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Income Tax: Historical Perspectives

World War I and Depression Years. During World War I, During the World War II years, there was a major
the Democrats altered the tax by adopting highly progres- shift in the taxing power of the federal government rela-
sive rates and structuring the base to consist of the tive to state and local governments. Federal revenues, as a
incomes of corporations and upper-income individuals. percent of total taxes collected by all levels of government,
Additionally, an excess profits tax was imposed. This was increased from 16 percent in 1940 to 51 percent in 1950.
a progressive tax on above-normal profits, and it generated With some modifications, the basic structure of the
most of the new tax revenue raised during World War I. income tax remained in place during the post-World War
Together the income tax and excess profits tax became an II years and continued in the early twenty-first century.
explicit means for the redistribution of income. To admin- Individual tax rates were reduced from wartime highs, and
ister these taxes, the Bureau of Internal Revenue reorgan- the tax base began to narrow with the adoption of exemp-
ized along functional lines, expanded in size, and tions, deductions, and credits. Inflation in the 1960s and
employed such experts as accountants, lawyers, and econ- 1970s created a condition called bracket creep. Taxpayers
omists. In 1916, “reporting at the source” was adopted, whose monetary incomes were increasing because of infla-
which required corporations to report salaries, dividends, tion, but with no equivalent increase in purchasing power,
and wages to the Treasury Department. were pushed into higher tax brackets and thus subject to
When the Republicans took control of the presidency higher marginal tax rates. Because the corporate rate
and Congress in 1921, taxes on corporations and upper- structure was not progressive, bracket creep did not apply
income taxpayers were reduced, the excess profits tax was to corporations. Although the corporate and individual
repealed, and the tax rate structure was adjusted to be less income taxes had generated roughly the same revenue in
progressive. Many preferences were incorporated into tax 1950, by 1980, partially as a result of bracket creep, the
law in the form of deductions, and the preferential taxa- individual income tax generated four times the revenue of
tion of capital gains was adopted. A capital gain is a gain the corporate tax.
that results from the sale of a capital asset, such as shares
of stock in a corporation. In 1932 under President After World War II. During the post-World War II years,
Hoover, and in 1935 and 1937 under President Roosevelt, the tax system was used increasingly as a means of financ-
tax rates increased and the tax base expanded. However, ing. A government may deliver services by direct payment
the income tax was not a dominant policy focus during or indirectly by subsidy through a reduction in tax. For
the 1930s, partially because the federal government relied example, the deduction for home mortgage interest pro-
heavily on excise taxes and debt to obtain funds to support vides a tax subsidy for investing in housing. The term tax
government activities. expenditure is used to describe subsidies for various pur-
poses achieved by use of exemptions, deductions, and
World War II. The most significant impact of World War credits. Exempt income is not subject to tax. A deduction
II on the individual income tax was to transform it to a reduces the amount of income that is subject to tax, and a
mass tax that was broadly based and progressive. In 1941, credit represents a direct reduction in the amount of tax
changes were made to both rates and base. Higher tax liability. From 1967 to 1982, tax expenditure increased
rates were adopted and lower exemptions were allowed, from 38 percent to 73.5 percent of tax receipts. Tax
thus expanding the base. Higher tax rates were adopted expenditure provisions complicate the determination of
again in 1942. With the inclusion of a surtax, tax rates taxable income, the base for the income tax.
ranged from 13 percent on the first $2,000 of taxable The sophisticated study of tax policy, which contin-
income to 82 percent on taxable income in excess of ued into the twenty-first century, began on a widespread
$200,000. The number of taxpayers increased from 3.9 basis during the post-World War II period. Central ques-
million in 1939 to 42.6 million in 1945. At the end of the tions concerned the impact of tax policy on the amount of
war, 60 percent of households paid the income tax. The investment, the movement of capital, and labor-force par-
efficiency of collection was enhanced by the adoption of ticipation.
payroll withholding in 1943. By 1944, the individual
income tax generated about 40 percent of federal rev- From 1980 to 2000. The 1980s began with the adoption
enues. of the Economic Recovery Tax Act (ERTA) during Presi-
For corporations, progressive tax rates, also called dent Reagan’s term. A key provision of this act was the
graduated tax rates, were introduced in 1935, repealed in indexing of tax rates for inflation to eliminate bracket
1938, so corporations paid a flat tax during World War II. creep. ERTA provided for significant reductions in tax
However, wartime corporations were subject to a gradu- rates and began to reduce the role of the income tax in the
ated tax on excess profits, with the maximum rate of 50 nation’s revenue system. During the 1980s, interest in tax
percent after an allowance for a substantial credit. reform grew, culminating in the passage of the Tax

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 377