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How the 100-Year Old Income Tax Unleashed the Modern U.S. Economy

For many, the income tax embodies all that is wrong with modern federal government

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March 6, 2013

This article originally appeared in The Atlantic on February 25, 2013.

By Charlotte Crane 

One hundred years ago today, Secretary of State Philander Knox certified to Congress that the Sixteenth Amendment had been ratified by Delaware and Wyoming, clinching the required 36 states. Congress was free, once again -- this time without the threat of obstruction from the Supreme Court - to do something that has changed the scope of government for the next century. Washington could tax incomes.

Almost ten years earlier, that Court, alarmed at the willingness of Congress to impose taxes that were only to be paid by the rich, had struck down the tax. Justice Field had declared it an "attack on capital" that was only the opening round of "a war constantly growing in intensity and bitterness." Some populists in Congress had threatened to enact the tax again in defiance of the Court, but in 1909 their energies had been diverted to the ratification effort in the States. Conservatives hoped the push for the income tax would wither in the state ratification process. But less than four years later, the amendment was ratified.

Many political observers rue this day in history. To them, the income tax embodies all that is wrong with the modern federal government. By encouraging some economic activity more than others, they say that the income tax, like much federal regulation, dampens economic growth and stifles entrepreneurial creativity.

Far worse, in their eyes, is that the income tax makes the federal government possible. It funds bloated services and enables all sorts of social and economic meddling in the sacred workings of the free market. But what would the past 100 years have looked like without the Sixteenth Amendment? Certainly not much like a free market--unless something else had come along to get rid of tariffs and tariff politics, which had been restraining the economy.

For much of the 19th century, the federal government had deliberately exercised its taxing power to affect the economy profoundly. The first substantive act of the First Congress--signed into law on July 4, 1789* -- imposed duties on tea, salt, beer, candles, sugar, cider, nails, shoes, soap, and other essentials. Since the country's founding, these fees had not only funded the government, but also had served to protect fledging American industries from foreign competition. Such tariff duties were imposed to ensure high prices--frequently as much as 50 percent higher--for foreign goods and thus to encourage US consumers to buy domestic. By shielding our markets from competition - and by making foreign soap and shoes too expensive for many to buy--these tariffs restrained trade and raised the cost of living for rich and poor alike.

The U.S. federal government had, since its earliest moments, behaved as if it was good to intervene this way in the economy. Battles over which industries deserved how much protection (which frequently amounted to fights over which Congressmen would end up most beloved by their most influential backers) often dominated federal politics. Up until the beginning of the twentieth century, such tariffs had sustained the federal government, except during the Civil War, when warships closed ports and made trade difficult. The knowledge that Congress would impose protective tariffs encouraged lobbyists and drove Washington debates. These lobbyists had always triumphed over those concerned about whether such tariffs hurt consumers without really benefitting the economy. The greed of the lobbyists and their clients was limited only by the fact that if the trade protection they sought was too successful, prices would be raised too high, consumers would refuse to buy, and there would be no imports and thus no federal revenue.

Progressive politicians embraced the income tax as way to raise money for the federal government without burdening the average household with the high living costs imposed by duties. Anyone who believed in free trade, who wanted to end protectionism and allow American markets to develop without obstruction, had to offer some revenue that didn't come from tariffs. Ratification of the Sixteenth Amendment let reformers finally welcome an alternative source of tax revenue: American incomes. And for at least a few years, the income tax would clear out the lobbyists, raising revenue evenly across every industry and depriving Congress of reasons to favor one industry over another.

Of course, tariffs did not die immediately when the permanent income tax was born. But once it was no longer the primary source of federal revenue, the tariff's politics changed. Congressmen could no longer declare that their special favors to pet industries were important sources of revenue. Relatively quickly, Congress substantially withdrew from the business of attempting to influence the economy by regularly granting such favors.

You could well argue that this withdrawal was only temporary. Our income tax code is carved out with thousands of exemptions and deductions to protect interest large and small, and we cannot say that favors are not still being carried by representatives with interests that are extracurricular to economic growth. The urge to reward political supporters in the name of economics is timeless and irresistible.

Nevertheless, the Sixteenth Amendment created a new political and economic environment. It freed us from the shackles of tariff politics, lowered living costs for many Americans, allowed the federal government to raise enough money to build roads, mount the world's greatest army, provide income security to the poor, and transform ourselves into the dominant country in the 20th century. In other words, the income tax not only enabled the modern federal government. It enabled the modern US economy.

- Charlotte Crane is a professor at the School of Law.