The news of the current tax reform proposal just hit my mailbox. As I perused the initial details of the proposed changes I began to wonder “How did we get to this place?” Where did the tax system that I work with day in and day out come from and how did it evolve to the state it currently is in as we await the possibility of more tax reform?
American Civil War
Government revenues prior to the American Civil War came largely from the levying of tariffs and duties on certain items. The social conscience of the country may have had an impact as the prominent items were liquor, tobacco, sugar and legal documents. Rebellions broke out against the tariffs and military force was used by Congress to enforce collection of the taxes.
The American Civil war devastated the country. The war against itself created massive amounts of debt. Financing of the debt was accomplished by the passing of the Revenue Act of 1861. Incomes exceeding $ 800 were subject to the tax and this really serves as the beginning of the modern tax system. The Act was ultimately rescinded in 1872.
Congress was given the power to “lay and collect taxes on income, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration” when the 16th Amendment was passed in 1913. Prior to passage of the amendment, the tax system required that taxes be levied in proportion to the state’s population. The 16th Amendment eliminated that clause and imposed income tax on income over $3,000. Less than 1% of Americans were impacted by the ratification of the 16th Amendment.
World War I
Three Revenue Acts came on the heels of World War I. Tax rates increased and exemption levels were lowered. The top tax rate of 7% in 1913 grew to 77% in 1918 in large part out of a need to finance the U.S. participation in World War I. As the country slid into economic turmoil, the tax rates followed suit and decreased to 24% on taxable income of $100,000 in the beginnings of the Great Depression.
World War II
Heavy deficits resulted from Roosevelt’s New Deal and World War II. Increased tax rates were needed to fund the deficits and to help prepare the United States for war and the support of its allies. In 1945, the top rate on taxable incomes of over $200,000 was 94%. Government receipts of $9 billion in 1941 grew to in excess of $45 billion by 1945.
Many say that the 1950s were the beginning of creation of a complex tax system. From 1951 to 1963, the top rate on taxable income over $400,000 was generally 91%. To counter the delays in reducing rates, many changes were made to the tax code during this period of time. It’s said that the changes to the tax code during this time heralded the beginnings of the tax “loophole.”
1960s and 1970s
Massive inflation in the 1960s and 1970s led to a growing government deficit. The addition of Medicare to the Social Security system helped fuel the gap between spending and revenue. Tax rates were not indexed for inflation, leading to a drop in taxpayer’s real income as they felt the pain of bracket creep. Tax rates during this turbulent social and financial era did not fall below 70%.
During the Regan presidency, the Economic Recover y Tax Act of 1981 was signed into law. Many herald this act as one of the most landmark changes to the tax landscape. Individual tax brackets were lowered by 25% and tax incentives were enacted to encourage business investment to spur the economy. Bracket creep was addressed by initiating inflation indexes. In 1986, the Act was followed by the Tax Reform Act which dropped the top tax rate to 28% for years beginning in 1988. In addition to reducing tax rates, the Bill aimed to simplify the tax code by broadening the tax base and eliminating many tax shelters that had been used to reduce taxable income. If the concept sounds familiar, it may be due to the fact that this Act has been recently cited as a model for the current tax proposals.
Other presidential administrations
Changes in administrations also brought changes to the tax code. The rise of taxes under Clinton helped to stem the tide of the rising federal deficit. Increases in the tax rates of higher income taxpayers coupled with spending cuts resulted in the first federal budget surplus since 1969. The Bush and Obama eras produced the Economic Growth and Tax Reconciliation Act of 2001; Jobs and Growth Tax Relief Reconciliation Act of 2003; Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 and the American Taxpayer Relief Act of 2012. Among the many changes were reductions in individual tax rates, preferential rates on capital gains and qualified dividends, doubling of the child tax credit and increases to the earned income tax credit. The top tax rate ultimately grew to 39.6%. Additional new taxes sprouted from the Affordable Care Act related to wages earned in excess of $200,000 and investment income. Taxpayers subject to these taxes realized a top rate greater than 39.6%.
So here we are today, on the brink of tax reform. The initial provisions as announced are:
- Reductions in the rate schedules for individuals
- Changes to the standard deduction
- The elimination of deductions for state and local income taxes, medical expenses, student loans, moving, alimony and unreimbursed employee expenses
- The alternative minimum tax, often the surprise tax for taxpayers is to be eliminated.
There are numerous other changes that are proposed and what will ultimately become law is yet to be seen. You’ll hear a lot about who the winners and who the losers are from the tax reform proposals. It seems without doubt that the history of the tax code is about to have an addition. When Albert Einstein was asked about completing his income tax form, he responded “This is a question too difficult for a mathematician. It should be asked of a philosopher.” Today’s environment seems to only bolster that response.
Cheryl Dickerson, CPA