From Tariffs to Taxes: The Long Shift in US Public Finance

Photo by Markus Winkler on Unsplash

Punchline: Can tariffs help pay the bills? The Trump administration seems to think they can at least cover part of the cost of new tax cuts. And there is historical precedent: in the 19th century, tariffs funded much of the federal government. But back then, government was small — just a few percent of GDP. Today, it is nearly ten times that size. This post looks at how US public finance evolved from reliance on trade taxes to broad-based income and payroll taxes — and why tariffs, while generating more revenue again in recent months, are unlikely to play a central fiscal role.

President Trump is a long-standing believer in tariffs. He sees them as a way to protect American industry and punish trading partners. But tariffs have another effect: they raise revenue. That may make them doubly attractive at a time when the Trump administration is pursuing large tax cuts that will widen the federal deficit.

There is a historical precedent for this. In the 19th century, tariffs were not just tools of trade policy. They were how Washington paid its bills.

This post reviews the evolution of US federal revenues from 1820 to 2005. It explains how the country moved from relying on tariffs to depending on income and payroll taxes. Understanding this shift helps clarify why tariffs can no longer play a central role in federal finance.

From Trade Taxes to a National Income Tax

The first graph below shows federal revenues as a share of GDP. The second breaks them down by source. Together, they reveal a decisive transformation in the early 20th century. Income and payroll taxes began to displace tariffs and excise taxes as the main sources of federal revenue.

Source: Congressional Research Service, U.S. Federal Government Revenues: 1790 to the Present, 2006, and www.measuringworth.com

Source: Congressional Research Service, U.S. Federal Government Revenues: 1790 to the Present, 2006.

Until then, tariffs had worked well. They were easy to administer. A few coastal customs houses could monitor most imports. Setting up a nationwide income tax system would have required a large bureaucracy which was unrealistic in a country with limited administrative capacity.

For much of the 19th century, tariffs, supplemented by land sales and excise taxes, were sufficient. Between 1820 and 1860, federal revenues averaged just 1.8% of GDP. The federal government was small, and its financial needs modest.

The Civil War changed that. Military spending surged. The federal government had to raise more revenue. It did so by increasing tariffs, expanding excise taxes, and introducing an income tax.

By 1865, the new tax generated nearly 15% of revenues. Land sales, already important, became even more significant during the war. Excise taxes, especially on alcohol and tobacco, also became a key source of revenue and their scope was broadened to cover a wider range of goods and services.

After the war, the income tax was repealed. It was later struck down by the Supreme Court in 1895. But excise taxes remained central. Between 1863 and 1913, they often made up close to 40% of federal revenues. Tariffs still accounted for about half.

This reliance on consumption taxes kept the system afloat. But it was regressive: the tax burden fell mainly on spending, not income.

Everything changed in 1913. The Sixteenth Amendment gave Congress the power to tax income. A new income tax was introduced — 1% for most earners, with higher rates for top incomes.

Though modest at first, it quickly became the backbone of federal finance. World War I broke out soon after. Revenue needs surged. The income tax scaled up and overtook tariffs as the government’s main source of funds.

The early 20th century also brought broader political shifts. The franchise widened. In 1920, the 19th Amendment gave women the right to vote. With more people participating in elections, demands for broader public provision of services grew.

1930s and the Rise of Payroll Taxes

The Great Depression triggered the next major shift. The economic crisis of the 1930s led to a sharp expansion of the federal role in social and economic policy. President Roosevelt’s New Deal introduced a range of programmes aimed at relief, recovery, and reform. To help fund these, new revenue instruments were developed.

The most important was the Social Security Act of 1935. It introduced payroll taxes to fund retirement benefits. These later expanded to cover other social insurance schemes. From 1946 to 2005, social insurance taxes rose from 1.4% to 6.5% of GDP. Over time, they came to rival, and in some years exceed, income taxes in importance.

World War II reinforced this transformation. The war demanded massive financial mobilisation. By the end of the war, the income tax had become a mass tax — affecting ordinary workers as well as the wealthy.

The 1960s brought new spending commitments. Programmes like Medicare and Medicaid further expanded the role of government. These were funded primarily through payroll taxes and general revenues. By then, the structure of federal taxation had stabilised. Income and payroll taxes did the heavy lifting. Tariffs and excise taxes played only minor roles.

The Decline of Tariffs

By 2005, customs duties and excise taxes together made up less than 5% of federal revenues. Tariffs, once dominant, had become marginal.

There are several reasons for this. Tariffs are economically inefficient, distorting trade and production. And they harm domestic consumers and reduce overall welfare.

The burden of tariffs falls disproportionately on lower-income households. In that sense, tariffs are inherently regressive. They also have natural limits. Raise them too much, and imports fall. That shrinks the base on which tariffs are levied. This is the logic behind the Laffer curve: higher rates eventually produce lower revenues.

Tariffs may still raise some funds. But not nearly enough to finance a large modern state. They are no longer a viable substitute for income or corporate taxes.

Conclusion

The history of US public finance reveals three broad shifts. Tariffs dominated until the early 20th century. Income taxes rose with war and the growing size of government. Payroll taxes followed, funding the expansion of social insurance. Each change reflected deeper political and economic developments from constitutional amendments to the emergence of a modern welfare state.

Equally striking is the growth of government itself. In 1820, federal revenues stood at about 2% of GDP. By 2000, they had risen to nearly 20%. The United States shifted from a minimal state funded by trade taxes and land sales to a modern public sector sustained by broad-based taxation.

The lesson for today’s policymakers is clear. Tariffs were able to fund government when it was small. But as the scale of public spending has grown, they have become ill-suited to that role.

The views expressed are my own. The work presented is preliminary and may contain errors. It should not be construed as investment advice. Readers are encouraged to seek professional investment guidance.