The Amendment Passes
Garnering considerably more support in the East than contemporary observers predicted, the Sixteenth Amendment was ratified on February 3, 1913. President Wilson was inaugurated in March, and during the summer Congress debated an income tax law that was ultimately included in the Underwood Tariff Act. Tariff rates were dropped to their lowest levels since before the Civil War. The new income tax was supposed to make up for the lost tariff revenue, and this part of the bill was short and simple, taking up only 14 pages of U.S. law. The four-page tax form (including instructions) defined income as coming from several sources, including wages, dividends, interest, business profits, and capital gains. It allowed deductions for expenses, including interest, taxes, casualty losses, depreciation, and uncollectible debt. All information was self-reported, and after determining net income, the following tax table applied for married couples:
| Income | Tax Rate |
| $0–$3,999 | 0% |
| $4,000–$20,000 | 1% |
| $20,001–$50,000 | 2% |
| $50,001–$75,000 | 3% |
| $75,001–$100,000 | 4% |
| $100,001–$250,000 | 5% |
| $250,001–$500,000 | 6% |
| Greater than $500,000 | 7% |
Source: www.irs.gov/pub/irs-utl/1913.pdf.
At the time, a middle-class family earned an annual income of around $500–$700 per year, so the vast majority of Americans were exempt from the tax.7 Largely for this reason, the arrival of the personal income tax was greeted with little public fanfare.
More Revenue Needed
The first tax returns were filed in the spring of 1914, and just a few months later World War I began in Europe. Initially, most Americans wanted no part of the conflict, but attitudes changed in 1915 when the German navy torpedoed the passenger ship Lusitania, killing 1,198 people, of whom 139 were Americans. This event inflamed anti-German feelings in the United States, and the U.S. federal government responded by increasing expenditures on defense goods. By 1916, higher defense spending combined with falling revenue from customs duties (due to fewer imports from war-torn Europe) caused the government to incur a sizable budget deficit. More revenue was needed, and the income tax was suddenly, conveniently available.
The Emergency Revenue Act of 1916 raised the tax rate on incomes above $4,000 from 1 percent to 2 percent, and pushed the top rate to 13 percent on incomes above $2 million. Several other taxes were also raised, including excise taxes on alcohol and tobacco and taxes on the profits of war munitions manufacturers. In addition, a federal inheritance tax was imposed. However, the deficit continued to expand because of the ongoing military buildup. So Congress raised rates again in 1917, just months before the United States finally declared war. The War Revenue Act of 1917 lowered the tax-exempt income level from $4,000 to $2,000 for a married couple and established tax brackets that ranged from a tax rate of 2 percent to 50 percent on incomes over $1 million. In addition, tax rates were increased on corporate profits and inheritances, and several excise taxes were raised.
The 1917 War Revenue Act was a significant event because, as Witte notes, “the crucial result was the discovery of how easily and quickly large sums of revenue could be raised through the income taxes” (1985, 81). The next year another Revenue Act (1918) was passed that returned the exempt income amount back to $4,000, but elevated the bottom tax rate to 12 percent and the top rate to 77 percent on incomes above $1 million. Higher tax rates in conjunction with the booming war economy caused federal revenue to soar. Here are federal revenue data from 1915 to 1920:
| Year | Revenue (millions) |
| 1915 | $683 |
| 1916 | $761 |
| 1917 | $1,100 |
| 1918 | $3,645 |
| 1919 | $5,130 |
| 1920 | $6,648 |
Source: U.S. Bureau of the Census (1975, 1106).
During these years, taxes on individual incomes and corporate profits accounted for about two-thirds of total revenue (Faulkner 1960, 598). The top rates were now punitive, a fact recognized by both President Wilson and Treasury Secretary Carter Glass. They believed that high tax rates could have an adverse affect on economic activity by reducing the incentive to earn income (Witte 1985, 88).
In summary, World War I was a very important event in the history of the U.S. income tax because it starkly demonstrated the income tax’s ability to raise major amounts of revenue quickly. In addition, it marked the first time the government instituted punitive tax rates. It was also the era when the income tax replaced excise taxes on tobacco and alcohol as the major source of federal revenue.8
Changing of the Guard
World War I and its aftermath cost the Democrats dearly in the 1918 and 1920 elections. They lost control of Congress in the 1918 elections, and incurred further damage by losing more congressional seats along with the White House in 1920. The Republicans assumed control of the government in March 1921 and held power for the remainder of the decade.
A major economic policy figure during the 1920s was Pittsburgh industrialist Andrew Mellon, who served as U.S. treasury secretary from 1921 to 1932. Mellon agreed with Woodrow Wilson’s and Carter Glass’s claim that high income tax rates reduced the incentive to earn taxable income, but Mellon took the argument a step further. He believed that if the disincentive to earn income was strong enough, then high tax rates could yield less revenue than if rates were lower. In other words, lowering income tax rates might cause people to earn enough additional income to cause an increase in tax revenue. This view was an important part of Mellon’s case about why income tax rates should be reduced, and congressional Republicans and Presidents Warren Harding and Calvin Coolidge were amenable to it.
The result was a series of tax laws passed during the 1920s that reduced income tax rates, including lowering the top rate from 73 percent to 24 percent. Many economists consider these lower tax rates to be one of the reasons that the U.S. economy performed so well during the decade. The income tax was also made more broadly based by reducing the income exemption so as to raise the number of taxpayers (although the tax was still directed at high incomes). In the early 1920s, the income exemption for married couples was reduced from $4,000 to $2,500.9 Given the tremendous economic growth that took place during the decade (per capita income rose about 30 percent from 1920 to 1929), ever-increasing numbers of Americans paid taxes.10
Meanwhile, the federal government was shrinking in relation to the overall economy. In 1920, federal outlays were $6.6 billion, which represented 7.3 percent of that year’s economic output. By 1929, federal outlays were $3.8 billion, or 3.5 percent of economic output.11
Raising Taxes during the Depression
The Great Depression (1929–1941) ranks among