The U.S. Federal Income Tax – An Historical Perspective

How many times have you looked at your income tax bill and thought your taxes were ridiculously high? If you’re like most Americans, the answer probably falls somewhere between “every time I look at my return,” and “it makes me sick to think about it, so I try not to look.”

Since this is the time of year to spread good cheer, we thought this might be the right time to give you an historical perspective on the evolution of our tax code (and its rates) over the years. Reviewing some of the old rates might even help you feel a little better.

The first thing you should know is that 1913 does not mark the birth of federal income taxes. That distinction dates to1862, when an income tax was instituted to pay the costs of the Civil War. At that time, people with income between $600 and $5,000 paid 5% and people whose income exceeded $10,000 paid 10%. In 2006 dollars, the lower rate would apply to people with incomes between approximately $13,000 and $108,000; the higher rates would apply to those whose income exceeded about $108,000. That tax was repealed in 1872.

Before we progress any further, here’s a little note about the following income amounts and tax rates: this article will present taxable income based on 2006 dollars to give you a basis for comparing the current tax rates and taxable income.

In 1894, a 2% tax on income was passed - this applied to virtually all Americans. The tax was declared unconstitutional in 1895 and, in 1909, the sixteenth amendment to the U.S. Constitution was proposed. That amendment was ratified in 1913, giving birth to what has evolved into our current tax system.

The first years were good for Americans in terms of tax rates. Income taxes started at 1% for those who made up to approximately $403,000 and topped out at a marginal rate of 7% for income exceeding $10,074,000. The expenses of World War I were so high, though, that in 1917 the top marginal rate was 67% on income greater than approximately $36 million (in 2006 dollars).

The top marginal rate fluctuated between a high of 77% and a low of 25% from 1918 through 1931. Then, in 1932, the top marginal rate skyrocketed to 63% on income greater than approximately $13 million and eventually topped out at 79% on income exceeding around $70,000,000 in 1936.

Our discussion of the rate roller coaster could go on forever and become very boring, but suffice it to say that, in the years between 1936 and 1981, the top rates fluctuated as Congress needed money. The maximum top rate in those years was 94%. This may sound onerous, but remember, there were numerous tax loopholes and shelters available to higher income individuals then.

In 1981, the tax code was amended to reduce the top tax rate to 50% and provide enhanced deductions for business properties. The effects of a change in monetary policy at the Federal Reserve Bank, coupled with the effects of the Economic Recovery Tax Act of 1981, threw the economy into a short-lived and painful recession in 1982. With the success of the 1981, 1982 and 1984 tax acts, Congress was convinced that lower tax rates equated to greater economic prosperity. In 1986, this philosophy, along with the recognition that there were simply too many loopholes in the tax law, led the President and Congress to enact the first comprehensive overhaul of the tax code since 1954. Taxes were lowered, but the definition of taxable income was refined. So many loopholes were repealed that some people who had never paid tax suddenly found themselves sending money to Uncle Sam. Ask any long-time real estate investor about the1986 tax act and you will likely hear a great deal of grumbling.

It’s now been twenty years since the birth of the 1986 tax act. Numerous changes have occurred since then, including significant tax increases in the 1990s and major tax reductions in the past few years. The top tax rate now is 35% and the tax code is extremely complicated. Even with all these changes, though, some things remain constant in the world of tax planning and one of the most significant of these is the rate game. The goal of the rate game is very simple – pay the least amount of taxes by engineering your income to fall into the lowest tax bracket possible.

This is December and the last month you have to modify that income before being hit with the 2007 tax bite. Congress has effectively removed most loopholes in the tax code, but income timing remains very much alive. There may be effective ways to reduce taxable income and push you into a lower tax bracket. Give us a call today and let’s talk about your options.

So let’s see – the top tax rate is not 94% and you might have some options to further minimize taxable income. That should be worth a little good cheer!

Happy holidays.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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