Why Do We Have a Federal Income Tax?

April 6, 2018

In 2018, we’ve become accustomed to the federal income tax as a matter of our everyday reality. For many of us, it’s hard to believe that Americans weren’t required to pay tax on their personal income at one point in time. But, in fact, the U.S. federal income tax structure is now just a bit over 100 years old. Prior to 1913, Americans didn’t busy themselves with preparing income tax returns, or bothering to hunt down the most qualified accountant that could give them the best results.  In those days, rather than relying on income tax revenue, the U.S. government was funded with other forms of income, such as tariffs and multiple excise taxes. So how and why the change to a federal income tax? In this article, we’ll tell the story of how the federal income tax came into being and illustrate some of the developments which contributed to its current structure.  

The War Between the States 

The very first tax on personal income was introduced during the American Civil War in 1861. This tax was intended as a temporary war measure, and so was discontinued after the end of the war. This first tax was also extremely simple in comparison to our modern system of taxation: initially, the income tax consisted of a flat tax of 3% on incomes above $800. This meant that only a very small percentage of the population (of the Union states) paid the tax. This first tax structure was created through the Revenue Act of 1861. 

During the course of the war, the income tax structure was revised several times, and the latter revisions established the layered tax tiers we’re familiar with today. As early as 1862, the tax structure provided that those with incomes above $600 but below $10,000 paid a 3% tax, and those with incomes above $10,000 paid a 5% tax. This rate structure was again revised in order to generate even greater revenue to fund the war.  

Pollock v. Farmers’ Loan & Trust Co. 

After the Civil War ended in 1865, the income tax was dropped, only for it to reappear near the turn of the century with the Wilson-Gorman Tariff Act of 1894. The Wilson-Gorman act lowered tariff rates, but it also created a 2% income tax to compensate for the tariff reductions. The income tax portion of the Wilson-Gorman Act was challenged in the case of Pollock v. Farmers’ Loan & Trust Co. in 1895. In the Pollock case, the legality of the income tax provisions of the Act were called into question.  Pollock asserted that a tax on interest, dividends and rents constituted a “direct tax” and therefore was subject to the apportionment requirement of the U.S. Constitution. The Wilson-Gorman Act didn’t apportion the 2% income tax so, it was argued, the tax was a direct tax and therefore, unconstitutional. 

The Pollock decision followed that line of reasoning, holding that the income tax provision was in fact a direct tax and therefore subject to the apportionment requirement. And because the income tax was not apportioned under the Act, it’s income tax provisions couldn’t be enforced. Furthermore, because the Pollock case held that a tax on interest, dividends and rents was a direct tax, an amendment to the U.S. Constitution was found to be necessary in order to create a sustainable federal income tax system. 

Income Tax and The Sixteenth Amendment 

The Sixteenth Amendment to the U.S. Constitution was a direct response to the Pollock case. This amendment provided that Congress had a power to tax income from any source and without any apportionment restriction. Essentially, what the amendment did was obviate the traditional distinction between “direct” taxes and “indirect” taxes, even though this distinction had been a cornerstone of U.S. taxation since the founding of the country. In effect, the Sixteenth Amendment consolidated the taxing power of Congress and enabled Congress to freely tax without the constraints put in place by our country’s founding fathers. 

A Ballooning Income Tax and the World Wars 

Even though Congressional taxing powers were greatly enhanced by passage of the Sixteenth Amendment, the income tax rate structure introduced in its wake was still very modest by modern standards. The Revenue Act of 1913, enacted immediately after passage of the Sixteenth Amendment, implemented a simple, seven layer progressive federal income tax system.  Its top tax rate was still only 7%, while its bottom rate was a low 1%. This modest structure was quickly replaced by a much more aggressive structure in response to America’s entry into World War One. As America entered the war, the top rate ultimately skyrocketed to an astonishing 77%. The top rate climbed even higher during World War Two, when it reached the dirrying height of 94%. The top rate has fluctuated widely since, and today it stands at 39.6% for individuals earning over $418,400.  

Obviously, a full history of the income tax would need to incorporate more facts and figures to show how rates have risen and fallen in response to social phenomena, international events and various presidential administrations; a history well beyond the scope of this article. But, what is clear is the fact that the development of U.S. income taxation has not followed anything like a linear, predictable, path. As we’ve briefly shown, many acts of chance and plenty of randomness have all contributed to the development of our current income tax structure. How the U.S. federal income tax will evolve is up for debate, but what is certain is that the income tax structure we have now is a far cry from where we began.

The attorneys at Mackay, Caswell & Callahan, P.C. work hard to stay up-to-date with the latest developments in the world of tax; they also have a firm grasp of the evolution of tax up to the present time, as this article makes clear. If you’re in New York and need the assistance of a qualified New York City tax attorney, get in touch with us today by visiting our site or giving us a call. 

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