A Brief History of U.S. Tax Brackets: The Evolution of Income Taxation and Why You Should Care
Taxes Rise
The U.S. tax system has evolved significantly since its introduction in 1913, with tax brackets and rates changing to reflect the country’s economic needs and policies. Early on, tax rates were modest, with the highest rate set at 7%. However, during World War I and the Great Depression, rates rose sharply, reaching 77% in 1918 for incomes above $1 million (about $20 million today).
The most dramatic increase came during World War II, when the top marginal tax rate reached an astounding 94% in 1944-1945 on incomes over $200,000 (equivalent to over $3.5 million today). During the post-war years, top rates remained high, with the 91-92% bracket persisting through the 1950s and early 1960s.
The below chart shows a timeline of the highest marginal tax brackets from 1913 to 2021 using data from the Tax Foundation.
Taxes Fall
The trend shifted in the 1960s with tax cuts under Presidents Kennedy and Johnson, bringing the top rate down to 70%. The most dramatic cuts came in the 1980s under President Reagan, with the top rate dropping to 50% and eventually 28%. Since the 1990’s, rates have shifted downward with about a 2% average drop during the President Bush tax cuts in 2001/2003 and another 2% drop on average during the President Trump tax cuts in 2017.
The highest rates above were applied to only the wealthiest individuals, and effective tax rates were much lower.
Here are two definitions you should know before I proceed:
- Marginal Tax Bracket: The tax rate that you pay on the next dollar earned. In most cases, this is largest driven by the tax bracket you fall into.
- Effective Tax Rate: The total taxes you pay divided by your taxable income. This will always be lower than your marginal tax bracket due to the progressive nature of our tax system.
The following chart overlays the effective tax rates for joint filers earning different income amounts in today’s dollars. By adjusting the income for inflation, we can estimate the effective taxes.
At the lower end with $50,000 of income, the highest effective rate paid in history was about 23.5% but that is now down to about 11.1%.
At the high end of $1,000,000 of income in a single year, the highest effective tax rate paid was 61.9% which has fallen to about 29.8%.
One of the most misunderstood aspects of historical tax brackets is that the highest rates—such as the 94% rate of the 1940s—were only applicable to the wealthiest few. In fact, the top tax rates were often imposed on incomes that today would be considered extreme by any measure. Adjusted for inflation, these high brackets were typically applied to those earning the equivalent of tens of millions or over a hundred million dollars in today’s terms.
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Summary
Why go through this history?
It’s important to understand the historical context of where tax rates have been and where they are today. We have been on a downward trend in tax rates since the 1980’s and now sit at historic lows since before World War II.
However, with our national debt and consistent national deficits, that may not always be the case.
In planning for your financial future, it’s important to have a tax plan in place to pay the lowest taxes you can which involves understanding your financial situation not just in the current year but in the future.
Through comprehensive financial planning, you can gain this insight and implement strategies to keep more of what you earn, grow your wealth more tax efficiently, and reduce your retirement tax bills.
Interesting Observations (at least to me)
- These tax estimates do not consider the impact of tax credits, deductions, or taxability of income sources like social security or capital gains tax. Nor does it include other taxes you can pay such as State Taxes, FICA, Sales Tax, Medicare Tax, and more. All of these complications can influence the ultimate tax rate.
- From 1936 to 1940, the top tax rate was 79% applying to incomes above $5 million. That’s about $112 million of income in today’s dollars!
- From 1965 to 1976 the tax rates were the same but if you look at the above chart the effective tax rates increase. That is because the tax bracket levels were not inflation adjusted so people were paying more taxes each year if their income rose with inflation.