A Brief History of Payroll: The 16th Amendment

Ian Zapolsky

min read

‍Ian Zapolsky is the Head of Partner Engineering at Check, and joined us in 2019 as the company’s first engineer. When he’s not reading up on the history of how people pay each other, he’s probably helping one of our partners launch and scale their payroll business. As a certified payroll nerd, Ian volunteered to share what he’s learned in a blog series about the history of payroll in the US.

Tip! Before you dive in, make sure you check out part 1 of this History of Payroll blog series.

Income taxes repealed after the Civil War, as tariffs bridge the gap

In the years after the Civil War, which was the impetus for Abraham Lincoln to create America's first income tax in 1861, the Federal Government's immediate need for additional tax revenue faded away. Lincoln's income tax was repealed by Congress in 1872, and by the 1880s Washington had paid off all of its Civil War debts and was running at a budget surplus from revenue collected mainly from tariffs on imports.

Protectionist tariffs, so-called because they insulated American businesses from international competition by taxing goods from overseas, had long been the primary revenue stream for the U.S. Government. However, the effects of the tariffs were felt disproportionately across America. In the North, manufacturing businesses boomed because of the uneven economic playing field created by import tariffs. Andrew Carnegie, who led the expansion of the American steel industry in the late 19th century and eventually achieved a personal fortune valued in today's dollars around $300 billion, admitted that tariffs had "played a great part in the development of manufacturing in the United States." At one point in the late 1800s, the tariff on British steel started at $28 per ton. Andrew Carnegie's first-ever order for steel was fulfilled at $68 per ton, meaning that the British would have had to sell steel at $40 per ton, with overseas shipping included, to pay the tariff and match the price in the U.S. market.

Businesses lobbied Congress to raise tariffs in order maintain these attractive competitive conditions, and it should be noted that these taxes gave America the head start it needed to develop world class manufacturing capabilities that eventually surpassed those of its foreign counterparts. This would prove to be enormously valuable during World War I and World War II. However, it all came at a cost to the average consumer in the form of higher prices on many common products.

Tensions run high as tariffs disproportionately impact US regions

In the South and West of the United States, rural farmers did not experience the economic benefits of a booming Northern manufacturing sector. Instead they felt the economic pain of the tariffs in the form of higher prices. Ultimately, a tariff, like a sales tax, is a regressive tax, because it leads to higher prices on consumer goods, which results in poor people paying a higher percentage of their income on the tax than rich people. This fact was not lost on Southern and Western American farmers, and in 1887, President Grover Cleveland, the first Democrat elected since James Buchanan before the Civil War (at this time the Democratic party was the party of the South), blasted tariffs as a "vicious, inequitable and illogical source of unnecessary taxation" in his State of the Union speech.

Grover Cleveland, 22nd and 24th President of the United States

An economic depression in the 1890s added fuel to the fire behind this rhetoric, and gave rise to the People's Party, also known as the Populists, a political party comprised primarily of poor, white cotton farmers in the South and wheat farmers in the Midwest who were hostile to elites, cities, banks, railroads, and capitalists. The Populists advanced the idea of a progressive income tax, and found support from many working and middle-class Americans in cities as well. As a result of the broad-based support, America passed its second income tax — a "flat" tax of 2% on incomes over $4,000 — in 1894. Illustrating the ideological split in the country at the time, the New York Tribune wrote upon its passing, "The Democratic hen has hatched a Populist chicken at last."

The Union Pacific, America's first transcontinental railroad completed in 1869, was the subject of this Populist cartoon depicting it as a bandit and oppressor. The character wielding the gun atop the train is William Vanderbilt, son of Cornelius Vanderbilt.

Income tax fairness challenged in the Supreme Court

Though less than 1% of Americans met the income threshold to pay this tax, the new legislation was quickly challenged in the Supreme Court, in Pollock v. Farmers' Loan and Trust Co. in 1895. In the case, the Court found that the tax violated Article 1, Section 9 of the Constitution, which holds that "direct taxes" (taxes that are levied on the income or profits of the person who pays them, rather than on goods or services) must be imposed in proportion to the states' populations. Justice Stephen J. Field issued a warning in his opinion: "The present assault on capital would be the stepping stone to others, larger and more sweeping, till our political contests will become a war of the poor against the rich; a war constantly growing in intensity and bitterness."

This did not deter the Democrats and the Populists, and the debate about the fairness of tariff-based taxation continued to rage across America. In Congress, Representative Cordell Hull of Tennessee (later Franklin D. Roosevelt's Secretary of State) denounced the tariff as an "infamous system of class legislation" that forced the working man to pay most of the cost of government while "virtually exempting the Carnegies, the Vanderbilts, the Morgans and the Rockefellers with their aggregated billions of hoarded wealth."

By the time President William Howard Taft took office in 1909, public outcry had grown over a tax system that undertaxed the rich and overtaxed the poor. Sensing the tide of popular opinion was shifting in support of a progressive income tax, Taft, despite being a conservative Republican, sent a letter to Congress in 1909 appealing to them to amend the Constitution to allow for the passage of such a tax. With support from Taft and several Western "progressive" Republicans, the Democrats finally won approval of the 16th Amendment:

"The Congress shall have power to lay and collect taxes on incomes, from whatever sources derived, without apportionment among the several states and without regard to any census or enumeration."

Woodrow Wilson (left), 28th President of the United States, and William Taft, 27th President of the United States

Income tax is in, and tariffs are (slowly) phased out

Within months of Woodrow Wilson's victory in the presidential election of 1912, the states had ratified the amendment, and the first Constitutional income tax was introduced in 1913. It set a "normal" rate of 1% on both individual and corporate incomes, and exempted married couples earning less than $4,001 (about six times the average American male's income at the time). A graduated surtax began at 1% on incomes over $20,000, rising to 6% on incomes over $500,000. The first Form 1040 appeared in 1914.

The income tax would fluctuate wildly in the coming 5 years as the U.S entered World War I. In 1917, the income tax's highest rate skyrocketed to 83%, and corporations were forced to pay a new progressive tax on "excess profits," defined to be anything more than an 8% annual rate of return on invested capital. These wartime policies fell away after the end of World War I, but the federal income tax remained, and became the chief source of federal revenues as tariffs were slowly phased out of American tax policy.