Aftermath. Thomas E. Hall
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the United States. The severity of the initial economic recession (1929–1933) is important to the history of the income tax because it caused plummeting incomes, which resulted in a huge decline in tax revenue. Consequently, the federal government experienced sizable budget deficits. The prevailing view at the time was that budget deficits should be avoided, and one way to balance the budget was to raise revenue. Mellon’s idea that lower tax rates could yield more revenue was thrown out the window. The government instead opted for higher tax rates.
President Herbert Hoover started the tax increase ball rolling in 1932. Figure 2.1 shows the top and bottom federal income tax rates from 1913 to 2011. The budget deficit was a major issue in the 1932 presidential election between incumbent Herbert Hoover and challenger Franklin Roosevelt, and both men pledged to balance the budget. In 1932, before the election, Hoover supported higher tax rates as a way to raise revenue, and Congress passed the tax increase in June. Figure 2.1 shows that tax rates rose substantially for high-income taxpayers as the top rate went from 24 percent to 63 percent. The corporate profit tax rate was increased as well. These higher tax rates, however, did not eliminate the budget deficit because the economy continued to plunge in 1932, in part because the higher tax rates reduced both spending and the incentive to earn income.
Figure 2.1 TOP AND BOTTOM FEDERAL MARGINAL TAX RATES ON INCOME, 1913–2011
SOURCES: 1913–2002, IRS, www.irs.gov; 2003–2011, Tax Foundation, www.taxfoundation.org.
The 1929–1933 recession had a huge impact on the fortunes of the country’s two major political parties. The Republicans went from enjoying substantial congressional majorities in the late 1920s to very thin margins (one seat in the Senate, two in the House) following the 1930 elections. The coup de grâce came in 1932, when the Democrats gained 12 Senate seats and nearly 100 House seats. The Democrats also won the presidency that year when Franklin Roosevelt scored a landslide victory over Hoover. The incoming president’s plans for economic stimulus included various New Deal programs for work relief and welfare that would require significant funding. Since the government’s budget was already in deficit and Roosevelt intended to spend even more, the plan was to raise tax rates to generate additional revenue. The public, many of whom blamed the Great Depression on a failure of capitalism, supported higher taxes so long as the increases were targeted at the upper-class capitalists.
Figure 2.2 shows federal revenue and spending data from 1929 to 1940. Roosevelt’s New Deal began in March 1933, and during the next few years, the programs required ever more funds. The economic recovery combined with the higher income tax rates that took effect in 1932 caused revenue to rise, but not fast enough to eliminate the federal budget deficit. So beginning in 1934, Congress passed and President Roosevelt signed a series of tax laws that substantially raised rates on personal income, corporate income, and inheritances. For example, the 1936 Revenue Act maintained the $2,500 exemption for a married couple, but raised tax rates to a maximum of 79 percent on incomes above $5 million. Corporate income was taxed at a maximum rate of 15 percent, plus a tax was instituted on undistributed profits. Francois Velde estimates that for households earning more than $4,000, this law nearly doubled the average tax rate from 6.4 percent to 11.6 percent (2009, 19). Another major tax change during the decade was the institution of the Social Security tax in 1937.12 The Social Security Act (1935) imposed a 2 percent payroll tax on the first $3,000 of wage income beginning in 1937. That year, the new tax accounted for 10.5 percent of federal tax revenue (Velde 2009, 19).13
Figure 2.2 FEDERAL RECEIPTS, SPENDING, AND BUDGET SURPLUS, 1929–1940
SOURCE: Economic Report of the President (1963, p. 238). Data are for fiscal year July 1–June 30.
Except for the Social Security levy, taxes assessed on income during the Depression were directed at high earners. This feature of the tax laws provided the upper class with a strong incentive to avoid paying taxes. After all, these income tax increases were not temporary war-funding measures; instead they were peacetime measures that might be in place for a long time. Wealthy Americans—some of whom considered Roosevelt (who was descended from an upper-class New York family) a “traitor to his class”—hired lawyers and accountants to figure out ways to avoid paying.14 For example, business owners could compensate themselves in the form of nontaxable fringe benefits instead of taxable wages and business profits. Corporations did similar sorts of things; one common method was to move operations offshore to avoid paying taxes. During congressional hearings in 1937, members of Congress were shown photographs of small shacks on Caribbean islands that served as corporate headquarters for tax purposes (Carson 1977, 120).
High tax rates also increased the opportunity for politicians to hand out more political favors in the form of tax breaks. Taxpayers subject to high rates had a strong incentive to appeal to their political representatives for relief. Members of Congress were able to hand out benefits in the form of tax exemptions for various activities, the implied quid pro quo being that the beneficiaries would lend political support and campaign contributions to their representatives and senators. Such an arrangement is less likely to occur if tax rates are low because income earners have a smaller incentive to avoid taxes.
When World War II broke out in Europe in 1939, President Roosevelt was concerned that the conflict would eventually engulf the United States. So he pushed for additional taxes to fund a military buildup. Rates were raised again in 1940, and that year the exempt amount for a married couple was lowered to $2,000. Then in 1941, the married exemption was lowered to $1,500, and the bottom tax rate was raised from 4 percent to 10 percent. The middle class was now paying federal income taxes.
World War II
Funding the enormous U.S. military effort during World War II led to a major expansion of the income tax. Just days after the December 7, 1941, Japanese attack on Pearl Harbor, the United States was formally at war with Japan, Germany, and Italy. And it was painfully clear to Americans that carrying out military operations in both Europe and the Pacific would require an enormous amount of physical and financial resources. There was considerable discussion about how this undertaking would be financed, and the Roosevelt administration decided that taxes would play an important role.
The income tax law was altered in 1942 to capture even more income earners. The marriage exemption was lowered to $1,200; for single earners, the amount was $624. Tax rates were raised again, the bottom rate to 19 percent and the top rate to 88 percent (on incomes above $200,000). This huge tax increase was initiated to help support the war effort: more income earners would now pay taxes, and those already paying would be subject to substantially higher rates. President Roosevelt hailed the new law as “the greatest tax bill in American history.”15 The following year, payroll withholding was instituted; this is the system under which income taxes are withheld from paychecks throughout the year. Previously, taxpayers paid their entire tax bill when filing their returns.
As was the case during World War I—only this time on a much larger scale—the combination of the lower income exemption, the higher tax rates, and the booming war economy caused both the number of taxpayers and taxes paid to soar. During fiscal year 1939, 7.5 million income tax returns were filed and $890 million was collected in taxes. In 1945, 49.9 million returns were filed and $17 billion in income taxes were collected (U.S. Bureau of the Census 1975, 1110). Corporate income taxes (including the tax on “excess profits”) also soared by a similar order of magnitude, from $1.2 billion in 1939 to $14.9 billion in 1944 (U.S. Bureau of the Census 1975, 1109). However, despite this surge in revenue, it was not enough to keep pace with wartime expenditures. From 1942 to 1945, the federal government incurred budget deficits totaling $184