Lincoln’s Hand in the Pocket—First U.S. Income Tax Funded the Civil War

Lincoln's Income Tax proposal was bitterly opposed by Democrats and mocked in the press.  Here he is not only depicted as a court fool, but his exaggerated nose is meant to suggest that he was a "greedy Jew."

Nobody, and I mean nobody—not even liberals—likes paying taxes.  Especially income taxes.  We are aware of the need to fund the essential work of government, and may even support wider spending for public benefit, but when the tax bite falls on us personally, it hurts. 

On August 5, 1861 President Abraham Lincoln signed into law the first American income tax.  It was a provision of the Revenue Act of 1861.  The new tax was  3% on all income above $800 to be,  “…levied, collected, and paid, upon the annual income of every person residing in the United States, whether such income is derived from any kind of property, or from any profession, trade, employment, or vocation carried on in the United States or elsewhere, or from any other source whatever…”  The same act hiked the tax to 5% on all citizens living outside the country.  It was essentially a flat rate tax. 

Needless to say, it was unpopular.  But the President had few alternatives.  He had raised a massive Army, outfitted, and armed it with money that the government didn’t have.  And despite the hopes for a quick victory, Lincoln knew that the War to Preserve the Union, as he called it, was apt to take a while. 

Since the foundation of the Republic the Federal government had been on a strict revenue diet for both philosophic and practical reasons.  The realm of Federal activity was strictly limited by the Constitution as it was interpreted at the time.  Most governmental functions fell to the individual states and local governments. 

Federal revenues were limited.  Most came either from the Tariff or from the sale of government land.  But because of anti-tariff feeling in the agricultural South, where the plantation elites relied on the importation of cheap manufactured goods from Europe and resented protectionist levies that benefited Northern manufacturers, import levies had been slashed in 1841 and lowered again in 1856.  Land sales were also in the decline as most Federal land east of the Mississippi was settled and western sales were slowed by the continuing border wars in Kansas and Indian peril elsewhere.   Then, of course, the secession of the Southern states cut Tariff revenue from important ports like Charleston, Savannah, and New Orleans.  

                               Secretary of the Treasury Salmon P. Chase conceived the Income Tax plan.

Lincoln was caught in a bind between soaring costs and plummeting income.  Lincoln turned to his Secretary of the Treasury Salmon P. Chase for advice.  Chase, like other members of Lincoln’s Cabinet, notably Secretary of State William H. Steward, had been Lincoln’s rivals for the Republican presidential nomination.  Unlike Steward, who entered the job thinking he could be a prime minister to weak President but soon came to respect and admire Lincoln, Chase always looked down on the President and frequently was engaged in political sniping and backstabbing.  None the less, Lincoln had to rely on his judgment and the support he had in financial circles. 

Chase discounted the possibility of any kind of new Federal Tax on property as un-Constitutional.  Instead he proposed borrowing most war funds by issuing bonds, the model of Albert Gallatin during the War of 1812.  He engaged Jay Cooke, a Philadelphia financier to handle the bonds.  Cooke performed spectacularly with special patriotic appeals that sold bonds not just to wealthy investors but to many middle class citizens.  Eventually nearly one quarter of all Northern families purchased war bonds.  But those bonds would eventually have to be repaid.  To reassure investors that there would be a revenue stream capable of repaying the bonds, Chase reluctantly advised the income tax. 

Surprisingly, given the fact that there was little ability for the government to assess actual income, voluntary compliance was relatively high, particularly in the industrial and commercial New England and Eastern states where both incomes and support of Lincoln’s war aims was highest.  The starting base for payment, $800, is estimated to be about the equivalent of $18,750 today.  When most Americans were still farmers and many city workers, even skilled craftsmen, earned far less, the tax fell on only a fraction of families.  Even with subsequent hikes and adjustments over the war 10% of families nationally and 15% in the northeast had paid some income tax by war’s end.  

New Yorkers line up to pay the first Income Tax in 1862.

The Revenue Act of 1862, which also created the office of Commissioner of Internal Revenue, moved from a flat rate to a modified “progressive” system that exempted the first $600, imposed a 3 percent rate on incomes between $600 and $10,000, and a 5 percent rate on those over $10,000. The first withholding taxes were imposed on Federal employees and on dividends paid by corporations.  In addition, the Act also imposed a raft of new or greatly hiked excises taxes—many of them sin taxes—and fees.  

Now freed from pesky southern Democrats, Congress also imposed a high new protective tariff, which would continue to be a hallmark of Republican policy for the next hundred years.  Even these measures were insufficient to the need. 

Key to financing the war was the Legal Tender Act of 1862 which authorized the Treasury to issue notes—Greenbacks—that were required to be recognized for the payment of all debts except redemption of bonds and payment of Tariffs.  This departure from traditional hard currency was inherently inflationary but combined with other measures kept inflation in the North well below the out of control Confederate rates and well below inflation during future American wars. 

A bonus was that shrewd investors could purchase war bonds with inflated Greenbacks and be repaid later in specie, which spurred more bond sales.  By war’s end, with costs running to an astonishing $2 million per day, income tax rates had been raised twice more.  In the end the income tax had proven to be a reliable and flexible revenue stream.  But although tolerated as a war time necessity, there was no public support to continue the tax. 

This wealthy tax payer paid a whopping $889 in Income Tax in 1884 and all he got was this lousy receipt.

After reductions in 1868, it was allowed to expire in 1872.  Efforts by Populists and other reformers in the late 19th Century to resurrect the tax were resisted.  An income tax adopted in 1898 was struck down by the Supreme Court because the tax was not levied proportionally among the states. 

It took the 1913 16th Amendment to the Constitution to make the income tax a permanent fixture in the U.S. tax system.