What comes after a watershed?
It's often been remarked -- by me and others -- that World War II marked a turning point in the history of federal taxation. Over scarcely half a decade, lawmakers transformed the federal levy on personal income from a class tax to a mass tax. When millions of middle-income Americans discovered the agony of completing a Form 1040, tax day became the occasion for a new civic ritual.
But what happened after the watershed? In particular, why did the wartime tax system survive almost intact through the 1950s? After all, these were years of rising conservative influence, with intermittent GOP majorities on Capitol Hill and a two-term Republican president. What prompted Republicans to embrace the modern income tax -- replete with top rates over 90 percent -- as their own?
This article is the first in a series exploring the history of federal taxation during the late 1940s and 1950s. This week I explore President Truman's clarion call for tax reform in 1950. In the next installment, I will describe the political reaction to that call, as well as the changes wrought by the outbreak of the Korean War. Later articles will extend the story through the Eisenhower years to the beginning of the Kennedy administration.
As World War II drew to a close, everyone wanted a tax cut. And everyone got one. Just weeks after V-J Day, Congress approved a reduction of $6 billion, or roughly 13 percent of total revenue. The measure, which enjoyed solid support from the White House, eliminated the corporate excess profits tax and rolled back regular income taxes on both corporations and individuals.1
But the 1945 law represented only a down payment on tax reduction, at least from the perspective of most Republicans and many Democrats. The law left tax burdens far higher than they were before the war, and a broad consensus supported the notion of further reductions.2
That consensus, however, did not include a pivotal figure: Truman. While supporting the notion of eventual tax cuts, he dug in his heels against any immediate reduction in revenue. Republican majorities in both the House and Senate had other ideas, and after a long struggle -- including three presidential vetoes -- they got their way. The Revenue Act of 1948 provided a tax cut of $6.5 billion, including something for pretty much everyone. "It was deliberately contrived to attract the votes, because we wanted to reduce taxes," Sen. Eugene Millikin said.3
If tax cuts were good politics, then Republicans must have been stumped by the electoral result of their largesse: Voters returned Democratic majorities to both houses in the election of 1948. But even these presumably sympathetic lawmakers were unwilling to roll back the cuts of the previous year, and they ignored Truman's request in early 1949 for a $4 billion tax increase. A sagging economy only served to reaffirm their natural inclination.
Still, fiscal pain was in the offing. The role of government in society changed dramatically over the course of the war, and there was no going back, at least not as long as a Democrat occupied the White House. Moreover, the nascent Cold War robbed the nation of some of its anticipated peace dividend. "The 1950 budget was a dark vista," recalled Randolph Paul, a leading tax expert of the era. "The country had learned in recent years the high cost of modern war; it was now learning about the high cost of unstable peace."4 Tax increases were in the air.
Truman Pushes Higher Taxes
Truman returned to Congress in January 1950 and asked for a $1 billion tax hike. Mixing traditional notions of old-school fiscal conservatism with a dash of Keynesian demand management, he called for a budget surplus. "In a period of high prosperity, it is not sound public policy for the government to operate at a deficit," he warned. "A government surplus at this time is vitally important to provide a margin for contingencies, to permit reduction of the public debt, to provide an adequate base for the future financing of our present commitments, and to reduce inflationary pressures."5
The nation was facing a deficit, Truman pointed out, and he laid the blame for the shortfall at the feet of GOP lawmakers and their "shortsighted tax reduction" of 1948.6 Spending cuts, while part of the solution, could not be expected to close the gap completely. "Drastic reductions in federal expenditures in the wrong places and at the wrong time could have serious disruptive effects throughout our economy," he warned. "It will require wisdom and courage to find and hold fast to the course of wise economy without straying into the field of foolish budget slashes."
Indeed, unwise spending cuts might produce the sort of business downturn that everyone feared. Any short-term rush to balance the budget could strangle the recovery in its cradle -- and imperil long-term fiscal health. "We should always keep in mind that the maintenance of a sound fiscal position on the part of the government is a long-range matter," Truman said. "Nothing could be more foolhardy than to attempt to bring about a balanced budget in 1951 by measures that would make it impossible to maintain a balanced budget in the following years."
The Tax Program
Truman began his request by outlining his goals. "In making changes in the tax laws, we should be sure they move toward, and not away from, the major principles of a good tax system," he said. "Our tax structure should recognize differences in ability to pay; it should provide incentives to new undertakings and the expansion of existing businesses; it should support the objective of increasing opportunities for all our citizens to obtain a better standard of living; and it should rigidly exclude unfairness or favoritism."
In pursuit of those ideals, Truman offered a mixture of rate increases, base broadening, and targeted tax reduction. He urged lawmakers, for instance, to raise taxes on the profits of large corporations, while reducing them for some small and medium-size businesses. He asked for heavier estate and gift taxes, which he considered unreasonably light. Perhaps most striking, he urged a rollback in various tax preferences and legal "quirks" that cost the government substantial revenue. "We should eliminate tax loopholes which enable some few to escape their share of the cost of government at the expense of the rest of the American people," he said.
In exchange for all this pain, Truman offered a sweetener: cuts in consumer excise taxes. These levies had long been out of favor with fiscal experts, who considered them (at best) a necessary but regressive evil. They were even more unpopular with taxpayers, who resented being nickel-and-dimed by their elected representatives. Indeed, excises were often called "nuisance taxes" by their detractors -- a designation that spoke volumes about their political standing.
In the realm of corporate income taxes, Truman asked for "a moderate increase" in the rates on income over $50,000. At the same time, he asked for a reduction in rates paid by medium-size corporations whose growth, Truman said, was "essential to the dynamic expansion of our economy." Less than one-tenth of corporations would actually see their rates rise, Truman said.
To encourage investment, Truman proposed that carryforward provisions be extended from two to five years to allow companies more flexibility in offsetting the losses of bad years against the profits of better ones. "This extension will give increased incentive to business investment affected by uncertain profit expectations," he said.
On the subject of estate and gift taxes, Truman had no sugar to couple with his bitter medicine. In general, these levies were carrying too little of the fiscal burden. "They now produce less than 2 percent of internal revenues compared with 7 percent 10 years ago," he said. Those flagging revenues were shifting more of the overall tax burden to less equitable levies.
Truman asked for lower exemptions, higher rates, and a crackdown on the use of life estates to transfer wealth tax free between generations. "These changes will not only bring in more revenue, but they will also improve the fairness of the estate and gift tax laws and bring these taxes nearer to their proper long-term place in our tax system," he said.
Truman's favorite source of new revenue -- judging, at least, by the passion of his rhetoric -- was a crackdown on loopholes. Too many Americans were skipping out on their social responsibility by using tax preferences to reduce their tax liabilities, he said. "The continued escape of privileged groups from taxation violates the fundamental democratic principle of fair treatment for all and undermines public confidence in the tax system," Truman said. "While few of these loopholes by themselves involve major revenue losses, collectively they result in the loss of many hundreds of millions of dollars every year."
Truman's definition of a loophole included a variety of preferences that were not exactly inadvertent. His central proposal was a rollback in depletion allowances, which had been a fixture of federal taxation for decades. "I know of no loophole in the tax laws so inequitable as the excessive depletion exemptions now enjoyed by oil and mining interests," he said.
Originally created to encourage oil production during World War I, depletion provisions were extended over and over, "allowing individuals to build up vast fortunes, with little more than token contributions to tax revenues," Truman said. He acknowledged that the nation still had an interest in fostering oil production. "But the tax bounties distributed under present law bear only a haphazard relationship to our real need for proper incentives to encourage the exploration, development and conservation of our mineral resources," he said. "A forward-looking resources program does not require that we give hundreds of millions of dollars annually in tax exemptions to a favored few at the expense of the many."
Truman also asked lawmakers to restrict the ability of nonprofit organizations to engage in business enterprise unrelated to their exempt purpose. And he pressed for elimination of "a quirk in the present law" that had allowed life insurance companies to escape income taxes entirely since 1946. "This anomalous situation has meant that neither the companies nor their policyholders have paid taxes on more than $1.5 billion of investment income per year, derived from productive assets worth about 60 billion dollars," he said. Finally, Truman asked Congress to curb tax avoidance techniques that took "unfair advantage of the difference between the tax rates on ordinary income and the lower tax rates on capital gains."
Pay as You Cut
Truman argued that new revenue derived from base broadening, along with money raised by higher corporate and estate tax rates, could be used to finance a rollback in excise taxation. "Excise taxes are still at substantially their wartime levels," he pointed out. "Some are depressing certain lines of business. Some burden consumption and fall with particular weight on low-income groups. Still others add to the cost of living by increasing business costs."
Rolling back these levies would remediate some of the inequity associated with regressive taxes on consumption, while also encouraging growth in affected industries. But even so, Truman was unwilling to countenance an excise reduction unless Congress paid for the reform. "I wish to make it very clear that I could not approve excise tax reductions unless they were accompanied by provisions for replacement of the revenue lost," he said. "Under present conditions, we cannot afford to reduce excise taxes first, in the hope that action will be taken later to make up for the loss in revenue."
The task facing Congress was clear: Raise taxes on those most able to pay and lower them for everyone else. In this context, closing loopholes was a crucial reform. While some of the most egregious tax preferences had existed for decades, their injustice had been aggravated by a general rise in tax rates. "A tax concession to a favored few is always unfair, but it becomes a gross injustice against the rest of the population when tax rates are high," Truman said. "The case for the elimination of these inequities would be strong even if there were no need for replacement revenue. It is compelling when excise relief depends on it."
In two weeks: congressional reaction and the outbreak of the Korean War.
1 For a useful summary and analysis of the act, see Carl Shoup, "The Revenue Act of 1945," Political Science Quarterly 60, no. 4 (1945).
2 John F. Witte, The Politics and Development of the Federal Income Tax 131 (1985).
4 Randolph E. Paul, Taxation in the United States 525 (1954).
5 Harry S. Truman, "Annual Budget Message to the Congress: Fiscal Year 1950," Jan. 10, 1949, available from John T. Woolley and Gerhard Peters, the American Presidency Project, Santa Barbara, CA, available at http://www.presidency.ucsb.edu/ws/?pid=13434. All subsequent Truman quotations are from this speech unless otherwise indicated.
6 Paul, Taxation in the United States, supra note 4, at 538.
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