June 1, 1933, was a bad day for J.P. (Jack) Morgan Jr. Summoned to testify before a Senate committee, the scion of Wall Street wilted visibly under public scrutiny. For more than a week, he and his partners had been badgered by the Banking Committee's chief counsel, Ferdinand Pecora. Eager to illuminate Wall Street's seamy underside, Pecora had grilled Morgan on his business practices. A week later, the banker found events moving from bad to worse.
Mesmerized by the humbling of Wall Street's gray eminence, reporters were having a field day. So, too, were the hearing's spectators, who jammed the Senate caucus room in hopes of snaring a front-row seat. At least one member of the committee found the whole scene revolting. "We are having a circus," complained Sen. Carter Glass, D-Va., "and the only things lacking now are peanuts and colored lemonade."
Charles Leef, a publicity agent for Barnum & Bailey Circus, seized on Glass's comment. The next day, he appeared at the June 1 hearing with Lya Graf, a circus performer of very small stature. Leef dropped Graf, who stood just 27 inches tall, in Morgan's lap, setting the stage for one brief conversation and countless famous photographs.
Graf and Morgan appeared together on the front page of newspapers across the country. It was a low point for Wall Street's most famous private banker, who found himself reduced to something of a public spectacle. The great House of Morgan, established by Jack Morgan's imperious father, J.P. Morgan Sr., had seldom been the subject of scrutiny, much less ridicule. But the Pecora investigation had brought many embarrassments to the firm, not the least of which concerned Morgan's personal tax returns.
The Investigation
Seventy years ago, Wall Street had a big problem. Financial leaders squirmed under the spotlight of Pecora's sensational investigation. Prompted by the crash of 1929, the Senate Banking Committee had begun a series of hearings on stock exchange practices. Wall Street critics expected the panel to spin a tale of financial malfeasance, and they were not disappointed. Pecora built a powerful case for financial regulation, and Congress responded with a series of regulatory measures, including the Glass-Steagall Act, the Securities Act of 1933, and the Securities Exchange Act of 1934.
Although history remembers Ferdinand Pecora as the patron saint of Wall Street regulation, he also deserves a spot in the pantheon of tax history. Pecora scored some of his most potent political points when he strayed into issues of taxation. In doing so, he demonstrated the potent role of scandal and outrage in the process of federal tax reform.
"Morgan Paid No Income Tax for 1931 or 1932," blared The New York Times on May 24, 1933. It was a stunning revelation. How could this giant of American wealth escape the income tax? The question rang through the halls of Congress, galvanizing critics of the federal revenue system.
Washington was riveted by the Morgan testimony. His very presence seemed improbable. The Richmond Times-Dispatch spoke for many when it breathlessly observed: "J. Pierpont Morgan, the twentieth-century embodiment of Croesus, Lorenzo the magnificent, Rothschild; the lordly Mr. Morgan, with his impregnable castle at Broad and Wall Streets and his private army of armed guards; the austere Mr. Morgan, to whose presence only the mighty are admitted, in a committee room and upon his bare brow the gaze of the 'peepul.' Truly an extraordinary event."
Pecora questioned Morgan on a range of topics, including sweetheart deals for political figures and insider favors for Wall Street cronies. But Morgan felt the glare of public scrutiny most acutely when Pecora turned his spotlight on the banker's personal tax returns.
Pecora quickly established that Morgan had paid no U.S. income taxes in 1931 and 1932. The news rocked the nation. "A cry of anguish ascended to high heavens," observed Business Week, "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."
The liberal press reacted with outrage. "Rich men of the country should not be able to escape income taxes at the very moment when the rest of the country is burdened with increased taxes and when the Government is so desperately in need of revenue," the Washington Daily News fumed. The New Republic was equally indignant. "What has rankled most in the hearts of the vocal public," the magazine wrote, "is that when millions of persons with small incomes were straining every nerve to meet their income taxes, these princes of wealth, who personally enjoyed luxuries denied to almost everyone else, did not pay any income tax at all."
Pecora, a consummate showman, lingered on the tax issues, milking them for every ounce of political advantage. He wagged his finger at the great financier, refusing to let Morgan off the hot seat. Pecora resisted testimony from assistants, even when Morgan claimed ignorance of certain issues. The counsel preferred to elicit a string of admissions that the banker was unfamiliar with his own tax returns.
Capital Losses
Soon enough, Morgan got his facts straight, but they did little to burnish his public image. None of the partners in J.P. Morgan & Co. had paid income taxes for 1931 and 1932. The firm had suffered dramatic losses in the market crash, wiping out every other source of income for the partners. Indeed, the firm's net worth had plunged from $119 million in 1929 to $53 million in 1931. When all was said and done, there was simply no taxable income for any of them. "I am not responsible for these figures," Morgan insisted wryly. "I viewed them with great regret when they appeared."
Morgan stressed that during the salad days of the 1920s, he and his partners had paid millions to the federal government, including large taxes on their capital gains. Between 1917 and 1929, Morgan and company had collectively ponied up more than $57 million. But that point seemed lost on reporters and lawmakers, not to mention the general public.
Perhaps even more galling to Morgan critics, the titan had paid taxes to Great Britain in every year in which he had escaped U.S. levies. Britain did not allow deductions for capital losses -- nor did it assess a tax on capital gains. Morgan's other sources of income, including the imputed rental value of his U.K. real estate holdings, left him subject to the British income tax, which he dutifully paid, even during the worst years of the Depression.
Of course, Morgan's modest payments to the British treasury during the depths of the Depression were balanced by equally modest payments during the prosperous 1920s. Since the British tax excluded capital income, the partners had paid relatively little tax in the 1920s, at least compared with their U.S. tax bills.
Pecora spent much of his time and energy trying to lay bare one particular tax maneuver. In 1931, he pointed out, the Morgan partners had claimed a $21 million loss. The firm had admitted a new partner, S. Parker Gilbert, on January 2, and the resulting reorganization produced a write-off for depreciated securities. Pecora hammered home the unusual timing. By waiting until January 2 rather than admitting Gilbert on December 31, the firm had been able to carry over the loss until 1933 rather than just through 1932. The maneuver required a tax return covering just two days, but the Bureau of Internal Revenue had accepted it without complaint.
The Bureau, it turned out, had a soft spot for Morgan. As Pecora gleefully related, the agency declined to examine certain Morgan- related returns simply by virtue of the firm's reputation. As one auditor scrawled on a return: "Returned without examination for the reason that the return was prepared in the office of J.P. Morgan & Co., and it has been our experience that any schedule made by that office is correct." Pecora hoped to demonstrate that such trust was misplaced.
However, Morgan had broken no laws. The only fraudulent activity Pecora uncovered concerned one junior partner, Thomas S. Lamont, who had sold depressed securities to his wife and then bought them back three months later in a wash sale. But Morgan himself, as well as all the other partners except Lamont, had done nothing illegal. As one Morgan defender complained: "It is not criminality. Mr. Pecora only makes it seem so."
Indeed, Pecora did make it seem so. By training and inclination, he was a prosecutor; he had no interest in being evenhanded. As historian John Brooks later observed, "Pecora, three- quarters righteous tribune of the people, was one-quarter demagogic inquisitor."
Pecora also had friends in high places. President Franklin D. Roosevelt welcomed the Wall Street investigation. Popular outrage was just what he needed to help build the case for wholesale economic reform. In his inaugural address, FDR had served notice on financiers. "The money changers have fled from their high seats in the temple of our civilization," he declared. "We may now restore that temple to the ancient truths." Pecora's investigation gave substance to that warning.
By mid-March 1933, Roosevelt was an active spectator in the investigation, cheering from the sidelines and even whispering a few suggestions in Pecora's ear. He met repeatedly with Pecora, counseling him on tactics and politics. It was FDR who suggested the panel call J.P. Morgan to testify.
Morality and Tax Avoidance
The Pecora investigation gave rise to a vigorous debate over the moral status of tax avoidance. The political world divided between those who considered legal tax avoidance morally neutral and those who regarded it as a grave moral failing.
Pecora stood squarely on the side of righteous indignation. "The country, in 1933, was in no mood for nice distinctions between tax 'evasion' and tax 'avoidance,'" he later recalled. Tax avoidance, even when legal, was simply unconscionable in times of national emergency. Pecora stopped short of a ringing moral indictment but clearly left the impression that Morgan and his partners had shirked their moral responsibilities. "Approved by the existing tax authorities or not," he explained, "the public could not see the justice or equity of financial giants paying nothing, while Tom, Dick, and Harry scraped the bottom of their modest purses to meet their tax obligations to the government."
Pecora may not have cared for fine distinctions between evasion and avoidance, but other policymakers did. Glass, for one, considered Morgan's tax avoidance a matter of good business. Business Week explained this position sympathetically: "He knew, as virtually everyone in banking circles who had given a moment's thought to it did, that if the Morgans had not written off enough losses to prevent income tax payments in the years just past, they were just foolish." Indeed, foolishness and stupidity were something of a touchstone for Morgan defenders, and Business Week drove the point home: "Any individual who pays unnecessary taxes is merely stupid. Among all the charges and innuendoes that have been flung about, not one yet accuses the Morgan outfit of stupidity."
Morgan himself stressed his fealty to the law: "I want to make clear about it that I take great pains, and I have all my life, to pay the income taxes and other taxes I am called upon to pay by the various governments." Moreover, he had sought professional advice to ensure that his returns were accurate. "I get the best advice I can find out," he assured the Banking Committee, "that I do not underpay or overpay."
To critics, Morgan's legal advice only broadened the locus of moral turpitude. Tax lawyers took a beating in the press. The New Republic bemoaned the role of high-priced legal talent. Gaming the system only served to discredit the income tax, it contended: "This is a genuine disservice to their country on the part of the Morgan partners -- and of all the others who, though well able to pay, employ the most expensive brains in order to find out how not to."
Pecora made the same point when looking back on the hearings. "So long as we have tax statutes," he predicted, "we will have keen- eyed lawyers and accountants seeking to circumvent them."
For someone like Morgan, professional tax advice was a necessity. But lawyers weren't just filing returns; like today, they were earning their fees with tax planning. "The law had holes through which any competent attorney could drive a team and a hayrack," explained Business Week.
Speaking of "holes" implied that the loss provisions were somehow inadvertent. But Morgan's loss deductions were not the product of legislative oversight or even complicated tax planning. Capital loss deductions were a deliberate and relatively straightforward aspect of the federal revenue system.
Wealthy taxpayers had long complained about the taxation of capital income. "Be it said that wealthy men protested the capital gains and losses provisions of the income tax law back in the boom years," Business Week pointed out. "Nobody listened to them." Even liberals acknowledged that capital income provisions made the revenue system unstable; inflating receipts during the go-go 1920s, they depressed revenue in the rocky 1930s.
Morgan critics insisted that the banker's tax avoidance, while technically legal, was nonetheless morally suspect. The nation's economic tribulations only worsened the offense in the eyes of people like Paul Y. Anderson, Pulitzer Prize-winning reporter for the St. Louis Post-Dispatch. Writing in The Nation, Anderson denounced the Morgan write-offs in typically colorful language. "For them to seize upon the 'capital-losses' provision of the existing law for the purpose of withholding contributions to the support of the government under which they have prospered so greatly, was as natural as for a hog to snap up an ear of corn," he wrote.
Anderson pointed out that he, too, could have taken loss deductions. "It would have been legal, no doubt, but on the moral side it would have been a plain case of cheating the government," he proclaimed. Anderson objected to the common refrain, offered frequently by Morgan's defenders, that tax avoidance was almost universal:
We have our faults. Some of us lose more than we can afford at golf, bridge, or poker; some indulge in an extravagant passion for old furniture or rare editions; still others punish their lives unbearably with poor rye, bad Scotch, and worse gin; but it manifestly unjust, if not libelous, to name us in the same breath with Morgan, Lamont, Stotesbury, Mitchell, and that gang.
Morgan's tax revelations came in the midst of Roosevelt's First 100 Days -- the legislative onslaught that gave shape to the early New Deal. His tax avoidance prompted lawmakers to add new tax provisions to the pending National Industrial Recovery Act (NIRA). As passed by the House, the NIRA bill limited the deduction for stock losses on securities held less than two years, denying taxpayers the right to carry forward short-term stock losses. In the Senate, Finance Committee Chair Pat Harrison, D-Miss., suggested that Congress prohibit partners from deducting from their personal income any securities losses that were disallowed to the partnership. Before passage, lawmakers also agreed to prevent taxpayers from carrying forward net business losses from one year to the next. And they prohibited the carryforward of losses from securities held less than two years.
The NIRA changes brought an end to congressional interest in the Pecora investigation. On June 10, 1933, the House Ways and Means Committee established a new subcommittee to investigate tax avoidance. Reporting in December 1933, the panel called for a wide range of tax reforms, including several revisions intended to stem Morgan-style tax avoidance.
In drafting the Revenue Act of 1934, House taxwriters considered a sweeping reform of partnership taxes. For a time, they seemed poised to entirely forbid the deduction of partnership losses against personal income. The Treasury Department objected, insisting that since profits were taxed as personal income, losses should be deductible as well.
Ultimately, lawmakers heeded the Treasury warning. In fact, the Revenue Act of 1934 left most partnership provisions unchanged. But Congress did try to narrow some of the Morgan "loopholes" through a revised treatment of capital gains and losses. Under the law, both would be recognized according to a sliding scale gauged to the length of time an asset had been held. Those held less than a year were recognized at 100 percent, while at the other end of the spectrum, those held more than 10 years were recognized at 30 percent. Capital losses could be deducted up to the amount of capital gains during the same year, plus $2,000.
Such changes helped calm the political outrage over Morgan's tax avoidance. But tax experts were not impressed with the limitation on capital loss deductions. George Haas, a former Treasury official, later offered this scathing assessment: "The widespread sense of injustice flowing out of this treatment impairs cooperation between taxpayers and the government in the administration of the income tax. In the minds of many, the present treatment is so patently unjust as to be repugnant to all sense of fair play."
The Importance of Outrage
In little over a year, the Pecora investigation produced significant, if not quite earth-shattering, revisions to the federal tax system. But its legislative impact was actually much broader than the flurry of tax legislation in 1933 and 1934. The Pecora hearings sparked a powerful drive for tax reform that propelled legislation throughout the 1930s.
By shining the spotlight on Morgan's tax returns, Pecora had prompted a national debate over tax avoidance. The discussion simmered throughout the Great Depression, kept alive by Roosevelt's passionate sense of tax justice. The Revenue Act of 1935, widely known as the Wealth Tax Act, drew much of its political momentum and progressive substance from the Pecora investigation. So, too, did the Revenue Acts of 1936 and 1937, both of which were rooted in rhetoric and tax morality.
It seems fair to say that Pecora's brief foray into tax policy helped establish the pattern for New Deal tax reform. Although rooted in congressional activism rather than White House leadership, it was an integral part of the New Deal's evolving tax program. Indignation and outrage became a rhetorical touchstone for Roosevelt's tax policy.