A History of US Economic Law Part 3: The Conception of the Income Tax
In 1894, the Democratic Party was under significant pressure to reduce the tariffs imposed by the 1890 McKinley Tariff. As I discussed in my previous blog the economy was in recession and the average Americans purchasing power had dropped. Government revenue had been significantly reduced by the recession.
However, it was difficult to build a consensus between the House and the Senate- a bill that started as significant tariff cuts was diluted by over 600 amendments in the Senate. The result was the Wilson-Gorman Tariff, a hodgepodge of tariff cuts and tariff increases that became law without the signature of President Cleveland.
For purposes of discussion here, the most important aspect of the Wilson-Gorman Tariff was that for the first time an income tax was imposed during peacetime. The tax consisted of 2% on all income over $4,000 for individuals and corporations.
This wasn’t the first income tax imposed in the US. The first was the Civil War income tax imposed in 1861 which was a progressive tax with rates ranging from 3%-10%. It was passed along with a slough of other taxes as an emergency measure. After the war, the income tax was gradually reduced and eventually eliminated in 1872 along with most of the other taxes imposed during the war.
Since the national debate was focused on more immediate issues surrounding the secession, war, and later reconstruction the argument over the income tax during the Civil War. The passage of the income tax in the Wilson-Gorman Tariff was far more controversial and led to a decade long national debate.
Many saw the income tax as a continuing backlash against the barons of industry, rather than a means to raise significant funds as demonstrated by an article written in “The Quarterly Journal of Economics” Vol. 9, No. 1, Oct. 1894
…it will be clear that the considerations which weighed with Congress in taking this important step were not fiscal, and that the provisions of the new act were not studied and perfected by its framers from this point of view. The very fact that the limit of exemption is set so high as $4,000 will be a standing demonstration that the measure was shaped to meet some supposed social or reformatory end, possibly with some sectional bearing, but at any rate, not as the best result of either modern theory or modern practice.
He then goes on to criticize the tax in detail from a conservative point of view.
Newspaper reports support the idea that the income tax was meant to redistribute the tax burden from the public at large to the extremely wealthy. From a New York Times article on Jan. 29th 1894
Representative McMillin is quoted as saying,
If a man owns $50,000,000 or $100,000,000 worth of property in the United States, as some do, he pays only on what he eats, what he drinks, what he wears and the other things he uses.
With this small exception this vast aggregation of wealth contributes nothing else to pay the expenses of the General Government.
The time has come when this should be changed, it seems to me. I ask of any reasonable person whether it is unjust to expect that a small per cent of this enormous revenus shall be placed upon the accumulated wealth of the country instead of placing all upon the consumption of the country.
Other New York Times articles suggest that the income tax was less than popular even among democrats but ultimately, the pressure to pass tariff reform was enough to pass the bill.
The income tax didn’t survive long. Charles Pollock owned ten shares of stock in the Farmers’ Loan & Trust Company and sued the company to prevent them from paying the tax. The resulting case went all the way to the Supreme Court, Pollock v. Farmers’ Loan & Trust Company 157 U.S. 429 (1895) resulted in a narrow 5 to 4 decision overturning the income tax.
Originally, the Constitution required that all direct taxes be
… apportioned among the several States which may be included within this Union, according to their respective Numbers, which shall be determined by adding the whole Number of free Persons, including those bound to Service for a Term of Years, and excluding Indians not taxed, three fifths of all other Persons.
The Court ruled,
A tax on the rents or income of real estate is a direct tax within the meaning of that term as used in the Constitution of the United States.
A tax upon income derived from the interest of bonds issued by a municipal corporation is a tax upon the power of the State and its instrumentalities to borrow money, and is consequently repugnant to the Constitution of the United States.
So much of the act "to reduce taxation, to provide revenue for the government, and for other purposes," 28 Stat. 509, c. 349, as provides for levying taxes upon rents or income derived from real estate, or from the interest on municipal bonds, is repugnant to the Constitution of the United States, and is invalid.
This case fueled the efforts of Progressives and Socialists sympathetic to the income tax both as a tool for raising greater revenues for the federal government and as a tool to reduce the large fortunes held by trusts and the extraordinarily wealthy. It would take another 18 years to pass and ratify the 16th Amendment effectively overturning Pollock but with the passage of the Wilson-Gormann Tariff and the subsequent Supreme Court Case, the idea of a peace time income tax became a topic of debate for the public at large.