportioned among the states according to the census. On the other hand, “Duties, Imposts and Excises shall be uniform throughout the United States.” (Emphasis added.) So if the tax was direct, it had to be apportioned among the states; if it was indirect (as American courts have long held), the rate structure, even if progressive, had to be the same in each state. The Sixteenth Amendment was intended to address the Pollock ruling that a tax on property income (but not wages and salaries) is direct and hence in need of apportionment.27
In fact, the distinction between direct and indirect taxes was anything but clear. Many definitions have been offered over the years. For example, it has been suggested that a direct tax is one which the federal government levies on citizens straightaway; whereas an indirect tax is one levied on the states, which in turn tax their citizens. That was how revenue was raised under the Articles of Confederation. It has also been said that a direct tax is one that cannot be passed along to others, unlike a sales tax. That would make the income tax a direct tax.
At different times, the Supreme Court has held the income tax to be either a direct or an indirect tax. No less an authority on the Constitution than Alexander Hamilton said, “It is a matter of regret that terms so uncertain and vague in so important a point are to be found in the Constitution.”28 The confusion is further illustrated by the fact that when Rufus King of Massachusetts asked the Constitutional Convention what “direct taxation” meant, James Madison recorded in his notes, “No one answered.”29
While the Supreme Court decided the case mostly on technical issues, Justice Stephen J. Field allowed himself a comment on more basic principles. He wrote that if a discriminatory tax is permitted to stand, “it will mark the hour when the sure decadence of our government will commence.”30 Justice John Harlan, leading the dissenters, wrote that the majority decision denied the national government a vital general power on which the very existence of the nation might someday depend.31
Opponents of the income tax won the day thanks to a sympathetic Supreme Court. It was to be a short-lived victory.
The Sixteenth Amendment
From 1895 to 1909 the income tax lost the spotlight, except for a vain attempt by Populists to use it to finance the Spanish-American war.32 Nonetheless, the Democrats endorsed it in their 1896 platform and called for a constitutional amendment to nullify Pollock in their 1908 platform.33 In 1908 former Republican president Theodore Roosevelt endorsed both an income tax and an inheritance tax.34 He had much to say about a graduated income tax in 1904 when he was elected president, scorning what he called “swollen inheritances and incomes.”35 In their 1904 race against Roosevelt, the Democrats (with candidate New York State Judge Alton B. Parker) left the income tax out of their platform. But things changed over the next four years.
The beginning of the new century saw a big increase in the cost of living — one-third between 1897 and 1913.36 The 1908 election brought a new group of liberal Republicans, called the Insurgents, to Congress. They joined with the Progressives to form an eight- to ten-member bloc of senators, mostly from the Midwest, that attacked the tariff and introduced income-tax legislation. A compromise worked out between nineteen Republican senators and the Democrats led to an income-tax amendment to a pending tariff bill. Republican Senate leader Nelson Aldrich of New York feared that the amendment would pass, so he delayed the vote for two months. Meanwhile, he asked President William Howard Taft to intervene. Taft offered a fateful compromise: immediate passage of a 4 percent excise tax on corporate profits and a constitutional amendment to allow an income tax without apportionment among the states.37 This caused an odd reversal. The old-line Republicans, who opposed the income tax, supported the corporate tax, while the Insurgents opposed it as a poor substitute for an income tax. The compromise bill passed.
Taft, a Republican Progressive and a member of the influential pro-intervention National Civic Federation, had seemed to accept the income tax during his campaign, but was not convinced of the need for a constitutional amendment. He changed his mind in 1909. Noting that ratification may be difficult, he said he had “become convinced that a great majority of the people of this country are in favor of vesting the National Government with power to levy an income tax.”38
In 1909, the income tax amendment passed overwhelmingly in both chambers of Congress. Rep. Sereno E. Payne, cosponsor of the then-pending Payne-Aldrich Tariff, was particularly concerned that, should the nation enter a war, “we have the power to exhaust every resource of taxing our people.”39
The issues thrashed out during ratification were related to class and geography. The West and South eyed the greater Northeastern wealth, which they felt was untouched by federal taxation, and pushed the ability-to-pay principle. The public in these regions was told that most people would never pay the tax. Northeasterners complained that the tax would victimize them. Idaho Republican Sen. William Borah, trying to allay fears that the tax would become an “assault on wealth,” said, “No sane man would take from industry its just reward or rob frugality of a fair and honest return.”40
An issue that caused some concern in New York was the prospective taxation of state and municipal bonds. The Republican Gov. Charles Evans Hughes, who otherwise supported the amendment, was the leading opponent of taxing the bonds. Sen. Elihu Root, a conservative progressive and J. P. Morgan associate, defended the provision. Significantly, Taft urged Republican party leaders in New York to support the amendment, putting to rest the theory that he regarded the amendment process as the burial ground of the income tax.41
Hughes’s concern was widely shared in New York, and the amendment went down to defeat in the legislature. The defeat was soon reversed, however. In 1910 the Democrats captured the state-
house and the governor’s mansion. The amendment was ratified in a new vote. After a slow start, old-line Republican losses to Democrats and Republican Insurgents were enough to gain the needed thirty-six states. The last state ratified on February 13, 1913. States refusing to ratify or failing to act were Connecticut, Rhode Island, Pennsylvania, Virginia, Florida, and Utah. Those were the only states that did not undergo the political upheavals of 1910 and 1912 in which Republican Insurgents and Populist Democrats threw out the Republican organization or forced concessions on it. As the Springfield Republican put it, “The Sixteenth Amendment owes its existence mainly to the West and South, where individual incomes of $5,000 or over are comparatively few.”42
Envy of the great new fortunes in the northeast fueled the drive for the income-tax amendment. But another conviction must also have been at work, at least for some supporters, namely, that the federal government ought to have access to greater revenues. Edwin L. Godkin, the libertarian editor of The Nation, warned, “With such a source of revenue put at its mercy, Congress will be more extravagant than ever”43 He and others worried about the dangers of the government’s new power. Virginia House Speaker Richard E. Byrd predicted that “a hand from Washington will be stretched out and placed upon every man’s business.… Heavy fines imposed by distant and unfamiliar tribunals will constantly menace the tax payer. An army of Federal officials, spies and detectives will descend upon the state.…”44
On the other side, The New York Evening Post wrote that the income tax would permit the lowering of the tariff to the benefit of consumers. Many free traders naively hoped that would be the case. But the income tax never brought about a cut in the tariff. Quite the contrary; in 1930 tariffs hit historic highs. Nor should anyone have expected otherwise, for now that the tariff was no longer needed to raise revenue, it was fully available for protective purposes. That was something that seems not to have occurred to free traders, with the exception of the libertarian sociologist William Graham Sumner. An effective revenue tariff by definition is a weak protective tariff; conversely, a strong protective tariff is a weak revenue tariff. If the tariff is to raise lots of money, it cannot be high enough to keep consumers from buying imports; if it prices imports out of reach, it will not raise much money.45 Before the income tax, the lawmakers had to find a happy medium between revenue and protection. With the income tax, it was freed from that restriction.
Your Money or Your Life Page 11