The capital gains preference has been remarkably durable. Added to the federal income tax in 1921, it has survived decades of complaint, including charges that it makes the tax system less fair and more complex. (Prior analysis: Tax Notes Federal, Feb. 1, 2021, p. 699.) Lawmakers have generally found such arguments unpersuasive. Only once have they agreed to eliminate the preference, and even then, just for a moment; after disappearing in 1988, it reappeared after a hiatus of just three years.
The preference has staying power.
Still, efforts to eliminate the capital gains break — or at least diminish it — have been a recurring feature of American tax politics. One of the most interesting episodes came during the 1930s, when lawmakers first moved to curb and reform the preference, only to change their minds and expand it four years later. Suspicious in 1934, they were solicitous in 1938.
The seesaw history of the capital gains preference during the 1930s tells us a lot about the New Deal and its shifting political fortunes. But it also tells us something about the preference itself, including its relationship to broader economic trends. Sometimes, when times are tough, as they were in 1934, the preference can be cast as a giveaway to the rich — and that can lead to new curbs and limits.
But at other tough times, that same preference can be cast as pro-growth and pro-recovery. And that can lead to its liberalization and expansion.
The politics, in other words, are not simple. And that’s something modern-day champions of reforming the preference — President Biden included — might want to keep in mind.
This week, we’ll take a look at the 1934 effort to reform and restructure the capital gains preference — first enacted in 1921, and left more or less undisturbed until the Great Depression changed the politics of taxing Wall Street. Next time, we’ll take a look at Wall Street’s successful effort to roll back those changes just four years later.
Punishing Wall Street
When Franklin D. Roosevelt assumed the presidency, he inherited a tax system largely created by Republicans. (Prior analysis: Tax Notes, Sept. 1, 2003, p. 1201.) To some degree, the tax system of 1933 was the fiscal legacy of Andrew Mellon, Treasury secretary for all three GOP presidents of the 1920s and the patron saint of tax cutters ever since.
But Mellon’s inveterate tax cutting had come to an end with the start of the Great Depression; Mellon himself endorsed tax increases to help shrink depression-borne deficits, and in 1932 his successor, Ogden L. Mills, cooperated with Democrats in Congress to enact a sweeping revenue law imposing the largest peacetime tax hike to that point in American history. The law imposed many new taxes and raised numerous old ones. It boosted income tax rates across the board; the top rate on individual income rose from 25 percent to 63 percent.
Lawmakers, however, chose to leave the capital gains rate unchanged: It remained 12.5 percent, exactly as Congress had provided in the Revenue Act of 1921. This turned some old problems into bigger new ones. “The substantial increases in individual income-tax rates that were effected by the Revenue Act of 1932 greatly accentuated the disparity in the tax treatment of capital gains as compared with income derived from other sources,” observed Treasury tax experts in a 1937 study of the topic.
By 1934 Congress was ready to change the treatment of capital gains, spurred on by simmering popular outrage directed at Wall Street. In 1933 the Senate Committee on Banking and Currency had conducted a high-profile investigation of the 1929 stock market crash, hauling before the panel an array of Wall Street titans and grilling them about their responsibility for the calamity.
Along the way, the panel’s lead investigator, Ferdinand Pecora, questioned these financiers about the details of their personal tax returns. The resulting headlines inflamed the nation, especially after the testimony of J.P. Morgan Jr. (Prior analysis: Tax Notes, Nov. 10, 2003, p. 688.) “Morgan Paid No Income Tax for 1931 or 1932,” declared The New York Times on May 24, 1933.
“A cry of anguish ascended to high heavens when millions of white collar workers discovered that they had been nicked for a considerable percentage of their earnings for 1930 and 1931 when J.P. Morgan and partners had paid no income tax at all,” observed Business Week.
Morgan’s failure to pay income taxes had much to do with his failure to earn any income. Neither Morgan nor his partners had paid income taxes because their firm had suffered huge losses in the market meltdown, wiping out every other source of income. “I am not responsible for these figures,” Morgan observed with wry dismay. “I viewed them with great regret when they appeared.”
The Morgan episode focused immediate attention on the tax treatment of capital losses, which Congress moved to limit in 1933, when the National Industrial Recovery Act limited the loss carryforward for short-term losses on the sale of stocks and bonds.
Sliding Scales
But the Pecora investigation also prompted Congress to take a hard look at the treatment of capital gains and losses more broadly. In 1934 the House Ways and Means Committee announced plans to revamp the treatment of capital gains for the first time since 1921.
In its report on the Revenue Act of 1934, the committee explained why it believed that reform was necessary. First, the contemporary regime, which granted preferential treatment for gains on assets held for a minimum of two years, produced “an unstable revenue,” with large receipts in prosperous years and low ones in lean years. Second, it failed to account for the effect of inflation on asset prices. Third, it encouraged taxpayers to realize losses immediately but to delay gains for two years, thereby depressing both revenues and asset prices during hard times. Fourth, it gave relief only to those taxpayers who could afford to delay realization for the full two years.
To rectify these problems, the committee suggested a new plan. Gains would be included in income and taxed at regular rates but would be subject to a sliding inclusion scale based on the length of time an asset had been held by the taxpayer.
Legislators in both houses signed on for this idea, and the Revenue Act of 1934 established a new system of exclusions based on holding periods. For assets held one year or less, 100 percent of the realized gain would be included in income and taxed at normal rates. For assets held between one and two years, 80 percent; between two and five years, 60 percent; between five and 10 years, 40 percent; and more than 10 years, 30 percent. Capital losses would be recognized using the same scale and netted against capital gains. If losses exceeded gains, the taxpayer could deduct losses up to the total of recognized gains plus an additional $2,000.
This scheme was not entirely novel. The Senate had considered a similar arrangement in 1921 when first debating a preference for capital gains, according to a 1951 Treasury study on capital gains (Treasury, “Federal Income Tax Treatment of Capital Gains and Losses: A Treasury Tax Study” (1951)). In 1928 another version of the idea had been proposed to the Ways and Means Committee by the staff of the Joint Committee on Internal Revenue Taxation (JCIRT).
At the time, JCIRT defended the plan as a way to compensate for timing inequities. “The tax on capital gains should approximate the tax which would have been paid if the gain had been realized in uniform annual amounts over the period during which the asset was held,” the JCIRT explained. (Whether the scheme as proposed would actually have resolved such inequities was another matter, as critics were eager to point out.)
By the time the Ways and Means Committee advanced the idea in 1934, Treasury officials were distinctly cool to it. The plan as enacted struck the department’s tax experts as complex and counterproductive. Indeed, Undersecretary of the Treasury Roswell Magill — a Republican, but also one of Roosevelt’s chief tax advisers throughout the 1930s — preferred a flat-rate capital gains preference along the lines of the 1921 provision.
Magill suggested to lawmakers that the new plan would actually accentuate the lock-in problems that it claimed to ameliorate. If the two-year holding period under current law was a problem, then adding a range of new, longer holding periods would only make matters worse. “The plan puts a premium on holding appreciated assets five years, in which case only one-fifth of the actual profit will be recognized,” Magill observed of the original Ways and Means proposal (the final version added another, 10-year period). “Thus, the proposal puts an even greater brake upon the sale of capital assets at a profit than is the case at present.”
Magill stressed that lock-in effects had probably contributed to the stock market bubble of the late 1920s. “Taxpayers have urged that the taxation of capital gains unduly hinders or delays sales of property which has appreciated in value, and, in this way, promotes the conditions which prevailed in 1929,” he wrote. “Undoubtedly this reluctance [to realize gains] on the part of many taxpayers caused them to overreach themselves in 1929.”
Business lobbyists echoed Magill’s concerns. While Congress was debating the 1934 reform, the Committee on Federal Taxation of the U.S. Chamber of Commerce issued a report opposing the plan. The proposed change to capital gains taxation would distort markets and encourage market bubbles, the panel warned. “Any tax structure which places heavy taxes upon capital gains, or offers inducement to the owners of capital assets to hold such assets so as later to take advantage of lower rates, tends to accentuate the undesirable business cycle aspect of the tax by their constant inducement to delay sales in times of rising prices, thus tending to stimulate inflation,” the group wrote.
Those warnings fell on deaf ears. The Pecora investigation had left Wall Street badly tarnished in the eyes of the public, and even nonfinancial business lobbyists like the chamber had yet to regain their footing on Capitol Hill. Lawmakers, meanwhile, were inclined to approach financial and tax issues with two goals in mind: revenue and moralistic posturing. For capital gains, both goals could be served by an emphasis on holding periods.
Congressional tax experts expected the new capital gains regime to raise about $30 million in added revenue, just under 10 percent of the total expected from the act as a whole. More important, this revenue would be relatively stable compared with the revenue generated by the flat-rate preference, which was notably cyclical.
Ultimately, however, it was the equity considerations that weighed most heavily for lawmakers. They believed that the new sliding-scale regime would operate more fairly than the flat-rate preference in operation since 1921, calibrating benefits more precisely and granting the largest benefits to those inclined to make the longest investments. They believed that it adjusted tax burdens for timing discrepancies in a way that a flat-rate preference never could.
To some degree, this argument also had a moralistic, politicized component. By emphasizing and multiplying holding periods, the act underscored the distinction that lawmakers often make between “investment” and “mere speculative profits” (to use the phrase that JCIRT staff did at the time). The former were admirable and worthy, deserving of a tax preference. The latter were dubious and suspect, with a moral status akin to slot machine winnings, and they deserved no tax break at all.
It’s important to understand what the 1934 capital gains reforms were not: They were not a frontal attack on the idea of taxing capital gains differently from other forms of individual income. Lawmakers never seriously considered simply treating capital gains as regular income. Such proposals had no serious traction in the tax policy community.
But Democratic policymakers of the early New Deal were keenly interested in curbing what they considered the abuses and inequities of capital gains taxation during the 1920s and early 1930s. They were aided by the theatrics of the Pecora investigation, as well as the real-world tragedy of the stock market crash and the Great Depression itself. Those factors combined to make reform possible even in the face of business opposition.
But if the titans of American finance were ill-positioned to resist progressive reforms in 1934, they would not remain hobbled for long. In just a few short years, in the face of a renewed economic slump, they would find traction for their own pro-business reforms to the capital gains provisions of the tax law.