How Federal Taxes Work

By: Dave Roos

History of Federal Taxes

Section 8 of the U.S. Constitution reads, "The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence [sic] and general Welfare of the United States." The earliest federal taxes were exclusively tariffs -- taxes on imported goods -- and excise taxes, sales taxes on certain items. Whisky, for example, was charged a steep excise tax in 1791, leading to the Whisky Rebellion of 1794.

The first federal income tax was created in 1862 to help fund the Civil War, but was abolished soon after. That first income tax required the appointment of a commissioner of Internal Revenue. The name didn't change to the Internal Revenue Service until the 1950s.


Congress tried to impose a flat federal income tax rate in the 1890s, but it was rejected by the Supreme Court. In 1907, President Theodore Roosevelt tried to reintroduce the income tax, proposing a progressive rate system that would tax each income class according to its means [source: Tax History Museum]. In 1913, 36 states ratified the 16th Amendment to the Constitution, giving the federal government power to directly levy income taxes.

In 1914, the Bureau of Internal Revenue issued the first personal income tax form, the 1040. Here's what it looked like. Individuals paid one percent on income over $3,000 ($4,000 for married couples) with an additional surtax between one and six percent, depending on income level [source: Tax History Museum].

After World War I, Woodrow Wilson raised the personal tax rate to two percent for income over $1,000 ($2,000 for couples) and added an eight percent tax for incomes over $6,000 [source: Tax History Museum]. By 1919, those with the largest personal income were paying as much as 77 percent in federal taxes! Luckily for those folks, it was back down to 50 percent by 1921.

In response to the widespread poverty caused by the Great Depression, particularly among the elderly, Roosevelt called for an "old-age" insurance program as part of his sweeping New Deal reforms. The Social Security Act of 1935 provided that security blanket, establishing the Federal Insurance Contributions Act (FICA) tax to pay for Social Security benefits [source: US Treasury].

The Revenue Act of 1935 introduced the Wealth Tax, raising the tax rate back up to 75 percent for the wealthiest people and addressing the trend of these people evading taxes through loopholes [source: IRS]. The Victory Tax of 1942 saw the first automatic withholding of income tax from worker's paychecks.

President Lyndon B. Johnson signed Medicare and Medicaid into law in 1965. Tax rates rose to fund the increased medical coverage. By 1980, the combined payroll tax -- the amount paid by individuals and their employers to fund Social Security and Medicare -- was 12.3 percent.