Wartime Tax Legislation and the Politics of Policymaking
by Joseph J. Thorndike
Date: Oct. 25, 2001

Full Text Published by Tax AnalystsTM


=============== SUMMARY ===============

House Republicans have taken a lot of heat for their economic stimulus package. Critics have attacked it as a giveaway to big business, chastising the GOP for including various special interest tax breaks. It's not the first time that tax policymakers have been accused of less-than-statesmanlike behavior in the face of national crisis. While wars often spark a burst of bipartisan unity, peacetime political dynamics never fully disappear. The Revenue Act of 1943 provides a case in point.


=============== FULL TEXT ===============

House Republicans have taken a lot of heat for their economic stimulus package. Critics have attacked it as a giveaway to big business, chastising the GOP for including various special interest tax breaks. It's not the first time that tax policymakers have been accused of less-than-statesmanlike behavior in the face of national crisis. While wars often spark a burst of bipartisan unity, peacetime political dynamics never fully disappear. The Revenue Act of 1943 provides a case in point.

Fiscal Policy as an Economic Tool

Until the 1930s, fiscal policy was not a popular tool for managing the national economy. The intellectual movement sparked by British economist John Maynard Keynes gained a foothold only during the latter years of the Great Depression.

Franklin Roosevelt is often remembered -- incorrectly -- as one of the first great Keynesians. In fact, Roosevelt was slow to embrace the idea that tax and spending policies might be used to manage the nation's overall economic health. The great New Deal public works projects had Keynesian elements, but they were almost incidental. Roosevelt saw programs like the Works Project Administration and the Civilian Conservation Corps primarily as relief efforts, designed to put food on the table for unemployed Americans. Any boost they gave to the national economy was welcome but secondary.

New Deal tax policy was even less influenced by Keynesian ideas than was spending policy. While some key figures -- notably Federal Reserve Board Chairman Marriner Eccles, a leading and early proponent of Keynes and his ideas -- contemplated the notion of a counter- cyclical tax policy, most viewed the issue through the prism of spending decisions.

In the later years of the New Deal, however, a cadre of committed Keynesians gained influence in the Roosevelt administration. They urged the president to adopt a more activist fiscal policy, and Roosevelt flirted with the idea. In fact, though, the president was a reluctant convert, and it was not until the start of World War II that countercyclical fiscal policy got its first real test.

World War II and Inflation

Different crises demand different fiscal policies. During the worst years of the Great Depression, Keynesians called for stimulative fiscal policy. As the European war intensified, however, inflation became the central concern. Roosevelt engineered a gradual enhancement of American military preparedness. Propelled by that effort, as well as war-borne European demand, the United States began to recover from its long depression.

For at least two years before the Pearl Harbor attack, policymakers thought long and hard about war taxation. The spending side of the fiscal equation was taken as something of a given; military needs would drive spending dramatically upward. Tax policy, however, would play a dual role: raising money to pay for the war and siphoning off purchasing power to help slow inflation. Treasury Department officials forecast a rising number of consumer dollars chasing ever fewer nonmilitary goods. Steep taxes would help check the growth in purchasing power, thereby forestalling inflation.

The Treasury Department made this case repeatedly. As one memo from early 1942 noted in discussing the tax system, "Under an ideal financial and productive system in time of war, once provision for private consumption has been made by the introduction of a subsistence ration, these instruments ought to be employed to siphon all released purchasing power into the hands of the Government."

Surprisingly, Congress agreed. After American entry into the war, legislators cast aside their normal resistance to tax increases, instead passing a stiff boost in federal revenues. The initial flush of wartime patriotism removed political obstacles, and both lawmakers and average citizens accepted the increase with hardly a murmur. That acceptance was significant, if only because the Revenue Act of 1942 thrust new tax burdens on so many Americans. The bill is best known for its broad extension of the individual income tax, previously applied only to wealthy Americans. The 1942 law extended its reach well into the middle class, bringing millions of new taxpayers into the income tax system. Treasury officials and congressional taxwriters hoped that a broader income tax would raise substantial new revenue while also reducing available purchasing power.

Revenue Act of 1943

Almost immediately after passage of the 1942 bill, policymakers began debating the next round of tax increases. The war's cost continued to escalate, and most Washington leaders were committed to paying for as much as possible with current revenues. Similarly, inflation concerns continued to mount, with prices rising for a broad array of consumer goods.

In late 1943, Treasury Secretary Henry Morgenthau asked Congress for another tax increase. He framed his appeal, in large part, as an anti-inflation effort. The new act, he argued must help stop inflation. "[N]othing in the economic field can interfere with the war effort as much as an uncontrolled rise in prices," he told the House Ways and Means Committee. "An inflationary price rise is a source of grave social injustice. It undermines morale and impedes war production. It strikes at random without consideration of equity or ability to bear the hardships which it imposes. Once it has acquired momentum, inflation is extremely difficult to control, and leaves a heritage of post-war stresses and strains that will haunt us for decades."

This time, Congress turned a deaf ear. By late 1943, the traditional dynamics of tax policymaking had reasserted themselves, and legislators were in no mood to enact another painful tax hike. In his January 1943 State of the Union speech, Roosevelt had asked for $16 billion in new taxes, but subsequent negotiation with Congress reduced that number to $10.5 billion. That figure included $6.5 billion from the individual income tax, $400 million in estate and gift taxes, $1 billion in new corporate taxes, and $2.5 billion in excise tax increases. In an effort to simplify the tax system, the administration also asked for repeal of the Victory Tax, a flat-rate income levy imposed on top of the normal income tax. The tax applied to many Americans not otherwise subject to income taxation.

The administration's proposed estate tax changes would have boosted rates, pushing them to 80 percent on sums more than $1.5 million. It would also have lowered the estate tax exemption to $40,000. Supporters insisted that the levy made only a small contribution to total revenue, and that rates in lower and middle brackets were still moderate. Congressional taxwriters, however, would have none of it.

Indeed, the whole package of proposals met with a chilly reception. One observer reported that lawmakers fell on the plans "like Caesar's assassins." Increases in the income tax and estate tax took much of the heat, but so, too, did Roosevelt's plan to repeal the Victory Tax. Repeal would have removed nine million low-income taxpayers from the rolls, but congressional leaders found little to like in that prospect.

Various administration officials echoed Morgenthau's call for higher taxes. Fed Chair Eccles asked for even steeper taxes: $13.8 billion, including $4 billion in taxes that would be refundable after the war (essentially a plan for forced saving). House Ways and Means Committee Chair Robert "Muley" Doughton, D-N.C., dismissed the proposal out of hand. "Amazing, fantastic, and visionary. I don't like it at all. If possible, it is worse than the Treasury program."

Ways and Means went to work on its own bill, which the House passed on November 24. The legislation bore little resemblance to the Treasury plan. Committee members argued that the need for new taxes had been diminished by revenue already in the pipeline. Coupled with promised reductions in nonmilitary sending, they insisted, this revenue would be nearly adequate. As for inflation, the panel declared that it could be controlled through discretionary spending cuts, effective price controls, rationing, and wage controls. Higher taxes were unnecessary.

The Ways and Means Committee specifically opposed corporate tax increases. It was important, they said, that "our corporations be kept in sound financial condition so that they may be able to convert to peacetime production and provide employment for men leaving the armed forces after the war." Small investors and charities would suffer too, they declared. The committee minority largely agreed, adding that higher income taxes would threaten "the liquidation of the middle class."

New revenue in the Ways and Means bill came from several sources, including repeal of the earned income credit and a new minimum tax for the Victory Tax. Excises provided another $1.2 billion, with much of the revenue coming from a 50 percent liquor tax hike. The bill reduced the invested-capital credit for large corporations, but increased the exemption for the excess profits tax from $5,000 to $10,000. Rates for the excess profits tax, however, went from 90 to 95 percent. Postal rate hikes added a little more money, bringing the bill's total to about $2 billion -- less than one-fifth of the administration's proposal.

The House bill got a bad reception, both from the Roosevelt administration and the press. Editorials across the country denounced the bill as inadequate. Meanwhile, Morgenthau tried to draft a better bill with the Senate Finance Committee. Seeking to placate conservatives made uneasy by the administration's penchant for estate tax and upper-bracket income tax hikes, he defended his bill as sufficiently tough on low-income taxpayers; those earning less than $5,000, he pointed out, would pay more than half.

As it turned out, Senate Finance Committee members were hardly more supportive than their House counterparts. The committee's report endorsed the general approach of the House bill and opposed most additional increases. The panel tinkered with the Victory Tax, and put off a long-planned increase in the social security payroll tax. The final compromise bill closely resembled the Senate package, and Congress sent it to the President in February 1944.

Roosevelt's Veto

FDR vetoed the bill. It was, in fact, the first tax bill in American history to meet that fate. In explaining his decision, Roosevelt contended that the bill did little to provide revenue but granted numerous tax favors to business interests. "In this respect," he complained, "it is not a tax bill but a tax relief bill providing relief not for the needy but for the greedy."

FDR objected to the elimination of planned increases in the social security tax, a move that ensured a substantial cut in anticipated revenue. He also cited a variety of provisions offering "indefensible special privileges to favored groups." Those privileges set a bad precedent, even threatening the viability of the tax system; by degrading fairness, they undermined the political consensus so fundamental to tax policy.

Roosevelt singled out five provisions for special criticism:

1. Permission for corporations reorganized under bankruptcy
protection to retain a high excess profits credit and
depreciation basis attributable to the contribution of
stockholders. Since these stockholders were generally
eliminated in the reorganization process, he asserted, the
provisions redounded to the benefit of bondholders who had
often purchased their bonds at a steep discount.

2. Extension of percentage depletion allowances to
additional minerals, including vermiculite, potash, feldspar,
mica, talc, lepidolite, barite, and spodumens. Roosevelt
questioned the appropriateness of percentage depletion
allowances in general, but he also pointed out that the War
Production Board had refused to certify several of these
minerals as being in short supply for war needs.

3. Permission for lumber companies to treat income from the
cutting of lumber as a capital gain rather than ordinary
income. "As a grower and seller of timber, I think that timber
should be treated as a crop and therefore as income when it is
sold," Roosevelt said. "This would encourage reforestation."

4. Exemption of natural gas pipelines from the excess
profits tax. This provision, he warned, might be exploited by
the oil companies eager for similar exemptions applicable to
their pipelines.

5. Extension of a tax subsidy on airmail contracts for
commercial airlines.

Roosevelt noted that some of his advisers had suggested signing the revenue act, arguing that having asked for a loaf of bread, he should be content with a small piece of crust. "I might have done so if I had not noted that the small piece of crust contained so many extraneous and inedible materials."

Roosevelt went on to criticize Congress for enacting complex tax laws, indicting legislators for complexities surrounding the Victory Tax. "The Nation will readily understand that it is not the fault of the Treasury Department that the income taxpayers are flooded with forms to fill out which are so complex that even Certified Public Accountants cannot interpret them. No, it is squarely the fault of the Congress of the United States in using language in drafting the law which not even a dictionary or a thesaurus can make clear." Taxpayers need simplification, Roosevelt stressed. "These taxpayers, now engaged in an effort to win the greatest war this Nation has ever faced, are not in a mood to study higher mathematics."

Roosevelt's veto did little to dissuade legislators. Within a week, Congress overrode the president's veto. As enacted, the 1943 Revenue Act failed to satisfy the twin imperatives of World War II tax policy: revenue raising and inflation control. It succeeded, however, in allowing legislators to duck the responsibilities of wartime policymaking, and it even made room for a few special favors.

Conclusion

Current lawmakers have an easier task than their predecessors. Both World War II and, to a lesser extent, Vietnam required painful tax increases. Today's legislators get to cut taxes, a far more palatable task.

As legislators set about it, we should bear in mind that peacetime political dynamics don't simply evaporate during crises. They take a break, but only a short one. In the case of the current stimulus bill, the hiatus may have been brief indeed.