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Timelines in Tax History: Moralistic Tax Policy in the 1930s

By: Joseph J. Thorndike

 

This timeline of 1930s U.S. tax history is drawn from the new Tax History Museum, part of the Tax History Project’s revamped website, which will be relaunched this fall.

 

As Franklin D. Roosevelt took the oath of office on March 4, 1933, the United States was struggling through the darkest days of the Great Depression. A quarter of the nation’s workers were unemployed, the banking system was nearing collapse, and economic activity had dropped to roughly a third of its 1929 level. The FDR presidential library in Hyde Park, New York, describes a desperate nation: “Factories were shut down, farms and homes were lost to foreclosure, mills and mines were abandoned, and people went hungry.”

 

President Roosevelt responded to this emergency with his famous New Deal, a disparate, ambitious, constantly evolving collection of legislative initiatives and executive actions. FDR’s initial effort to stanch the bleeding included a national bank holiday, sweeping agricultural reform, large-scale industrial planning, and various relief and job creation programs.

 

Serious tax reform was absent from the early New Deal. The Agricultural Adjustment Act and the National Industrial Recovery Act both included significant tax provisions, but neither changed the basic structure of the federal revenue system.

 

Indeed, Roosevelt left many regressive taxes intact. Excise levies on alcohol, tobacco, and other consumer goods fell heavily on the poor, but Roosevelt and his Treasury experts believed they were impractical to eliminate, at least over the short term.

 

Many tax experts believed that excises could eventually be replaced by broader income taxes, which would raise the same amount of revenue in a much more progressive fashion. But politics made that substitution difficult. As a result, excises provided a large, if declining, share of federal revenue throughout the 1930s and beyond.

 

Still, Roosevelt began a gradual process of changing the politics of taxation. In 1935 tax reform rose to the top of the New Deal agenda, when Roosevelt urged Congress to raise taxes on the rich, slowing the concentration of wealth and economic power. In making the case, he unleashed moralistic rhetoric on fairness and fiscal citizenship that reshaped American taxation for decades to come.

 

1933

In late May of 1933, Wall Street titan J.P. Morgan admitted to the Senate Banking Committee that he had paid no income taxes during 1931 and 1932. The revelation shocked Americans — or at least the ones who had been paying income taxes.

 

“A cry of anguish ascended to high heavens when millions of white collar workers discovered that they had been nicked for a considerable percentage of their earnings for 1930 and 1931 when J.P. Morgan and partners had paid no income tax at all,” observed Business Week magazine.

 

Editorial writers were indignant.

 

“Rich men of the country should not be able to escape income taxes at the very moment when the rest of the country is burdened with increased taxes and when the Government is so desperately in need of revenue,” The Washington Daily News declared.

 

Roosevelt urged Congress to raise taxes on the rich, slowing the concentration of wealth and economic power. In making the case, he unleashed moralistic rhetoric on fairness and fiscal citizenship that reshaped American taxation for decades to come.

 

The New Republic agreed. “What has rankled most in the hearts of the vocal public is that when millions of persons with small incomes were straining every nerve to meet their income taxes, these princes of wealth, who personally enjoyed luxuries denied to almost everyone else, did not pay any income tax at all,” the magazine wrote.

 

The Banking Committee’s chief counsel, Ferdinand Pecora, made the most of Morgan’s revelation, pressing for details. But the explanation for Morgan’s failure to pay taxes was simple: He didn’t owe any.

 

The firm J.P. Morgan & Co. had suffered dramatic losses in the stock market’s Great Crash, its value plunging from $119 million in 1929 to $53 million in 1931. For the firm’s partners, those losses could be deducted against other forms of income. When all the math was done, none of the partners was left with any taxable income for the two years in question.

 

Morgan was unapologetic about the result. “I am not responsible for these figures,” he told Pecora and the committee. “I viewed them with great regret when they appeared.”

 

Morgan pointed out that during the boom years of the 1920s, he and his partners had paid millions to the federal government, including large taxes on their capital gains; between 1917 and 1929, Morgan and company had paid more than $57 million, he said.

 

Morgan’s failure to pay taxes, in other words, was the result of legal tax avoidance rather than illegal tax evasion. The banker and his partners had simply followed the rules as Congress had written them. At the end of the day, those rules freed them of any tax liability.

 

But if Morgan’s nonpayment was legal, it was still controversial. “The country, in 1933, was in no mood for nice distinctions between tax ‘evasion’ and tax ‘avoidance,’” Pecora later recalled in his memoirs. Indeed, the Morgan tax revelation helped kick-start a broader debate about federal tax reform.

 

“Unintentionally John Pierpont Morgan & Partners did the U.S. Government a good turn by paying no income tax in 1931 and 1932,” observed Time magazine. “Disclosure of their non-taxability before the Senate Banking & Currency Committee started not only a hot dither of excitement in the press but also a tax reform movement by a startled Congress.”

 

At the heart of this new tax reform movement was an argument over the moral status of tax avoidance. On one side were people (like Morgan) who insisted that legal tax avoidance was morally neutral; people had no responsibility to pay more than the law required — even when the law required no payment at all.

 

On the other side of the debate were people arguing that taxpayers had a moral responsibility to the nation and their fellow citizens — a responsibility that transcended narrow technicalities of the law. Taxpayers had a duty to pay, they contended, even when the law imposed no obligation.

 

Roosevelt, still on the sidelines of most tax debates in 1933, would soon emerge as the leading champion of this moralistic vision of tax reform.

 

1934

Congress offered its first legislative response to the Morgan revelations in the Revenue Act of 1934. “The primary purpose of the bill is to increase the revenue by preventing tax avoidance,” explained the House Ways and Means Committee in its report. The legislation was not especially ambitious; as the tax scholars Roy and Gladys Blakey noted at the time, it was “a very limited measure dealing almost entirely with the ‘plugging up of holes’ through which taxpayers had been escaping.”

 

But the “plugging up of holes” was popular in the wake of Morgan’s revelation. The Ways and Means Committee joined forces with the Joint Committee on Internal Revenue Taxation and the Treasury Department to develop a list of nefarious tax avoidance techniques.

 

Thanks to Morgan — and the political climate of the 1930s — loss deductions had come to seem nefarious. As a result, lawmakers used the 1934 revenue law to sharply limit their deductibility against other forms of income.

 

As enacted, the 1934 law made many technical changes designed to eliminate or at least narrow the “holes” that taxpayers were using to minimize their tax bills. Chief among them was the deduction for capital losses — the same deduction that Morgan and other investors had used to keep their taxes low during the early 1930s.

 

Many tax experts didn’t regard loss deductions as a form of tax avoidance, let alone a loophole. Loss deductions were widely viewed as a legitimate input in the calculation of economic income.

 

But thanks to Morgan — and the political climate of the 1930s — loss deductions had come to seem nefarious. As a result, lawmakers used the 1934 revenue law to sharply limit their deductibility against other forms of income.

 

Many tax experts found this move — as well as similar efforts to curb tax avoidance by limiting reasonable deductions — to be unfortunate. Or worse.

 

“The widespread sense of injustice flowing out of this treatment impairs cooperation between taxpayers and the government in the administration of the income tax,” complained Treasury expert George Haas in a departmental memo. “In the minds of many, the present treatment is so patently unjust as to be repugnant to all sense of fair play.”

 

Even the Blakeys, while generally sympathetic to the 1934 reforms, believed lawmakers had gotten ahead of themselves. “The atmosphere of the New Deal carried some provisions of doubtful wisdom further than they would have gone in less disturbed times,” they wrote.

 

1935

Wealth Tax Act

On June 19, 1935, Roosevelt sent a provocative message to Congress, making the case for dramatic tax reform. He decried the growth of large hereditary fortunes, the decline in progressive taxation, and the dangerous power of big business.

 

“Our revenue laws have operated in many ways to the unfair advantage of the few, and they have done little to prevent an unjust concentration of wealth and economic power,” he declared.

 

FDR’s tax message was the beginning of his sustained, controversial campaign to revamp the federal revenue system. The issue would help shape the rest of his presidency, embittering many of Roosevelt’s most passionate political foes and influencing tax policy not just during the latter half of the Great Depression, but also World War II. It began, however, with a bang in the Revenue Act of 1935.

 

Congress responded to Roosevelt’s message by enacting the Revenue Act of 1935, popularly known as the Wealth Tax Act. The law included several provisions that seemed, at least superficially, to answer the president’s concerns. For instance, lawmakers raised income tax rates for all individuals earning more than $50,000 annually. They also created a graduated rate structure for the corporate income tax, replacing the flat rate levy with a two-rate tax designed to favor small companies over large ones. Finally, the law also increased estate tax rates, with an eye toward curbing the growth of large family fortunes.

 

The tax increases were substantial, if narrowly targeted. Indeed, the narrow targeting was intentional. After all, FDR had asked Congress to curb the advantages of “the few,” and lawmakers responded with taxes on barely a handful of people.

 

Consider, for instance, the new top bracket for the individual income tax. In the Revenue Act of 1934, the top rate was set at 63 percent for all income exceeding $1 million. The Wealth Tax Act created a new top-bracket starting at $5 million and set the rate at 79 percent.

 

This new bracket was rarefied air by any measure. In 2022 a similar top bracket would start at $98.7 million, after adjusting for inflation — quite a bit more than the actual top bracket threshold for single filers, which starts at $539,900.

 

Judged in its historical context, the new top bracket was still exceedingly narrow. Indeed, it could hardly have been any narrower. According to official estimates at the time, exactly one taxpayer had reported income of more than $5 million in 1933 (the most recent year with available data at the time the bill was being debated).

 

“The number of individuals affected by the proposed surtax increases is not large,” the committee’s Democratic majority noted in its report, with considerable understatement.

The top bracket’s solitary denizen appears to have been John D. Rockefeller Jr.

 

Social Security

On August 14, 1935, Roosevelt signed the Social Security Act, establishing a system of old-age benefits for workers. The law also provided benefits for injured and unemployed workers, dependent mothers and children, and people with disabilities. Most members of the labor force were included in the new system, but many groups were excluded, at least initially, including self-employed professionals, farm laborers, domestic workers, and civil servants.

 

As originally designed, Social Security provided monthly stipends to workers age 65 and older, with benefits based on previous earnings. The program was financed with a flat rate payroll tax levied equally on both workers and employers. This financing mechanism outraged many liberals, including members of the Roosevelt administration, who complained that such a tax was regressive. Social insurance programs, they insisted, should be financed with progressive levies.

 

But Roosevelt himself was a great champion of the payroll tax, insisting that it would help protect the new program from its political enemies. “We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions,” Roosevelt said, according to a 1941 memorandum written by Luther Gulick, one of his advisers. “With those taxes in there, no damn politician can ever scrap my Social Security program. Those taxes aren't a matter of economics, they're straight politics.”

 

1936

As he approached his reelection campaign, Roosevelt turned his attention to a fundamental restructuring of corporate income taxation. On March 3 he sent Congress a special message suggesting that lawmakers replace the existing corporate income tax with an entirely new levy on undistributed corporate earnings.

 

The move was partly driven by necessity, the Supreme Court having just invalidated the Agricultural Adjustment Act’s processing tax. The decision eliminated roughly $500 million in annual revenue, even as lawmakers were committing the nation to roughly $120 million in new annual spending as part of a veterans bonus program.

 

FDR’s preferred solution to this revenue crunch was a new tax on the money stashed away in corporate treasuries. He and his allies believed that an undistributed profits tax (UPT) would serve three vital ends.

 

Everyone, Roosevelt believed, should be required to shoulder their 'fair share' of the tax burden. Legal devices that interfered with that sort of fiscal accountability — like retained earnings — were ripe for reform.

 

First, it could be made to raise added revenue for the cash-strapped treasury. If reasonably structured, Roosevelt insisted, it could certainly meet the government’s immediate need for $620 million in new annual revenue.

 

Second, the UPT would jump-start the nation’s economic recovery by forcing companies to disgorge their “idle” surpluses. When stashed away in corporate bank accounts, profits were essentially “sterile,” doing little to contribute to the nation’s prosperity. When distributed to shareholders, however, those same profits were likely to be spent. That spending would boost aggregate demand and rekindle the fires of prosperity.

 

Third, the UPT would prevent shareholders from using corporations as a tax shelter. By retaining profits within the corporation rather than distributing them to shareholders, companies could shield those earnings from the high rates of the individual income tax. Shareholders, in other words, could use the corporation as a sort of piggy bank — one that protected deposits from the tax man’s grasp, at least until they were withdrawn.

 

It was this last argument, rooted in notions of fairness and tax equity, that Roosevelt emphasized when presenting his new tax to Congress. And why not? Increasingly, Roosevelt was framing every tax issue in terms of fairness of the responsibilities of fiscal citizenship. Everyone, he believed, should be required to shoulder their “fair share” of the tax burden. Legal devices that interfered with that sort of fiscal accountability — like retained earnings — were ripe for reform.

 

Congress was receptive to FDR’s suggestion for the new tax. But lawmakers ultimately declined to replace the existing corporate income tax with their new levy. Instead, the UPT appeared as a supplement to the existing tax.

 

The UPT imposed a graduated tax on earnings, with rates rising from 7 percent to 27 percent depending on the percentage of total earnings retained by the corporation. It represented a significant increase in the total tax burden facing large corporations, even ones that tried to distribute a significant portion of their earnings.

 

Not surprisingly, the new tax was enormously unpopular among business leaders. They resented not simply its economic burden, but also its infringement on managerial prerogatives. The new tax would force corporate managers to be reckless, they complained. Companies would be prevented from holding adequate financial reserves and discouraged from making productive investments. The tax would also impede the growth of small businesses, these critics insisted, and slow the nation’s recovery from the Great Depression.

 

These complaints failed to sway lawmakers, who were eager to give Roosevelt the tax he wanted. But FDR’s victory was expensive, at least in political terms. Enactment of the UPT left its opponents angry and agitated. Indeed, no piece of New Deal tax legislation drew stronger, broader, and more durable opposition. As a result, the UPT was besieged from the moment of its passage, with foes mounting a powerful campaign to destroy it.

 

1937

Fresh off his victory in the 1936 election, Roosevelt doubled down in his campaign against tax avoidance. On June 1, 1937, he asked Congress for new legislation to shut down the “clever little schemes” that many wealthy taxpayers were using to shield their income from high tax rates. “When our legitimate revenues are attacked, the whole structure of our Government is attacked,” FDR declared.

 

In urging Congress to act, Roosevelt tried to blur the distinction between legal tax avoidance and illegal tax evasion. “Methods of escape or intended escape from tax liability are many,” he said. “Some are instances of avoidance which appear to have the color of legality; others are on the borderline of legality; others are plainly contrary even to the letter of the law.” But these legal distinctions had no moral weight.

 

“All are alike in that they represent a determined effort on the part of those who use them to dodge the payment of taxes which Congress based on ability to pay,” Roosevelt contended. “All are alike in that failure to pay results in shifting the tax load to the shoulders of others less able to pay, and in mulcting the Treasury of the Government’s just due.”

 

The president ended with a rousing call to arms. “In this immediate problem the decency of American morals is involved,” he declared. “The example of successful tax dodging by a minority of very rich individuals breeds efforts by other people to dodge other laws as well as tax laws.”

 

Roosevelt gave Congress a list of particularly egregious tax avoidance schemes. Treasury experts had identified both the schemes and the taxpayers using them in a memo to FDR. The president wanted to include the names in his message to Congress, but advisers warned him that this might be illegal.

 

Eventually, many of the names leaked to the press anyway.

 

Congress created a special Joint Committee on Tax Evasion and Avoidance, which conducted a series of high-profile hearings on tax avoidance. Administration allies called particular taxpayers before the panel and grilled them on the details of their avoidance efforts. Among the targets were several members of the du Pont family, the actor Charles Laughton, newspaper publisher Robert Scripps, top executives with U.S. Steel and General Motors, and violinist Fritz Kreisler.

 

During the debate, administration critics suggested that Roosevelt and some of his family members were themselves engaged in tax avoidance. But the White House denied the suggestion vigorously, and the charges gained no traction.

 

Eventually, Congress passed the Revenue Act of 1937, shutting down various avoidance techniques and narrowing the availability of others. In particular, the law limited the use of personal holding companies, multiple-family trusts, and the incorporation of country estates, racing stables, yachts, and other hobbies. But the law left other avoidance techniques — including several identified in the Treasury memo — more or less intact, including the tax exemption for state and local bonds.

 

1938

Congress had begun considering changes to the new tax on undistributed corporate profits almost immediately after its creation. Lawmakers established a special committee to recommend changes, and in 1938 opponents of the UPT were ready to drive a stake through its heart.

 

The Revenue Act of 1938 dramatically reduced the tax rates applied to retained earnings. Even more important, it extended the tax only through the end of 1939, putting the end in sight for UPT opponents.

 

Context was everything in this campaign to gut the UPT. Shortly after the tax was created, Roosevelt won a resounding victory in his reelection campaign. He followed up with his anti-loophole legislation in 1937 — another achievement, albeit less transformative.

 

But by late 1937, the United States was already mired in a resurgent economic slump, sometimes called the Roosevelt Recession. New Deal critics were quick to blame FDR’s spending and tax policies for the downturn, complaining especially that they undermined “business confidence.”

 

By 1938, the New Deal tax program was purely defensive. But Roosevelt’s opponents had the upper hand, and their two-year campaign to gut the UPT was about to bear fruit. The Revenue Act of 1938 dramatically reduced the tax rates applied to retained earnings. Even more important, it extended the tax only through the end of 1939, putting the end in sight for UPT opponents.

 

Roosevelt was outraged at the move to dismantle his fiscal innovation. He also objected to the proposed reduction in the tax on capital gains, arguing that it would be unfair and unnecessary.

 

Together, these two issues so rankled FDR that he sent lawmakers a letter as they began drafting the final bill. This sort of presidential intervention in the legislative process was unusual, but Roosevelt was not easily cowed by tradition or precedent.

 

“It is most important to hold fast to that which is good in the tax system. Equal taxation of incomes of similar size and equal taxation of corporations and individual taxpayers are axiomatic,” Roosevelt told the lawmakers.

 

By contrast, introducing new disparities would be a grave mistake. “The repeal of the undistributed profits tax and the reduction of the tax on capital gains to a fraction of the tax on other forms of income strike at the root of fundamental principles of taxation,” FDR declared.

 

Congress was unmoved. Lawmakers passed the legislation, including both the UPT changes and the capital gains tax revisions. Roosevelt could not bring himself to sign the final bill, but neither was he willing to veto it. Instead, he allowed it to become law without his signature — the first time any president had declined to sign a revenue bill since the income tax amendment to the Constitution was ratified in 1913.

Company Tax Notes
Category FREE CONTENT;ARTICLE / WHITEPAPER
Intended Audience CPA - small firm
CPA - medium firm
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Published Date 09/06/2022

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