By Cathy Miller, MBA, CFP®, CRPS®, CDFA™
With the latest tax bill, the Tax Cuts and Jobs Act (TCJA), being passed by the U.S. House of Representatives (November 16) and the Senate (December 1), it seems like an appropriate time to explore the history of taxation (and tax code changes) in the U.S. and how we stack up to the rest of the world.
How We Arrived Where We Are
Today, it’s easy to think taxes are too high, but in reality, they are lower now for many people than they were during various times in our nation’s history. The first federal income taxes (both corporate and personal) were temporary—enacted in 1861 to help pay for the American Civil War. Pegged at 3 percent for incomes above $800 (with minor modifications in 1862), and levied with a specific purpose, these taxes were repealed in 1872. In 1913, income tax as we know it was signed into law. At that time, corporations were taxed at 1 percent, as were personal incomes above $3,000. Those with incomes above $500,000 also paid a 6 percent surtax.
While corporate tax rates increased in a steady manner at first, moving from 1 percent in 1913 to 14 percent in 1932-35, personal income taxes soared. By 1918, the top income tax rate had increased to 77 percent (on incomes above $1,000,000) to finance World War I. It was then reduced substantially—to 24% in 1929 on the eve of the Great Depression. During the Great Depression, corporations were taxed at two different rates for the first time (8 percent under $40,000; 15 percent over), with the bracket “break” reduced to $25,000 in 1938.
At the same time, personal tax rates for the wealthy were exploding. The top marginal personal tax rate climbed to 63 percent during the Great Depression, and it didn’t stop there. In 1944, Congress enacted a top marginal tax rate of 94 percent on those making above $200,000 (equivalent to $2.8 million, today). The bracket spread at the time was great—the poorest 20% of Americans paid only a 1.7 percent tax rate.
During this period, Congress also adjusted the bracket ranges, increasing the percentage of Americans who were paying tax from 7 percent (1940) to 64 percent (1944). By 2016, per the Tax Policy Center, that percentage had dropped to 44 percent.
The top personal tax rate hovered around 90 percent until 1964, when it dropped to 77 percent. Over that same period, corporate tax rates rose gradually—from a range of 15-37 percent in 1940 to a range of 22-50 percent in 1964.
Taxes in the Modern Era
Personal and corporate tax rates fluctuated only slightly until the early 1980s, when both personal and corporate tax rates dropped.
- From 1982 to 1986, the top personal tax rate was 50 percent. From 1986 to 1991, it dropped to a low of 31 percent.
- In 1981, the lowest corporate tax rate dropped from 20 to 17 percent, and it fell to 15 percent in 1993 and stayed there. Over the same period, the top corporate rate dropped from 46 to 39 percent.
The 1990s saw more changes, with the top personal tax rate first rising to 39.6 percent and then falling (in 2001) to 35 percent. As of 2013, it returned to 39.6 when George W. Bush-era tax cuts were made permanent for all taxpayers except those in the highest tax bracket. During that same period, Congress introduced an eight-bracket tax code for corporate taxes, but the overall rates stayed essentially the same.
Regarding taxes, the U.S. is currently a bit of an anomaly compared to the rest of the industrialized world. In most countries, individual incomes—especially for top earners—are taxed at higher rates than in the U.S. Globally, corporations are taxed at a lower rate than in the U.S. According to the Congressional Budget Office (CBO), the U.S. has the fourth highest marginal effective tax rate in the world.
Tax Changes and Their Effects on the U.S.
Let’s consider how tax rate modifications have impacted the U.S. and its citizens. Although the overall rise and fall that occurred over time had an impact, in many cases it was mitigated by inflation or bracket adjustments. However, there are several standout examples of how both tax rate increases and cuts have significantly impacted the U.S. and its economy.
In general, taxes largely increased from 1861 to 1964, and some of those increases were extreme. Nevertheless, the tax increases related to FDR’s Great Depression stimulus package (the New Deal) are in a class by themselves. By 1936, President Roosevelt (FDR) and Congress had raised the top tax rate to 76 percent—further stagnating the economy before recovery from the Depression really began. Before Congress raised the rate to 94 percent in 1944, President Roosevelt (FDR) unsuccessfully proposed a 100 percent tax on incomes over $25,000!
On the tax cut side, the drops haven’t been as drastic as the increases, but they have been big enough to have a significant impact:
- The Economic Recovery Tax Act of 1981 dropped all individual tax brackets by 25% (and changed the way companies accounted for capital expenditures, which encouraged equipment investments). Ironically, President Reagan’s efforts to also bring inflation under control were too successful, so the economic growth necessary to pay for the tax cuts didn’t fully materialize. Even so, despite Reagan paring back some of his tax cuts, more than 400,000 Americans had reached the millionaire rank by 1985.
- The Tax Reform Act of 1986 lowered the top rate from 50 to 28% and cut the maximum corporate tax from 50 to 35%. At the time, it was hailed as one of the most significant tax reform packages ever passed, and it was praised for simplifying the tax code and closing many loopholes that let special interests “game” the system. However, by 2006, per the Tax Foundation (an independent tax policy institute) Congress had passed nearly 15,000 tax law changes, and many of the loopholes that had been closed in 1986 were back in the tax code.
Where We Are with the Tax Cuts and Jobs Act (TCJA)
The Senate recently passed the TCJA, clearing the way for reconciliation of the House and Senate bills and eventual passage of a final plan. It’s impossible to know with certainty what that will look like, because the members of Congress have varied ideas about what is best for the country and its economy. However, there is concurrence on several aspects of the plan. Key areas of agreement include:
- Double the standard deduction from $12,000 to $24,000 for single filers; twice that amount for married couples.
- Repeal the limitation on itemized deductions currently imposed on high-income taxpayers (known as the "Pease limit").
- Eliminate the alternative minimum tax (the Senate bill does so only through 2025 to comply with reconciliation rules).
- Retain the current 20% top tax rate on dividends and capital gains and the 3.8% surtax on investment income imposed by the Affordable Care Act (Obamacare).
- Double the estate tax exemption. Current (2018) tax law exempts the first $5.6M (singles) and $11.2M (couples).
We at Atlanta Financial are eagerly awaiting the outcome of the latest tax reform effort, and look forward to sharing the details and planning tips as soon as the legislative outlook becomes more certain.