The Surprisingly Entertaining History Of The Income Tax

Mar 24, 2012
Originally published on May 22, 2012 10:07 am

The U.S. has a really conflicted history with the income tax. For most of American history, there was no income tax at all. At one point it was ruled unconstitutional.

Today, income tax is the federal government's main source of revenue. That raises a question: How did something that was once so strange to us become so central?

The answer includes a few wars, a Supreme Court justice on his deathbed, and Donald Duck.

For More: Read our post, "From Abe Lincoln To Donald Duck: History Of The Income Tax"

Subscribe to the podcast. Music: Nero's "The Promise" and Danny Kaye's "I Paid My Income Tax Today." Find us: Twitter/ Facebook/ Spotify/ Tumblr.

Copyright 2018 NPR. To see more, visit http://www.npr.org/.

(SOUNDBITE OF ARCHIVED RECORDING)

PRESIDENT BARACK OBAMA: We need to change our tax code so that people like me and an awful lot of members of Congress pay our fair share of taxes.

MITT ROMNEY: I said today that we're going to cut taxes on everyone across the country by 20 percent, including the top 1 percent.

(SOUNDBITE OF SONG, "PROMISES")

NERO: (Singing) As long as I don't break these promises, and they still feel oh so wasted on myself. Promises.

DAVID KESTENBAUM, HOST:

Hello and welcome to PLANET MONEY. I'm David Kestenbaum.

ROBERT SMITH, HOST:

And I'm Robert Smith. Today is Friday, March 23. And that was Barack Obama and Mitt Romney you heard at the top talking about income taxes.

KESTENBAUM: On the podcast, we asked a simple question about the income tax. How did this complicated thing come to exist in the first place? It's not explicitly laid out in the Constitution. And for most of American history, there was no income tax.

SMITH: Getting to the income tax that we know and love took four wars, a Supreme Court justice on his death bed and a duck - coming up. But first, the PLANET MONEY indicator with Jacob Goldstein.

JACOB GOLDSTEIN, BYLINE: Today's PLANET MONEY indicator is two. Two giant global banks - Barclays and Deutsche Bank - have said, you know what? Our U.S. subsidiaries, they're not banks anymore.

SMITH: So you're allowed to just do that? You can just change the name of what you are? Pry the B-A-N-K off the front of the building?

GOLDSTEIN: Well, OK, I oversold it a little bit. That's not exactly what they did. What they actually said was, our U.S. subsidiaries, they are not bank holding companies anymore. And you can kind of tell by this phrase bank holding company. It's some kind of a regulatory term. And it has become important now because under Dodd-Frank - this is the big financial overhaul law that we have - these U.S. subsidiaries as bank holding companies, they would have had to hold bigger safety cushions. They would have had to hold more capital. Banks - basically, they don't like to hold more capital. But as it turns out, if their subsidiaries are not bank holding companies anymore, these new rules don't apply.

SMITH: You know, I'm just going say this - this just sounds crazy to me that an institution can change their name, bring in the lawyers, you know, come up with a different description of what they are, and then all of a sudden, boom, like, we're no danger. We're no problem to the economy. We're not even called a bank anymore.

GOLDSTEIN: Well, it may not work out that way in the end because there's also this other new rule in Dodd-Frank. And under this other rule, regulators can look at any finance company, whether it's a bank holding company or not, and say you are so big that if you went out of business, you would mess up the whole economy. And therefore, we have these special rules that apply to you. And those special rules can include holding more capital - which, remember, is what these guys are trying to get out of by ceasing to be bank holding companies.

SMITH: Ah, but there's this nice cat-and-mouse thing going where, you know, they come up with a regulation, bank comes up with a good idea, got to go back to a new regulation.

GOLDSTEIN: And this is - this is the eternal story of bank regulation. It goes back as far as you can go back, and it will go into the future as far as you can go into the future. And it's just - it's just the nature of it. Of course banks are going to try and do whatever they can to get the best deal out of whatever the rules are. And regulators are going to look at that and try and change the rule somewhere. And that's just the way it's going to always work.

SMITH: Thank you, Jacob.

GOLDSTEIN: Thanks.

KESTENBAUM: On to the income tax. So the income tax is the largest source of revenue for the United States government. When people talk about paying taxes, this is what they mean. And it feels like a big part of being American. Every year, we fill out the tax forms. We go through the tax tables. Sometimes we write a big check.

SMITH: But our country has this really conflicted history with the income tax. It was not designed by our Founding Fathers. It's not in the Constitution. For most of American history, there was no income tax at all. So today on the podcast, we have for you a brief and hopefully entertaining history of the income tax, how something that was once so strange became an American tradition.

SMITH: In the early years, our brand-new government needed some way to raise money, but there was no need to mess around with an income tax. The government had a much simpler way. Just tax the stuff that comes into the ports.

JOE THORNDIKE: For a long time, really, the only way that they raised money was using tariff duties - you know, duties on imported goods.

SMITH: This is tax historian Joe Thorndike. And tariffs are simple, right? You send out a tax collector to all the major ports, ship pulls into port, you go through the manifest, check the cargo, and you add up whatever you want to tax - sugar, guns, books. Simple.

KESTENBAUM: But there is one big problem with tariffs. They fail you the one time you really, really, really need revenue.

THORNDIKE: Tariff duties are a great way to raise money as long as you're not fighting a war.

KESTENBAUM: Yeah because someone's blocking your port, right? (Laughter).

THORNDIKE: Yeah, or sinking your ships on the way across the ocean. And that does tend to depress trade a little bit.

KESTENBAUM: So when in the United States, do people start to think and talk about an income tax?

THORNDIKE: Well, you know, the earliest reference in American history that I know of comes during the War of 1812 when the treasury secretary sort of throws it out there. It's really kind of a throwaway in a report that he sends to Congress, you know. Hey, we could consider taxing incomes.

SMITH: Which is a great idea, right? Everyone in the nation is making some sort of income. The country's at war. Why not require people to shave off a fraction of the cash that they make and send it to the government?

KESTENBAUM: But this suggestion during the War of 1812, it goes nowhere. An income tax is actually a very complicated thing to pull off successfully. There are three big obstacles to getting it right. The first goal is logistics. Like, how do you make sure people pay a percentage of their income?

THORNDIKE: Oh, it's enormously complicated because it really does come down to the individual who's filing this return. And that person, we're going to expect them - to begin with - just to keep track of how much they're earning. Then you expect a lot of honesty from them about reporting those records to the government. And to make sure that they're actually doing the job, you then have to create this huge administrative apparatus to go in and enforce it. And you have to give these people the power to dig through the personal financial records of every taxpayer, and that's usually pretty unappealing to taxpayers.

KESTENBAUM: And the government is not going to radically reform the tax code unless it has to, unless there's something incredibly expensive it needs to fund. This is how a lot of taxes come about - there's a war.

SMITH: And, in fact, 50 years after the idea of the income tax is first floated, such a war comes to pass - the Civil War. This is a very, very, very expensive war. Congress needs money to feed its soldiers, buy guns, cannons, ships. So this time, it's not just one guy bringing up the income tax as a suggestion. This time, Congress makes it law. And even more importantly, they come up with a way to enforce it.

THORNDIKE: Congress provides for the creation of the Bureau of Internal Revenue, which is the same agency we have today.

SMITH: This is the first real income tax in the United States, but it doesn't look quite like the one we have today. During the Civil War, only the wealthy had to pay income taxes.

KESTENBAUM: And the government does this really very clever thing to get rich people to pay it. It makes tax returns public.

THORNDIKE: During the Civil War, anyone could go in and look up your income tax return or at least your report of how much you earned. And the idea was that this would help improve compliance because your neighbor would see you driving around on your brand-new plow and he'd say, wait a minute. That guy - how did he get all that money? I'm going to see how much he reported on his income tax. And they'd go in and they'd check it out. And they could report to the agency and say, hey, you know, I don't think that this is the right number. This guy looks like he's living too large for this sort of an income. They sort of conscripted every American and made them a tax collector.

SMITH: So who is living large in, let's say, Washington, D.C., in 1864? Well, we pulled up a copy of the tax assessor sheets for D.C. during the Civil War, and there happens to be a guy here - Abraham Lincoln, address - White House.

KESTENBAUM: I love how you could just write White House.

SMITH: Everyone knows where it is. It's right in the center of town. And the taxes he paid - I'm sure people were very interested in this - $1,296.

KESTENBAUM: There are also entries here for restaurant owners, for liquor dealers, some guy who lived on longboat maybe in the Potomac River. It's clear from this list that people were paying taxes. The plan worked.

SMITH: Well, some people were paying taxes - the North part of the country. Remember, this is the Civil War. The South also attempted an income tax - attempted.

THORNDIKE: They had a much less effective tax system. And their income tax was much less effective than the North's version.

KESTENBAUM: Is there a case to be made that the Civil War was sort of an economic battle and the North was better at that and raising money, and that's one reason it won?

THORNDIKE: Oh, absolutely. I mean, taxes do have a lot to do with the North winning the war - not just taxes, but the North's ability to borrow money. It just had a better economic foundation for fighting a big war like that.

SMITH: You know, the income tax worked so well during the war, you would think that the U.S. government would want to keep it around. I mean, it's nice to have extra money when you're actually rebuilding from all the carnage and such. But once the conflict ended, there was this big argument about whether to keep the income tax around or not.

KESTENBAUM: And now the income tax hits its second obstacle - a legal obstacle. Remember how we said the income tax only hits the rich? Well, the rich did not like it, and the rich have lawyers. In 1895, a legal challenge to the income tax reaches the U.S. Supreme Court. Here's economic historian John Steele Gordon.

JOHN STEELE GORDON: My great, great uncle was one of the lead lawyers in that case. And guess which side he was on?

KESTENBAUM: Trying to shoot down the income tax.

GORDON: You got it. And he became a - he was a Morgan partner five years later (laughter).

KESTENBAUM: The argument John Steele Gordon's great, great uncle made in court was that the income tax violated a little document that we like to call the U.S. Constitution. Here, I'll read the line to you. It says, quote,

KESTENBAUM: "direct taxes shall be apportioned among the states according to their respective numbers."

SMITH: I will translate that for you. If the federal government wants to raise money directly from people or property, then it has to divide the tax burden up equally among the states according to their population. So if a state had 10 percent of America's population, it should only have to pay about 10 percent of the tax. And the income tax wasn't taxing according to population. It was taxing according to income.

KESTENBAUM: So the question before the Supreme Court is, and as is often the case, it's something kind of annoyingly subtle and hard to follow. The question is, is the income tax a direct tax?

SMITH: You know, I stayed up late last night reading court documents. This is a huge rabbit hole of complicated things, but it comes down to this. If any part of this income tax law passed by Congress, if any of the many taxes embedded inside were considered a direct tax, then Congress did it wrong. The law is unconstitutional.

KESTENBAUM: That is the question the justices had to decide.

GORDON: A very interesting thing happened in the Supreme Court. One justice was ill. In fact, he was dying - Justice Jackson from Tennessee. And so it was argued before eight justices, and they split 4-4 as to whether or not the income tax was a direct tax and therefore unconstitutional.

KESTENBAUM: That's why we have an odd number of justices and you can't have a tie, right?

GORDON: Exactly. It was 4-4 tie. And the court decided that the case was simply too important to be tied. And so they hauled Justice Jackson out of his deathbed. They now had an odd number of justices, and everybody knew that he was in favor of the income tax because he'd said so publicly.

KESTENBAUM: Was he really dying?

GORDON: Yes, he really died two months later.

KESTENBAUM: So the lawyers re-argue the case. Justice Robert Jackson is in the final days of his life. He is a pro-income tax guy, so he's going to break the tie in favor of the income tax. And the tie was broken, case was decided 5-4.

SMITH: But the crazy thing is it was 5-4 the other way. It was a 5-4 decision against the income tax.

GORDON: One of the other justices - we don't know who - switched his vote. And so the tax was unconstitutional - no income tax.

SMITH: How did people react at the time to this little intrigue?

GORDON: Oh, they - yeah, there was a lot of fuss in the papers about it, but the Supreme Court was silent, as it so often is, as to its internal workings.

SMITH: We really don't know who switched their vote?

GORDON: No, we really don't know who. But somebody switched their vote, we just don't know who.

SMITH: So there's this weird stretch in the middle of American history where the income tax has been ruled unconstitutional, but this didn't in any way settle the argument. I mean, if anything, the debate over income tax in America grew more heated. This is a time when a lot of big industrialists are getting filthy rich - J.P. Morgan, Rockefeller, Carnegie. And at this exact time, the nation has no income tax.

KESTENBAUM: The people who are not J.P. Morgan or Rockefeller or Carnegie in the country, a lot of them feel those guys, the rich, need to bear more of the burden. So nearly 20 years after the income tax is ruled unconstitutional, we get an amendment to the Constitution - the 16th Amendment ratified in 1913, a single sentence which begins - the Congress shall have the power to lay and collect taxes on incomes.

SMITH: Just in time for another war - World War I. So the income tax has cleared two hurdles so far - logistics, check, legality, check. The income tax needs one more thing to bring it into the modern age, one more L word - love.

KESTENBAUM: Aw. The income tax up to this point has been a tax on the rich, right? Everyone else was exempt. In fact, when they bring the income tax back after the constitutional amendment, less than 2 percent of the population has to pay it. All this changes though with World War II. The government needs more money, and now ordinary folks are asked to pay. Again, Joe Thorndike.

THORNDIKE: This is a real revolution because for most Americans, they've never had this kind of direct tax-paying relationship with the federal government. You know, they're paying excise taxes on alcohol, tobacco or consumer goods, but those things are usually levied somewhere other than, like, on the consumer. You know, they're levied at the manufacturer level. For the first time, Americans are sort of confronting the federal government as a tax collector.

KESTENBAUM: And the middle class has never paid this tax before. They're not sure what to do. A poll in 1943 showed that one-third to one-half of people were unclear what their tax responsibilities were.

THORNDIKE: And there was a lot of concern that Americans just wouldn't do it, that they wouldn't understand that they were supposed to or that they had to or even just how to do it.

SMITH: Government clearly needs to get the word out. It needs a spokesperson to help explain the income tax. They need somebody with credibility, somebody who people respect, somebody instantly recognizable, easy to understand.

(SOUNDBITE OF FILM, "THE SPIRIT OF '43")

CLARENCE NASH: (As Donald Duck) That is not right.

KESTENBAUM: They go with Donald Duck. This is a short film by Disney from 1943 commissioned by the government. In it, Donald Duck is marching around his house patriotically listening to the radio and talking back to it.

(SOUNDBITE OF FILM, "THE SPIRIT OF '43")

FRED SHIELDS: (As Narrator) Your whole country is mobilizing for total war. Your country needs you.

NASH: (As Donald Duck) OK.

KESTENBAUM: Donald Duck runs, and he gets a gun and a sword and an axe and boxing gloves.

(SOUNDBITE OF FILM, "THE SPIRIT OF '43")

SHIELDS: (As Narrator) Are you a patriotic American?

NASH: (As Donald Duck) Yes, sir.

SHIELDS: (As Narrator) Eager to do your part?

NASH: (As Donald Duck) Yes, sir.

SHIELDS: (As Narrator) Then there's something important you can do.

NASH: (As Donald Duck) Oh, boy. Oh, boy. Oh, boy. I'll do it.

SHIELDS: (As Narrator) You won't get a medal for doing it.

NASH: (As Donald Duck) Oh, that's all right.

SHIELDS: (As Narrator) It may mean a sacrifice on your part...

NASH: (As Donald Duck) I'll do it anyway.

SHIELDS: (As Narrator) ...But it will be a vital help to your country in this hour of need.

NASH: (As Donald Duck) I'll do anything - anything.

SHIELDS: (As Narrator) Shall I tell you what it is?

NASH: (As Donald Duck) Yes, what is it? Tell me.

SHIELDS: (As Narrator) Shall I?

NASH: (As Donald Duck) Tell me what it is.

SHIELDS: (As Narrator) Your income tax.

NASH: (As Donald Duck) Income tax?

SHIELDS: (As Narrator) Yes, your income tax.

NASH: (As Donald Duck) That dumb, old income tax.

SMITH: We love this video. We have been watching it over and over again, and you should too. We're going to put it on the PLANET MONEY blog. It was actually nominated for an Academy Award, David, right?

KESTENBAUM: In 1943, yeah.

SMITH: 1943.

KESTENBAUM: They actually walked Donald Duck through filling out his whole tax return.

(SOUNDBITE OF FILM, "THE SPIRIT OF '43")

SHIELDS: (As Narrator) You made less than $3,000 last year?

NASH: (As Donald Duck) Yes, sir.

SHIELDS: (As Narrator) Well, then you can use the new simplified form.

KESTENBAUM: Donald Duck writes in his occupation - actor, income $2,501. He lists his dependents, three - Huey, Dewey and Louie. Then they have him look up how much he owes in the tax tables.

SMITH: It's basically wartime propaganda, but it is very, very successful propaganda. People pay their taxes to fight the Axis. Maybe people never fully get over this final hurdle and start to love paying the income tax, but they accept it. In 1944, a poll shows that 90 percent of Americans think the tax code is fair.

KESTENBAUM: And this is the end of our story. With the help of Donald Duck, the income tax is established and the debate shifts in America. It's no longer, should there be an income tax or not? After World War II, the heated argument becomes a fight over who pays what. Tax rates for the rich go up and down. Exemptions get piled on top of loopholes which get piled on top of credits. The tax code becomes a jungle of rules and regulations.

SMITH: And yet, for all the fights over fairness, for all the election rhetoric we hear every four years over how horrible our tax system is, come April 15, most people suck it up and they pay. Again, tax historian Joe Thorndike.

THORNDIKE: Yeah, I mean, I think that that's one of the myths actually of American history. You know, you hear it all the time. Americans are an anti-tax people. We hate taxes.

KESTENBAUM: The whole country was founded because were upset about paying a tax.

THORNDIKE: That's true, although it's arguable that what they were upset about was that they weren't levying that tax themselves, not that they didn't want to pay taxes, but that they wanted to have the authority to levy that tax on their own. I think what's remarkable about Americans, there is an anti-tax strain, but just as impressive is the willingness of Americans to actually pay their taxes. It - to some degree, this has to do with wars, but wars can't explain why people continue to pay their taxes during the long periods of peace. I think that Americans, by and large, over the decades and centuries, have felt like the government is giving them something they want and they're willing to pay for it. I really think it's almost that simple an equation.

And when faith in government starts to erode, which I think has happened significantly in the last several decades, then willingness to pay taxes begins to erode. And you start to see numbers like that 90 percent of, you know, Americans think the tax system is fair - those numbers start to drop pretty dramatically. They're not in the basement, even now. People tend to be remarkably OK with the amount of taxes that they're paying. Their real suspicion is that other people are getting away with murder, and that makes them feel like a chump.

(SOUNDBITE OF SONG, "I PAID MY INCOME TAX TODAY")

IRVING BERLIN: (Singing) I paid my income tax today. I never felt so proud before to be right there with the millions more who paid their income tax today.

SMITH: On a future podcast, we will dig into the actual tax code itself. So if there's some part that makes you feel like a chump, let us know. You can send us email - planetmoney@npr.org

KESTENBAUM: On our blog, npr.org/money, we will link to Joe Thorndike's book "War And Taxes," which he cowrote with Steven Bank and Kirk Stark. That's where a lot of the numbers in this podcast came from.

SMITH: And also on the blog, you can watch the entirety of that Donald Duck short.

KESTENBAUM: I'm David Kestenbaum.

SMITH: And I'm Robert Smith. Thanks for listening.

(SOUNDBITE OF SONG, "I PAID MY INCOME TAX TODAY")

BERLIN: (Singing) That certainly makes me feel OK. Ten-thousand more and that ain't hay. We must pay for this war somehow. Uncle Sam was worried, but he isn't now. I paid my income tax today. Transcript provided by NPR, Copyright NPR.