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October 1, 2009
Tax History: Risky Business: Using Taxes to Insure Against Loss
Joseph J. Thorndike

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Recently, Martin A. Sullivan railed against the risk inducements that pervade our tax system. Touching on everything from the bias toward debt over equity to the treatment of executive compensation, he made a compelling case for limiting provisions that encourage risk taking and risky behavior.

But if risk-inducing provisions are so bad, how did they make it into law in the first place? Cynics will point to the influence of big business and special interests, and such nefarious characters have certainly played a part in the story. But many, perhaps even most, of these provisions began as well-intentioned ventures in creative public finance. If we want to understand the popularity of risk inducements in the tax system, we need to consider how risk and taxation were linked in the first place.

It's a long story, and a broad one, embracing the entire history of the income tax, from the early 20th century to today. At various points, this linkage has been shaped by economic crisis and dislocation. The effect of these periodic crises, moreover, has been varied. At some times, like the early 1930s, economic crises have prompted lawmakers to reconsider tax preferences that encouraged risk. At other times -- and perhaps more often -- economic worries have encouraged lawmakers to establish new preferences for risk.

This article explores a crisis of the latter type: the aftermath of World War I. As Americans emerged from their brief but costly venture in overseas warmaking, they pondered a frightening transition back to peacetime economics. Political leaders and policy entrepreneurs had plenty of ideas about how the country might navigate this tricky crossing, including more than a few tax reforms. But one such reform, offered by a prominent tax economist, deserves a special look: the creation of a new government insurance program designed to guarantee business against loss.

The Perils of Peace

Wars tend to come with a hangover. The boom occasioned by military production almost always proves hard to digest or divest when peace returns. Demand for industrial goods falls precipitously as government spending contracts. Meanwhile, labor supplies tend to rise as returning soldiers flood the job market. And to make matters worse (or perhaps better, although it depends on your perspective and how things play out), pent-up consumer demand threatens a new bout of inflation, often adding to inflationary spirals that tend to develop during wartime itself.

Such was the puzzle facing U.S. policymakers after World War I. (It was, in fact, even more complicated, because the United States was trying to negotiate the economic transition at home while still attending to the fragile health of war-ravaged economies in Europe.) In the short run, things proved better than expected, as consumer demand surged and the nation dodged a recession in the immediate aftermath of the war. But prices surged too, prompting a skeptical Federal Reserve to complain about "an unprecedented orgy of extravagance, a mania for speculation, over-extended business in nearly all lines and in every section of the country, and general demoralization of the agencies of production and distribution." Central bankers reacted as central bankers do, slashing the money supply and precipitating exactly the sort of recession in 1920 that they had feared the year before.

Meanwhile, dislocation in the labor market prompted a wave of strikes. Workers in cities across the nation walked off the job in 1919, seeking higher wages and better working conditions. More than 4 million workers -- by some accounts, at least one of every five in the nation -- joined a strike that year. In February the nation watched as Seattle workers organized a general strike, paralyzing the city for days. In September, Boston police officers walked off the job, unleashing a wave of looting and violence. And every week in between, countless smaller strikes disrupted business and created fear in the hearts of ardent capitalists everywhere.

Radical organizations, while not leading most of these strikes, discerned a rare opportunity. A violent minority stepped up their crusade against capitalism generally and American elites specifically, unleashing a bomb campaign targeting prominent government officials. Political and business leaders responded with authority. While many strikers saw real and immediate benefits from their activism, the labor movement increasingly struggled against a backlash of anti-Communist hysteria.

Postwar Tax Reform

Amid this social and economic dislocation, policymakers debated a variety of measures to encourage prosperity, or at least forestall depression. Tax reform was especially popular, as politicians in both parties rushed to reduce heavy wartime levies. But lawmakers could not easily agree on which taxes to cut. Some hoped to reduce the burden on poor and middle-income Americans by slashing consumption taxes, including the wide array of excise taxes imposed during the war. But other political leaders targeted business and individual income taxes, insisting that both were impeding recovery and slowing the transition to a healthy peacetime economy.

The debate over business taxes was not strictly partisan. Many Democrats joined the Republican rush, for instance, to repeal the excess profit tax -- a wartime innovation that raised enormous revenue but embittered business leaders. Originally levied on both corporations and individuals, it was designed as a bulwark against war profiteering. Liberals hoped, however, that it would become much more. Specifically, they sought to retain the tax after the war as a tool for regulating business and promoting social equity.

Business leaders inveighed against the excess profit tax, insisting that it was arbitrary, complex, and unfair. And most economists agreed. Even some who had helped create the levy during the war -- giants of the field like Yale Prof. Thomas S. Adams -- abandoned the tax in the face of its all-too-apparent shortcomings. Business leaders, Adams declared, had ample reason to resent the levy's "intricacy and capricious inequalities."

Nonetheless, a few brave economists ventured to support the tax. One was David Friday, an expert in farm economics as well as tax policy. Friday insisted that the tax was both fair and efficient. "The excess profits tax or some other form of tax on differential profits should be continued not merely because it is just and furnishes a much needed correction to the workings of our price system," he wrote. "It is the tax that least impedes enterprise and business activity."

Another Innovation

Friday had plans for the excess profit tax, and he explained them in an article published early in 1919, "Maintaining Productive Output: A Problem in Reconstruction." The challenge facing the nation, he said, was twofold. First and most immediately, resources devoted to warmaking had to be rechanneled toward peacetime production. Second, the nation also needed to create a new industrial order, "utilizing this period of change to bring industrial process into closer conformity with our ideal industrial program by conserving what we have learned through our war experience."

What Friday had in mind, at least on the second count, was finding some way to maintain high industrial output even as government spending declined. The war had demonstrated that the nation harbored enormous productive capacity that might well evaporate absent careful regulation. To be sure, the wartime increase in national product had been funded by the state. But the actual cost of fighting the war was much smaller than the increase in national product that it sparked. Government, Friday believed, must find some way to keep the spigot open. "The essence of the process," he explained, "would be that we would waste two billion dollars of our productive capacity in order to keep ten to fourteen billion dollars' worth of resources from running to waste because of unemployment."

But how to spend the money? Friday had a plan, and it hinged on the notion of business confidence. He believed prosperity depended on the willingness of business to invest in productive capacity. "It has become trite to say that many things will be different after the war," he wrote, "but it is certain that the industrial situation will still remain such that men who have jobs will have them because they are employed on the initiative of some entrepreneur, and plant and machinery will be kept running because some entrepreneur so decides."

Prosperity, in other words, was a function of business psychology. Attending to the delicate psyches of business leaders was no easy task, especially because many reflexively opposed any form of government intervention in the economy. How could government encourage business investment -- business risk taking, if you will -- without impinging on the jealously guarded prerogatives of private enterprise? More specifically, how could business leaders be induced to keep factories running and workers employed? The latter was vital, Friday insisted, because employed workers were the linchpin of America's new consumer-driven economy.

The U.S. economy, Friday suggested, harbored a latent tendency toward the underuse of resources. "It seems that somewhere in the present industrial process there is a factor of retardation which is only occasionally cast out by such a holocaust as war," he wrote. The problem lay in the nature of business profits. Small profits, or even ordinary ones, were often insufficient to tempt business leaders into investment. Small profits were sometimes adequate to encourage production, Friday acknowledged, but just as frequently, they left investors timid. If the profits available to business were small, then presumably costs were fairly high (or at least close to the price of finished goods). If costs rose -- or prices declined -- then profits might evaporate entirely, and the business would face a loss. And that, Friday believed, was the root of underproduction: the fear of loss.

The task facing policymakers, in Friday's view, was to minimize or eliminate the risk of loss. Insurance was the obvious answer. If businesses could pool their risk of loss -- much as homeowners and builders pooled their risk of fire -- then investment would flow more readily. Entrepreneurs required some sort of guarantee that their costs would be met regardless of available or likely profits, Friday said. Relieved of their anxiety about the prospect of rising costs or falling prices, business leaders would keep production running at a high level.

Only government could provide cost insurance of this sort, Friday explained, for only government could "exercise the taxing power necessary to take from the more fortunate industries those fortuitous profits which are the obverse of the losses incident to the modern industrial process." Friday was not specific about the tax instrument that would accomplish this goal most effectively, suggesting only that the system be "adjusted in such a manner as to take from certain enterprises the amount needed to cover the insured losses arising from the risks of modern business." But presumably, the excess profit tax would do just that. And because Friday was inclined to support that tax for a variety of reasons, it seems likely that he considered it the best tool for financing his program of loss insurance.

Business loss insurance had many virtues, according to Friday. It would not challenge the private ownership of the means of production, as advocated by the ideologically suspect socialists and their radical colleagues on the left. Nor would it reduce efficiency incentives or promote unwise investment. "There would still be the same incentive to exercise care in the direction of production," he contended, "and to attain proficiency in its prosecution, for without these no adequate rate of profit could be realized."

These claims seem dubious in retrospect, but they made more sense when evaluated in the context of their time. Socialism was not an abstract threat in 1919. Bolsheviks were a long way from sparking a left-wing revolution in the United States, but more incremental forms of socialism -- especially in key industries like transportation -- were plausible. If Friday's claims about the conservative nature of his plan seem overstated, they were more reasonable in a political environment where real challenges to the profit motive were finding support (at least among workers).

Friday's plan to insure business against risk was novel -- perhaps too novel for his fellow economists, let alone policymakers. The proposal went nowhere. But the history of the idea is still significant, if only for the light it sheds on policy innovation in the tax community. In 1919 the income tax was still young and fresh, relatively unencumbered by the complexity that later engulfed it (although people were already complaining about complexity). As such, the tax -- and its cousin, the excess profit tax -- was ripe for adornment and repurposing. Policy entrepreneurs spilled a lot of ink in the 1920s dreaming up ways to use fiscal instruments for a variety of economic and social purposes. Economists and policymakers may have disdained Friday's proposal for encouraging risk, but they soon found other, if more indirect, routes to the same end. Their chosen tools would be less innovative than Friday's, but they were broadly similar in motivation: They sought to encourage risk.

Today, risk-inducing tax provisions are getting some well-deserved scrutiny. In the context of our times, that skepticism seems fully appropriate. But historically speaking, reforms designed to discourage risk are only one of several possible responses to an economic crisis. At other watershed moments, like the end of World War I, policymakers sought not to limit risk, but to encourage it. Their policy innovations, ironically, may well deserve part of the blame for subsequent bubbles. In tax, like everything else, what goes around comes around.

Relevant Documents

    Clay J. Anderson and Federal Reserve Bank of Philadelphia, A Half Century of Federal Reserve Policymaking, 1914-1964 (1965).

    David Friday, "Maintaining Productive Output: A Problem in Reconstruction," 27 The Journal of Political Economy (1919).

    David Friday, et al., "The Excess Profits Tax -- Discussion," 10 American Economic Review (1920).