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September 8, 2011
News Analysis: Graduated Corporate Rates: Bad Idea in 1935, Bad Idea Today
Joseph J. Thorndike

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How did we ever end up with graduated corporate rates? After all, there aren't many people willing to defend them these days. Lawmakers, of course, implicitly endorse graduation whenever they choose not to repeal it, but you would have to search long and hard for an affirmative defense of the idea. Or a compelling one.

By contrast, plenty of critics have called for proportional taxation of corporate profits. Jeffrey L. Kwall made the case in a June contribution to the Shelf Project, and Martin Sullivan added his voice the following month.1

But repeal won't be easy. Graduated corporate rates have been on the books since 1935, when President Franklin D. Roosevelt sold the idea to a skeptical Congress. Lawmakers listened carefully to business leaders who tore the proposal to shreds, but then voted for it anyway.

And we've been stuck with it ever since.

Roosevelt Suggests

Indirectly, Supreme Court Justice Louis Brandeis was the father of graduated corporate rates. During the early decades of the 20th century, Brandeis made a reputation as the nation's most vigorous opponent of big business. He warned repeatedly of the dangers posed by corporate consolidation, and his list of possible remedies was long. Time and again, however, he urged lawmakers to use tax policy to curb bigness.

In particular, Brandeis endorsed two ideas to curb corporate consolidation: a tax on intercorporate dividends and a progressive rate schedule for the corporate income tax. As a sitting justice on the Supreme Court during FDR's presidency, Brandeis was limited in his ability to advance those ideas personally. But he had plenty of followers -- both inside and outside the Roosevelt administration -- who were eager to make his case.

One such acolyte was Herman Oliphant, general counsel at Treasury. In late 1934, Oliphant drafted a sweeping program for tax reform that featured both of Brandeis's anti-monopoly measures.

Both parts of the plan were necessary, as Oliphant explained to his boss, Treasury Secretary Henry Morgenthau Jr. A punitive tax on intercorporate dividends would slow the growth of holding companies -- long the bête noire of anti-monopoly crusaders -- by making them too expensive.

But such a tax needed a backstop. Faced with a dividend tax, corporations might simply choose to merge with one another. The resulting combinations would be larger than their constituent corporations, defeating the whole purpose of the new tax.

To thwart that impulse, Oliphant proposed a graduated rate structure for the corporate income tax. By taxing corporations according to the size of their income, mergers would be too expensive.

Eventually, Oliphant's two-part plan made its way into FDR's June 1935 message to Congress on tax reform. The president suggested, in particular, that Congress replace the existing flat rate tax on corporate income (then set at 13.75 percent) with graduated rates ranging from 10.75 to 16.75 percent.2

In defending the rate structure, Roosevelt offered an argument rooted in the benefit theory of tax equity. "The advantages and the protections conferred upon corporations by Government increase in value as the size of the corporation increases," he said.3 Some of these advantages were conferred by whichever state chartered a corporation, but others came from the federal government. Roosevelt argued:

    Great corporations are protected in a considerable measure from the taxing power and regulatory power of the States by virtue of the interstate character of their businesses. As the profit to such a corporation increases, so the value of its advantages and protection increases.4

Greater benefits justified greater burdens, Roosevelt concluded. "The smaller corporations should not carry burdens beyond their powers," he said. "The vast concentrations of capital should be ready to carry burdens commensurate with their powers and advantages."5

Business Objects

Not everyone agreed. Many critics insisted Roosevelt was simply trying to destroy large corporations. "It looks to some like an effort to drive business back to the horse-and-buggy stage by penalizing large units," wrote Raymond Clapper in The Washington Post.6

Clapper's metaphor proved popular. In testimony before Congress, Robert L. Lund of the National Association of Manufacturers struck a similar note. "It would tend to return us, industrially, past the horse-and-buggy stage to the monkey stage of economic evolution," he declared with typical disdain for understatement. "Progress in business will cease. Advancement will be impossible. Business will be at a standstill."7

Lund offered lawmakers a variety of cogent objections to the graduated rate proposal. In particular, he insisted that it took no account of taxpaying ability. Companies don't pay taxes; people do, he said. As a result, the ability-to-pay standard was useful only when applied to individuals. In fact, when New Dealers used it to justify graduated rates for corporations, it yielded perverse results. Many large corporations had stockholders with small incomes, while some small businesses were owned by people with very large incomes, he said. A graduated tax on corporate income would spare the latter and soak the former.

Administration officials tried to counter those arguments by insisting that ability to pay was still a useful guide to corporate taxation. Ability was defined differently for corporations than it was for individuals, they said. Big corporations enjoyed greater access to capital than their smaller competitors. They also tended to dominate their markets more effectively, and they enjoyed important economies of scale. Taken together, these advantages left big companies with a greater capacity to pay taxes than their smaller competitors.8

Whether these arguments actually persuaded lawmakers is unclear. But eventually, Congress approved a watered-down version of FDR's proposal, introducing graduated rates that ranged from 12.5 percent on income below $2,000 to 15 percent on income above $40,000. At the same time, lawmakers reduced the 100 percent deduction for dividends paid by one corporation to another, replacing it with a 90 percent reduction.9

The graduated rates took effect on January 1, 1936. They have remained on the books ever since. But that doesn't mean they should stay there any longer. As Kwall has observed, graduated rates have few active defenders (but many passive ones, including many members of Congress).

Periodically, tax officials and economists take a run at the rates. In 1985, Treasury officials said that "a system of graduated rates must be based on the ability to pay concept and that ability has no application to corporations."10

Indeed, it's hard to marshal a compelling case for retaining the rates. As Sullivan has pointed out, "graduated corporate tax rates have no economic justification except as a poorly targeted benefit for small businesses."11

Poor, but not free. Imposing today's top 35 percent rate on all corporate income would raise about $2.5 billion annually, which is reason enough to undo this New Deal innovation.

And it's about time.


1 For Kwall's article, see Tax Notes, June 27, 2011, p. 1395, Doc 2011-12306, or 2011 TNT 126-7. For Sullivan's analysis, see Tax Notes, July 18, 2011, p. 215, Doc 2011-15346, or 2011 TNT 137-2.

2 Franklin D. Roosevelt, message to Congress on tax revision, June 19, 1935, the American Presidency Project, available at

3 Id.

4 Id.

5 Id.

6 Quoted in "Press Comment on President's Tax Message," The New York Times, June 21, 1935, 3; Randolph E. Paul, Taxation in the United States (1954), 185.

7 "Proposed Taxation of Individual and Corporate Income, Inheritances and Gifts," in Committee on Ways and Means, House of Representatives (1935), 199.

8 Roy G. Blakey and Gladys Blakey, "The Revenue Act of 1935," American Economic Review 25, no. 4 (1935): 682.

9 Steven A. Bank, From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present (2010), 153.

10 Quoted in Kwall, supra, note 1.

11 Sullivan, supra note 1.