Tulane Economics Working Paper Series
The Internal Revenue Service and the American Middle Class
Bibek Adhikari
Department of Economics
Tulane University
[email protected]
James Alm
Department of Economics
Tulane University
[email protected]
Working Paper 1523
November 2015
JEL codes: A1, A2
The Internal Revenue Service and the American Middle Class
Bibek Adhikari and James Alm
Tulane University
The United States Internal Revenue Service (IRS) is a federal government agency within the
Department of the Treasury. It is responsible for administering all federal tax laws, including
collecting taxes (issuing tax refunds), enforcing tax laws, and assisting taxpayers in meeting
their tax obligations. The IRS was established in July 1862 with the passage of the Revenue Act
of 1862, which established the nation’s first income tax to help finance the Civil War. The
income tax was repealed 10 years later, and in 1884 Congress revived the income tax. However,
within a year this tax was declared unconstitutional by the U.S. Supreme Court. In 1913,
Congress amended the U.S. Constitution to allow for the imposition of an income tax with the
passage of the 16th Amendment (“The Congress shall have the power to lay and collect taxes on
incomes, from whatever source derived, without apportionment among the several States, and
without regard to any census or emuneration”). The name of the agency was changed from its
original name (Bureau of Internal Revenue) to its current name in 1953.
During the Civil War and until World War II, the income tax was levied only on high income
individuals. The initial marginal tax rate in the Civil War was only 3 percent, and even in 1913
the top rate was only 7 percent. Indeed, some individuals considered paying income taxes as
proof of their financial success, and they proudly reported that they had paid their income
taxes. By the time of World War II, the top rate was close to 90 percent. It was during World
War II that the IRS greatly enlarged its scope to affect the vast bulk of the American middle
class. This was due largely to the expansion of the individual income tax base to include most
income earners and to the application of employer source withholding, both done in order to
finance the war effort. During this period, the revenues of the IRS increased from $3.4 billion (4
percent of GDP) in 1936 to $40.7 billion (18 percent of GDP) in 1946. Also, the number of
income tax returns increased from less than 4 million in 1933 to nearly 44 million in 1943, and
the number of IRS employees nearly quadrupled during World War II. At present, the IRS
collects roughly $3 trillion (18 percent of GDP) from 145 million tax returns using a total staff of
over 100,000 and a budget of $11.6 billion. Marginal tax rates have varied enormously over
time, reaching a top marginal tax rate of 92 percent in the 1950s before declining in the last
several decades to 35 percent. See Tables 1 and 2.
Table 1: The Size of the Internal Revenue Service and Gross Revenue Collections
Year
1866
1876
1886
1896
Number of
IRS Employees
4,461
5,184
3,292
3,991
Number of IRS Employees
per 1000 Population
0.12
0.11
0.06
0.06
Gross Revenue Collections
(in millions of dollars)
$310.1
116.,8
116.9
146.8
Gross Revenue Collections
(as percent of GDP)
3.42%
1.39
0.95
0.94
1906
1916
1926
1936
1946
1956
1966
1976
1986
1996
2006
2013
3,703
4,718
14,333
17,054
59,693
50,682
63,508
85,455
96,395
102,082
91,717
86,974
0.04
0.05
0.12
0.13
0.42
0.30
0.32
0.39
0.40
0.38
0.31
0.27
249.1
512.7
2,836.0
3,448.6
40,672.1
75,112.6
128,880.0
302,519.8
782,251.8
1,486,546.7
2,518,680.2
2,855,059.4
0.79
1.02
2.90
4.06
17.85
16.69
15.81
16.11
17.04
18.35
18.18
17.03
Sources: L. Shelley Davis, IRS Historical Fact Book: A Chronology 1646-1992, IRS Historical Studies,
Washington, D.C. (1992); and IRS Data Book , Washington, D.C. (2013).
Table 2: Number of Individual Income Tax Returns and the Top Marginal Tax Rate
Top Marginal Tax Rate
Number of:
(in percent)
Year
Income Tax Returns Taxable Returns Nontaxable Returns
7%
1913
357,598
----43.5
1923
7,698,321
4,270,121
3,428,200
63
1933
3,723,558
1,747,740
1,975,818
88
1943
43,602,456
40,318,602
3,283,854
92
1953
57,838,184
45,223,151
12,615,033
91
1963
63,943,236
51,323,221
12,620,015
70
1973
80,693,000
64,267,000
16,425,000
50
1983
96,321,310
78,016,323
18,304,987
39.6
1993
114,601,819
86,435,367
28,166,452
35
2003
130,423,626
101,392,812
29,030,814
35
2012
144,928,472
108,995,860
35,932,612
Source: IRS Statistics of Income, Washington, D.C., various issues.
The individual income tax is the largest single component of the $2.9 trillion in revenue that IRS
collected in 2013. Included here is the administration of the Earned Income Tax Credit (EITC),
which is a wage supplement that supports low- and moderate-income workers with children. At
present, it is nation’s largest federal anti-poverty program, and in 2013 more than 18 percent of
income tax filers received the EITC with a $2407 credit. Apart from the individual income tax,
the IRS also administers the collection of income taxes from businesses, employment taxes
(Medicare, Medicaid, and Social Security taxes), the estate tax, the gift tax, and all federal
excise taxes (e.g., alcohol, tobacco, fuels). Table 3 provides the number of returns and the gross
amount of revenue collected in 2013 from each of the major tax types.
Table 3: Number and Amount of Tax Collections and Refunds, by Type of Tax, 2013
Returns
Collections
Refunds
Tax
(in thousands)
(in thousands of dollars) (in thousands of dollars)
Individual Income Tax
145,996
$1,539,658,421
$312,775,138
Business Income Taxes
39,039
311,993,954
41,569,223
Employment Taxes
29,958
897,847,151
6,375,725
Estate Tax
32
14,051,771
963,243
Gift Tax
313
5,778,377
84,086
Excise Taxes
909
61,033,674
1,137,764
Source: IRS Statistics of Income, Washington, D.C. (2013).
Another way in which the IRS affects American middle class is through its role as the largest
spending agency in the federal government. After World War II and especially in the 1980s,
many “tax expenditures” were introduced or expanded to include the middle class, where a tax
expenditure represents a revenue loss due to exemptions, deductions, credits, and other
special provisions. The IRS therefore “spends” via foregone tax revenues on housing, on health
programs, on promoting saving and investment, on education, on child support, and so on.
Some of the tax expenditures are larger than the budgets of the departments that spend
money for the same purposes. For example, the tax expenditures for homeownership exceed
total spending by the Department of Housing and Urban Development.
In 2015, IRS-administered tax expenditures are estimated to equal more than $1.2 trillion, or
roughly 7 percent of GDP. Some of the tax expenditures that are most relevant to the middle
class Americans are the exclusion of employer contributions for medical care and pensions, the
mortgage interest deduction, the exclusion of net imputed rental income, the exclusion of
capital gains, the various deductions for state and local taxes, the deduction for charitable
contributions deduction, and the child tax credit. See Table 4. Many of these benefit
disproportionately higher income individuals, given that the tax benefit of any deduction is
larger for individuals in higher marginal tax brackets.
Table 4: Estimated Tax Expenditures, 2015
Tax Expenditure Type
Exclusion of employer contributions for medical care
Deductibility of mortgage interest on owner-occupied homes
Exclusion of net imputed rental income
Capital gains (except agriculture, timber, iron ore, and coal)
Defined contribution employer plans
Deferral of income from controlled foreign corporations
Capital gains exclusion on home sales
Deductibility of nonbusiness state and local taxes, other than on owner-occupied homes
Deductibility of charitable contributions, other than education and health
Defined benefit employer plans
Estimated Amount
(in millions of dollars)
$207,200
73,910
79,810
68,850
61,050
75,540
56,510
49,290
46,630
42,340
Exclusion of interest on public purpose State and local bonds
Deductibility of State and local property tax on owner-occupied homes
Step-up basis of capital gains at death
Social Security benefits for retired workers
Self-employed plans
Treatment of qualified dividends
Exclusion of interest on life insurance savings
Child tax credit
Total Tax Expenditures, All Categories
Source: Office of Management and Budget, Analytical Perspectives, Washington, D.C. (2014).
35,010
33,880
32,370
29,840
25,530
26,650
23,040
23,500
1,241,615
The IRS has on many occasions been the source of controversy. In the 1990s, the IRS was
accused of abusive and aggressive behavior. Senate hearings were held, leading to the passage
of the Taxpayer Bill of Rights, which ensured taxpayers of greater protection in any disputes
with the IRS and which also established the Office of the Taxpayer Advocate. More recently, the
IRS was accused of targeting for special scrutiny conservative organizations (e.g., “Tea Party”
groups) that were applying to the IRS for nonprofit and tax-exempt classification, again leading
to Congressional hearings in 2013 and 2014.
An important part of IRS activities is enforcement of the tax laws. The IRS attempts to improve
taxpayer compliance by several main strategies: providing better services to taxpayers,
simplifying the tax code, and auditing taxpayers. The number of tax audits has generally fallen
over time, to less than 0.8 percent of all returns in 2013. Even so, the IRS has achieved some
success in maintaining taxpayer compliance. The so-called “tax gap”, or the taxes that should be
paid but are not, is estimated to equal $450 billion in 2006, the most recent year for which
detailed estimates are available. This estimate implies that the voluntary compliance rate is
83.1 percent, or that nearly 5/6 of all legally due taxes are paid. Voluntary compliance is
significantly higher for income subject to employer withholding, approaching nearly 100
percent for the largely middle class individuals who receive only wage income.