Taxation

Taxation in the United States changed dramatically from 1929 to 1945. In 1929, the total of local, state, and federal taxes amounted to roughly $10 billion (about one-tenth of the gross national product); by 1945, total taxes had risen to approximately $50 billion (about one-fourth of GNP). While state and local taxes rose by roughly 50 percent in that period, federal internal revenue collections soared from just under $3 billion to nearly $44 billion. The federal individual income tax also came to include far more people than ever before: in 1929, some 2.5 million individuals filed taxable federal returns; in 1945, nearly 43 million did so.

The most significant changes in taxation thus came at the federal level, because of the New Deal, the economic mobilization for World War II, and the great expansion of the federal government during the administration of President Franklin D. Roosevelt. Although the New Deal brought some reform to the federal tax system, the war years had a far larger impact on taxation: from 1939 to 1945, the number of people paying income taxes increased from some 4 million in 1939 to almost 43 million; individual income tax payments became a more important source of federal revenue than corporate income taxes; and the withholding tax system was adopted. The changes in the federal income tax enabled FISCAL POLICY based on KEYNESIANISM to be implemented more easily during and after World War II.

At the outset of the Hoover presidency in 1929, state and local taxes exceeded federal taxes by about a two-to-one ratio, and local property taxes accounted for approximately half of the total tax incomes of government at all levels. During World War I, the administration of President Woodrow Wilson had extended the income tax (authorized by the Sixteenth Amendment to the Constitution in 1913) rather than sales taxes to help pay for the war. It had also made individual and corporate income taxes more progressive (that is, more graduated, with higher tax rates for higher incomes). During the 1920s, the Republican administrations scaled back individual and corporate income taxes. Local governments continued to rely chiefly on property taxes in the decade, while state governments expanded sales taxes much more than income taxes to help pay for their increasing costs of constructing roads and schools.

As the Great Depression developed, federal individual and corporate income taxes fell sharply in the early 1930s because of plummeting business and personal income. With the great majority of federal tax revenues coming from income taxes (about 80 percent in the first years of the Hoover presidency), the federal deficit approached $3 billion in 1932—more than half of the government’s expenditures. President Herbert C. Hoover, sharing the orthodox belief that balanced budgets were essential to economic health, asked Congress for increased taxes. Congress, led by Republican representative Fiorello La Guardia of New York, defeated Hoover’s request for a national sales tax, but it did make the Revenue Act of 1932 the largest peacetime tax increase in American history to that point. Excise taxes (levies on the production, sale, or consumption of commodities and services) were increased significantly, and by 1933 they accounted for half of federal tax income.

When Franklin D. Roosevelt became president in 1933, the budget situation remained as worrisome as it had been in 1932. He and many of his advisers (including Henry Morgenthau, Jr., treasury secretary from 1934 to 1945) also believed in the balanced budget, although they were willing to incur budget deficits if necessary to provide help for impoverished and unemployed Americans. Raising revenues thus became a priority, especially as New Deal programs increased the costs of government. One reason for supporting the end of Prohibition was to levy excise taxes on alcohol. A key part of the Agricultural Adjustment Act of 1933 was the processing tax paid by processors of farm goods (millers, canners, and so forth) to help support agricultural subsidies. The National Industrial Recovery Act of 1933 included an excess profits tax and a small tax on capital stock. In 1935, the Social Security Act imposed payroll taxes on employers and employees to pay for benefits.

But the major New Deal tax efforts involved the income tax. Roosevelt, Morgenthau and his Treasury staff, and others in the administration wanted to reform the income tax system, not only to increase revenues to pay for government programs but also to make taxes more progressive and to make use of money held by wealthy individuals and corporations. In the early years of the New Deal, regressive excise taxes increased by the 1932 legislation contributed more to federal revenues than did individual and corporate income taxes combined. The Revenue Act of 1934 raised taxes on higher incomes and on gift and estate taxes, but this only marked the beginning of New Deal attempts to restructure the tax system.

The first major effort to reform the income tax structure came with the Revenue Act of 1935, which became known as the “Wealth Tax” because it sought to levy much higher taxes on high incomes and corporate profits. It was the result not only of administration analysis of the tax system, but also of the political atmosphere of 1935, in particular the success of Senator Huey P. Long in capturing a large national following with his Share Our Wealth program of heavy taxes on the wealthy to be redistributed to the general public.

In June 1935, Roosevelt sent a revenue bill to Congress asking for increased taxes on high personal incomes, for graduated corporate income taxes, and for new taxes on excess corporate profits, intercorporate dividends, and inheritances, as well as for a constitutional amendment to allow the federal government to tax interest earned on state and municipal bonds. Business and the wealthy bitterly opposed the proposal, and conservatives in Congress diluted it. Roosevelt, who often seemed more interested in gaining political credit for proposing the bill than in fighting for it, settled for some increase in personal and corporate taxes, for a scaled-down intercorporate dividend tax, and for a new estate tax. Hardly a wealth tax at all in its final form, the Revenue Act of 1935 did little to redistribute income or even raise revenues. Still, it began the efforts for significant tax reform.

In 1936, Roosevelt and Morgenthau proposed another tax reform bill, this one involving a graduated tax on undistributed corporate profits. The undistributed profits tax would replace other corporate taxes and thus eliminate what seemed “double taxation,” whereby corporations paid taxes on profits and then individuals paid taxes on dividends received from corporate profits. It would close an important loophole—by preventing dividend distributions, wealthy corporate directors were able to avoid taxes on higher incomes. And the tax would increase revenues—a necessity after the Supreme Court had invalidated the

Agricultural Adjustment Act and its processing tax and after Congress had authorized prepaying bonuses to World War I veterans.

As the administration saw it, the bill also had two other virtues: it might reduce the concentration of economic power by forcing big business to seek money for expansion in the money market instead of relying on its pools of undistributed profits, and it might stimulate the economy by forcing idle money out of corporate coffers and into the hands of smaller stockholders who would spend it or invest it. Following another battle with Congress, the Revenue Act of 1936 ultimately implemented a smaller undistributed profits tax than Roosevelt had requested, though it retained the corporate income tax. It constituted a significant reform and further embittered business against the administration.

The Revenue Act of 1937 then closed a number of additional loopholes (involving, for example, personal holding companies, artificial losses on property sales, and nonresident taxpayers), again with the aim of making the tax system more productive as well as fairer. Roosevelt and Morgenthau wanted still further reforms in 1938, including an increase in the undistributed profits tax and the imposition of a graduated tax on capital gains. But by 1938, Congress was in the hands of the conservative coalition, and the recession of 1937-1938 (the so-called Roosevelt Recession) had emboldened conservative and business critics of the New Deal. The Revenue Act of 1938 eliminated the graduated corporate income tax and reduced the undistributed profits tax, and the Revenue Act of 1939 then eliminated the undistributed profits tax.

The Revenue Acts of 1935 to 1937 constituted the high water mark of New Deal tax reform. The legislation did make federal taxes somewhat more progressive, imposed new taxes on business, and at least partly closed a number of loopholes. But the tax measures did not bring about any real redistribution of income, wealth, or economic power, and were weakened significantly in the late 1930s. Moreover, the increasing reliance of state governments on sales taxes (which more than doubled in the 1930s) and the imposition of the new Social Security payroll tax outweighed any small increase in the progressivity of the federal income taxes.

But although tax reform was essentially dead by the late 1930s, major revision of the tax system did come during World War II because of the need to raise money to meet the enormous costs of mobilizing for war. The federal government spent some $300 billion during the war, which it financed by a combination of increased revenues and massive borrowing. Wartime mobilization created a full-production, full-employment economy with rising personal and corporate incomes and thus more money to be taxed. And in addition to producing revenue to help pay for the war, taxes helped to siphon money from consumers and thus combat inflation. During the war, the tax system underwent significant change, particularly in greatly expanding the reach of the federal income taxes. Tax measures early in the 1940s began the process by lowering the threshold for paying federal income taxes.

The major tax legislation of the war years, and one of the most important in American history, was the Revenue Act of 1942. It taxed all incomes over $624, vastly enlarging the number of Americans paying income taxes; and it led to the adoption in 1943 of the withholding system of payroll deductions to simplify the collection of taxes from so many more people. The number of taxable incomes soared from 7.4 million in 1940 to 40.2 million by 1943. And by 1944, for the first time, individual income taxes exceeded corporate income taxes. The expanded tax base and the withholding provision also made it much easier for the government to increase or decrease revenues and implement Keynesian fiscal policy during and after the war.

Wanting to increase revenues further, Roosevelt in 1943 sent the Congress legislation that would have produced $10.5 billion more in taxes. Congress, controlled more firmly than before by the conservative coalition after the election of 1942, provided for an increase of only some $2 billion, and rather than hiking taxes on the wealthy and on business profits gave generous tax benefits to business. Angrily calling it “not a tax bill but a relief bill providing not for the needy but for the greedy,” Roosevelt vetoed the bill in February 1944—and, for the first time in history, Congress passed a tax bill over the president’s veto.

By the end of World War II, the American tax system, and especially the federal income tax, was far different from what it had been a decade and a half earlier. Federal taxes, about half the size of state and local taxes in 1929, were more than four times their size by 1945. Individual and corporate income taxes, which contributed less than half of federal tax revenues in 1933, produced about 80 percent in 1945. Individual income taxes, with their enormously expanded base, exceeded corporate income taxes. The new withholding system allowed for the easy and routine collection of taxes. The modern American tax system—mass-based more than class-based—had been created, with the demands and politics of World War II playing a more important role than the reforms of the New Deal.

Further reading: John Morton Blum, From the Mor-genthau Diaries, 3 vols. (Boston: Houghton Mifflin, 1959, 1965, 1967); W. Elliot Brownlee, Federal Taxation in America: A Short History (New York: Cambridge University

Press, 1996);-, Funding the Modern American State,

1941-1995 (New York: Cambridge University Press, 1996); Mark Leff, The Limits of Symbolic Reform: The New Deal and Taxation, 1933-1939 (New York: Cambridge University Press, 1984); Herbert Stein, The Fiscal Revolution in America (Chicago: University of Chicago Press, 1969); John Witte, The Politics and Development of the Federal Income Tax (Madison: University of Wisconsin Press, 1985).