As the 19th century wound down, the industrialization of the U.S., by then the world's largest and most productive economy, was piling up fortunes of unprecedented size.
Cornelius Vanderbilt had died the richest self-made man in the world when he left his heirs $105 million in 1877. His son William Henry Vanderbilt doubled his father's fortune in just eight years. When Andrew Carnegie agreed to sell Carnegie Steel Corporation to J.P. Morgan for $480 million in 1901, Morgan told him, "Congratulations on becoming the richest man in the world." By 1910, John D. Rockefeller was worth $1 billion.
But the rich remained undertaxed. The government still relied mostly on the tariff to fund its operations and the tariff fell most heavily on those at the lower end of the socioeconomic scale. An attempt to impose an income tax on the rich in 1894 had been thrown out by the Supreme Court the following year.
The political pressure to make the rich "pay their fair share," however, had not abated. It had only increased as the country's political center moved to the left at the dawn of the new century. President Theodore Roosevelt belonged to the progressive wing of the Republican Party and had moved to enforce such measures as the Sherman Antitrust Act, long thought a dead letter. He even advocated an estate tax with the explicit purpose of preventing the "transmission in their entirety of those fortunes swollen beyond all healthy limits."
By the time William Howard Taft became president in 1909, the short-lived recession of 1907 had thrown the federal government into deficit. Many, including Representative Cordell Hull of Tennessee -- later secretary of state under President Franklin D. Roosevelt -- wanted to simply repass the income tax of 1894 and dare the Supreme Court, which had become more liberal, to nullify it a second time.
This idea horrified Taft, who revered the Supreme Court. He was afraid that any such move would put in jeopardy the court's role as final arbiter of the Constitution. (Taft would serve as Chief Justice from 1921 to 1930, a job he much preferred to the presidency.)
So Taft offered a very lawyerly alternative. He proposed a constitutional amendment that would allow the government to levy an income tax "without apportionment among the states and without regard to any census or enumeration," thus making moot the Supreme Court's 1895 ruling in Pollock v. Farmers' Loan & Trust. Congress passed the amendment and sent it to the states for ratification on July 12, 1909.
Meanwhile, Taft proposed a 2 percent tax on corporate profits. In 1909, the overwhelming majority of stocks and bonds were owned by the wealthy. It was still uncommon in the early 20th century for people even to have bank accounts, let alone own securities. So a tax on corporate profits was, in effect, a tax on the rich. And it wouldn't have a Pollock problem because, technically, it wasn't an income tax at all. Rather, as Taft formulated it, it was an excise tax, measured in income, on the privilege of doing business as a corporation.
There was, of course, a lawsuit regarding the matter, but the high court ruled unanimously in 1911 that the corporate tax was an indirect one and thus constitutional.
The 16th Amendment was declared in effect on Feb. 25, 1913, after Delaware became the 36th state to ratify it. A week later, Woodrow Wilson took office and a new, strongly Democratic Congress quickly passed a personal-income tax bill. Wilson signed it into law on Oct. 3, 1913.
The law was only 14 pages long and called for a 1 percent tax on income above $3,000. With an additional marital deduction of $1,000, only 2 percent of American families were affected. But the tax was also graduated so that it rose to 7 percent on income over $500,000, equal to earnings of about $10 million today.
There were numerous other deductions as well, including the first $20,000 of dividend income, interest on all debt and other taxes. Among the 357,598 people who filed 1040 forms (as they were called even then) in 1914 was Assistant Secretary of the Navy Franklin Roosevelt, whose form can be seen here.
Although he had a very comfortable gross income of $14,244.86, Roosevelt's taxable income was only $989.67 and his effective tax rate (the percentage of total income taxed away) would have been only 0.6 percent.
It was a modest tax at most, but the rich were, at last, beginning to pay their "fair share."
Unfortunately, Congress didn't integrate the new personal-income tax with the corporate tax that had been originally intended only as a stop-gap measure. The failure to do so would have many perverse effects. One is that bond interest is a deduction from corporate-income taxes, but dividends are paid out of after-tax income and then subject to taxation at the personal level, skewing corporate investment decisions.
Worse, the rich -- or more accurately their accountants and lawyers -- soon learned how to exploit the two separate, unrelated tax systems in order to postpone taxes, reduce them or escape them altogether. The personal-corporate income-tax interaction has been the great engine of complexity that has now resulted in a tax code that stretches to tens of thousands of pages.
No reform of the tax code can succeed unless these two taxes are integrated into a single system. Indeed, if they had been at the beginning, there would be no talk of a Buffett Rule today to get the rich to pay up. In fact, the Buffett Rule is purely an artifact of that larger failure, plus no little demagogy.
(John Steele Gordon is the author of numerous books, including "Hamilton's Blessing: The Extraordinary Life and Times of Our National Debt." The opinions expressed are his own. This is the second in a two-part series. Read part one.)
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