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Tax History: Should It Stay or Should It Go? Defending the Income Tax in 1948

Posted on June 29, 2020

In the aftermath of World War II, the modern income tax remained a work in progress. The demands of fighting (and financing) a global war had prompted Congress to refashion both the individual and corporate levies, and both had become mainstays of federal finance. In 1939 the individual and corporate taxes provided 16 percent and 18 percent of total federal revenue, respectively. By the end of the war, those figures had risen to 41 percent and 35 percent.

The income tax had clearly proved its mettle. But not everyone wanted the levy to retain its pride of place in the tax system. Champions of a consumption-based fiscal regime had been agitating for a national sales tax for decades, and the future of the income tax remained a subject of lively debate.

One of the more prominent voices in this argument was that of Harold M. Groves, an economist at the University of Wisconsin. Described by a contemporary as “an unreconstructed liberal,” Groves was nonetheless an outsider in New Deal circles; having lost out on a key Treasury Department post in 1934, he remained a sympathetic but distant observer of Franklin D. Roosevelt’s ambitious tax reform efforts.

A Moderate Liberal

Groves was, like many liberal economists of the era, something less than doctrinaire. He was deeply enthusiastic about progressive tax reform, driven by an abiding concern about inequality. But he was sensitive to the distortions and inefficiencies that progressive taxes might inflict on the nation’s economy, especially if poorly conceived and implemented.

In 1943 Groves had managed to alienate some of his ideological allies when he accepted a commission from the Committee for Economic Development (CED) to prepare a major tax study. The CED was a business group, but one with a distinctly progressive cast, and the published version of Groves’s study, Production, Jobs and Taxes, made a generally liberal case for tax reform. The 1944 book endorsed a broad-based personal income tax, greater reliance on the estate tax, and the elimination of capital gains preferences. It also opposed a national sales tax.

Along the way, however, the book offered some kind words about business investment incentives. Even worse, it criticized both the excess profits tax enacted during the war and the corporate income tax itself, which Groves considered both unwise and unfair.

Such comments struck many liberals as heresy, and Groves found himself the object of “bitter hostility” from many of his erstwhile friends and colleagues, recalled John A. Gronouski in a remembrance of Groves published after his death. But Groves was a consistent critic of progressive excess, and the hostile reception greeting his book didn’t stop him from reprising those themes in a short book published four years later, Trouble Spots in Taxation.

Time and Place

As its name suggests, Trouble Spots explored various issues in postwar tax theory and policy. Perhaps its most interesting chapter, however, concerned the practical future of the income tax. That future, of course, is now our past, and in reading the chapter, Groves’s prescience is striking: Many of the issues he identified in 1948 remain unresolved (or at least relevant) more than seven decades later.

Groves began by defending his assertion that income taxes were the way of the future, at least for the United States in the middle decades of the 20th century. To be effective, taxes must necessarily be suited to their temporal, economic, and geographic environment, he contended.

“The selection of a leading tax in a tax system must, of course, be related to the conditions of time and place,” Groves wrote. An income tax would be inappropriate for a predominantly agricultural nation, especially one dominated by subsistence farming. Nor would it serve in a country like the Soviet Union, where free markets were absent and government controlled both prices and production.

Nor, for that matter, would income taxes have been especially suitable to America in the 1870s, Groves said. The United States was too agricultural in those years. Perhaps even more important, the country didn’t have enough accountants. “The practice of accounting, now widely applied and greatly refined, was then in its infancy,” Groves observed. “It is an open question whether the income tax owes more to the accounting profession or the reverse!”

Perhaps most striking, Groves didn’t believe that 19th-century America was culturally or politically suited to an income tax, which necessarily relied heavily on norms of voluntary compliance. “The citizenry was not yet schooled in its responsibilities toward government,” he wrote. By contrast, 20th-century Americans had learned the hard way that government was something to take seriously. “Whatever else may be said about the recent wars, they have been a first-class lesson in discipline for taxpayers,” Groves wrote.

These assertions about American political culture seem a bit myopic, ignoring the generally successful American experience with income taxation during the Civil War. But Groves would probably have explained that myopia by emphasizing the “mass” quality of modern income taxes, which were paid by a much larger percentage of the total population than the relatively narrow Civil War tax. Also, whatever lessons Americans might have learned about income taxpaying during the Civil War were unlearned in the four decades afterward, when the tax was either entirely absent from the revenue system or confined to a small sliver of the population.

Rational Tax

If the income tax had been ill-suited to the America of 1870, it was much better adapted to the America of 1948. Indeed, it was “a rational way to raise revenue” in the current context, Groves contended.

Groves repeatedly returned to the word “rational” when describing the income tax. He seemed to have meant several things by it. First, the income tax was rational because “all taxes (with a few exceptions) come out of income eventually and a presumption favors taking them out directly,” he said.

By contrast, consumption taxes burdened taxpayers in a roundabout way. “Why approach taxpayers indirectly, for instance, according to the number of mechanical refrigerators they buy?” he asked rhetorically. “Surely this item on consumers’ budgets bears no consistent relationship to what there is to pay taxes with nor is it relevant to any relationship between taxpayers and the government. Cash and not refrigerators is the medium in which we pay our taxes.”

Groves also appreciated the predictable incidence of the individual income tax. “Better than most other taxes, it stays put, or remains with those who pay it in the first instance,” he wrote. “Because the tax is imposed upon the individual in his role as citizen, is based on the totality of income, and is differentiated among recipients, its effect upon the price structure is probably negligible.”

There were other reasons to prefer an income tax over most alternatives (including its utility as a tool of countercyclical demand management in a newly Keynesian world), but those two factors were crucial for Groves — and central to his notion of “rational” taxation.

Groves understood that rationality wasn’t always the driving force in tax policymaking. Indeed, sometimes rationality was a strike against a particular tax. Sometimes lawmakers or the public actually prefer an irrational tax — say one with an obscure or uncertain incidence. “Rationality in the tax system may not always be preferred by the public, influenced as the latter is by nonrational or irrational appeals,” Groves acknowledged. But policymakers had an obligation to strive for rationality all the same; “a rational critic is obliged to prefer a reasonable to an arbitrary or capricious distribution of the tax load,” he added.

How Broad a Base?

It was one thing to endorse the general notion of an income tax and something else again to specify the design of that tax, Groves acknowledged. “There are income taxes and income taxes, and the next question to consider is what kind we should have,” he wrote.

Of particular concern was the breadth of the tax base, Groves insisted. Until World War II, the individual income tax had generally been confined to a relatively small percentage of the population. It was designed to be a narrow burden on the rich, not a broad tax on the middle class, and certainly not a tax on the poor. Under the fiscal stress of World War II, however, lawmakers had transformed the levy from a “class tax” to a “mass tax.” The number of individual taxpayers rose from 7.9 million in 1939 to 49.9 million in 1945; according to historian W. Elliot Brownlee, nearly 90 percent of working Americans were submitting income tax returns by the end of the war, and roughly 60 percent were actually paying income taxes.

Now, with the war over, some policymakers (and taxpayers) hoped for a return to the old ways. Groves acknowledged the intuitive and logical appeal of returning to a system marked by high exemptions and a correspondingly small number of actual taxpayers. “The case for not taxing low incomes rests soundly on the idea that providing public luxuries at the expense of private necessities is poor economics,” Groves wrote. “In other words, there could hardly be a defense for levying taxes that compelled low-income recipients to live in hovels while monumental public buildings were being constructed.”

But given the realities of postwar finance, tax revenue would likely be in high demand. The actual choice facing policymakers probably wasn’t one between higher spending and lower taxes: The spending would likely stay high no matter what. “The practical choice may not lie between more expenditure and less income tax. It may be instead between more income tax and more some-other-kind-of-tax,” Groves wrote. “The alternative to a rational and progressive levy applied to the masses may be a sales tax, which hits them even harder and which is generally less equitable.” (Emphasis in original.)

Such a hard reality suggested that income tax exemptions should stay relatively low — at least until lawmakers could ensure that other, less desirable alternatives could be ruled off the table.

Skin in the Game

Groves argued for the importance of tax consciousness. Today, we tend to treat tax consciousness as a conservative talking point, but in the mid-20th century, it enjoyed wide currency among liberals as well.

Groves believed that low exemptions would encourage more responsible civic engagement by voters, especially at the lower end of the income range. “Citizens probably do vote more responsibly when they have an equity in the consequences,” he wrote. “All government is in some degree a case of spending other people’s money; but there is some warrant for minimizing this characteristic.”

Keeping the tax base broad was also good for the tax morale of rich taxpayers. “Taxpayers’ morale is adversely affected if only a small number are required to finance exclusively the benefits of governmental services voted by the masses,” Groves argued. “Morale, even of the large taxpayer, is not to be lightly squandered. Many wealthy taxpayers are public-spirited citizens; witness their substantial contributions to philanthropies. They do resent being ‘shaken down’ and ‘played for suckers’ by taxes to which most of the voters have contributed no equity.”

Indeed, as a matter of practical politics, Groves advised his colleagues on the left to resist the temptation to soak the rich with a narrow income tax while still arguing for a strong welfare state. “Probably low-income groups are ill-advised to oppose a broad-based income tax,” he wrote. “Wide participation in financing important social services reduces opposition to their extension.”

Clearly, Groves learned something from Roosevelt’s innovations in financing Social Security. Roosevelt’s insistence on using a payroll tax to finance his retirement program had been deeply unpopular among social welfare experts, who saw it as unfair and counterproductive. But by 1948, it had already proved a political success — a lesson not lost on pragmatic liberal reformers like Groves.

For all his talk about keeping exemptions relatively low, however, Groves had a strong sense that the battle was already lost. Once upon a time, conservatives had argued against high exemptions, relying heavily on tax consciousness arguments. But since Roosevelt had managed to change the terms of tax debate in American politics, most conservatives had abandoned that effort, throwing in their lot with the champions of tax relief generally and higher exemptions in particular.

“The pressures of politics are all against a broad-based income tax,” Groves complained. “Even conservative politicians usually deem it expedient to promise and deliver a more generous allowance for living expenses. The broad-based tax strikes large numbers of voters and they are sensitive to direct taxes.”

Corporate Taxes

For an avowed liberal, Groves was no fan of that most popular of progressive fiscal instruments, the corporate income tax. As noted above, he argued against the tax in his 1944 book for the CED. In 1948 he repeated his critique, undeterred by the drubbing he had received from his friends on the left four years earlier.

Groves rejected most arguments in defense of the tax, including claims that government was a “silent partner” in corporate enterprise and deserved its share of the profits, or that modern business had a tendency toward monopoly profits that demanded recapture through a targeted tax. He bemoaned the extra burden the corporate tax placed on some types of income while sparing others. And perhaps most striking, he complained loud and long about the uncertain burden of the tax, which seemed likely to be passed along in unknown (and perhaps unknowable) ways.

Ultimately, the tax was more trouble than it was worth, Groves concluded. “The corporate tax is not rationally defensible and should be deemphasized when revenues permit and when even more irrational features have been eliminated,” he wrote. The best thing to be said in defense of it was that other taxes were worse. “The plausible case for the corporate tax is that we employ other taxes that have even less claim to rationality and that aggravate inequalities in addition,” Groves said.

Avoidance and Evasion

Groves was well aware that income taxes were hard to administer. In particular, they were vulnerable to avoidance and evasion. “The rationality of this tax could rapidly disappear were its administration weak and were it featured by wholesale evasion,” he wrote.

For the sake of his lay audience, Groves was careful to delineate the distinction between evasion and avoidance. “Evasion consists of minimizing taxes in violation of law, avoidance, of doing so within legal bounds,” he explained. “Any tax is escapable if one pays the price of avoiding the conditions on which it is based. Thus one can beat even the poll tax — by committing suicide.”

Groves dismissed the liberal tendency to demonize avoidance. “Avoidance of a tax involves no legal culpability and in most cases it is also morally irreproachable,” he insisted. “Some have maintained that sharp practice and excessive zeal in minimizing income taxes should be condemned. Most people, however, accept compliance with the requirements of law as the full measure of a taxpayer’s duty.”

But if the taxpayer escaped opprobrium by adhering to the letter of the law, lawmakers could not, Groves warned. “In the opinion of many critics, Congress has left too many loopholes in the income and death tax statutes,” he wrote. “Indeed, there is reason to believe that some of this failure to tighten the tax laws is deliberate. There are those in Congress who calculate, cynically, that high rates are a bone to throw to the demagogic masses and that these rates can and should be made ineffective by leaving holes in the tax fences.”

Like other tax experts of the postwar era (including Stanley Surrey), Groves didn’t shy away from the “loophole” terminology, despite its imprecision. (Prior analysis: Tax Notes, Feb. 11, 2013, p. 663.) Indeed, he seemed to value the term for the moral judgment it implied. To those who objected that a loophole wasn’t actually a loophole when its inclusion in the law was deliberate, Groves insisted it was still deserving of the term. He simply believed it was Congress that deserved the opprobrium for its creation, not the taxpayer for its use. “This is playing reckless politics with the tax laws and throwing concern for equity and rationality out the window,” he said of the congressional penchant for peddling tax preferences.

A Tenuous Thing

Ultimately, Groves was distinctly optimistic about the prospects for “rational” income taxation, despite the failures of feckless lawmakers. “There are administrative and political difficulties in income taxation,” he granted. “We have not yet demonstrated that we can apply a direct tax with high rates to large numbers of low-income farmers, professional men, and individual businessmen. Nor have we demonstrated the discipline to maintain the breadth of base and the high effective rates necessary to make a direct tax supply most of our revenue needs.”

But Americans hadn’t overcome those challenges because they hadn’t yet tried to meet them, at least outside the extraordinary context of a global war. A determined effort could well produce impressive results. “The federal government has never really tried to administer a mass income tax,” Groves concluded. “As we grow more civilized, with civic virtues and accounting practices responding to intensive cultivation, we may expect a distinct trend toward rationality in taxation.” (Emphasis in original.)

If Groves were alive today, would he believe his hopes had been realized? Perhaps not. He almost certainly would be dismayed to find the corporate income tax still kicking around.

But he might be impressed by the survival, however tenuous and compromised, of the individual income tax. It may be far from perfect, and in many respects, it may be a very different fiscal instrument than the one Groves was describing in 1948. But 72 years isn’t a bad run for any major tax. If sheer survival is a measure of success, this one seems to have suited its time and place reasonably well.

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