U.S. military effort. So Congress passed several tax laws that raised tariffs; increased excise taxes on many products, including alcohol and tobacco; and imposed the nation’s first federal income tax. The public was amenable to these taxes because they supported the war. But when the war ended, the taxes were no longer viewed as necessary, so Congress eliminated many of them, including the income tax. It retained the higher tariffs on imports and the excise taxes on alcohol and tobacco. The federal government was once again largely dependent on import tariffs and excise taxes on alcohol and tobacco for revenue. States continued to rely on property taxes.
The rise of the capitalists during the post–Civil War era changed the composition of America’s elite by replacing landowners and merchants with business owners, such as Andrew Carnegie (steel), John D. Rockefeller (oil), J. P. Morgan (banking), and Philip Armour (meat packing). These capitalists owned land and paid property taxes, but those taxes were not a major consideration to them. Tariffs were not a burden either; in fact, many industrialists benefited enormously from import taxes because they offered protection from foreign import competition. So the capitalist business tycoons had an incredible deal: they were able to accumulate unprecedented amounts of income and wealth, largely free of taxes, and were made even richer by the protective tariff that was primarily paid by the middle class.
Vast fortunes allowed the upper class to enjoy lifestyles that were mind-boggling by the standards of the day: multiple mansions, scores of servants, yachts, private railcars, fabulous collections of art and jewelry, grand tours of Europe. A social observer of the era reports that “in the mansion of the genteel captain of industry there must be five or six servants to receive you, as well as a butler. The butler and three servants in livery served you dinner. . . . To serve a cup of tea two servants were necessary” (Josephson 1934, 334). Many of the United States’ so-called 400 richest families led lives similar to European royalty, something that did not go over well with many citizens of the democratic United States.
As the industrial boom continued, public resentment built up against both the wealthy capitalists and the U.S. system of taxation. Farmers, who dominated the politics of western and southern states, accumulated a long list of grievances. They were increasingly bitter over their belief that they paid more than their share of the tax burden. They resented the protective tariff that lined the pockets of the industrialists by causing the high prices the farmers paid for finished goods. They were being decimated by bouts of farm price deflation that occurred during the frequent economic recessions. Farmers attributed these business downturns to financial machinations of eastern capitalists, such as the 1873 crisis set off by the failure of Philadelphia financier Jay Cooke’s bank. Farmers also abhorred the gold standard, the monetary system in place that was blamed for the deflation taking place during the era. The gold standard was widely supported by eastern manufacturing and financial interests who valued “sound money.” Southerners had an additional item on their list of complaints: federal tax revenue was being used to pay increasingly generous pensions to Union army veterans and their families. By the late 1890s, those pensions consumed as much as 45 percent of federal revenue (Brownlee 1996, 31). Former Confederates paid taxes to support those pensions but, of course, did not receive them.
As a result of these and other factors, the Republicans experienced a gradual erosion of political rule. The Democrats, who had western and southern support, won control of the House of Representatives in the 1874 elections and the Senate in 1878. During the ensuing years, Democrats and Republicans traded power back and forth. But when Democrat Grover Cleveland was sworn in for his second term as president (1893–1897), the Democrats held both houses of Congress. Now was their big chance to enact the United States’ first peacetime income tax.
Early Federal Income Taxes
As noted earlier, the first federal income tax was imposed in 1861 to help pay for the Civil War. Viewed as temporary (it expired in 1872), the tax was designed to collect revenue from high-income earners. It exempted the first $800 of income (later lowered to $600) at a time when a typical worker earned about $300 per year. Tax rates were altered twice, varying from 3 percent to 10 percent.2 During the war, the tax provided about 25 percent of federal revenue.3 As an indicator of where high-income earners lived at the time, well over half of the income tax’s revenue was paid by residents and businesses located in New York, Pennsylvania, and Massachusetts (Seligman 1914, 472). Prosperous New York, with roughly 17 percent of the U.S. population, paid 33 percent of U.S. federal income taxes.
When the Democrats resurrected the income tax in 1894, it had strong public support. Included as part of a tariff bill, the first $4,000 of income from all sources, including dividends and interest, was exempted, and income above that amount was taxed at a rate of 2 percent. During congressional debate on the bill, northeastern politicians were opposed, in part because they were aware that their constituents would pay most of the tax. Supporters framed the debate as rich versus poor, where the rich should pay their fair share. Opponents countered that an income tax was a socialistic seizure of property. The bill passed Congress and became law in August 1894.
The following year, a court case involving the income tax was argued before the U.S. Supreme Court. The major issue was whether the income tax was a “direct” tax. If so, then the U.S. Constitution clearly states that it must be apportioned based on states’ populations. In other words, if New York had twice the population of Georgia, then total taxes collected from residents and businesses in New York should be two times the amount collected from Georgia. But at the time, with so much of the nation’s financial wealth and income concentrated in New York, a tax on high-income earners would cause total taxes paid by New Yorkers to be far more than twice the amount paid by all residents and businesses in Georgia. Thus, the tax would not be apportioned according to the two states’ populations, which would violate the Constitution’s clause on direct taxes.
It is not exactly clear what the Framers of the U.S. Constitution meant by the term “direct tax” because many of those involved in writing and ratifying the document had different things in mind. But the term became interpreted in constitutional law as meaning a tax on property or a head tax (an identical tax imposed on each person). The issue in the court case hinged on the following: a tax on property is clearly a direct tax, but what about a tax on the income earned from property?4 Is that a direct tax or an indirect tax? If it was a direct tax, then the 1894 income tax law was unconstitutional; but if it was an indirect tax, then it would be constitutional and not subject to the clause about apportionment based on states’ populations. This issue never came up while the Civil War income tax was in effect, apparently because the members of Congress thought it was an indirect tax.
In a decision that set off a major legal debate that lasted years, the U.S. Supreme Court ruled in 1895 that the income tax assessed on income derived from land was a direct tax.5 Thus, the 1894 income tax law was ruled unconstitutional. Following a rehearing on the case, the Court later stated that taxing income earned on personal property (which includes assets such as stocks and bonds) was a direct tax. Income tax proponents were devastated by these rulings because they meant that the creation of a lasting income tax law would require a constitutional amendment that could take years to bring about.
That effort did take years, in part because the nation’s focus shifted to the debate over the gold standard, which was the major issue in the hotly contested 1896 national election. During his campaign, Democratic presidential candidate William Jennings Bryan made his famous “Cross of Gold” speech, claiming that farmers were being crucified by the gold standard and the deflation it caused. The Republicans and their candidate William McKinley firmly backed the gold standard. It was East and Midwest versus West and South, and McKinley won a close race while congressional Republicans managed to retain their majorities in both the House and Senate. With the Republicans in control, the gold standard was retained and the income tax was moved to the back burner. Yet public support for an income tax continued.
Moving toward a Constitutional Amendment
The
