Menu
Tax Notes logo

Tax History: Channeling FDR’s Ghost, Democrats Return to Graduated Corporate Rates

Posted on Sep. 20, 2021

The corporate income tax lost its graduated rates in 2017. Now Democrats on the House Ways and Means Committee want to replace the current flat rate tax with a new set of graduated brackets. If they succeed, it will mark a return to form: The corporate tax featured graduated rates for over 80 years.

Still, the return of a progressive rate structure would be surprising. Graduated rates had few defenders by the time they disappeared in 2017. And to be fair, supporters were thin on the ground even when Franklin D. Roosevelt first proposed them in 1935.

So why did Roosevelt ask for them in the first place? And why did a reluctant Congress agree to enact them? According to Steven A. Bank, professor of law at the University of California, Los Angeles, the answer to both questions is power. Specifically, the concentrated economic power of large corporate enterprises, which worried both Roosevelt and many of his congressional allies.

In the Beginning

In his paper “Taxing Bigness,” published in 2013 by the Tax Law Review, Bank offers a quick review of the earliest corporate income tax. At the dawn of the modern tax in 1913, corporations paid a genuinely flat rate tax of 1 percent with no exemption. In 1918 Congress added a $2,000 exemption, which effectively established a two-rate structure, with a zero rate up to the exemption and a 12 percent rate on income above the exemption. (Positive rates had climbed substantially during World War I.)

The two-rate system remained in place through 1932 (surviving a failed effort in 1927 to create a set of explicitly graduated rates). But in the face of surging deficits brought on by the Great Depression, lawmakers agreed to eliminate the exemption and extend the corporate tax to the first dollar of profits. As Herbert Hoover relinquished the Oval Office to Roosevelt in March 1933, U.S. corporations were paying a true flat tax of 13.75 percent on all net corporate profits.

FDR’s Proposal

At the start of his presidency, Roosevelt mostly ignored tax policy. But in 1935, he unveiled a sweeping tax reform program, including plans for adding graduated rates to the existing corporate tax.

In presenting his plan to Congress, Roosevelt began with a concession of sorts. He acknowledged that large-scale business enterprise had important benefits, both for companies and for communities. “With large-scale enterprise has come the great corporation drawing its resources from widely diversified activities and from a numerous group of investors,” Roosevelt said. “The community has profited in those cases in which large-scale production has resulted in substantial economies and lower prices.”

But if large corporations gave much to the nation, they also received much in return. And these benefits increased with corporate size. Smaller companies, meanwhile, got fewer benefits. They also faced an uphill battle in trying to compete with larger corporations. “Without such small enterprises our competitive economic society would cease,” Roosevelt warned.

Roosevelt had a solution in mind. “It seems only equitable to adjust our tax system in accordance with economic capacity, advantage, and fact. The smaller corporations should not carry burdens beyond their powers; the vast concentrations of capital should be ready to carry burdens commensurate with their powers and their advantages,” he concluded.

Specifically, Roosevelt suggested that Congress replace the flat rate corporate tax of 13.75 percent with a dual-rate tax graduated by the size of corporate income. The first bracket would pay at a rate of 10.75 percent and the second bracket at a rate of 16.75 percent. Roosevelt declined to specify the income levels for each bracket, leaving that decision to Congress.

Puzzling Purpose

As Bank explains, the 1935 proposal for a graduated rate structure emerged from the early New Deal’s fixation on the perils of concentrated economic power. During Roosevelt’s first term, he writes, “there was an increasing concern about the growth in corporate power and its role in the stock market crash and ensuing depression.” New Deal policymakers had come to view large corporations as uniquely threatening — and fundamentally different from their smaller competitors. “It became common to consider large and small corporations to be different entities altogether, rather than different sizes on the same continuum,” Bank writes.

But if New Dealers believed large corporations were that serious a threat, why did they advance such a modest proposal? After all, Roosevelt asked Congress to create just two brackets, with the bottom getting a rate cut from current levels and the top a 3 percentage point increase. Such a modest revision to current law seemed unlikely to tame the growth of large corporations.

Even more striking was Roosevelt’s decision to leave bracket definitions to Congress. If big business was fundamentally different from small business — if great size created a difference in kind, not just scale — then defining brackets would seem . . . important? Crucial? Foundational? Certainly not something to ignore.

But for Roosevelt, the details of his proposal were largely unimportant. According to Bank, Roosevelt’s modest proposal was designed to accomplish two things, neither of which depended on its specifics: to establish the principle of taxing corporations according to size and create a mechanism for levying such differentiated taxes in the future.

Roosevelt himself underscored the importance of introducing his new idea, aware the principles could have important, long-run influence on policy formulation. “We have established the principle of graduated taxation in respect to personal incomes, gifts and estates,” he told Congress in his tax message. “We should apply the same principle to corporations.”

In offering his plan, however, Roosevelt also had practical goals in mind. Introducing a graduated rate structure, no matter how modest, would create a new architecture for corporate taxation. That architecture, in turn, would open the door to new possibilities. Roosevelt’s proposal “decoupled the rates for large and small corporations and thereby offered a mechanism to tax bigness in a targeted manner,” Bank explains.

Roosevelt, in other words, was playing the long game. He (or his advisers, at least) understood the power of ideas and legal infrastructure. Even a modest reform to the existing corporate tax would establish the principle of graduated rates, as well as a mechanism for differentiating between corporations according to the size of their profits. Afterward, it would be relatively easy to change the key variables. “This explains why neither the size of the rate differential nor the threshold at which the top rate was set were as important as establishing the very existence of such distinctions,” Bank writes.

Opponents Understood

Almost everyone involved in the 1935 tax debate understood the stakes. Congress was lukewarm to Roosevelt’s proposal for a graduated rate structure, but the president fought hard to keep it in the bill because he understood its long-run importance. But Roosevelt acceded to a series of measures watering down the proposal’s already modest rate differentials because he was interested in the idea, not the details, of the tax.

Opponents of the graduated tax also understood the high stakes surrounding Roosevelt’s low-key proposal. Business leaders opposed to the change fought like they were engaged in an all-or-nothing battle — because they were. They weren’t especially worried about the economic burden of slightly higher rates (although some claimed to be). Rather, they understood that Roosevelt’s proposal was likely to become “the camel’s head inside the tent.” Bank quotes a slew of business critics to that effect, all of them harping on the dangers of letting the president introduce his dangerous “principle” of graduated corporate taxation.

One comment captured the business anxiety perfectly. “The fact that the graduation proposed in the House bill is confined to the narrow limit of 1 percent does not alter the fact that it introduces a new principle into the taxation of corporations — a principle that seems to me to be unfair and unsound,” complained a representative of the Armstrong Cork Co. during a Senate hearing. “Experience teaches that once the opening wedge is driven, the field covered by a new tax tends to expand steadily.”

Ultimately, Congress gave Roosevelt his graduated rates, ranging from 12.5 percent on income below $2,000 to 15 percent on income greater than $40,000. Given that lawmakers started with a flat rate corporate tax of 13.75 percent, these new rates and brackets hardly seemed like a major departure — except in principle.

Which was all that mattered to almost everyone in this debate.

Principle in Operation

If business leaders were afraid of Roosevelt’s principle, subsequent events vindicated their fears, according to Bank. The top rate climbed from 13.75 percent in 1935 before Roosevelt’s reform to 19 percent in 1938. It reached 40 percent in 1942 when the wartime revenue crunch sent tax rates soaring across the board. Meanwhile, the differential between the top and bottom rates also grew, Bank points out, doubling from 7 percentage points in 1935 to 15 percentage points in 1942. From 1952 until 1963, the top rate was 52 percent while the differential was 22 percentage points.

In practice, however, the graduated rate structure served less as a penalty on bigness than as a shield for small companies. “Rather than imposing very high rates on the most successful large corporations, the graduated rate scheme mostly operated to protect the smallest corporations from the high rates,” Bank writes. Indeed, protecting small companies had always been one of the professed aims of the graduated rate structure. But over time, that aim took center stage. “In the latter half of the twentieth century, the government’s official posture toward the graduated corporate rate structure has been that it is a subsidy for small business,” Bank contends.

Few Defenders

The graduated rate structure survived the 20th century. But by the time it finally disappeared in 2017, it had few vigorous defenders.

Indeed, tax reformers had been targeting the graduated rates for years — even decades. The Treasury Department had tried to eliminate them during the great tax reform drive of the mid-1980s, dismissing them as something like a tragic error. “The progressive rate structure for individuals is premised on the ability-to-pay concept, which in turn reflects an assumption that additional amounts of income are increasingly available for discretionary, non-essential consumption,” the department’s tax staff explained in its landmark 1984 study, “Tax Reform for Fairness, Simplicity, and Economic Growth.” “These concepts have no relevance to corporate income.”

Other critics, including my colleague Martin A. Sullivan, were equally dismissive of arguments about small business needs. “Graduated corporate tax rates have no economic justification except as a poorly targeted benefit for small business,” Sullivan wrote in 2011. (Prior analysis: Tax Notes, July 18, 2011, p. 215.)

Apparently, however, there’s a healthy appetite for old ideas on Capitol Hill. So if you’ve been waxing nostalgic for the good old days of graduated corporate rates, gone missing these past few years, then the House Ways and Means Committee has a plan for you — and the ghost of FDR.

Copy RID