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Tax History: Should We Tax Excess Profits or Pandemic Profits?

Posted on Apr. 20, 2020

The excess profits tax may seem like a throwback, but it’s worth taking seriously. A fiscal innovation of the early 20th century, it’s gotten a fresh look in the time of coronavirus. And although it may be a long way from becoming legislative reality, its reappearance can tell us something important about the broader argument over corporate taxation. It’s certainly done that before.

Historically, the excess profits tax has always been framed (initially, at least) as an emergency measure. But it has also been freighted with broader implications for the taxation of private enterprise. Beginning with its first appearance during World War I, the tax raised important questions about what claim the federal government might have on corporate profits — not just during wartime, but once peace returned as well.

As so often happens in tax, these fundamental questions were sorted out on technical terrain. Specifically, the battle was joined in a series of pivotal debates over how lawmakers should define the “excess” in excess profits. Taxpayers and policymakers had strong opinions about that definition, not all of them determined by simple, bottom-line calculations. Indeed, the question of how to define excess lay near the heart of progressive tax reform in the crucial years during and after World War I.

Today’s nascent debate over excess profits taxation is still murky and ill-defined. But there are hints that similar questions about the definition of excess might be lurking beneath the surface — and might still be important in the months and years to come.

Recent Proposals

Let’s start with a quick overview of some recent proposals for a tax on excess profits. One of the most prominent has come from University of California, Berkeley economist Gabriel Zucman. Always happy to stir the pot, Zucman has been beating the drum for an excess profits tax for most of the last month, especially on Twitter. In a March 30 piece for The New York Times, he and his department colleague Emmanuel Saez offered a reasonably specific suggestion.

“The government should impose excess profits taxes, as it has done several times in the past during periods of crisis,” Saez and Zucman wrote. “In 1918, all profits made by corporations above and beyond an 8 percent rate of return on their capital were deemed abnormal, and abnormal profits were taxed at progressive rates of up to 80 percent.” Lawmakers imposed similar taxes during both World War II and the Korean War, Saez and Zucman note. “These taxes all had one goal,” they emphasize. “Making sure that no one could benefit outrageously from a situation in which the masses suffered.”

Another, less specific proposal for taxing excess profits comes from Mike Davis, a contributing editor for The Nation magazine. Davis suggests that such an excess profits tax might serve two ends, curbing monopoly profits among companies profiting from the coronavirus crisis, while also rescuing one of its most prominent victims: the U.S. Postal Service.

Although he’s notably vague on the details, Davis seems to envision a fiscal twofer: Congress would create a new tax that would raise additional, earmarked funds for the USPS. This tax, moreover, would target one of the greatest beneficiaries of the crisis: Amazon.com. (Not one to mince words, Davis describes Amazon founder Jeff Bezos as “a profiteer whose power to exploit the emergency far exceeds that of the steel industry or munitions makers during the past century’s world wars.”)

“Today’s progressive Democrats should be at least as bold as Wilson, Roosevelt, and Harry Truman and draft a new excess profits tax bill in the House, with Amazon particularly in mind,” Davis writes. “Here’s a revenue stream that could not only save the Postal Service but rebuild it after years of budget cuts and unfair competition with FedEx and UPS.”

Finally, the most thoughtful proposal for an excess profits tax comes from University of Michigan law professor Reuven S. Avi-Yonah. “Given that most corporations are losing money but some are now earning excess profits due to the crisis, it is time to revive the wartime excess profits taxes that the U.S. deployed in World War I and World War II to prevent the winners of those emergencies from achieving this form of opportunistic unjust enrichment,” Avi-Yonah writes in The American Prospect.

Avi-Yonah examines the crucial question of how to define excess profits. He describes the two methods used during World War II to calculate “normal profits,” which were then used to identify excess profits: the average earnings method and the invested capital method. I’ll return to those methods below, since they are essential, but for the time being, it’s important that Avi-Yonah believes the average earnings method would be appropriate for any similar tax enacted during the current crisis.

Original Debate

Having surveyed some contemporary proposals, let’s return to the history of excess profits taxation. Specifically, let’s start at the beginning: World War I, when some of the most important arguments about taxing excess profits got their first public airing.

Even before the United States entered the war, President Woodrow Wilson signed into law an excess profits tax. That tax, like the narrower munitions tax that preceded it, was grounded in widespread concerns over war profiteering. Our guide to those concerns, as well as the broader debate over wartime profits taxation, is Ajay Mehrotra, a law professor at Northwestern University and executive director of the American Bar Foundation.

In his prizewinning book, Making the Modern American Fiscal State: Law, Politics, and the Rise of Progressive Taxation, 1877-1929, Mehrotra recounts the grand ambitions of the Wilsonian excess profits tax. The Revenue Act of 1917, passed in March of that year, featured a profits tax that signaled the “Wilson administration’s desire to alter the concept and meaning of business profits,” according to Mehrotra. More specifically, the act’s use of the term “excess profits” carried an important, normative implication “that there was some reasonable level of earnings that a business was entitled to, but that any surplus amount above that level was ‘unreasonable’ or ‘abnormal’”:

Such surpluses generated by the war were windfall gains that exceeded a legitimate amount of financial profit. A tax on these profits reflected the belief that the broader public, operating through the powers of the state, had a legitimate stake in collecting excess profits generated by war profiteering. Profits, in this sense, were no longer simply the gains earned by private effort.

This view of private sector profits was unsettling for those of a traditional, conservative mind-set — and exciting for those with more progressive and redistributive ambitions. A public claim to the “excess” share of private profits might be tolerable for corporate taxpayers, if such a claim could be restricted to periods of national emergency. But what if an emergency claim opened the door to similar claims in less extraordinary times? Might public claims on private profits become routine? Could they become a fixture of modern public finance?

That was certainly the hope of many progressive reformers, including one with outsize influence on the wartime tax debate: House Ways and Means Committee Chair Claude Kitchin.

Kitchin and his allies hoped to make the World War I excess profits tax a permanent feature of the federal tax system. Kitchin believed that the levy would do more than simply raise more money from big corporations and the shareholders who owned them; it would also discourage the growth of monopolies, checking the concentration of political and economic power that seemed to be a hallmark of modern capitalism.

Throughout World War I, policymakers in Congress and the Wilson administration wrestled over the design, scope, and functionality of the excess profits tax. Many of their arguments were driven by revenue needs, which continued to escalate along with the American war effort. But the arguments also reflected a continuing division over the purpose and future of the excess profits tax. Was the tax an emergency measure designed to raise much-needed revenue in wartime? Or was it destined to be something more durable? A permanent addition to the federal tax system that would recast the relationship between the state and private enterprise?

During the war, this argument played out principally in legislative efforts to define which profits were normal and which ones excessive. The first version of the excess profits tax, enacted on March 3, 1917, used an invested capital method: The law decreed that anything greater than an 8 percent rate of return on invested capital was excessive and therefore subject to taxation using a system of graduated rates ranging from 8 percent to 60 percent.

The invested capital method was unpopular with taxpayers, many of whom found it burdensome. Many academic and governmental tax experts also disliked the method, arguing that it was confusing and hard to administer. Edwin R.A. Seligman, perhaps the most prominent tax economist of the era, complained that “what constitutes capital is so elusive as to be virtually impossible of precise calculation.”

Mehrotra writes that even more striking was the conclusion of an official Treasury Department study: Commissioned just months after the law was passed, it found that large corporations were able to manipulate the new tax, inflating the base from which they calculated their rates of return. Small businesses, with less accounting flexibility, ended up bearing a relatively higher burden under the law. The excess profits tax was missing its mark.

In response to those concerns, Treasury developed an alternative form of excess profits taxation. The new tax calculated excess profits using an average earnings method: Companies would be taxed at a flat rate on all wartime profits that exceeded an average of several years’ earnings from the prewar period. Treasury Secretary William McAdoo recommended the new approach in a letter to Kitchin, insisting that it would more directly limit war profits while avoiding many of the complexities and inequities bedeviling the invested capital method.

Kitchin disagreed with that approach. “From the beginning, populist lawmakers like him wanted to make the excess-profits tax a permanent part of the national tax system,” Mehrotra writes. “Enacting a tax that relied on prewar earnings as its baseline would mean conceding that the levy was a temporary measure – one that could be discarded easily at the end of the conflict.” Better to structure the tax in such a way that it could survive the transition to a peacetime economy, in Kitchin’s view.

Treasury officials continued to lobby hard for the new tax, convinced that it more precisely targeted war profiteers. Perhaps even more important, some of the department’s most senior leaders were also uneasy with the larger ambitions implied by the invested capital method. Taxing on the basis of returns to capital seemed to imply a permanent government interest in regulating corporate profits.

One of the department’s top lawyers, Russell Leffingwell, wrote a confidential memo to Wilson’s personal secretary outlining those concerns. In the message, he drew a bright line between a war profits tax (using an average earnings method) and an excess profits tax (using an invested capital method):

A war profits tax finds its sanction in the conviction of all patriotic men of whatever economic school, that no one should profit largely by the war. The excess profits tax must rest upon the wholly indefensible notion that it is a function of taxation to bring all profits down to one level with relation to the amount of capital invested, and to deprive industry, foresight and sagacity of their fruits. The excess profits tax exempts capital and burdens brains, ability and energy.

These were serious concerns, striking at the heart of Kitchin’s legislative agenda. Leffingwell believed that excess profits taxes using the invested capital method “challenged the profit motive and the fundamental precepts of modern American capitalism,” Mehrotra writes. It was one thing to curb war profiteering. It was something else entirely “to undermine the long-term incentives that he believed were the driving force of the nation’s economic growth and productivity.”

Leffingwell didn’t manage to slay the original excess profits tax, which remained on the books (in modified form) for the rest of the war. However, he and his Wilson administration colleagues persuaded Congress to adopt a second profits tax using the average earnings method, effectively saddling businesses with two extraordinary profits taxes for the duration of the conflict.

In public statements, the second of those levies was explicitly framed as temporary. More important, its very structure — including the method of calculation — reinforced its temporary status. Meanwhile, champions of a permanent excess profits tax could cling to the hope that the original, invested capital levy might survive the war, becoming a permanent feature of the federal tax system. It was an uneasy compromise.

It was also a deeply complicated one. In that sense, it was an accurate reflection of the tumultuous political debate that had long surrounded the question of how to tax corporate profits, in both war and peace. More than a decade later, when that debate was still far from resolved, yet another Treasury Department study did a good job describing the dysfunction of the World War I legislation:

In the provisions of the acts, however, in the hearings, and in the congressional debates accompanying their passage, there was more than a hint that excess profits taxation might become a permanent feature of the federal revenue system. Congress wavered between the ‘war profits’ principle for basing the tax, which was assumed suitable only for temporary use, and the ‘excess profits’ principle, which was believed capable of continuing imposition. . . . Because of conflicting views as to the proper course to purpose, the United States used both principles in part and produced a pretty thoroughly confusing result.

As it happens, Kitchin had lost the battle for a permanent excess profits tax, even if he didn’t know it then. The tax, however it was structured, remained deeply unpopular with the business leaders, and agitation for repeal began even before the war ended. In 1919 Wilson told Congress that the levy “should be made the basis of a permanent tax system which will reach undue profits without discouraging the enterprise and activity of our business men.”

But lawmakers were already sprinting toward repeal. Even Wilson’s Treasury secretary, Carter Glass, complained in his 1919 annual report that the excess profits tax “encourages wasteful expenditure, puts a premium on overcapitalization and a penalty on brains, energy, and enterprise, discourages new ventures, and confirms old ventures and their monopolies.”

Congress repealed the tax, in all its complicated glory, in 1921. Kitchin’s hope for a permanent version of the levy — and a permanent federal role in regulating corporate profits — came to nothing.

Crisis and Beyond

The excess profits tax was never popular with the businesses that paid it. But when framed narrowly as a war tax, it was at least tolerable for the duration. Or perhaps it’s more accurate to say that it was hard to resist, since a tax designed to curb profiteering enjoyed broad popular support during the war.

That support didn’t extend, however, to peacetime taxes on excess profits. The normal corporate income tax, of course, survived the war relatively unscathed (although with reduced rates). But peacetime taxes on excess profits remained popular only among a small cohort of progressive lawmakers and the left-leaning fiscal experts who advised them. The excess profits tax never transcended its role as an emergency levy.

Lawmakers revived the excess profits tax during World War II and again during the Korean War. Both times, the levies were explicitly designed to be temporary. The latter iterations of the tax continued to use both the invested capital and average earnings methods for calculating excess profits. But all excess profits taxes after World War I allowed taxpayers to choose the method they preferred. Just as important, the taxes were always framed in public debate as extraordinary, temporary measures. Even more important, perhaps, provisions for unwinding them were enacted during the actual war emergencies themselves.

Business leaders never took for granted the temporary status of these taxes; they remained ever vigilant, perhaps remembering the grander ambitions of Kitchin and his fellow progressives. But those ambitions proved to be a hard sell after the end of the First World War. Which underscores the central point about these taxes: Their political viability depends on the extraordinary circumstances surrounding their enactment. That viability starts to erode when people begin to suspect that such a tax might stick around after the emergency has ended.

Pandemic Plans

Which brings us back to current proposals for pandemic taxes. Of the three plans described at the start of this article, at least two seem as though they might survive the emergency. The Saez-Zucman plan, by explicitly invoking the invested capital method of calculation, opens the door to taxing non-emergency profits that exceed some sort of fixed, statutory standard. There may be defensible reasons for taxing extraordinary returns to capital routinely — but those reasons aren’t associated with national emergencies and cannot, politically, count on the support that these emergencies provide.

Similarly, Davis’s plan to save the post office by taxing Amazon seems to harbor larger, non-emergency ambitions. I suspect that Davis might admit to those motives, but his plan still raises questions about the effort to cloak anti-monopoly taxation in the mantle of emergency legislation.

Avi-Yonah’s proposal, by contrast, is the only one of the three excess profits plans to target pandemic profits rather than outsize profits more generally. His rhetorical framing is clear. “As the nation and world undergoes the coronavirus crisis, it is unconscionable that some corporations would profit while everyone else suffers,” he writes. “There is no reason not to use this opportunity to revive the excess profits tax and apply it to profits that derive entirely from the pandemic.”

More important, Avi-Yonah’s embrace of the average earnings method for calculating excess profits is consistent with his relatively narrow target. This technical question of how to define the tax base may seem obscure. But in the history of American excess profits taxation, it has been a central point of contention, second only to arguments over rates (and even that’s debatable).

As I have argued recently, I’m not entirely convinced that the moral arguments buttressing wartime excess profits taxes will translate so easily to the current pandemic emergency; limiting the profits of arms manufacturers carries a different moral and political valence than limiting the profits of vaccine producers. (Prior analysis: Tax Notes Federal, Mar. 30, 2020, p. 2023.)

But if we accept the notion that the current pandemic emergency is analogous to war, Avi-Yonah’s proposed tax would be broadly consistent with the political history of American excess profits taxes. While such a tax might still be a hard sell in American politics, it’s likely to fare better than more ambitious efforts to tax outsize corporate profits more generally.

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