History of the U.S. Tax System
The federal, state, and local tax systems
in the United States have been marked by
significant changes over the years in
response to changing circumstances and
changes in the role of government. The types
of taxes collected, their relative
proportions, and the magnitudes of the
revenues collected are all far different than
they were 50 or 100 years ago. Some of these
changes are traceable to specific historical
events, such as a war or the passage of the
16th Amendment to the Constitution that
granted the Congress the power to levy a tax
on personal income. Other changes were more
gradual, responding to changes in society, in
our economy, and in the roles and
responsibilities that government has taken
unto itself.
For most of our nation's history,
individual taxpayers rarely had any
significant contact with Federal tax
authorities as most of the Federal
government's tax revenues were derived from
excise taxes, tariffs, and customs duties.
Before the Revolutionary War, the colonial
government had only a limited need for
revenue, while each of the colonies had
greater responsibilities and thus greater
revenue needs, which they met with different
types of taxes. For example, the southern
colonies primarily taxed imports and exports,
the middle colonies at times imposed a
property tax and a "head" or poll tax levied
on each adult male, and the New England
colonies raised revenue primarily through
general real estate taxes, excises taxes, and
taxes based on occupation.
England's need for revenues to pay for its
wars against France led it to impose a series
of taxes on the American colonies. In 1765,
the English Parliament passed the Stamp Act,
which was the first tax imposed directly on
the American colonies, and then Parliament
imposed a tax on tea. Even though colonists
were forced to pay these taxes, they lacked
representation in the English Parliament.
This led to the rallying cry of the American
Revolution that "taxation without
representation is tyranny" and established a
persistent wariness regarding taxation as
part of the American culture.
The Articles of Confederation, adopted in
1781, reflected the American fear of a strong
central government and so retained much of
the political power in the States. The
national government had few responsibilities
and no nationwide tax system, relying on
donations from the States for its revenue.
Under the Articles, each State was a
sovereign entity and could levy tax as it
pleased.
When the Constitution was adopted in 1789,
the Founding Fathers recognized that no
government could function if it relied
entirely on other governments for its
resources, thus the Federal Government was
granted the authority to raise taxes. The
Constitution endowed the Congress with the
power to "…lay and collect taxes,
duties, imposts, and excises, pay the Debts
and provide for the common Defense and
general Welfare of the United States." Ever
on guard against the power of the central
government to eclipse that of the states, the
collection of the taxes was left as the
responsibility of the State governments.
To pay the debts of the Revolutionary War,
Congress levied excise taxes on distilled
spirits, tobacco and snuff, refined sugar,
carriages, property sold at auctions, and
various legal documents. Even in the early
days of the Republic, however, social
purposes influenced what was taxed. For
example, Pennsylvania imposed an excise tax
on liquor sales partly "to restrain persons
in low circumstances from an immoderate use
thereof." Additional support for such a
targeted tax came from property owners, who
hoped thereby to keep their property tax
rates low, providing an early example of the
political tensions often underlying tax
policy decisions.
Though social policies sometimes governed
the course of tax policy even in the early
days of the Republic, the nature of these
policies did not extend either to the
collection of taxes so as to equalize incomes
and wealth, or for the purpose of
redistributing income or wealth. As Thomas
Jefferson once wrote regarding the "general
Welfare" clause:
To take from one, because it is thought his
own industry and that of his father has
acquired too much, in order to spare to
others who (or whose fathers) have not
exercised equal industry and skill, is to
violate arbitrarily the first principle of
association, "to guarantee to everyone a
free exercise of his industry and the
fruits acquired by it."
With the establishment of the new nation,
the citizens of the various colonies now had
proper democratic representation, yet many
Americans still opposed and resisted taxes
they deemed unfair or improper. In 1794, a
group of farmers in southwestern Pennsylvania
physically opposed the tax on whiskey,
forcing President Washington to send Federal
troops to suppress the Whiskey Rebellion,
establishing the important precedent that the
Federal government was determined to enforce
its revenue laws. The Whiskey Rebellion also
confirmed, however, that the resistance to
unfair or high taxes that led to the
Declaration of Independence did not evaporate
with the forming of a new, representative
government.
During the confrontation with France in
the late 1790's, the Federal Government
imposed the first direct taxes on the owners
of houses, land, slaves, and estates. These
taxes are called direct taxes because they
are a recurring tax paid directly by the
taxpayer to the government based on the value
of the item that is the basis for the tax.
The issue of direct taxes as opposed to
indirect taxes played a crucial role in the
evolution of Federal tax policy in the
following years. When Thomas Jefferson was
elected President in 1802, direct taxes were
abolished and for the next 10 years there
were no internal revenue taxes other than
excises.
To raise money for the War of 1812,
Congress imposed additional excise taxes,
raised certain customs duties, and raised
money by issuing Treasury notes. In 1817
Congress repealed these taxes, and for the
next 44 years the Federal Government
collected no internal revenue. Instead, the
Government received most of its revenue from
high customs duties and through the sale of
public land.
When the Civil War erupted, the Congress
passed the Revenue Act of 1861, which
restored earlier excises taxes and imposed a
tax on personal incomes. The income tax was
levied at 3 percent on all incomes higher
than $800 a year. This tax on personal income
was a new direction for a Federal tax system
based mainly on excise taxes and customs
duties. Certain inadequacies of the income
tax were quickly acknowledged by Congress and
thus none was collected until the following
year.
By the spring of 1862 it was clear the war
would not end quickly and with the Union's
debt growing at the rate of $2 million daily
it was equally clear the Federal government
would need additional revenues. On July 1,
1862 the Congress passed new excise taxes on
such items as playing cards, gunpowder,
feathers, telegrams, iron, leather, pianos,
yachts, billiard tables, drugs, patent
medicines, and whiskey. Many legal documents
were also taxed and license fees were
collected for almost all professions and
trades.
The 1862 law also made important reforms
to the Federal income tax that presaged
important features of the current tax. For
example, a two-tiered rate structure was
enacted, with taxable incomes up to $10,000
taxed at a 3 percent rate and higher incomes
taxed at 5 percent. A standard deduction of
$600 was enacted and a variety of deductions
were permitted for such things as rental
housing, repairs, losses, and other taxes
paid. In addition, to assure timely
collection, taxes were "withheld at the
source" by employers.
The need for Federal revenue declined
sharply after the war and most taxes were
repealed. By 1868, the main source of
Government revenue derived from liquor and
tobacco taxes. The income tax was abolished
in 1872. From 1868 to 1913, almost 90 percent
of all revenue was collected from the
remaining excises.
Under the Constitution, Congress could
impose direct taxes only if they were levied
in proportion to each State's population.
Thus, when a flat rate Federal income tax was
enacted in 1894, it was quickly challenged
and in 1895 the U.S. Supreme Court ruled it
unconstitutional because it was a direct tax
not apportioned according to the population
of each state.
Lacking the revenue from an income tax and
with all other forms of internal taxes facing
stiff resistance, from 1896 until 1910 the
Federal government relied heavily on high
tariffs for its revenues. The War Revenue Act
of 1899 sought to raise funds for the
Spanish-American War through the sale of
bonds, taxes on recreational facilities used
by workers, and doubled taxes on beer and
tobacco. A tax was even imposed on chewing
gum. The Act expired in 1902, so that Federal
receipts fell from 1.7 percent of Gross
Domestic Product to 1.3 percent.
While the War Revenue Act returned to
traditional revenue sources following the
Supreme Court's 1895 ruling on the income
tax, debate on alternative revenue sources
remained lively. The nation was becoming
increasingly aware that high tariffs and
excise taxes were not sound economic policy
and often fell disproportionately on the less
affluent. Proposals to reinstate the income
tax were introduced by Congressmen from
agricultural areas whose constituents feared
a Federal tax on property, especially on
land, as a replacement for the excises.
Eventually, the income tax debate pitted
southern and western Members of Congress
representing more agricultural and rural
areas against the industrial northeast. The
debate resulted in an agreement calling for a
tax, called an excise tax, to be imposed on
business income, and a Constitutional
amendment to allow the Federal government to
impose tax on individuals' lawful incomes
without regard to the population of each
State.
By 1913, 36 States had ratified the 16th
Amendment to the Constitution. In October,
Congress passed a new income tax law with
rates beginning at 1 percent and rising to 7
percent for taxpayers with income in excess
of $500,000. Less than 1 percent of the
population paid income tax at the time. Form
1040 was introduced as the standard tax
reporting form and, though changed in many
ways over the years, remains in use
today.
One of the problems with the new income
tax law was how to define "lawful" income.
Congress addressed this problem by amending
the law in 1916 by deleting the word "lawful"
from the definition of income. As a result,
all income became subject to tax, even if it
was earned by illegal means. Several years
later, the Supreme Court declared the Fifth
Amendment could not be used by bootleggers
and others who earned income through illegal
activities to avoid paying taxes.
Consequently, many who broke various laws
associated with illegal activities and were
able to escape justice for these crimes were
incarcerated on tax evasion charges.
Prior to the enactment of the income tax,
most citizens were able to pursue their
private economic affairs without the direct
knowledge of the government. Individuals
earned their wages, businesses earned their
profits, and wealth was accumulated and
dispensed with little or no interaction with
government entities. The income tax
fundamentally changed this relationship,
giving the government the right and the need
to know about all manner of an individual or
business' economic life. Congress recognized
the inherent invasiveness of the income tax
into the taxpayer's personal affairs and so
in 1916 it provided citizens with some degree
of protection by requiring that information
from tax returns be kept confidential.
The entry of the United States into World
War I greatly increased the need for revenue
and Congress responded by passing the 1916
Revenue Act. The 1916 Act raised the lowest
tax rate from 1 percent to 2 percent and
raised the top rate to 15 percent on
taxpayers with incomes in excess of $1.5
million. The 1916 Act also imposed taxes on
estates and excess business profits.
Driven by the war and largely funded by
the new income tax, by 1917 the Federal
budget was almost equal to the total budget
for all the years between 1791 and 1916.
Needing still more tax revenue, the War
Revenue Act of 1917 lowered exemptions and
greatly increased tax rates. In 1916, a
taxpayer needed $1.5 million in taxable
income to face a 15 percent rate. By 1917 a
taxpayer with only $40,000 faced a 16 percent
rate and the individual with $1.5 million
faced a tax rate of 67 percent.
Another revenue act was passed in 1918,
which hiked tax rates once again, this time
raising the bottom rate to 6 percent and the
top rate to 77 percent. These changes
increased revenue from $761 million in 1916
to $3.6 billion in 1918, which represented
about 25 percent of Gross Domestic Product
(GDP). Even in 1918, however, only 5 percent
of the population paid income taxes and yet
the income tax funded one-third of the cost
of the war.
The economy boomed during the 1920s and
increasing revenues from the income tax
followed. This allowed Congress to cut taxes
five times, ultimately returning the bottom
tax rate to 1 percent and the top rate down
to 25 percent and reducing the Federal tax
burden as a share of GDP to 13 percent. As
tax rates and tax collections declined, the
economy was strengthened further.
In October of 1929 the stock market crash
marked the beginning of the Great Depression.
As the economy shrank, government receipts
also fell. In 1932, the Federal government
collected only $1.9 billion, compared to $6.6
billion in 1920. In the face of rising budget
deficits which reached $2.7 billion in 1931,
Congress followed the prevailing economic
wisdom at the time and passed the Tax Act of
1932 which dramatically increased tax rates
once again. This was followed by another tax
increase in 1936 that further improved the
government's finances while further weakening
the economy. By 1936 the lowest tax rate had
reached 4 percent and the top rate was up to
79 percent. In 1939, Congress systematically
codified the tax laws so that all subsequent
tax legislation until 1954 amended this basic
code. The combination of a shrunken economy
and the repeated tax increases raised the
Federal government's tax burden to 6.8
percent of GDP by 1940.
The state of the economy during the Great
Depression led to passage of the Social
Security Act in 1935. This law provided
payments known as "unemployment compensation"
to workers who lost their jobs. Other
sections of the Act gave public aid to the
aged, the needy, the handicapped, and to
certain minors. These programs were financed
by a 2 percent tax, one half of which was
subtracted directly from an employee's
paycheck and one half collected from
employers on the employee's behalf. The tax
was levied on the first $3,000 of the
employee's salary or wage.
Even before the United States entered the
Second World War, increasing defense spending
and the need for monies to support the
opponents of Axis aggression led to the
passage in 1940 of two tax laws that
increased individual and corporate taxes,
which were followed by another tax hike in
1941. By the end of the war the nature of the
income tax had been fundamentally altered.
Reductions in exemption levels meant that
taxpayers with taxable incomes of only $500
faced a bottom tax rate of 23 percent, while
taxpayers with incomes over $1 million faced
a top rate of 94 percent. These tax changes
increased federal receipts from $8.7 billion
in 1941 to $45.2 billion in 1945. Even with
an economy stimulated by war-time production,
federal taxes as a share of GDP grew from 7.6
percent in 1941 to 20.4 percent in 1945.
Beyond the rates and revenues, however,
another aspect about the income tax that
changed was the increase in the number of
income taxpayers from 4 million in 1939 to 43
million in 1945.
Another important feature of the income
tax that changed was the return to income tax
withholding as had been done during the Civil
War. This greatly eased the collection of the
tax for both the taxpayer and the Bureau of
Internal Revenue. However, it also greatly
reduced the taxpayer's awareness of the
amount of tax being collected, i.e. it
reduced the transparency of the tax, which
made it easier to raise taxes in the
future.
Tax cuts following the war reduced the
Federal tax burden as a share of GDP from its
wartime high of 20.9 percent in 1944 to 14.4
percent in 1950. However, the Korean War
created a need for additional revenues which,
combined with the extension of Social
Security coverage to self-employed persons,
meant that by 1952 the tax burden had
returned to 19.0 percent of GDP.
In 1953 the Bureau of Internal Revenue was
renamed the Internal Revenue Service (IRS),
following a reorganization of its function.
The new name was chosen to stress the service
aspect of its work. By 1959, the IRS had
become the world's largest accounting,
collection, and forms-processing
organization. Computers were introduced to
automate and streamline its work and to
improve service to taxpayers. In 1961,
Congress passed a law requiring individual
taxpayers to use their Social Security number
as a means of tax form identification. By
1967, all business and personal tax returns
were handled by computer systems, and by the
late 1960s, the IRS had developed a
computerized method for selecting tax returns
to be examined. This made the selection of
returns for audit fairer to the taxpayer and
allowed the IRS to focus its audit resources
on those returns most likely to require an
audit.
Throughout the 1950s tax policy was
increasingly seen as a tool for raising
revenue and for changing the incentives in
the economy, but also as a tool for
stabilizing macroeconomic activity. The
economy remained subject to frequent boom and
bust cycles and many policymakers readily
accepted the new economic policy of raising
or lowering taxes and spending to adjust
aggregate demand and thereby smooth the
business cycle. Even so, however, the maximum
tax rate in 1954 remained at 87 percent of
taxable income. While the income tax
underwent some manner of revision or
amendment almost every year since the major
reorganization of 1954, certain years marked
especially significant changes. For example,
the Tax Reform Act of 1969 reduced income tax
rates for individuals and private
foundations.
Beginning in the late 1960s and continuing
through the 1970s the United States
experienced persistent and rising inflation
rates, ultimately reaching 13.3 percent in
1979. Inflation has a deleterious effect on
many aspects of an economy, but it also can
play havoc with an income tax system unless
appropriate precautions are taken.
Specifically, unless the tax system's
parameters, i.e. its brackets and its fixed
exemptions, deductions, and credits, are
indexed for inflation, a rising price level
will steadily shift taxpayers into ever
higher tax brackets by reducing the value of
those exemptions and deductions.
During this time, the income tax was not
indexed for inflation and so, driven by a
rising inflation, and despite repeated
legislated tax cuts, the tax burden rose from
19.4 percent of GDP to 20.8 percent of GDP.
Combined with high marginal tax rates, rising
inflation, and a heavy regulatory burden,
this high tax burden caused the economy to
under-perform badly, all of which laid the
groundwork for the Reagan tax cut, also known
as the Economic Recovery Tax Act of 1981.
The Economic Recovery Tax Act of 1981,
which enjoyed strong bi-partisan support in
the Congress, represented a fundamental shift
in the course of federal income tax policy.
Championed in principle for many years by
then-Congressman Jack Kemp (R-NY) and
then-Senator Bill Roth (R- DE), it featured a
25 percent reduction in individual tax
brackets, phased in over 3 years, and indexed
for inflation thereafter. This brought the
top tax bracket down to 50 percent.
The 1981 Act also featured a dramatic
departure in the treatment of business
outlays for plant and equipment, i.e. capital
cost recovery, or tax depreciation.
Heretofore, capital cost recovery had
attempted roughly to follow a concept known
as economic depreciation, which refers to the
decline in the market value of a producing
asset over a specified period of time. The
1981 Act explicitly displaced the notion of
economic depreciation, instituting instead
the Accelerated Cost Recovery System which
greatly reduced the disincentive facing
business investment and ultimately prepared
the way for the subsequent boom in capital
formation. In addition to accelerated cost
recovery, the 1981 Act also instituted a 10
percent Investment Tax Credit to spur
additional capital formation.
Prior to, and in many circles even after
the 1981 tax cut, the prevailing view was
that tax policy is most effective in
modulating aggregate demand whenever demand
and supply become mismatched, i.e. whenever
the economy went in to recession or became
"over-heated". The 1981 tax cut represented a
new way of looking at tax policy, though it
was in fact a return to a more traditional,
or neoclassical, economic perspective. The
essential idea was that taxes have their
first and primary effect on the economic
incentives facing individuals and businesses.
Thus, the tax rate on the last dollar earned,
i.e. the marginal dollar, is much more
important to economic activity than the tax
rate facing the first dollar earned or than
the average tax rate. By reducing marginal
tax rates it was believed the natural forces
of economic growth would be less restrained.
The most productive individuals would then
shift more of their energies to productive
activities rather than leisure and businesses
would take advantage of many more now
profitable opportunities. It was also thought
that reducing marginal tax rates would
significantly expand the tax base as
individuals shifted more of their income and
activities into taxable forms and out of
tax-exempt forms.
The 1981 tax cut actually represented two
departures from previous tax policy
philosophies, one explicit and intended and
the second by implication. The first change
was the new focus on marginal tax rates and
incentives as the key factors in how the tax
system affects economic activity. The second
policy departure was the de facto shift away
from income taxation and toward taxing
consumption. Accelerated cost recovery was
one manifestation of this shift on the
business side, but the individual side also
saw a significant shift in the enactment of
various provisions to reduce the multiple
taxation of individual saving. The Individual
Retirement Account, for example, was enacted
in 1981.
Simultaneously with the enactment of the
tax cuts in 1981 the Federal Reserve Board,
with the full support of the Reagan
Administration, altered monetary policy so as
to bring inflation under control. The Federal
Reserve's actions brought inflation down
faster and further than was anticipated at
the time, and one consequence was that the
economy fell into a deep recession in 1982.
Another consequence of the collapse in
inflation was that federal spending levels,
which had been predicated on a higher level
of expected inflation, were suddenly much
higher in inflation-adjusted terms. The
combination of the tax cuts, the recession,
and the one-time increase in
inflation-adjusted federal spending produced
historically high budget deficits which, in
turn, led to a tax increase in 1984 that
pared back some of the tax cuts enacted in
1981, especially on the business side.
As inflation came down and as more and
more of the tax cuts from the 1981 Act went
into effect, the economic began a strong and
sustained pattern of growth. Though the
painful medicine of disinflation slowed and
initially hid the process, the beneficial
effects of marginal rate cuts and reductions
in the disincentives to invest took hold as
promised.
The Social Security system remained
essentially unchanged from its enactment
until 1956. However, beginning in 1956 Social
Security began an almost steady evolution as
more and more benefits were added, beginning
with the addition of Disability Insurance
benefits. In 1958, benefits were extended to
dependents of disabled workers. In 1967,
disability benefits were extended to widows
and widowers. The 1972 amendments provided
for automatic cost-of-living benefits.
In 1965, Congress enacted the Medicare
program, providing for the medical needs of
persons aged 65 or older, regardless of
income. The 1965 Social Security Amendments
also created the Medicaid programs, which
provides medical assistance for persons with
low incomes and resources.
Of course, the expansions of Social
Security and the creation of Medicare and
Medicaid required additional tax revenues,
and thus the basic payroll tax was repeatedly
increased over the years. Between 1949 and
1962 the payroll tax rate climbed steadily
from its initial rate of 2 percent to 6
percent. The expansions in 1965 led to
further rate increases, with the combined
payroll tax rate climbing to 12.3 percent in
1980. Thus, in 31 years the maximum Social
Security tax burden rose from a mere $60 in
1949 to $3,175 in 1980.
Despite the increased payroll tax burden,
the benefit expansions Congress enacted in
previous years led the Social Security
program to an acute funding crises in the
early 1980s. Eventually, Congress legislated
some minor programmatic changes in Social
Security benefits, along with an increase in
the payroll tax rate to 15.3 percent by 1990.
Between 1980 and 1990, the maximum Social
Security payroll tax burden more than doubled
to $7,849.
Following the enactment of the 1981, 1982,
and 1984 tax changes there was a growing
sense that the income tax was in need of a
more fundamental overhaul. The economic boom
following the 1982 recession convinced many
political leaders of both parties that lower
marginal tax rates were essential to a strong
economy, while the constant changing of the
law instilled in policy makers an
appreciation for the complexity of the tax
system. Further, the debates during this
period led to a general understanding of the
distortions imposed on the economy, and the
lost jobs and wages, arising from the many
peculiarities in the definition of the tax
base. A new and broadly held philosophy of
tax policy developed that the income tax
would be greatly improved by repealing these
various special provisions and lowering tax
rates further. Thus, in his 1984 State of the
Union speech President Reagan called for a
sweeping reform of the income tax so it would
have a broader base and lower rates and would
be fairer, simpler, and more consistent with
economic efficiency.
The culmination of this effort was the Tax
Reform Act of 1986, which brought the top
statutory tax rate down from 50 percent to 28
percent while the corporate tax rate was
reduced from 50 percent to 35 percent. The
number of tax brackets was reduced and the
personal exemption and standard deduction
amounts were increased and indexed for
inflation, thereby relieving millions of
taxpayers of any Federal income tax burden.
However, the Act also created new personal
and corporate Alternative Minimum Taxes,
which proved to be overly complicated,
unnecessary, and economically harmful.
The 1986 Tax Reform Act was roughly
revenue neutral, that is, it was not intended
to raise or lower taxes, but it shifted some
of the tax burden from individuals to
businesses. Much of the increase in the tax
on business was the result of an increase in
the tax on business capital formation. It
achieved some simplifications for individuals
through the elimination of such things as
income averaging, the deduction for consumer
interest, and the deduction for state and
local sales taxes. But in many respects the
Act greatly added to the complexity of
business taxation, especially in the area of
international taxation. Some of the
over-reaching provisions of the Act also led
to a downturn in the real estate markets
which played a significant role in the
subsequent collapse of the Savings and Loan
industry.
Seen in a broader picture, the 1986 tax
act represented the penultimate installment
of an extraordinary process of tax rate
reductions. Over the 22 year period from 1964
to 1986 the top individual tax rate was
reduced from 91 to 28 percent. However,
because upper-income taxpayers increasingly
chose to receive their income in taxable
form, and because of the broadening of the
tax base, the progressivity of the tax system
actually rose during this period.
The 1986 tax act also represented a
temporary reversal in the evolution of the
tax system. Though called an income tax, the
Federal tax system had for many years
actually been a hybrid income and consumption
tax, with the balance shifting toward or away
from a consumption tax with many of the major
tax acts. The 1986 tax act shifted the
balance once again toward the income tax. Of
greatest importance in this regard was the
return to references to economic depreciation
in the formulation of the capital cost
recovery system and the significant new
restrictions on the use of Individual
Retirement Accounts.
Between 1986 and 1990 the Federal tax
burden rose as a share of GDP from 17.5 to 18
percent. Despite this increase in the overall
tax burden, persistent budget deficits due to
even higher levels of government spending
created near constant pressure to increase
taxes. Thus, in 1990 the Congress enacted a
significant tax increase featuring an
increase in the top tax rate to 31 percent.
Shortly after his election, President Clinton
insisted on and the Congress enacted a second
major tax increase in 1993 in which the top
tax rate was raised to 36 percent and a 10
percent surcharge was added, leaving the
effective top tax rate at 39.6 percent.
Clearly, the trend toward lower marginal tax
rates had been reversed, but, as it turns
out, only temporarily.
The Taxpayer Relief Act of 1997 made
additional changes to the tax code providing
a modest tax cut. The centerpiece of the 1997
Act was a significant new tax benefit to
certain families with children through the
Per Child Tax credit. The truly significant
feature of this tax relief, however, was that
the credit was refundable for many
lower-income families. That is, in many cases
the family paid a "negative" income tax, or
received a credit in excess of their
pre-credit tax liability. Though the tax
system had provided for individual tax
credits before, such as the Earned Income Tax
credit, the Per Child Tax credit began a new
trend in federal tax policy. Previously tax
relief was generally given in the form of
lower tax rates or increased deductions or
exemptions. The 1997 Act really launched the
modern proliferation of individual tax
credits and especially refundable credits
that are in essence spending programs
operating through the tax system.
The years immediately following the 1993
tax increase also saw another trend continue,
which was to once again shift the balance of
the hybrid income tax-consumption tax toward
the consumption tax. The movement in this
case was entirely on the individual side in
the form of a proliferation of tax vehicles
to promote purpose-specific saving. For
example, Medical Savings Accounts were
enacted to facilitate saving for medical
expenses. An Education IRA and the Section
529 Qualified Tuition Program was enacted to
help taxpayers pay for future education
expenses. In addition, a new form of saving
vehicle was enacted, called the Roth IRA,
which differed from other retirement savings
vehicles like the traditional IRA and
employer-based 401(k) plans in that
contributions were made in after-tax dollars
and distributions were tax free.
Despite the higher tax rates, other
economic fundamentals such as low inflation
and low interest rates, an improved
international picture with the collapse of
the Soviet Union, and the advent of a
qualitatively and quantitatively new
information technologies led to a strong
economic performance throughout the 1990s.
This, in turn, led to an extraordinary
increase in the aggregate tax burden, with
Federal taxes as a share of GDP reaching a
postwar high of 20.8 percent in 2000.
By 2001, the total tax take had produced a
projected unified budget surplus of $281
billion, with a cumulative 10 year projected
surplus of $5.6 trillion. Much of this
surplus reflected a rising tax burden as a
share of GDP due to the interaction of rising
real incomes and a progressive tax rate
structure. Consequently, under President
George W. Bush's leadership the Congress
halted the projected future increases in the
tax burden by passing the Economic Growth and
Tax Relief and Reconciliation Act of 2001.
The centerpiece of the 2001 tax cut was to
regain some of the ground lost in the 1990s
in terms of lower marginal tax rates. Though
the rate reductions are to be phased in over
many years, ultimately the top tax rate will
fall from 39.6 percent to 33 percent.
The 2001 tax cut represented a resumption
of a number of other trends in tax policy.
For example, it expanded the Per Child Tax
credit from $500 to $1000 per child. It also
increased the Dependent Child Tax credit. The
2001 tax cut also continued the move toward a
consumption tax by expanding a variety of
savings incentives. Another feature of the
2001 tax cut that is particularly noteworthy
is that it put the estate, gift, and
generation-skipping taxes on course for
eventual repeal, which is also another step
toward a consumption tax. One novel feature
of the 2001 tax cut compared to most large
tax bills is that it was almost devoid of
business tax provisions.
The 2001 tax cut will provide additional
strength to the economy in the coming years
as more and more of its provisions are phased
in, and indeed one argument for its enactment
had always been as a form of insurance
against an economic downturn. However,
unbeknownst to the Bush Administration and
the Congress, the economy was already in a
downturn as the Act was being debated.
Thankfully, the downturn was brief and
shallow, but it is already clear that the tax
cuts that were enacted and went into effect
in 2001 played a significant role in
supporting the economy, shortening the
duration of the downturn, and preparing the
economy for a robust recovery.
One lesson from the economic slowdown was
the danger of ever taking a strong economy
for granted. The strong growth of the 1990s
led to talk of a "new" economy that many
assumed was virtually recession proof. The
popularity of this assumption was easy to
understand when one considers that there had
only been one very mild recession in the
previous 18 years.
Taking this lesson to heart, and despite
the increasing benefits of the 2001 tax cut
and the early signs of a recovery, President
Bush called for and the Congress eventually
enacted an economic stimulus bill. The bill
included an extension of unemployment
benefits to assist those workers and families
under financial stress due to the downturn.
The bill also included a provision to
providing a temporary but significant
acceleration of depreciation allowances for
business investment, thereby assuring that
the recovery and expansion will be strong and
balanced. Interestingly, the depreciation
provision also means that the Federal tax on
business has resumed its evolution toward a
consumption tax, once again paralleling the
trend in individual taxation.
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See Also
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