The Civil War
The Civil War represented a watershed moment in the history of American taxation. The quick, limited engagement both sides confidently predicted soon proved a chimera. Instead, the exigencies of protracted, destructive warfare engulfing private property and civilian populations as well as commissioned combatants demanded innovations in government financing. While the outcome of the conflict may be attributed to any number of contingent factors, the varying fiscal strategies undertaken by the Union and Confederate governments undoubtedly influenced the capacity of both societies to sustain the war effort. North and South employed markedly different approaches. The North's proved more efficacious in the long run.
Confederate War Financing
The antebellum south enjoyed one of the lightest tax burdens of all contemporary civilized societies. Local or state governments assessed all obligations. By contrast, the hastily assembled Confederate government lacked the bureaucratic infrastructure to levy or collect internal taxes. Its citizens possessed neither a tradition of compliance nor a means to remit payment. Land and slaves comprised the bulk of southern capital; liquid forms of wealth like specie or paper currency were hard to come by in a predominantly agrarian region.
Efforts to raise war revenue through various methods of taxation proved ineffective. The Confederate Congress enacted a minor tariff in 1861, but it contributed only $3.5 million in four years. That same year, Congress implemented a small direct tax (0.5 percent) on real and personal property. But the government in Richmond was forced to rely on the individual states to collect the levy. Reprising the scenario played out during the Revolutionary War, most states did not collect the tax at all, preferring to meet their quota by borrowing money or printing state notes to cover it.
By the spring of 1863, the crushing burden of inflation motivated Richmond to come up with an alternative to fiat money. In April, they followed the Union’s lead and enacted comprehensive legislation that included a progressive income tax, an 8 percent levy on certain goods held for sale, excise, and license duties, and a 10 percent profits tax on wholesalers. These provisions also included a 10 percent tax-in-kind on agricultural products. The latter burdened yeoman more than the progressive income tax encumbered urban salaried workers, since laborers could remit depreciated currency to meet their obligations. Adding to the inequity, the law exempted some of the most lucrative property owned by wealthy planters their slaves from assessment. Lawmakers considered a tax on slaves to be a direct tax, constitutionally permissible only after an apportionment on the basis of population. Since the war precluded any opportunity to count heads, they concluded that no direct tax was possible. Accumulating war debts and heightened condemnation of a "rich man’s war, poor man’s fight" led to revision of the tax law in February 1864, which suspended the requirement for a census-based apportionment of direct taxes and imposed a 5 percent levy on land and slaves. These changes came too late, however, to have any sustained impact on the Confederate war effort.
Union War Financing
In addition to its developed industrial base, the North entered the war with several apparent institutional advantages, including an established Treasury and tariff structure. With the exodus of southern representatives, the Republican-dominated Congress ratcheted up tariff rates throughout the war, beginning in 1862 with the Morill Tariff Act, which reversed the downward trend instituted by the Democrats between 1846 and 1857. Subsequent tariff legislation, especially the 1864 act, raised rates further. Protective tariffs were politically popular among manufacturers, northern laborers, and even some commercial farmers. But Customs duties amounted to about $75 million annually, only nominally more, after adjusting for inflation, than the value of duties collected during the 1850s. Still, the high rate structure established in the Civil War would remain a hallmark of the post-war political economy of the Republican party.
In order for the bond program to be successful, the North needed an unrestricted currency supply for citizens to pay for them and a source of income to guarantee the interest. The Legal Tender Act filled the first requirement. Passed in February 1862, the act authorized the issue of $150 million in Treasury notes, known as Greenbacks. In contrast to Confederate paper, however, Congress required citizens, banks, and governments to accept Greenbacks as legal tender for public and private debts, except for interest on federal bonds and customs duties. This policy allowed buyers to purchase bonds with greenbacks while the interest accrued to them was paid in gold (funded, in part, by specie payments of customs duties). Investors enjoyed a bountiful windfall, since government securities purchased with depreciated currency were redeemed with gold valued at the prewar level. Taxpayers essentially made up the difference. Because most bonds were acquired by the wealthy or by financial institutions, the program concentrated investment capital in the hands of those likely to use it, much as Alexander Hamilton’s debt plan had sought to do.
The first federal income tax in American history actually preceded the Internal Revenue Act of 1862. Passed in August 1861, it had helped assure the financial community that the government would have a reliable source of income to pay the interest on war bonds. Initially, Salmon Chase and Thaddeus Stevens, Chairman of the House Ways and Means Committee, wanted to implement an emergency property tax similar to the one adopted during the War of 1812. This way, the government could adapt the administrative system that state and local governments had developed for their own property taxes. But legislators understood such a property tax as a direct tax. Article 1, Section 9 of the Constitution required the federal government to apportion the burden among states on the basis of population rather than property values. Emphasizing population over property value would actually render the tax quite regressive. Residents of lower-density western states, border states, and poor northeastern states stood to bear a greater burden than those of highly-populated urban states, despite the latter’s valued real estate. Their representatives also complained that a property tax would not touch substantial "intangible" property like stocks, bonds, mortgages, or cash.
As an alternative, policy makers sought to follow the example of British Liberals, who had turned to income taxation in order to finance the Crimean War without heavy property taxation. Justin Morrill, (R-VT), Chairman of the Ways and Means Subcommittee on Taxation and the architect of the regressive tariff structure, introduced a proposal for the first federal income tax. Because it did not tax property directly, congressional leaders viewed the income tax as indirect, and thus immune from constitutional strictures.
"While the rich and the thrifty will be obliged to contribute largely from the abundance of their means . . . no burdens have been imposed on the industrious laborer and mechanic . . . The food of the poor is untaxed; and no one will be affected by the provisions of this bill whose living depends solely on his manual labor."
In response, Congress approved two new laws in 1864 that increased tax rates and expanded the progressivity of income taxation. The first bill passed in June upped inheritance, excise, license, and gross receipts business taxes, along with stamp duties and ad valorem manufacturing taxes. The same act proceeded to assess incomes between $600 and $5,000 at 5 percent, those between $5,000 and $10,000 at 7.5 percent, and established a maximum rate of 10 percent. Despite protest by certain legislators regarding the unfairness of graduated rates, the 1864 act affirmed this method of taxing income according to "ability to pay." An emergency income tax bill passed in July imposed an additional tax of 5 percent on all incomes in excess of $600, on top of the rates set by previous income tax bills. Congress had discovered that the income tax, in addition to its rhetorical value, also provided a flexible and lucrative source of revenue. Receipts increased from over $20 million in 1864 (when collections were made under the 1862 income tax) to almost $61 million in 1865 (when collections were made under the 1864 act and emergency supplement).
Federal taxes were also instrumental in instituting a system of national banking during the war. The National Banking Acts of 1863 and 1864 imposed a system of "free banking" — banks established by general incorporation as opposed to specific charters — on a national level. State banks were granted national charters and allowed to issue national bank notes (these notes were separate from Greenbacks). One third of a national bank’s capital had to consist of federal bonds, since the new national notes were to be backed by federal bonds. The National Banking Acts thus served as another means to induce bankers to purchase bonds. In an attempt to avoid increased regulation, however, many state banks declined to seek national charters. To remedy this problem, the 1864 act imposed a 10 percent tax on state bank notes to drive them out of existence. As a result of this tax, the number of national banks tripled by the war’s end, while their purchase of U.S. bonds nearly quadrupled.