America's Fiscal Constitution (35 page)

The unwillingness of Americans to mortgage the nation’s future tax revenues for the purpose of stimulating the economy disturbed British economist John Maynard Keynes, whom Roosevelt thought had little understanding of democratic governance. Keynes’s celebrated book,
The General Theory of Employment, Interest and Money
, described how debt-financed stimulus could potentially raise employment in an economy with few imports, excess capacity and savings, and high unemployment. In these circumstances, Keynes prescribed public spending financed with debt that could be fully monetized. In the preface to the German edition of his book and his correspondence with economist Frederick Hayek, Keynes acknowledged that his prescriptions might be more suited to a nation guided by an expert elite. In 1940 Keynes presciently predicted that it might take a war to encourage Americans to borrow more.

When that war came the following year, the federal government needed every single dollar of available credit and savings. After World War II federal leaders were thankful that the taxpayers had not been saddled with even higher debt service in the 1930s. The American Fiscal Tradition had survived the Great Depression intact.

PART IV

CONTAINING THE BURDEN OF WORLD WAR II DEBT WHILE INCREASING COMMITMENTS: 1941 – 1976

11

W
AR AND
T
AXES

1941–1949: Years when deficits exceeded debt service = 5 (1941–1945, World War II)

A N
EW
T
AX
S
YSTEM

When Adolf Hitler’s armies occupied much of Europe in the summer of 1940, Congress appropriated $5 billion to strengthen the nation’s army and navy. It authorized a national defense bond and raised taxes. Federal military spending grew steadily from $199 million per month in July 1940 to $1.9 billion per month in November 1941.
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Republican Senate leaders Arthur Vandenberg and Robert Taft opposed what they perceived as a White House agenda to lead the United States into war. As a result, President Roosevelt had difficulty obtaining congressional approval to register young Americans to prepare for a future military draft.

Public attitudes changed completely on December 7, 1941, when Japanese aircraft attacked Pearl Harbor. Four days later, when Germany declared war on the United States, Hitler gave a speech disparaging American racial diversity and asked how “a state like that can hold together—a country where everything is built on the dollar.”
²
Americans responded with one voice, and their elected officials spent dollars like never before. In 1942 the German sphere of control in Europe had a population and national income greater than those of the United States. That year it managed to produce fifteen thousand aircraft and five thousand tanks. The
United States produced forty-eight thousand aircraft and seventeen thousand tanks in 1942 and vastly more each of the next several years.
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President Roosevelt did not mince words in his 1942 State of the Union address: “War costs money. That means taxes and bonds and bonds and taxes.”
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Treasury Secretary Henry Morgenthau initially proposed that tax revenues pay for half the war’s costs—the same goal articulated by Secretary William McAdoo when the United States entered World War I.
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High levels of taxation allowed the nation to borrow at a low interest rate during World War II and service the debt after the war. By 1943 Roosevelt told Morgenthau that paying a third of the war’s cost with new taxes was a more realistic goal.

In April 1942 Roosevelt asked Congress to tax 100 percent of personal incomes over $25,000 per individual and $50,000 per family. Senator Taft, who emerged as the Republican leader on fiscal issues, expressed the prevailing sense of the members of Congress in both parties: “The rate might be 90 percent, but it should never be 100 percent.”
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Congress imposed high tax rates on wealthy citizens and corporations. Memories of high inflation during World War I led to bipartisan support for taxes that would restrict the purchasing power of most Americans, including families with middle incomes who had never paid income tax. The White House and members of Congress could not immediately agree, however, on the best form of broad-based taxation. Some—including Roosevelt’s budget director and most Republicans—favored a national sales tax. Morgenthau and Ways and Means Committee Chairman Robert Doughton preferred to lower the standard exemption from the income tax and raise all income tax rates.

The Revenue Act of 1942 passed with only two dissenting votes in the House and none in the Senate. It helped finance the war and laid the foundation of the future federal income tax system. The Revenue Act’s high taxes on corporate income and its broad-based tax on personal income soon yielded federal revenues amounting to almost a fifth of national income. Surtax rates applicable to various income brackets ranged from 13 percent to 82 percent. Corporate tax rates rose from 31 percent to 40 percent.
⁷
Taxes on extraordinary returns on investment supplemented taxes on corporate income.

The taxation of middle-income Americans imposed by the Revenue Act marked a turning point in the federal fiscal system. In the nineteenth
century import taxes produced most of the federal revenue. Income taxes had not touched the majority of Americans during the Civil War and World War I.

The Revenue Act of 1942, in contrast, reached middle incomes by lowering the standard exemption, which fell to $500 even while inflation and a tight labor market pushed up wages.
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In 1939, 7.6 million Americans filed federal income tax returns and reported gross income—the top line on tax returns—totaling 27 percent of national income.
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The $929 million they paid in income taxes equaled just 3.66 percent of total reported gross income.
¹⁰
By 1943, 43.7 million Americans filed tax returns and reported gross income equal to 54 percent of total national income. They paid $14.6 billion—13.7 percent of reported gross income—in income taxes.
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While World War II marked the beginning of the broad-based personal income tax, an even higher percentage of the workforce would pay federal income taxes later in the twentieth century. In the 1940s, the standard deduction amounted to a higher percentage of average income than it would be in later decades. In 1948 the personal deduction was almost half of average income, while by 1981 it ranged from 30 percent of average income for single filers to 16 percent for married filers with two dependents.
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During the 2012 election, Republican presidential nominee Mitt Romney sparked a controversy by noting that “47 percent” of the workforce paid no net income tax. In fact, because of the erosion in the value of the standard deduction, a higher share of American households paid income taxes at the end of the twentieth century than during World War II. The top 1 percent of taxpayers paid almost a third of all personal income taxes during World War II, a share substantially lower than in the “conservative” 1920s and greater than the share they paid in the twenty-first century.

Certain features of personal income taxation have been remarkably stable ever since passage of the Revenue Act of 1942. Personal income tax revenues have generally remained in the range of 7 to 9 percent of national income. Since its enactment American taxpayers have reported gross taxable income in a narrow band around 60 percent of the total value of national income. In other words, if total national income were depicted as a pie chart, about three-fifths would be labeled gross personal income subject to taxation and reported on tax forms.

E
XCLUSIONS
, D
EDUCTIONS
,
AND
W
ITHHOLDING

Because a relatively stable 60 percent or so of national income has been subject to federal personal income taxation since World War II, federal officials and commentators naturally turn to the other 40 percent when considering how to raise additional revenue. The reasoning underlying the structure of the World War II tax system—created at a time when virtually all Americans understood the need for higher taxes and higher tax revenues—sheds light on various exclusions and deductions from personal income taxation.

Ways and Means Committee Chairman Robert Doughton and Senator Robert Taft struggled with how best to handle a category of noncash compensation—pension contributions—that was excluded from personal income taxation until the receipt of pensions by the beneficiary. Their resolution of that issue had a profound long-term effect on the American economy and tax revenues.

Although Doughton and Taft had very different backgrounds, they worked together to find common ground during the war. Whereas Muley Bob Doughton’s father was a rural populist active in the Farmers Alliance that rallied around William Jennings Bryan, Taft’s father, William Howard Taft, beat Bryan in the 1908 presidential race. Few employers had pension plans before World War II. Since the 1920s it had been clear that employer contributions to pension trust funds and earnings on those trust funds would not be taxed until the employee received the pension distribution. Doughton and Secretary Morgenthau feared that managers would try to escape paying high wartime tax rates by diverting part of their compensation into custom-designed pension plans. Taft acknowledged this risk of abuse but resisted standardized pensions that would reduce the flexibility of individual firms to craft their own pension plans. Doughton and Taft settled the matter by agreeing that employer pension contributions would be taxed only when employees received their pensions, but only so long as a pension plan was available to a broad base of employees. Tax lawyers interpreted that policy in a manner that excluded employer-funded medical insurance from the taxable income of employees.

Wartime shortages of skilled labor and federal wage ceilings prompted many large employers to offer pension and medical insurance plans during World War II.
¹³
The exclusion of that form of compensation from taxable income began to significantly limit the share of national income appearing
on personal tax returns. By 2005, for example, the $7.4 trillion in gross income that appeared on the top line of personal income tax returns excluded $900 billion in the estimated value of pension and insurance contributions and related investment income.
¹⁴

Interest payments had always been deductible from gross taxable income. The income tax had originally applied to wealthy Americans, for whom interest payments were typically a business expense. Then, after World War II, many Americans bought houses and deducted the interest they paid on home mortgages. Since interest was cost for landlords, it seemed only fair that Americans who invested in their own housing should also be able to deduct mortgage interest. That deduction did, however, narrow the base of net taxable income.

After passage of the Revenue Act of 1942, those far-reaching decisions concerning exclusions and deductions seemed far less pressing to Secretary Morgenthau than did the practical issue of tax collection. Tens of millions of Americans at the time had never filed a tax form. Beardsley Ruml, CEO of R. H. Macy & Company, urged Secretary Morgenthau to withhold an estimated amount of income taxes from paychecks. Congress engaged in a spirited fight about whether to forgive some amount of taxes for 1942—which were due in April 1943—if withholding began in 1943. Doughton compromised on the issue with Senator Arthur Vandenberg, clearing the way for broad-based withholding of income tax from wages and salaries.

Even withholding did not end Secretary Morgenthau’s challenge in collecting the broad-based income tax. A Gallup poll showed that most Americans thought withholding dispensed with the requirement to file annual tax returns. The Treasury Department did not have the personnel to audit tens of millions of tax forms, much less discover all those who should have filed them but did not do so. Morgenthau feared that even innocent noncompliance would erode the moral force of a tax system dependent on self-reporting.

So Morgenthau and his staff enlisted the power of mass media. Radio stations frequently aired an upbeat jingle by Irving Berlin, “I Paid My Federal Income Taxes Today.” Radio personality Roy Rogers promoted income taxes as an expression of wartime patriotism. A Donald Duck cartoon shown to more than thirty million moviegoers demonstrated how to fill out tax forms. By the end of the war, forty-nine million households were filing tax returns, more than ten times the number in 1939.
¹⁵

President Roosevelt favored even higher taxes. Because Congress dismissed his idea of taxing all income over a certain level, in March 1943 he signed an executive order banning salaries of more than $25,000. Congress superseded that executive order when it raised the debt ceiling to $210 billion, the first—but far from the last—use of congressional power over the debt ceiling to accomplish another purpose.
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