A Brief History of Taxes in the U.S.

Benjamin Franklin is credited with saying that nothing is certain in this world but death and taxes. That was back in 1789 and it still holds true in the U.S. today.

U.S. taxation has thrived and faltered from implementing the first income tax to various attempts at tax reform. Some changes have been more taxpayer-friendly than others. Here's a closer look at the history of the U.S. tax system.

Early History of U.S. Taxation

Benjamin Franklin spoke about taxation well before the U.S. officially launched an income tax. Before the Civil War, the nation derived most of its income from banknotes. The tax rate imposed on individuals was minimal, from 1% to 1.5%. American citizens received virtually nothing in exchange. Civil services and protections on the frontier and coasts were minimal.

The need to finance the Civil War resulted in the first version of an income tax in 1862. President Lincoln signed a law that created the Commissioner of Internal Revenue and imposed an income tax on individuals ranging from rates of 3% on incomes of $600 to $10,000 and 5% on incomes over $10,000.

This version of the tax was repealed 10 years later but it came back to life in 1894 with the Wilson Tariff Act. The act levied a 2% tax on incomes over $4,000. The U.S. Supreme Court ruled one year later that the tax was unconstitutional.

“Through the Civil War and beyond, income tax was tried, disputed in the courts, and finally resolved with the passage of the 16th Amendment in 1913, constitutionally establishing income taxes,” according to Thomas J. Cryan, an attorney and the author of Disrupting Taxes.

Birth of the Federal Income Tax

The federal income tax as we know it was officially born on Feb. 3, 1913, when Congress ratified the 16th Amendment to the U.S. Constitution after an on-again-off-again effort that lasted decades.

The amendment read, “Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and regard to any census or enumeration.”

However, less than 1% of Americans had to pay the tax in the first days after its inception, thanks to the amendment’s provisions for numerous taxpayer-friendly deductions and exemptions. The rate was only 1% of net income at that point. Congress later added a 6% rate for incomes of more than $500,000.

Numerous tweaks and add-ons occurred in the 1940s. The Revenue Act of 1942 increased tax rates and the number of citizens who had to pay it. The Current Tax Payment Act passed a year later, heralding the beginning of the tax withholding process by employers. Standard deductions were created in 1944 with the passage of the Individual Income Tax Act.

“The withholding system was implemented simply because the collection was easy,” says Cryan, “not because it was the soundest, most equitable, or most efficient tax system.”

However, the Internal Revenue Service attempted to make the tax process more efficient over the years. The first toll-free telephone line was introduced in 1965. Electronic filing began in 1986 although it was limited at first. Taxpayers who owed money were able to electronically file their returns beginning in 1992.

Tax Reforms and Major Changes

Reforms have been ongoing. The federal government has made some major changes to the tax system incrementally.

The Alternative Minimum Tax (AMT)

Annette Nellen, a certified public accountant (CPA) and attorney who serves as a professor and the director of the MST Program at San Jose State University cites the alternative minimum tax (AMT) as a major adjustment. The AMT was created in 1969 because “it was found that a few hundred high-income individuals were able to use a combination of exclusions, deductions, and credits to pay little or no income tax,” Nellen says.

The Tax Reform Act (TRA)

Nellen also mentions the Tax Reform Act that was legislated in 1986. She says it broadened the AMT so more high-income individuals would be subject to it.

“The Tax Reform Act of 1986 made numerous changes to the tax law including taxing ordinary and capital gains income at the same rate and there were only two brackets (15% and 28%). It also added passive activity loss limitation rules that shut down a tax shelter industry that many middle- to high-income individuals had been using to minimize their taxes.”

The American Taxpayer Relief Act (ATRA)

The American Taxpayer Relief Act (ATRA) restored the top income tax rate to 39.6% in 2012 after it was cut to 35% by President George W. Bush’s tax cuts in 2001 and 2003.

The Tax Cuts and Jobs Act (TCJA)

President Trump signed the Tax Cuts and Jobs Act (TCJA) into law in 2017 and introduced some sweeping changes to the U.S. tax system. They included significantly increasing standard deductions and reducing personal income tax rates. The 35% top rate created by ATRA had increased back to 39.6% but the TCJA dropped it to 37%. The 15%, 25%, 28%, and 33% rates imposed on lower-income earners were cut to 12%, 22%, 24%, and 32% respectively.

The cap on the itemized deduction for interest paid on home mortgages was reduced, however, and a reduced limit was imposed on the state and local tax (SALT) itemized deduction as well. Some miscellaneous itemized deductions were eliminated entirely.

The Inflation Reduction Act

The Inflation Reduction Act (IRA) came along in 2022. According to Nellen, “The IRA included numerous new and modified energy credits for individuals and businesses. It's possible that some of these credits may be repealed or downsized as part of any extension of expiring provisions of the TCJA or new tax breaks such as not imposing income tax on tips or overtime pay of employees.”

Excise and "Sin" Taxes

Taxation doesn’t begin and end with those taxes imposed on income and earnings. Excise taxes, often called sin taxes, can take a hefty bite out of taxpayers’ bank accounts as well. These taxes are imposed on the sale of specific products and services.

They’re generally paid by retailers, producers, and wholesalers but these entities pass them down to the consumers who purchase them. Commonly affected purchases include alcohol, tobacco, health insurance, and gasoline. The excise tax on cigarettes averages about $1 a pack. Beer and wine are typically taxed at a lower rate than distilled spirits.

“The key purpose of excise taxes on alcohol and tobacco is to tax undesired behavior, particularly the purchase of cigarettes by young people,” Nellen says, “and to generate a small amount of revenue. There are several federal excise taxes, but the ones on alcohol, tobacco, and gasoline are best known. Excise taxes are a small part of government tax collections, representing less than 2% of total federal tax revenues. For 2023, excise taxes were $75.8 billion, representing 1.7% of total tax collections of $4.4 trillion.”

Cryan agrees about the deterrent nature of these taxes. “Excise taxes on alcohol and tobacco traditionally lean to increased prices at the time of the retail sale. This price increase will often reduce consumption which can have the follow-along effect of a decrease in consumption related to less health harms.”

Numerous consumers continue to spend that extra dollar on a pack of cigarettes, but it’s a safe guess that their wallets will feel the effect because they also have to deal with income tax on that money.

The Bottom Line

Taxation in the U.S. has always been a shapeshifting beast and this can be exacerbated by all its various applications, from income to that modest purchase you just made at your favorite liquor store. Tax laws don’t just change every five to ten years. They can occur annually just as you’re getting used to the last ones that were imposed.

They’re inevitable, however, just as Benjamin Franklin asserted. Taxpayers can benefit from keeping a watchful eye on the ever-evolving changes and checking in with a tax professional when changes are looming so they can best prepare for the impact whether it be affirmative or negative.