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Tax History: The Late, Not-So-Great Effort to Replace the Corporate Tax in 1936

Posted on Jan. 23, 2017

The last time Congress tried to replace the corporate tax, things did not go well.

People talk about reforming the corporate tax all the time, but serious proposals to replace it are rare. In fact, the last time lawmakers really gave it a shot was 1936, when President Franklin D. Roosevelt suggested a new tax on undistributed corporate profits.

As Congress ponders another plan for wholesale replacement, lawmakers should take a beat to consider that earlier episode. While ancient by policy standards, it still holds two important lessons for today:

 

1. Wholesale tax replacement is exceedingly difficult, agitating special interests and energizing powerful opponents.

2. Ambitious proposals can yield surprising and sometimes problematic results -- especially when wholesale reform devolves into dysfunctional half-measures.

 

Different Problems

 

 

Every tax reform proposal develops in a context, taking its shape from the problems it seeks to fix. Today, for instance, supporters of the destination-based cash flow tax defend it as a way to modernize corporate taxation in the face of economic globalization. They say it will eliminate incentives for profit shifting, encourage new investment in U.S. businesses, and dispense with the unhealthy bias toward debt financing.

By contrast, the great corporate tax debate of the 1930s focused on a different set of problems and opportunities. Specifically, the undistributed profits tax (UPT) was touted as a way to jump-start the nation's Depression-wracked economy while also curbing tax avoidance.

On its face, the promises of 1936 sound a lot like the promises of 2017 (with less emphasis on fairness and more on the economic benefits of tax replacement). But the UPT's mechanism for promoting economic growth was specific to its time: Advocates said it would boost aggregate demand by forcing corporations to disgorge "sterile" accumulations of retained earnings and distribute the money to shareholders who would actually spend it.

As UCLA law professor Steven Bank explains in his sweeping history of the corporate income tax, From Sword to Shield, policymakers spent most of the 1920s looking for ways to shield corporate profits from high individual tax rates, thereby encouraging investment. But the Great Depression led to some serious rethinking of that goal. "Observers assailed corporate-retained earnings because of their alleged role in fostering nonproductive investment, excessive compensation, and the trend toward what Louis Brandeis famously derided as 'the curse of bigness,'" Bank wrote.

The case against retained earnings was expressed especially cogently in a May 1932 memo by several members of Roosevelt's famous "brains trust." In the midst of FDR's first campaign for the White House, a trio of economic experts -- spearheaded by Columbia University law professor Adolf Berle but also including Rexford Tugwell and Raymond Moley -- told Roosevelt that retained earnings were a principal cause of the Great Crash, as well as the ensuing Depression.

"Corporate hoarding" had "upset the balance of production and consumption," the experts argued. According to Bank:

 

The theory was that profits, which might have been distributed to shareholders or paid to employees and made available for consumption, were instead left idle. To combat the overcapacity problem, companies closed plants, and prices increased because the companies had to spread the overhead costs over fewer products. Meanwhile, workers went unemployed, and shareholders failed to see a return on their investment. Furthermore, according to the memorandum, the managers' investment of liquid surplus in the market enhanced volatility as managers quickly withdrew money and parked it in short-term securities or in savings accounts.

 

The brains trust memo made sense to many economists, especially those struggling to explain the cause and tenacious persistence of the Great Depression. It resonated especially with policy experts inclined to blame the slump on "overinvestment" and "underconsumption."

To fix the problem, the brains trust suggested a new, punitive tax on undistributed corporate earnings. The members of the trust argued that the tax, which had some precedent in American fiscal policy, would "discourage unreasonable accumulation of corporate surplus and simultaneously provide an incentive for corporate managers to increase dividend distributions to small investors, thereby breaking the cycle of overproduction and underconsumption," Bank said.

It took a while for the tax to make its way from staff memo to legislative language, but four years later, Roosevelt proposed the UPT. Not coincidentally, 1936 was an election year, and champions of the tax were convinced of not only its economic utility but also its political appeal.

Shielding Incomes

 

 

Roosevelt's 1936 campaign was heavy on class-tinged rhetoric. "We know now that government by organized money is just as dangerous as government by organized mob," he said in one of his most famous radio addresses. "Never before in all our history have these forces been so united against one candidate as they stand today. They are unanimous in their hate for me -- and I welcome their hatred."

A campaign rooted in class politics had plenty of room for a specific kind of tax reform. New Dealers generally, and FDR in particular, were eager to spotlight the "clever little schemes" that allowed wealthy and well-advised taxpayers to avoid paying "their fair share." The UPT soon emerged as one of the administration's leading solutions to that problem.

According to many New Deal tax experts, retained earnings were a popular mechanism for avoiding taxes. Existing provisions of the tax law, including a modest levy on accumulated earnings, had failed to curb earnings retention. "Given the large spread between the corporate and individual tax rates and the accumulated earnings tax's apparent failure to guard against the abuse of the corporate form to take advantage of this spread, [Treasury Secretary Henry] Morgenthau considered the undistributed profits tax to be a valuable tool against tax avoidance," Bank wrote.

Morgenthau asked Treasury General Counsel Herman Oliphant to draft a workable version of the retained earnings tax, and he responded with an ambitious proposal that replaced the existing corporate income tax in its entirety.

When Roosevelt took Oliphant's plan to Congress, he ignored the broad economic justifications that the brains trust had laid out in the 1932 memo and instead emphasized the UPT's role in curbing tax avoidance. No longer would investors be able to shield a large portion of their income from high (and rising) personal income tax rates, he insisted. Instead, the new UPT would force that money out of corporations and into the individual tax base.

During public debate, the antiavoidance argument continued to eclipse most other justifications for taxing undistributed earnings. To be sure, the underconsumption-overinvestment thesis surfaced during congressional debate, but it was never the chosen terrain for UPT advocates. Instead, they harped on fairness arguments. As FDR surrogate (and Commissioner of Internal Revenue) Guy Helvering explained in a typical statement to Congress: "The fundamental objective of this proposal is to increase the Federal revenues by plugging up a major source of tax avoidance and tax evasion now existing, and thereby greatly to increase the fairness and balance of the Federal income-tax structure as a whole."

The Peril of Half-Measures

 

 

One of the most notable aspects of the UPT proposal was its boldness. FDR emphasized that the tax should be enacted as a wholesale replacement for the existing corporate tax, arguing that it would work only when other corporate levies disappeared. As Bank points out, the UPT was specifically designed to eliminate the double taxation of corporate profits; as long as profits were not retained by the corporation, they would be taxed only once, at the individual level. In fact, by eliminating the entity-level tax on distributed earnings, the UPT "was designed to provide corporations with a means to integrate the corporate and shareholder-level taxes with respect to their own income."

The House of Representatives accepted the UPT in roughly the same form that FDR proposed it. Lawmakers agreed to completely replace the existing corporate tax and introduce a new levy that taxed undistributed profits using graduated rates. Those rates were scaled to both the total amount of corporate income and the percentage of net income that a company chose to retain.

The resulting range of rates was large. At the low end, the UPT began with a 1 percent tax on the first 10 percent of net income retained by companies with less than $10,000 in net income. At the top, however, the House version of the UPT imposed a levy of 42.5 percent on the undistributed profits greater than 57.5 percent of net income for companies with more than $10,000 in total net income. The House legislation also made dividends received taxable to individuals at normal income tax rates.

In theory, the heavy tax on retained earnings would encourage companies to issue larger dividends. Champions of the UPT expected that tax-averse shareholders would pressure corporate management to distribute a larger share of company earnings to minimize the tax bite.

Predictably, however, management was aghast. Business groups attacked the UPT as dangerous, unworkable, and unfair. Corporate saving was healthy and often necessary for most companies, they said. Business leaders complained that the government was trying to usurp private sector prerogatives, depriving managers of the authority to actually manage, and that by setting a limit on the appropriate (i.e., untaxed) amount of retained income, the UPT was an attempt to regulate private enterprise in new and dangerous ways.

Many business leaders simply urged caution, arguing that wholesale replacement of the existing corporate tax would be destabilizing and potentially catastrophic (both to government revenue and to corporate finances). Indeed, the revenue argument soon became one of their favorites, allowing business groups to claim the moral high ground of fiscal responsibility and charge New Dealers with reckless disregard for the security of the fisc.

While members of the House were unmoved by those complaints, senators were more sympathetic. In the upper chamber, the ambitious UPT began to unravel. As Bank explained, business opponents continued to stress the tax's novelty, warning that it was untested and unknown. As one critic put it (in terms that might today be directed at the destination-based cash flow tax):

 

At a time like the present, when the need for revenue is so great, when we are spending so much more than what we are taking on, when business is recuperating from the worst depression in our history, and when industry is so sensitive to every disturbing influence, how can we possibly afford to gamble such a vast sum of known public revenue for what is so much an adventure into the wilderness?

 

The warnings proved potent. Worried senators floated a plan to scale back the new levy, making it a supplement to the existing corporate income tax rather than a replacement. They also suggested that it be made temporary, reducing the UPT to an experiment.

Ultimately, senators agreed on a watered-down version of the UPT that retained the tax in principle but hollowed out its regulatory effect. The compromise retained a 7 percent tax on undistributed profits but imposed a 4 percent tax on dividends distributed to shareholders. The small rate differential between the two ensured that the pressure to increase dividends would be only modest.

Eventually, a House-Senate conference committee restored some aspects of the UPT. But it preserved the levy as a half-measure, refusing to make it a full replacement for the existing corporate income tax and retaining an individual tax on dividends. In the end, the Revenue Act of 1936 made the tax rate differential between distributed and undistributed profits small, at least for most taxpayers (treatment varied according to the tax bracket of individual dividend recipients).

The surprising element of that compromise was to make double taxation of dividends a permanent feature of the corporate tax system, Bank wrote. Critics of the UPT had insisted on an individual dividend tax to keep the new UPT levy from infringing on managerial prerogatives. "The theory behind business support of a separate tax on dividends in 1936 was that if distributed earnings were subject to the same additional increment of taxation as retained earnings, shareholders and managers would remain aligned in support of retained earnings," Bank said.

Pitfalls of Ambition

 

 

The UPT enacted in 1936 didn't stay on the books for long. Within two years Congress had gutted it, and after 1939 it disappeared entirely. By contrast, however, the double taxation of dividends proved much more durable. Conceived as a weapon to neutralize the UPT (or at least some of its grander regulatory ambitions to regulate corporate finance), the dividend tax survived long after its target had disappeared. In the many decades since the UPT expired, business leaders have had ample time to regret their instrumental embrace of the dividend tax (assuming that any of them actually remember it).

But the UPT deserves remembering, if only as an object lesson in the pitfalls of ambitious tax reform. It serves as a reminder that plans for sweeping tax reform -- and especially tax replacement -- are exceedingly hard to pass and even harder to pass in anything resembling their original form.

And perhaps most important, half-measures are not always half as dangerous. They sometimes come with their own set of distinct problems -- and a surprising capacity to stick around.

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