The major political battle over wartime finance was the portion of the war costs to be funded by taxes and the portion through borrowing. Democrats tended to favor taxes and Republicans borrowing. Both parties realized that both taxes and borrowing had to be resorted to, but they differed over whether taxes should account for 20%, 33% or even 50% of the burden. Too much borrowing could create inflation, but too much taxation could reduce incentives to put the economy on a wartime footing. In the end, taxes financed a third of the war effort.
The best types of taxes to implement were also hotly debated. The national income tax was dropped after the Civil War in favor of reliance on tariffs. The Supreme Court ruled federal income taxes unconstitutional, but in 1909 under President Taft the political stars realigned and a constitutional amendment (the 16th) allowing imposition of an income tax was sent to the states and ratified by the necessary number (then 36) in 1913. Soon after, Congress enacted an income tax into law. About 15% of American households helped pay for the war with their income taxes, but most of the tax burden fell on corporations in the form of an “excess profits” tax. Estate taxes were also considerable.
To some extent the government also taxed interest payments on its own bonds as detailed in the accompanying document. Its evolving goal was to increase government revenues and reduce class antagonisms by taxing only the wealthiest bondholders, those subject to the highest income, estate and excess profit taxes. Tax exemptions had to be expanded, however, to attract more middle class bond investors caught in the tax “bracket creep” created by double digit wartime inflation.
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