History of the US Federal Tax System

It's safe to say that no one really enjoys paying taxes. The federal tax rate has fluctuated over the years, and it's been kinder at some points than at others. From back before the ink dried on the Declaration of Independence to when President Ronald Reagan took office, the U.S. government has collected quite a lot of money from taxpayers at different points in history. 

Here's an overview of the U.S. federal tax system throughout American history.

Taxation in the 1700s

There were no income taxes and no federal government prior to the Revolutionary War, at least not in America. The people 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.

The Revolutionary War 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 tea, all without giving American colonists a say in the matter. The colonists didn’t take this well. They organized 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.

U.S. Federal Tax System in the Early Days

Individual states financed the federal government in the years following the birth of the nation. 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.

Excise taxes, or sales taxes on specific goods, were common, and it turned out that people 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 at all. The Whiskey Rebellion followed, forcing President George Washington to send federal troops to southwestern Pennsylvania to impose order on an angry and unruly mob of farmers who wanted the federal government to leave their liquor alone.

The federal government proceeded to impose “direct” taxes after this. Individuals were taxed based on the value of things they owned, including enslaved people and land, but not on income. 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 fizzled for a time, and the country made ends meet through the sale of public land and customs duties 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 know as the Internal Revenue Service (IRS) 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. Individual states were relieved of that duty. 

Income Tax Is Repealed

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 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 as a direct tax.

This time, however, the lowest rate was only 1% for those with incomes 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 figure out what they owed and report it to the IRS every year.

Tax Rates Skyrocket in 1916

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 15% for taxpayers who enjoyed incomes of more than $2 million a year.

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 $2 million suddenly found themselves paying taxes at the staggering rate of 67%. Rates were increased yet again with the Revenue Act of 1918, increasing the top rate to 77% on incomes of $1 million or more.

Taxes During 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 changed 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 ensuing 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 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%, with 1% paid by workers and 1% paid by their employers. It was levied on annual wages up to $3,000. It was first collected in 1937, but benefits weren’t paid out for another three years, by which time the Depression had ended. 

Taxes and World War II

Tax rates continued to escalate in the 1940s as the U.S. engaged in World War II and needed money to fund that war effort. New tax laws were passed, raising rates and eliminating exemptions. Those with an annual income of $200,000 or more had to pay a top income tax rate of 94% by 1944. The lowest tax rate was 23%.

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 personal exemptions 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.

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 1960s and 1970s.

The IRS got its first toll-free telephone line in 1965, and computers were introduced in the late 1960s, providing IRS agents with an easier way to scrutinize returns. Most taxpayers could file their returns electronically by 1992. The Taxpayer Advocate Service was rolled out in 1998 to assist taxpayers who ran afoul of the IRS.

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 and President Reagan spared taxpayers even more when he moved into the White House. The highest tax rate was 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. 

Then Came the TCJA

President Donald Trump's Tax Cuts and Jobs Act (TCJA) dropped the top tax rate to 37% in 2018. Tax rates ranged from 10% to 37% during his presidency. He also doubled the standard deduction. The personal exemption has been suspended through 2025.

President Joe Biden won election in 2020 and kept tax rates and standard deductions the same. These tax rates are indexed for inflation every year. The IRS releases these updates annually, as well as other updates to forms, standard deductions, marginal rates, and more.

In Response to the COVID-19 Pandemic

The IRS and the federal government stepped up to the plate with assistance for taxpayers when the COVID-19 pandemic left the nation reeling. The maximum child tax credit was increased from $2,000 to $3,600 by the American Rescue Plan Act in 2021. The increase was subject to some rules and income restrictions, but the restrictions were rather generous. And families were paid in advance. They didn't have to wait to claim the credit when they filed their 2021 returns in 2022.

The IRS also sent economic impact or "stimulus" payments to American taxpayers as the economy and employment faltered under the impact of COVID.

The American Rescue Plan let those who were collecting unemployment compensation exclude up to $10,200 of that money from their taxable incomes.

Unfortunately, these provisions have all expired. The child tax credit reverts back to the $2,000 maximum for the 2022 tax year, the return you'll file in 2023, and the unemployment compensation rule was in place for only one year: tax year 2020. The stimulus payments were sent out in 2020 and 2021.

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