This Paper narrates the historical highlights that marked the development of the taxation system in the United States. It covers the wars of England until the reforms established by the different Presidents of the United States. It also outlines and discusses the current U.S. tax system. The different levels of tax jurisdiction, i.e. those imposed by the Federal government; those imposed by the state government; and, those imposed by the local governments, are explained lengthily. It includes a brief discussion of the different types of taxes these jurisdictions impose, as well as their percentages and tax base.
It traces the history of the creation of the Internal Revenue Service (IRS) formerly the Bureau of Internal Revenue and the various reorganizations it went through such as a change from geographical system to a functional system. It also tackles the marked characteristic of its culture—that of secrecy and of intrusiveness to the privacy rights of the taxpayers.
Finally, it presents the proposed Fair Tax Act or H. B. no. 25 authored by Representative John Linder (R-Georgia, 7th) of the House of Representatives. It proposes the abolition and elimination of the federal income tax code and other hidden taxes in lieu of a 23% on final sale of goods and services. Corollary to this, the 16th Amendment of the Constitution, withholding from wages and salaries, filing of individual returns, the IRS, all federal income taxes would have to give way. Moreover, a rebate of sales tax for expenditures equivalent to the federal poverty level, is assured. It is believed that this proposed tax reform espouses the equality principle mandated by the Constitution and it will result in encouraging capital formation and investment and therefore, consequently promote efficiency and economic growth.
Introduction to the U.S. Tax System
The U.S. tax system is dynamic and is marked by changes as it responds to the changing times and changing roles that government has defined itself to take (DOT, n.d.). During the colonial era, the taxes imposed were for imports and exports, property taxes, poll tax for every adult male, real estate taxes, excise taxes and those based on occupation. There was no need then for raising revenues until expenses were incurred for the wars of England (DOT, n.d.). The Stamp Act and tax on tea were directly imposed on American colonies. This sparked the American Revolution considering that it did not have representation in the English Parliament that enacted the tax measures. They claimed that “taxation without representation is tyranny” (DOT, n.d.).
In 1781, the Articles of Confederation was adopted. Under this system, each State had the power to impose tax as it is deemed as sovereign. The national government on the other hand, relied on donations from the States and did not have a tax system (DOT, n.d.).
The ratification of the Constitution in 1789, brought about the authority and power of the Federal Government to levy taxes to pay its obligations, for defense and the common good of the U.S. based on a realization that the government cannot operate and function without its own resources (DOT, n.d.). The States were left the task of collecting these taxes.
During the presidency of Jefferson, direct taxes were abolished because of its association with the French confrontation in 1970s. Instead there were only excise taxes for the succeeding years. The Civil War brought the passage of the Revenue Act of 1861 which re-imposed excise taxes as well as on personal incomes. A 3 percent tax was imposed on “all incomes higher than $800 a year” (DOT, n.d.).
In 1862, a law was passed which made reforms to the Federal income tax. With incomes of up to $10,000 were taxed with a tax rate of 3% while those higher than $10,000 at 5 % rate (DOT, n.d.). A variety of deductions were implemented which included a standard of $600 and others for “rental housing, repairs, losses, and other taxes paid (DOT, n.d.). These were “withheld at source by employers” (DOT, n.d.).
The U.S. Constitution allows imposition of direct taxes provided these are imposed in proportional to the population of the State. However, in 1894, a Federal income tax imposed a flat rate and which was declared as unconstitutional by the U.S. Supreme Court (DOT, n.d.). After the lapse of War Revenue Act of 1899, there was a great need to raise revenues. Thus, an income debate ensued and which resulted to the creation of an excise tax on business income and a tax on individual’s income without considering the population of the State. This required an amendment to the Constitution. This was ratified by 36 states. Even those who broke the law paid income tax as well as those who may have earned their income by illegal means. The dropping of the word ‘lawful’ in the law was interpreted by the Supreme Court as to include those earned through illegal activities. The enactment of the law imposing income tax was felt by many as invading into the private affairs of the taxpayer which unlike before its enactment, remained to be private. This was the reason why Congress in 1916 provided for the confidentiality of information derived from tax returns (DOT, n.d.).
In the 1920s, the economy flourished and taxes were cut, thus, strengthening the economy. However, the failure of the stock market in 1929 led to the Great Depression. The Tax Act of 1932 was enacted to address the rising deficit in government budget (DOT, n.d.). In 1935, the passage of the Social Security Act financed programs for the needy. The tax was imposed based “on the first $3,000 of the employee’s salary” (DOT, n.d.).
The Second World War brought an increased need for revenues and monies to meet expenses for defense spending. Two laws were passed in 1940, increasing individual income and corporate taxes (DOT, n.d.). After a year, there was another tax increase with exemption reductions—leaving 23% bottom rate of tax for incomes of $500 and a 94% top rate for taxable incomes of more than one million U.S. dollars (DOT, n.d.). The withholding tax system was revived for ease of collection. The Korean War (WWII) also required additional revenues. This was met with the expansion of the coverage of the Social Security law as to include those self-employed (DOT, n.d.).
The Bureau of Internal Revenue was reorganized and renamed as Internal Revenue Services (IRS). This name was adopted to emphasize its service oriented nature of work (DOT, n.d.). Its historical origin, functions and responsibilities shall be discussed in the subsequent major section.
Tax policy was perceived not only as a means of raising revenues and shifts in incentive structures but also a stabilizer for the country’s broader economic activity. There was a rising inflation—price level raised, failure to index tax for income, and repeated tax cuts by the legislature “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” (DOT, n.d.). This Act was proposed by Congressman Jack Kemp and Senator Bill Roth. It provided a reduction of 25% in individual tax brackets spread over a period of 3 years. Moreover, income was indexed for inflation (DOT, n.d.). It also substituted the concept of economic depreciation in treating business outlays with the concept of “Accelerated Cost Recovery System” which led to an increase in capital formation (DOT, n.d.). In addition, the Federal Reserve Board modified its monetary policy to lower inflation (DOT, n.d.).
In 1986, the Tax Reform Act was enacted which sought to simplify income taxation and make it consistent and economically efficient. This had an effect of bringing the tax rate down to 28% from 50% for individuals. On the other hand, corporate rate was lowered to 35% from a 50% tax rate (DOT, n.d.).
Under the present regime of President Bush, Congress passed the Economic Growth and Tax Relief and Reconciliation Act of 2001 which is sought to stop the anticipated increases in tax burdens. The rate reductions contained in the Act is to be implemented by phases over the years (DOT, n.d.).
The Current U.S. Tax System
The U.S. tax system is said to be complicated and complex (Roach, 2007). Taxes in the U.S. are imposed by different levels of tax jurisdictions: those imposed by the Federal government; those imposed by the state government; and, those imposed by the local governments (Roach, 2007).
Federal tax revenues are mainly consisting of individual income tax; social security, other payroll taxes; corporate income tax; estate; gift; and excise taxes (Brumbaugh, Esenwein & Gravelle, 2005). These federal taxes are provided for under the U.S. tax code otherwise known as the Internal Revenue Code of 1986 (Title 26, U.S.C.).
Federal income tax is based on two principles: 1) Not all income is taxable; and 2) there is a difference in conceptual understanding between the terms “effective tax rate” and marginal tax rate” (Roach, 2007).
First, all income is not taxable – there are important differences among “total income,” “adjusted gross income,” and “taxable income.” Second, you need to know the distinction between a person’s “effective tax rate” and “marginal tax rate.” Total income is derived by an individual or spouses from all sources, i.e. salary, wages; investment income; and other sources. Total income less expenses which are considered non-taxable would result in Adjusted Gross Income (AGI) (Roach, 2007). However, “taxable income is AGI less deductions and exemptions” (Roach, 2007). AGI less exemptions as granted by law would result in the taxable income. There are two kinds of deductions: standard which amount the law fixes. For instance, in 2003, the standard deduction fixed was “$4,500 for single individuals and $9,500 for married couples” (Roach, 2007). The second type is itemized deduction. The law allows the tax filer to opt for itemized if after adding all the expenses, the sum is greater than that provided by law under standard deduction (Roach, 2007). This taxable income is subject to “increasing marginal rates” (Roach, 2007). According to David Brumbaugh, et al. in their 2005 CRS Report to Congress entitled “Overview of Federal Tax System,” different tax rates apply on different portions of the taxable income (Brumbaugh, et al., 2005). For instance, in 2005 the statutory marginal rate for single return/single filer on the first $7,300 is 10% of the amount over $0; and $7,300-$29,700 is $730 + 15% of the amount over $7,300 and so on. “Long term capital gains and dividend income are taxed at lower rates 5% for those in the 10% and 15% brackets” (Brumbaugh, et al., 2005).
Anent Social Security and other payroll taxes, these are employed to support and social insurance programs such as the Social Security and the Medicare. These taxes are imposed directly on income and are directly deducted from the pay while those self-employed pay these taxes when they file their income tax return. These deductions appear as “FICA” taxes or the Federal Insurance Contributions Act (Roach, 2007). The total rate for these payroll taxes is 15.3% of wages with each half or 7.65% each being shouldered by the employer and by the employee (Brumbaugh, et al., 2005). In 2005, this is imposed on the “first $90,000 of wages, with the cap adjusted annually for increases for average wages in the economy” (Brumbaugh, et al., 2005). The Medicare tax rate is 1.45% (Brumbaugh, et al., 2005). Other federal payroll taxes are for insurance in case of unemployment (FUTA) and those for retirement program (Brumbaugh, et al., 2005).
The rates for corporate income tax are “graduated from 15%, 25%, 34%, and 35%” (Brumbaugh, et al., 2005). The base on which corporate income tax rate is applied is net income or gross revenue less costs which is equivalent to profits (Brumbaugh, et al., 2005). The costs of deductions are “salaries or wages paid, depreciation, cost of raw materials, and interest payments” (Brumbaugh, et al., 2005).
The estate and gift taxes play a minor role in the federal tax structure. Only 1.3% of the federal tax collections comprise gift and estate taxes (OMB, 2005). Estate tax is a tax imposed by reason of transfer of property at death. It is the liability of the estate as against the heirs in case of inheritance tax. The base is the value of “property transferred at death less allowable deductions and exemptions” (Brumbaugh, et al., 2005). This is subject to graduating rates from 18% to 48% depending on the size of the property being transferred (Brumbaugh, et al., 2005). Administration expenses, charity donations are among the few allowable deductions (Brumbaugh, et al., 2005).
Gift taxes are complementary to estate taxes. It was established in order that the estate tax imposition may not be circumvented by transferring property during the lifetime of the benefactor to avoid estate tax liability. The exemption granted covers the first $11,000 value of the gift (Roach, 2007). The estate tax is to be repealed by 2010 under the Economic Growth and Tax Relief Reconciliation Act of 2001(EGTRRA, P.L. 107-16) (Brumbaugh, et al., 2005).
Excise taxes are imposed for the “consumption of goods and services” (Brumbaugh, et al., 2005). In fiscal year 2003, the largest receipts in excise taxes were tax from gasoline (OMB, 2005). Excise taxes are imposed on manufacturers for production or sale of products such as services in telephone, air passengers, fuels, gasoline, tobacco, etc. (Roach, 2007). This type of tax is a regressive tax since the lower income household bracket would spend more than the higher income household bracket.
The taxes imposed by the state and local governments are much similar to those in the federal tax structure (Roach, 2007). Many states have imposed sales tax—only the percentages vary. For instance, in Colorado, a 2.9% sales tax is imposed while 7.25% is imposed in California (Roach, 2007). Local governments also impose local sales tax but these are generally lower in rate than that imposed by the state, albeit with a few exceptions like in New York where the state impose 4% while the local government impose a higher rate (Roach, 2007).
Income tax is also levied by the state. Some states have progressive tax rates similar to the federal tax structure while others have only one tax rate (Roach, 2007). Property taxes are also levied by the state and local governments. In fact, it is largest source of revenue. Property taxes refer to taxes levied on real property, private houses and commercial properties (Roach, 2007). It is the local government that collects property taxes but a portion of this is reserved for the state purposes (Roach, 2007).
History of the Internal Revenue Service (IRS)
The law instituting a tariff system and the imposition of excise taxes on whiskey in 1791 is the very same law which created the Office of the Commissioner of Revenue, the predecessor of the IRS (TRACIRS, 2005).
The Civil War and the growing need to raise more revenues in 1862 brought about the re-establishment of the Office of the Commissioner of Revenue after its dismantling. The reserves were bloated due to the income tax. However, the end of the civil war marked the end of the income tax period as well. In 1894 the need for an income tax law surfaced again. However, the Supreme Court declared the new income tax law lobbied by the populists and which Congress passed into law, as unconstitutional. Thus, the Constitution’s Sixteenth Amendment was ratified on February 13, 1913 which provided, “The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration” (TRACIRS, 2005).
It is claimed that the federal tax system is strengthened by three factors: 1) the creation of the Office; 2) the institution of the income tax permanently; and, 3) passage of the law requiring the withholding of taxes from the employees (TRACIRS, 2005). By reason of the institutionalization of income tax system, emphasis was placed on the agency, Bureau of Internal Revenue.
The Bureau of Internal Revenue was reorganized and renamed as the Internal Revenue Service (IRS) in 1953. This change in name was confirmed and formalized in a decision rendered by the Treasury numbered 6038. The IRS was involved in a controversy of corruption and patronage system which led to congressional hearings and investigations. . In 1959, computerization was done to handle tax processing. The IRS required the use of the Social Security number for tax identification purposes (DOT, n.d.).
The reported abuses of the IRS personnel led to another reorganization under the IRS Restructuring and Reform Act of 1998. There was a budget allocated for its computerization improvement as well as, the replacement of the geographical system into functional system (TRACIRS, 2005). Thus, “ one unit would deal with wage and investment returns filed by individual taxpayers, a second with the returns of small businesses and the self-employed, a third with those of large and mid-sized businesses and the fourth with tax exempt organizations” (TRACIRS, 2005). Moreover, the positions, IRS commissioner and chief counsel are presidential appointees but subject to confirmation by the U.S. Senate (IRS-DOT, n.d.).
According to Joseph J. Thorndike, the IRS is responsible for its “its deep-seated culture of secrecy” and for which reason it created a “gaping hole in historical record” (Thorndike, 1998). The interpretation of the IRS of the limits of record disclosure with respect to the information of the taxpayer is very broad. In fact, this broad interpretation prevented historians from further investigating whether the IRS was used by Nixon against his enemies (Thorndike, 1998). The House of Representatives approved a law that will increase IRS accountability and transparency by giving the National Archives the authority to go over its records (Thorndike, 1998).
The Fair Tax Bill and its Implications
Representative John Linder (R-Georgia, 7th) introduced H.R. 25 before the U.S. House of Representatives. The Fair Tax Act is an innovation in tax legislation reform. It seeks to eliminate and abrogate all federal taxes, i.e. income taxes, capital gains tax, payroll taxes (social security and Medicare taxes), gift and estate taxes and substitute them with a national retail sales tax (Linder, n.d.). It also seeks to abolish the Sixteenth Amendment since it has given the Congress the power to impose taxes on income of the citizens and by virtue of which, it has created a controversial agency, the IRS (Johnston, 1999). It is claimed that the IRS intruded and invaded privacy of the taxpayers. Based on an investigation, the most audited class of taxpayers is the lower class and not the upper class even if it is the latter that has the propensity to commit evasion in taxes (Johnston, 1999).
With the Fair Tax Act, a “23% tax on the final sale of goods and services” would be imposed (Longley, n.d.). Under this regime, no withholding from wages shall be necessary since payroll taxes will be covered by this 23%. Only final sale shall be subject to tax and not intermediate sales (Longley, n.d.).
Income taxation will be streamlined as there would be no individual tax returns would have to be prepared and to be filed. It eliminates the complexities of the provisions of the federal tax code, as well as the IRS regulations (Linder, n.d.).
Under the Fair Tax system, the taxpayers would be able to hold on to the full amount of their wages/salaries without deductions. The 23% is imposed on the goods or service at the time it is bought. According to Salvato (2005), “most Americans fall into the 15 per cent tax bracket and have to pay 7.65 per cent in payroll taxes (just about 23 per cent right there). Then add in all of the hidden taxes placed on goods and services, 23 per cent is less than what most people pay now.”
Many claim that the proposed tax reform is fair since the taxes that are to be collected from everyone is “directly proportionate to what people spend (Salvato, 2005). Conversely, those who spend less because of less income would pay proportionately lesser taxes. Thus, tax liability will depend largely on the lifestyle of a person.
Under the proposed new tax system, a rebate is provided for every American family. This “rebate of sales tax is equal to spending up to the federal poverty level. The rebate would be paid in advance and updated according to the Department of Health and Human Services poverty guidelines. Based on the 2003 guidelines, a family of four would be able to spend $24,240 annually tax free. They would receive a monthly rebate of $465 each and every month ($5,575 annually)” (Longley, n.d.).
The Fair Tax Act will also abolish the IRS. It is claimed that the in order to exact compliance from the taxpayer, the IRS agents have every opportunity to abuse and harass American citizens (Linder, n.d.). The White House Council of Economic Advisers prepared a report which revealed that the abolition of the complex federal income tax code would “increase efficiency and promote investment and growth” (Longley, n.d.). It can revolutionize the economy and encourage growth and investment. It gives incentives for capital investment and thereby creates more jobs.
Brumbaugh, D., Esenwein, G. and Gravelle, J. (2005). CRS Report for Congress: Overview of the Federal Tax System. Retrieved on May 26, 2007 from http://kuhl.house.gov/UploadedFiles/fedtaxsystemoverview.pdf.
Department of the Treasury. Official Web Site “Fact Sheets: Taxes History of the U.S. Tax System.” Retrieved on May 27, 2007 from
Internal Revenue Service of the Department of the Treasury official web site. Retrieved on May 27, 2007 from http://www.irs.gov/irs/article/0,,id=149200,00.html
IRS Restructuring and Reform Act of 1998 or Pub. L. No. 105-206, 112 Stat. 685 (July 22, 1998).
Johnston, J. (1999) “The Fair Tax Act of 1999- Is this for real?” Suite 101. Retrieved on May 28, 2007) from http://www.suite101.com/article.cfm/libertarian/29228
Linder, J. “The Fair Tax” U.S. Congress: John Linder web site. Retrieved on May 28, 2007 from http://www.johnlinder.com/IssueDetails.asp?IssueID=9
Longley, R. “Is a ‘Fair’ Tax in America’s future?” About.com: US Government Info Resources. Retrieved on May 27, 2007 from http://usgovinfo.about.com/cs/taxes/a/aafairtax.htm
Office of Management and Budget (2005). Budget of the U.S. Government, Fiscal Year 2006,
Analytical Perspectives. Washington: GPO.
Office of Management and Budget (2005). Budget of the U.S. Government, Fiscal Year 2006,
Historical Tables. Washington: GPO.
Roach, B. (2007). “Taxation in the United States.” Environmental Information Coalition, National Council for Science and the Environment. Retrieved on May 27, 2007 from http://www.eoearth.org/article/Taxation_in_the_United_States
Salvato, F. (2005). “An incredible opportunity for Congress and America.” Enter Stage Right Web Site. Retrieved on May 27, 2007 from http://www.enterstageright.com/archive/articles/0405/0405fairtax.htm
Trac syr.edu (2005) “IRS History” TRAC: IRS at Work. Retrieved on May 27, 2007 from http://trac.syr.edu/tracirs/atwork/current/irsHistory.html
Thorndike, J. (1998) “The IRS is Hiding its History” Tax History Project. Retrieved on May 28, 2007 from http://www.taxhistory.org/thp/readings.nsf/cf7c9c870b600b9585256df80075b9dd/9de7fcd59915a3be85256e430079327d?OpenDocument
 Table 2, CRS-4 of 2005 CRS Report for Congress: Overview of the Federal Tax System.
 1953-2 C.B. 443 (Aug. 21, 1953), filed with Division of the Federal Register on Aug. 26, 1953.
 Pub. L. No. 105-206, 112 Stat. 685 (July 22, 1998).