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Our Federal Tax System

The Federal Tax System-

The federal tax system in the United States has been marked by significant changes over the years in response to the ever changing role of the government. While the law itself is complex, the concept is relatively simple. Income from all sources is taxed, unless specifically exempted by the law.

The types and amounts of tax collected are completely different than they were 200 years ago. Some of these changes are traceable to specific events, such as a war, or the passage of the 16th Amendment which gave Congress the power to levy a tax on personal income. Other changes were more gradual, responding to changes in society, the economy, and in the role of the federal government. For most of our country's history, individuals rarely had any contact with the federal government as most of the government's tax revenues were derived from excise taxes, tariffs, and customs duties.

In 1765, the English Parliament passed the Stamp Act, the first tax imposed directly on the American colonies. Colonists lacked representation in the English Parliament. This led to the rallying cry of the American Revolution "taxation without representation is tyranny" and established a persistent wariness regarding taxation.

Before the Revolutionary War, the federal government had only a limited need for revenue, while each of the colonies had greater responsibilities and revenue needs, which were met with different types of taxes. The south taxed primarily imports and exports, the middle colonies imposed a property tax and a "head" or poll tax levied on each adult male, and the northern colonies taxed real estate, had excise taxes, and taxes based on occupation.

The Revolutionary War Period-

To pay the debts of the Revolutionary War, Congress levied excise taxes on distilled spirits, tobacco and snuff, refined sugar, carriages, property sold at auctions, and various legal documents.

The Articles of Confederation of 1781 reflected the American fear of a strong federal government. The federal government had few responsibilities and no tax. It relied solely on donations from the States. When the Constitution was passed in 1789, it was

The Revolutionary War Period - continued

recognized that no government could function if it relied entirely on other governments for its resources. Therefore, the federal government was granted the authority to raise taxes.

Article I, Section 8, Clause 1 of the U.S. Constitution states Congress shall have the power to impose "Taxes, Duties, Imposts and Excises,". However Article I, Section 9 requires that, "No Capitation, or other direct, tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken." Therefore, any taxes imposed had to be uniform throughout the United States. The Constitution limited Congress' ability to impose direct taxes, by requiring it to distribute taxes in proportion to each state's population.

The Post-Revolutionary War Period

After the Revolutionary War the citizens had representation, but many still opposed taxes. From 1791 to 1802, the federal government was supported by taxes on distilled spirits, carriages, refined sugar, tobacco and snuff, property sold at auction, corporate bonds, and slaves. In 1794, farmers in Pennsylvania opposed the tax on whiskey, forcing President Washington to send federal troops to suppress the Whiskey Rebellion, and establishing the important precedent that the federal government was determined to enforce its revenue laws. On the other hand, The Whiskey Rebellion also established that the resistance to taxes that led to the Declaration of Independence and the Revolutionary War did not evaporate with the new federal government.

To raise money for the War of 1812, Congress imposed additional excise taxes, sales taxes on gold, silverware, jewelry, and watches, and raised certain customs duties. Congress also raised money by issuing Treasury notes. In 1817 Congress did away with those taxes, relying solely on tariffs on imported goods, and for the next 44 years the federal government collected no taxes.

The Civil War Period

The Revenue Act of 1861, the first U.S. personal income tax, was imposed on August 5, 1861. This tax on personal income was a new direction for a federal tax system. It was amended on July 1, 1862. It taxed 3% of all incomes from $600 to $10,000 per year. The standard deduction was $600. Individuals with an annual income of more than $10,000 paid a 5% tax rate. This tax was the forerunner of our modern personal income tax as it

The Civil War Period -continued

was based on the concepts of graduated taxation and "withholding at the source" by employers. An "inheritance" tax also made its debut.

The Act of 1862 established the office of Commissioner of Internal Revenue. The Commissioner was given the power to assess, levy, and collect taxes, and the right to enforce the tax laws through seizure of property and through prosecution.

By 1866, tax collections had reached their highest point in history. The federal government collected more than $310 million. In 1867, heeding public opposition to the income tax, Congress cut the tax rate. The need for federal revenue declined sharply after the war and the personal income tax was abolished in 1872.

The Post-Civil War Period

With the passage of The Wilson Tariff Act in 1894 Congress revived the flat rate federal income tax. The Bureau of Internal Revenue was created with an income tax division. However, the Supreme Court ruled the law unconstitutional in Pollock v. Farmers' Loan & Trust Co. the following year. The Supreme Court ruled that taxes on rents from real estate, interest income, dividend income, and from personal property were direct taxes on property, and therefore had to be apportioned according to the population of each state. Under the Constitution, Congress could impose direct taxes only if they were levied in proportion to each State's population. Thus, a federal income tax was impractical from the time of the Pollock decision until ratification of the Sixteenth Amendment. What seemed to be a straightforward limitation in the Constitution on the power of the Congress proved inexact and unclear when applied to an income tax. The Bureau of Internal Revenue’s income tax division was closed.

From 1896 until 1910 the Federal government relied heavily on high tariffs for its revenues. The War Revenue Act of 1899 raised funds for the Spanish-American War through the sale of bonds, taxes on recreational facilities, and it doubled the tax on beer and tobacco. The War Revenue Act expired in 1902. From 1868 to 1913, 90% of all revenue was collected from excise taxes on liquor, beer, wine and tobacco.

The 16th Amendment

In 1909 President Taft recommended that Congress propose a constitutional amendment that would give the government the power to tax incomes without apportioning the burden among the states populations.

The 16th amendment was ratified by Wyoming on February 3, 1913, providing the three-quarter majority of states necessary to amend the Constitution. It allowed the Federal government to tax the income of individuals without regard to the population of each State. The 16th Amendment states "The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.". It made the income tax a permanent fixture in the U.S. tax system and resulted in a revenue law that taxed incomes of both individuals and corporations.

On October 3, 1913 President Woodrow Wilson signed into law the Revenue Act of 1913, also known as the Tariff Act of 1913. Congress levied a 1% tax on net personal incomes above $3,000 and rising to 7% on incomes of more than $500,000. Less than 1% of the population was subject to income tax in 1913. It also lowered basic tariff rates from 40% to 25%, the lowest rates since the Walker Tariff of 1857. In 1913 the first Form 1040 appeared as the standard tax reporting form, and March 1st was the date specified as the filing deadline.

Before the income tax most citizens were able to pursue their financial affairs without any knowledge by the federal government. Individuals earned their money and wealth was accumulated and dispensed with little or no interaction with the federal government.

The United States entry into World War I greatly increased the need for revenue. One problem with the income tax law was how to define "lawful" income. Congress responded by passing the 1916 Revenue Act. It deleted the word "lawful" from the definition of income. Consequently, all income, regardless of how it was obtained, became subject to tax. The Supreme Court would subsequently rule the Fifth Amendment could not be used by bootleggers and others who earned income through illegal activities to avoid paying income taxes. As a result, many who broke various laws and were able to escape prosecution for those crimes were convicted on tax evasion charges.

The 16th Amendment - continued

The 1916 Act raised the lowest tax rate from 1% to 2% and raised the top rate to 15% on taxpayers with incomes in excess of$1.5 million. The 1916 Act also imposed taxes on estates and excess business profits.

The income tax fundamentally changed the relationship between the citizens and the federal government by giving the federal government the right and the need to know all about an individual’s or business's financial life. Consequently, in 1916 Congress required that information from income tax returns be kept confidential.

Needing still more tax revenue, the War Revenue Act of 1917 lowered exemptions and greatly increased income tax rates.

The Revenue Act of 1918, passed to raise even greater sums for the World War I effort, increased income tax rates once again, this time raising the lowest rate to 6%. The top rate of income tax rose to 77%. The Revenue Act of 1918 codified all existing tax laws and pushed the filing deadline forward to March 15th where it remained until 1954 when it was moved ahead to April 15th. In 1918, 5% of the U.S. population paid income taxes, as compared to just 1% five years earlier.

The 1920’s

The Prohibition Unit was established to enforce the National Prohibition Act of 1919, commonly known as the Volstead Act, which, under the 18th Amendment to the Constitution prohibited the manufacture, sale, and transportation of alcoholic beverages. When it was first established in 1920, the Prohibition Unit was a division of the Bureau of Internal Revenue. On April 1, 1927 it became an independent entity within the Department of the Treasury, changing its name from the Prohibition Unit to the Bureau of Prohibition.

The tax rates dropped sharply after World War I. During the 1920s, with a booming economy, Congress cut taxes five times returning the lowest tax rate to 1% and lowering the highest rate to 25%. As tax rates and tax collections declined, the economy got even stronger.

The 1920’s - continued

On a cold wintry morning in February, 1929 two cars; a Cadillac sedan and a Peerless, both outfitted to look like Chicago Police detective sedans, pulled up to the SMC Cartage Company garage at 2122 North Clark Street in the Lincoln Park neighborhood on Chicago's North Side that served as the headquarters of Bugs Moran’s North Side Gang. Four gunmen, two disguised as police officers and toting Thompson submachine guns, killed seven men in a storm of seventy machine-gun bullets and two shotgun shells. To show by-standers that everything was under control, the two men in street clothes were "arrested" and came out with their hands up, led by the two phony uniformed cops. Al Capone, the Chicago gangster, had orchestrated the most notorious gangland killing of the 20th century - the St. Valentine's Day Massacre. The massacre was Capone's effort to dispose of Bugs Moran, who, as it turned out, wasn’t in the garage at the time. Moran, spotting the police cars outside, had decided to keep walking. No one was ever arrested for the crime.

The economy grew steadily during most of the 1920’s. It was a golden age as innovations such as radio, automobiles, aviation, and the telephone became popular. On August 24, 1921, the Dow Jones Industrial Average stood at 63.9. By September 3, 1929 it had risen more than six fold to 381.2. During the summer of 1929 it became clear that the economy was contracting, and the stock market would soon go through a series of unsettling price declines in early October.

On October 29, 1929 the stock market crashed and the Great Depression began. As the economy shrank, government tax receipts also fell. In 1932, the federal government collected only $1.9 billion, compared to $6.6 billion in 1920. In the face of rising budget deficits which reached $2.7 billion in 1931, Congress followed the prevailing economic wisdom of the time and passed the Tax Act of 1932 which dramatically increased tax rates. This further improved the government's finances while further weakening the economy. By 1936 the lowest personal income tax rate had reached 4% and the highest tax rate was 79%.

The 1930’s

During a routine warehouse raid in Chicago in 1931 by the Treasury Department’s Bureau of Prohibition, agents Eliot Ness and The Untouchables discovered what was clearly a crudely coded set of accounts in a desk drawer. They, and Frank Wilson, an undercover agent in the Bureau of Internal Revenue’s Intelligence Unit, then

The 1930’s - continued

concentrated on gathering evidence and pursuing Public Enemy No. 1, Al Capone, for his failure to pay income tax on this substantial illegal income. Capone had always done his business through front men and it was previously believed he had no books or accounting records in his own name. Even his mansion was in his wife's name. Capone was tried in federal court in 1931. Capone was found guilty on five of 22 counts of tax evasion for the years 1925, 1926, and 1927, and willful failure to file tax returns for 1928 and 1929. Capone's legal team offered to pay all outstanding income taxes plus interest and told their client to expect a severe fine. On October 17, 1931 the judge sentenced Capone to eleven years in a federal prison and one year in the county jail, as well as an earlier six-month contempt of court sentence. He ultimately served only six and a half years because of time off for good behavior. He also had to pay fines and court costs totaling $80,000. Capone’s isolation from his associates and the repeal of Prohibition ended his criminal career.

Other notable tax evaders:

  • On October 10, 1973, Spiro T. Agnew, the 39th Vice President of the United States, resigned and then pleaded nolo contendere (no contest) to criminal charges of tax evasion and money laundering;
  • Soviet spy Aldrich Ames earned more than $2 million for his espionage and was also charged with tax evasion as none of the money was reported on his income tax returns. Ames attempted to have the tax evasion charge dismissed on the grounds his espionage profits were illegal, but the charges stood. The $2 million remains to this day in an undisclosed bank account. Russian intelligence has refused to disclose this bank account information in order for the United States to seize it, arguing that that money was rightfully earned by Ames;
  • Leona Helmsley the billionaire New York City hotel operator and real estate investor nicknamed "The Queen of Mean." She was convicted of federal income tax evasion in 1989 and served 19 months in prison, after receiving an initial sentence of 16 years;

Irwin A. Schiff a prominent member of the group which refers to itself as the tax honesty movement, and which has been referred to by the Internal Revenue Service and other government agencies as the tax protester movement. Schiff is known for writing and promoting literature that claims the United States income tax is applied incorrectly. He has lost several civil cases against the federal government and has a record of multiple convictions for various federal tax crimes. Schiff is serving a 13-plus year sentence for

The 1930’s -continued

tax crimes as Inmate #08537-014 at the Federal Correction Institution at Fort Dix, New Jersey.

The Social Security Act

In 1935 Congress passed the Social Security Act. This law provides payments to the aged, the needy, the handicapped, and to certain minors. These programs were initially financed by a 2% tax, one half of which was subtracted directly from an employee's paycheck and one half was collected from employers. The tax was levied on the first $3,000 of the employee's salary or wage.

In 1939, Congress again codified the tax laws and all subsequent tax legislation until 1954 amended the 1939 code.

The World War II Period

The Revenue Act of 1942 was hailed by President Roosevelt as "the greatest tax bill in American history,". It increased taxes and the number of Americans subject to the income tax, created deductions for medical expenses and investment expenses, and reduced the personal exemption amount from $1,500 to $1,200 for married couples. The exemption amount for each dependent was reduced from $400 to $350 and a 5% Victory tax on all individuals with incomes over $624 was created, with postwar credit. The top tax rate reached 94% during the World War II and remained at 91% until 1964.