Tax Cheaters in America: How Reform Sparked Resistance and Fraud

“The Congress shall have 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 enumeration.” The Sixteenth Amendment to the United States Constitution was adopted on February 3, 1913.

Tariff on Imported Goods or Excise Tax

Early in the 20th Century the government received its revenue through two methods – tariffs on imported goods and the excise tax, which was a consumer product tax. Each source contributed approximately half of the government’s revenue. The cost of nearly every consumable item – food, clothes, tobacco, alcohol, and others – was inflated to pass the tax to the consumer. On the surface this seems a reasonable means of collecting revenue, but the wages of the majority of citizens were very low.

Many workers lived in slums throughout the major cities, and their meager earnings never stretched far enough to properly take care of their family. By adding a surcharge to essentially anything they purchased, it pushed their poverty level to an even less desirable standard. At that time the poor and working class received no entitlements from the government.

It is likely that wealthy Americans barely noticed the product surcharge, but for the lower class it was crippling. The tax system, or lack of one, gave the small group of upper class and wealthy a pass, and laid the burden of financing the government on the backs of the tens of millions of poor and working class citizens.

As the country began to understand the unfairness of the tax system, a sense of anger began to grow. That anger was directed at rich and upper class Americans.Less than two decades later, the laws were changed and the nation’s revenue bill became largely the responsibility of the upper class and wealthy. This huge reversal of political course met with an equal response from the wealthy and their corporations. Some of them responded through corruption and tax evasion.

Tax Fraud

Sal thought buying an armored car was the best decision he had ever made. He owned a chain of Italian restaurants in New York City and he was making a killing, especially since he was hiding his income and not paying taxes. The car made its rounds three times a day picking up cash from each establishment. The cash was distributed to a special hiding place.

The Federal Revenue agents finally caught up with him in 1922 and found his stash of money. It totaled over $2.5 million dollars. In today’s currency that would amount to $25 million of untaxed dollars. Sal had felt that most business people he knew were doing the same – underreporting, or just hiding income from the tax man.

Between 1895 and 1904 nearly 2,000 American companies merged with their former competitors. This merging created some of the largest corporations in the world, many of which still exist. Record profits were being made and the fortunes of many industrialists – Rockefeller, Vanderbilt, JP Morgan, and Carnegie continued to grow. Much of those profits were untaxed, while their workers suffered under the weight of paying the nation’s revenue bill.

The Industrial Revolution created steady jobs, and a new sense of citizenship. Cities and smaller communities began to grow, and Americans started looking to their government for more support. In 1895, the U.S. Supreme Court had dismissed the idea of income taxes as unconstitutional because it was not apportioned according to the population of each state, as the Constitution then required.

Tax Reform – Woodrow Wilson

By 1913 Woodrow Wilson’s administration began working towards reforming the tax laws and addressing the needs of the nation’s workers. Wilson heard the cries from the voices of the Progressive Movement people. It would be unfair, and certainly unjust, to continue to place the burden on the working class and poor, and ignore taxing the elite.

The largest portion of the nation’s collective income was earned by a small group of wealthy individuals and their businesses – and, they paid little, or no, tax.

Understanding Tax Implications for the Working Class

Between 1913 and 1916, several pieces of legislation, including the ratification of the 16th Amendment, were enacted, and it modernized the Federal tax system. By 1917, America was involved in World War I, and that cost had to be figured into the needed revenue.

The new tax laws focused on the wealthiest Americans, and did away with the old ideas of draining the poor through consumer product taxes. A member of Wilson’s Cabinet was heard to say that the tax reforms would be “soaking the rich.”

The new Federal Income tax system assessed a small rate of tax on annual incomes starting at $3,000.00 for single filers, and $4,000.00 for families. Essentially, by placing the threshold for taxation at that amount, the entire middle and working class were exempt from taxation. Only 1 out of 271 were even required to file a tax return.

The big earners paid a graduated rate of tax. The more they earned, the more they were taxed. By the 1917/1918 tax season the highest earners were paying the rate of 71% of their income to taxes. The high tax rates continued for a number of years post war and were called by some “the greatest burden that had ever been laid upon the American people.” It was, however, the greatest burden ever laid upon rich Americans.

There were two reasons that the Federal government went after the rich, and their businesses. The public excuse was the cost of operating an expanding bureaucracy. By introducing the new income tax program, import tariffs were reduced and that would encourage more trade. The enormous expense of World War I magnified the need for income taxes.

Political Concern that the Rich Would Run the Country

The private reason was the growing concern of politicians that American businesses were becoming too powerful. Some whispered that without governmental controls, the rich and their corporations might soon be running the country.

No longer were the silent poor carrying the burden of financing the government. Under-trained and unprepared for what was facing them, the Internal Revenue’s auditing department quickly realized that they were also understaffed. With the new tax laws in place and the soaring rates of taxation, fraudulent tax returns began pouring into the Internal Revenue Service.

By 1918/19 tax fraud was so rampant that thousands more revenue inspectors had to be hired, and nearly every day a headline about tax cheaters appeared in the major newspapers.

Newspapers loved the subject and published daily headlines like:

“Stop Thief! Income Tax Frauds Rob United States Treasury of $320 Million,” Truth, July 29, 1916.

“Evasions of Munitions Tax Total $17 Million,” Dallas Morning News, October 18, 1917.

“5 Million Added to Tax by Audit of Coal Profits, Some Unreported Figures Are Evasions –Others Due,” Wilkes-Barre Times, August 28, 1918.

“Wool Dealers Sentenced to Prison in Tax Fraud,” Grand Rapids Press, January 28, 1919.

“Income Tax Fraud Involves Millions: Revenue Collector Says Arrests are Expected to Result in Recovering Much,” Trenton Evening Times, June 19, 1919.

“Cincinnati Stove Men Charged with Tax Fraud,” Duluth News-Tribune, January 26, 1921.

“$2 Million Dollar Furrier Tax Charged to Two,” Grand Rapids Press, January 25, 1922.

“Hints of Men Higher Up in Tax Fraud, Whether Wealthy Property Owners Can be Charged,” Sun, March 11, 1922.

“Eight Men Indicted in Tax Fraud Probe Two Former City Employees, Alleged Go-Betweens,” Sun, April 28, 1922.

Profile of a Tax Cheater

Tax fraud became the central concern of the Internal Revenue Service and soon they produced a profile of a tax cheater – – a high income male, over 50, filing a complicated return, and engaged in criminal activities. The profile was misleading. Although, there was no doubt that criminals were involved in tax evasion, there were plenty of respectable citizens and legitimate businesses who were also defrauding the government.

The head of the Morrison Hotel (largest in the Chicago) was indicted for filing false returns in 1918 and 1919. He had understated his income and it was alleged that he owed over $62,000.00 ($845,000.00 in current dollars) in back taxes. The owner of the National Fruit Products Company was arrested and charged with filing a fraudulent income tax return. He too had under-reported his 1919 income at $20,338.14, but the warrant claimed his income was $130,580 ($1.7 million in current dollars).

Internal Revenue Service

In some larger cases the agents for Internal Revenue and independent accounting firms conspired together to defraud the government. In the case of the Coast Wise Warehouses (1919), revenue agents and accounting firm employees designed an elaborate plan to evade taxes that included multiple phony holding companies, dummy sets of books and a list of bogus expenses.

The Internal Revenue was quoted as saying they hoped to recover $25 to $50 million in unpaid back taxes, and as many as 30 individuals were involved in the swindle.

Company Cheaters

A margarine company had been selling their margarine for several years to dealers as butter without the payment of taxes. Margarine was taxed at a much lower rate than butter. The Oleomargarine Company colored the product with palm oil and passed it on to the dealers and consumers as butter.

In 1919 the Internal Revenue auditors claimed the margarine company owed at least $851,000 ($11.7 million in current dollars) in back taxes. In that same year the Internal Revenue announced that they had uncovered at least 6000 business-related tax fraud cases in the years 1918/1919. One single manufacturer was said to owe at least $1.5 million dollars ($20 million in current dollars) in back taxes. Revenue agents routinely began shutting down plants and seizing business equipment.

Tax fraud involved the manipulating of expenses, phony receipts, the use of numerous sets of books, and many times the misdirecting of income to bogus accounts. Many retailers of the period dealt strictly in cash. Although the majority were never caught or prosecuted, it was thought the understating of income by cash retailers was huge.

Corporation Cheaters

On the corporate side, in an attempt to evade big taxes one large firm created 96 bogus personal holding companies. Despite the complexity of their scheme, the Treasury was still able to uncover the crime and claimed millions in back taxes. The owners were prosecuted and jailed. A number of wealthy business owners incorporated their many personal estates, so that they could deduct their personal maintenance expenses from business taxes.

Some argued that the negative response from the wealthy over paying income taxes was because the tax rate was just too high. The tax rate was high, but, the well-off had not seemed troubled when it was the working class and poor paying the majority of taxes. There was likely possibly due to an attitude of entitlement held by some of the elite. Decades later the billionaire tax cheat Leona Helmsley expressed her feeling of entitlement saying “only little people pay taxes.”

In less than ten years after the ratification of the 16th Amendment,tax evasion was widespread and out of control in America. The burden of the country’s tax revenue had been shifted from the working class and poor to the shoulders of wealthy Americans. Prior to World War II, 80% of Americans were not paying any income taxes. It would not be until after World War II, with the introduction of withholding tax, that the nation had a more equitable tax system.

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