The Evolution of Federal Income Tax, Social Security, Medicare, and Workers Comp

Gusto Editors

Do you know the history of workplace taxes?

Although it may seem unimaginable, there was a time when the IRS didn’t exist in the United States. The latter half of the 19th century and the first half of the 20th century brought significant changes to how the government taxes individuals and businesses. 

Gusto, along with our partners at CPA Academy, presented a webinar all about the evolution of payroll, benefits, and taxes. Our presentation titled, “The History of Payroll & Benefits: How Did We Get Here?” featured the tax expertise of Greg Kyte, founder of Comedy CPE, and Caleb Newquist, Gusto’s Editor-at-Large. You can watch the full presentation here.

In this article, you’ll learn about the history of taxes including the 16th Amendment, Social Security, Medicare, unemployment, and workers’ compensation.  

Why was the 16th Amendment created?

Greg and Caleb discussed the history and evolution of workplace benefits and taxes, and they unpacked the history of federal income taxes and the 16th Amendment. 

The government initially imposed income taxes to finance the Civil War in 1862 and, as a result, created what is now called the Internal Revenue Service:

“The IRS was established specifically to collect income tax from the people. The one thing that’s interesting is that the United States, of course, was collecting taxes prior to that, but apparently, it was a simple enough process to where you didn’t need a whole bureaucracy managing it, but they did [need a system] once [they started collecting] income tax, so the IRS was established.”

Greg Kyte

The federal government created the Commissioner of Internal Revenue to collect taxes. Although the IRS originates from the Commissioner of Internal Revenue, it didn’t become known as the Internal Revenue Service until 1918. 

Tax manager dressed in the suit working with documents and laptop at the modern office.

After the Civil War concluded, the federal government reversed income taxes. Income taxes were then re-imposed in the 16th Amendment in 1913:

“The 16th Amendment was passed in 1913, and the 16th Amendment is what granted Congress the power to impose a personal income tax.”

Greg Kyte

After Congress passed the 16th Amendment, people had to pay income taxes, and employers began withholding federal income taxes from employee paychecks.  

“Apparently, withholding taxes had been there the whole time. They knew that people wouldn’t want to pay it in one big lump at the end [of the year], so they started taking it off the top right from the get-go.”

Greg Kyte

Greg observed that income taxes have fluctuated dramatically since Congress established them in 1913. The government implemented the highest income tax rate in U.S. history during World War II:

“The highest rate of income tax that ever was in the history of the United States was 94% income tax. … It was 94% of everything you made over $200,000, and that was in 1944 through 1945. Again, interesting, that lines up with the tail end of World War II, so [it was] probably an effort to finance the war.”

Greg Kyte

People had to pay 94% of their income after making $200,000, worth almost $3.2 million as of 2022. In contrast, the highest income tax in 2022 is only 37%: 

“The current highest rate that we have right now in 2022 is 37%, and that’s levied on any income above $524,000 if you’re single [and] $628,000.00 if you’re married filing jointly.”

Greg Kyte

Those making over $524,000 pay a higher rate than others, but the income tax isn’t anywhere near the exorbitant 94% rate.  

Social Security and the Medicare Act of 1965 impact

Congress created Social Security through the Social Security Act of 1935. Like many tax and work reforms, Congress created Social Security in response to the Great Depression. Social Security taxes started at only 1%:

“Social Security started at 1% with an employer match, so it was a total of 2%—1% of it paid by the employee [and an] additional 1% by the employer. The original base limit was just a meager $3,000, so [for] everything above $3,000, you did not have to pay any Social Security.”

Greg Kyte

In 1935, employees only paid 1%, and they didn’t need to pay Social Security after making $3,000, which, with inflation, is worth around $61,500 as of 2022. 

Worried senior couple checking bank documents at home.

Since 2021, employees pay 6.2% in Social Security taxes:

“It’s 6.2%, and again, that’s the employee’s part, [which] is matched by the employer. The taxable base limit that just went up for 2022 is now $147,000, so [if your] income [is] above $147,000, you don’t have to pay Social Security on that.”

Greg Kyte

Employees still receive an employer match on Social Security, so the total amounts to 12.4%. 

Unlike Social Security and income taxes, Congress didn’t implement Medicare until the latter half of the 20th century: 

“Medicare didn’t come into play until 1965, so it was a little bit later to the game. … The rate started at 0.35%, and again, that was for employees, and the employers had to pay an equivalent 0.35% of wages back when it started in 1965, and now the rate today is 1.45%. Again, that’s for employees, [and] employers have to match it with another 1.45%.”

Greg Kyte

The amount employees pay for Medicare has increased from .35% to 1.45%. Additionally, the Affordable Care Act of 2010 increased the percentage that higher earners pay:

“You have to pay 2.35% to Medicare for any income that you earn over $200,000 if you’re single [or] over $250,000 if you’re married filing jointly, and that extra .9% is what’s used to fund the provisions that are within the Affordable Care Act.”

Greg Kyte

One important distinction between Social Security and Medicare taxes is that there’s no cap on the amount you can pay for Medicare. People don’t need to pay Social Security taxes after making an income of over $147,000, but there is no limit to the amount someone can pay in Medicare taxes. 

How do unemployment and workers’ comp work?

Congress implemented unemployment legislation in the Social Security Act of 1935. Employees pay 6% on the first $7,000 of their annual income. Individual states are in control of unemployment taxes: 

“All unemployment is managed through each individual state. The federal government was like, ‘Hey, if the states are managing it themselves, then we don’t have to get all that money in here to the federal government.’ … A state can require that up to 5.4% of that 6% comes to the state. Almost all states are like that, where 5.4% goes to the state unemployment tax, and the remaining 0.6% goes to the federal unemployment tax. … That’s the general rule, [but] that’s not everywhere in every state and territory in the United States.”

Greg Kyte

As with unemployment, individual states manage workers’ compensation regulations. Workers’ compensation is a type of insurance designed to reimburse employees who become injured or ill from their work or work environment. Workers’ compensation benefits reimburse employees for medical bills and lost wages. Individual states implemented workers’ compensation requirements from 1911 to 1948.  

Male bank employee explains the loan application process.

Before workers’ compensation became the norm in the United States, injured or ill employees had to sue their employers to recover damages:

“If you got injured on the job, you could sue your employer to receive compensation, [but it was] almost never successful. … The reason why it was almost never successful is because if the employer could prove that the employee was negligent, even a little bit negligent, then the suit would fail. Also, the employer could show that another employee was negligent and that resulted in the injury that the employee sustained.”

Greg Kyte

If an employer could prove that the injured worker or another employee was negligent, they could avoid paying out damages for medical bills. 

Today, employers are required to get workers’ compensation insurance, but it ensures that injured or ill employees can’t sue them:

“You have to obtain workers’ comp for your employees, but what you get for that is employees cannot sue their employers for work-related injuries because those employers have workers’ comp to cover it.”

Greg Kyte

The amount that employers need to pay for workers’ compensation insurance depends on their state and the nature of their work. 

“The lowest workers’ comp rate is [in] Washington, D.C., where it’s $0.51 per every $100.00 of covered wages. The highest state is Alaska, where workers’ comp is $2.25 per every $100.00 of covered wages, and also, the amount that you have to pay varies in terms of what your job is. As an accountant, I have to pay a lot less in workers’ comp because it’s [not] a very dangerous job.”

Greg Kyte

If your business involves physical work that can result in workplace accidents and injuries, your workers’ compensation insurance will likely be higher than an industry with fewer injuries. 

Although the federal government controls payroll, Social Security, and Medicare taxes, states primarily control workers’ compensation and unemployment. 

Learn more about the history and evolution of taxes

Taxes have changed significantly throughout U.S. history. The American Civil War created a need for consistent payroll taxes and the IRS. Throughout the 20th century, the federal government implemented more employee taxes with the Social Security Act of 1935 and the Medicare Act of 1965. Additionally, employers are now required to pay for workers’ compensation insurance, and employees need to pay unemployment taxes on the first $7,000 of their annual income. 

If you’re ready to learn more about the history and evolution of payroll, benefits, and taxes, read Part One and Part Two of this webinar article series. You can also watch the entire webinar here.

Looking for more ways to improve your craft as an accountant? Consider signing up for Gusto Pro! Gusto Pro is a doorway into the future of accounting. Tap into our expert resources and certification program so you can build a resilient firm and support your clients into the future. Learn more about Gusto Pro.

Gusto Editors Gusto Editors, contributing authors on Gusto, provide actionable tips and expert advice on HR and payroll for successful business management.
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