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Tax History: Compromising on the Current Tax Payment Act of 1943

Posted on Mar. 25, 2024

Franklin Roosevelt described the Revenue Act of 1942 as the “greatest tax bill in American history.” A low bar, to be sure, but the law was certainly dramatic, even transformative. Most fundamentally, it raised an enormous amount of new revenue: Federal tax receipts climbed from $14.6 billion in fiscal 1942 to $24 billion in 1943. Much of this revenue came from higher income tax rates, which Congress pushed to new heights for both individuals and corporations.

More important, however, the 1942 tax law dramatically increased the number of people paying income taxes. Millions of Americans joined the rolls for the first time, recasting the very nature of the individual income tax. “For the first time in our history,” declared Treasury Secretary Henry Morgenthau Jr. during debate over the measure, “the income tax is becoming a people’s tax.”

For all its accomplishments, the 1942 act was not without problems. To begin with, it didn’t raise enough money for the “total war” that the United States was fighting. The nation needed more tax hikes, bigger than anything Congress had approved in 1942. And many worried Congress wasn’t up to the job. “I do not know when we are going to get total war on taxes,” Morgenthau complained. (Unless otherwise indicated, Morgenthau quotations are drawn from John Morton Blum, From the Morgenthau Diaries: Years of War (1959).)

The law also lacked a crucial administrative provision: collection at the source for individual income taxes. Nor did it move taxpayers to a system of current collection. Since 1913, taxpayers had been running a year behind: Each spring, they filed a return and paid taxes on the previous year’s income. In theory, people saved enough during the course of the year to make good on the eventual tax bill. In practice, some number of improvident taxpayers found themselves short of cash when tax day rolled around.

The problem was expected to get much worse under the 1942 law, with its new, vastly broader income tax. Would middle-class taxpayers remember to file? If they did, would they be able to pay what they owed?

Withholding was the obvious answer to these questions, at least prospectively. Collecting income taxes at the source had been tried before, both during the Civil War and between 1913 and 1916. But those experiments were limited to certain kinds of income, and neither lasted very long. The first disappeared along with the income tax itself in 1872. The second succumbed to complaints from the business community, which resented the cost and inconvenience of collecting taxes on behalf of the government.

By 1942, however, withholding was already in operation, having been introduced as part of the Social Security program established in 1935. “By mid-1940, the Bureau of Old-Age Benefits had processed, without the benefit of electronic computers, more than 312 million individual wage reports forwarded by the Bureau of Internal Revenue (BIR) and had posted more than 99 percent of them to more than 50 million individual employee accounts,” noted W. Elliot Brownlee in Federal Taxation in America: A Short History.

When Congress was drafting the 1942 revenue act, the Treasury Department suggested a withholding system for individual income taxes. But Congress had punted, planning to revisit the idea the following year.

But the delay left policymakers worried, especially at Treasury. The 1942 act required millions of Americans to pay income taxes for the first time. But it didn’t provide them with much help or guidance. As these neophyte taxpayers came face-to-face with their new fiscal responsibilities, would they understand what they needed to do?

“I didn’t sleep last night; I was worrying about this thing,” a worried Morgenthau told his staff just five days before the 1943 filing deadline. “Suppose we have to go out and try to arrest five million people?”

A New Bill

Heading into 1943, Treasury experts had begun drafting plans for a new tax law. Eager to fix problems with the old one while also raising new revenue, they approached the task with marching orders from the president.

New taxes, Roosevelt had decreed, should not be “too complicated.” They must also be easy to administer. Finally, Treasury should avoid any “harassment” of the business community.

In addition to these generalities, Roosevelt had some specific requirements. The nation needed higher individual and corporate income taxes, he said. It would also be wise to expand the Social Security program; expanded benefits in the future (desirable in their own right) could be funded with higher payroll taxes in the present. During the interim, the treasury would get a nice boost. Finally, Roosevelt asked for “a very stiff withholding tax” to simplify and streamline tax collection from individuals.

It was hard to know how seriously to take these preferences, given Roosevelt’s sporadic interest in tax policy. Sometimes he focused intently on the issue, taking firm positions and voicing them publicly. More often, he was happy to delegate to Treasury; taxes seemed to bore him. In mid-December, just a few days after delivering his tax preferences to Morgenthau, FDR had already moved on. “I could tell by the look on his face that he hadn’t seen the budget, and he didn’t know, and didn’t care,” the secretary told his staff.

Still, withholding was clearly a high priority, both for the president and his tax staff. So was the introduction of “current collection,” which would spare taxpayers the need to save during one year for taxes due in the next.

Rather than paying 1943 taxes in a lump sum in early 1944, Treasury wanted taxpayers to stay current: People should pay 1943 taxes incrementally throughout the year. Withholding would provide the mechanism for this current collection, at least for most taxpayers, as current taxes were withdrawn from current paychecks.

Transition Problems

The move to current collection created a transition problem: Absent any relief provisions, taxpayers would be expected to double up on tax payments. “The problem of transition was hard to solve,” recalled Treasury General Counsel Randolph Paul in his 1954 history of the period. “In the first year, 1943, some taxpayers would be required to pay, at the same time, the tax on 1942 income and part of the tax on 1943 income.” Withholding would smooth the process of making those double payments, at least to some degree. But it would not eliminate the extra burden.

Some sort of transition relief seemed unavoidable, and Treasury developed some suggestions (most of which involved a delay in meeting past tax obligations). But the most popular proposal for relief came from Beardsley Ruml, treasurer of the R.H. Macy Co. and chair of the Federal Reserve Bank of New York.

Ruml’s scheme was simple, at least in broad strokes. Like most people, he believed that individual income taxes should be paid currently, probably (although not necessarily) through a system of withholding. To ease the transition — and avoid the doubling-up problem — Ruml proposed to simply cancel 1942 tax liabilities. People would begin incremental payments in 1943, and those payments would be applied to 1943 tax liabilities.

The flow of money into the treasury would continue uninterrupted, Ruml insisted. The canceled taxes would only be evident on “judgment day,” he suggested, when the books were finally closed once and for all. And at that point, he added, “these would be bad debts in any case.” (For more on Ruml’s plan, see prior analysis: Tax Notes Federal, Mar. 4, 2024, p. 1731.)

Roosevelt and his tax experts believed that Ruml’s plan for wholesale tax forgiveness was “unnecessary, inequitable, and inflationary.” They didn’t dispute that money would continue to flow into the treasury at a good clip. But they were aghast at the windfall that cancellation would deliver to taxpayers — especially rich ones.

Elinor Morgenthau, wife of the Treasury secretary, said as much when trying to bolster her husband’s resolve. Forgiveness, she said, was “just 100 percent against your philosophy of giving no one, especially the very rich, preferential treatment.”

Predictably, most taxpayers didn’t share this moral outrage; cancellation seemed pretty attractive to people facing the income tax for the first time. As a result, Ruml’s plan continued to gain popularity throughout the latter half of 1942 and the beginning of 1943.

Treasury had resisted the Ruml plan when it first surfaced the year before. Indeed, the department’s opposition had successfully scuttled the idea during debate over the 1942 revenue act. But the battle continued as lawmakers began drafting 1943 legislation, and Treasury gave Roosevelt some talking points to help undermine the Ruml plan’s political appeal.

The plan, Morgenthau told the president in a February 11, 1943, memo, would deliver disproportionate windfalls to the nation’s very richest taxpayers:

  • Those earning more than $1 million in 1942 (about $16.9 million in 2024 dollars) would save at least $854,000 ($14.4 million) in taxes.

  • Taxpayers earning $100,000 ($1.7 million) would save $64,000 ($1.1 million).

  • Taxpayers earning $10,000 ($169,000) would save $2,150 ($36,400).

  • Taxpayers earning $2,000 ($33,800) would save just $140 ($2,370).

For Morgenthau and Roosevelt, the unfairness of this distribution was self-evident. But Ruml’s plan also threatened the very purpose of raising taxes in the first place. The nation needed money for the war effort. Canceling 1942 tax liabilities, when coupled with withholding of 1943 taxes, would leave the flow of money into the treasury basically unchanged. But it would obviously sacrifice billions in uncollected revenue; instead of collecting two years of taxes, the government would get just one.

Moreover, cancellation might not be as popular as its champions expected, the Treasury secretary contended. “As Morgenthau saw it, the cancellation of a year’s taxes would be a psychological deterrent to the war effort, injurious to the morale of soldiers who had every reason to expect some sacrifice at home,” Blum explained. “It would also lead to the release of funds which had been set aside for meeting taxes already due, funds which would then contribute to inflation.”

On March 12, three days before the annual tax filing deadline, Roosevelt attacked the Ruml plan during a press conference. “The fact, of course, still remains,” he said. “The individual does, especially in the higher brackets, save a great deal of money in taxes to the government through the Ruml Plan.”

Pressed to elaborate, Roosevelt stayed on message, underscoring the distributional inequity of blanket forgiveness. Treasury, he said, had provided him with details on who would benefit most — including those people earning the 10 largest incomes in 1942. “Of course, we can’t give the names of any of these people, obviously,” he said.

Reporters seemed to have a hard time grasping Roosevelt’s point, focusing instead on Ruml’s assurance that money would continue to flow into the treasury. Wasn’t that the only thing that mattered?

Roosevelt seemed to get a bit confused when trying to answer this question. At one point, he nearly stumbled into clarity, thanks to a helpful question from one reporter. “Mr. President, do those figures show that the actual collections by the Treasury would be less this year under the Ruml Plan, or do they show that from rich people and other people less money would be collected if you collected one year’s tax, than if you collected two years’ taxes in one?”

So close. And yet Roosevelt let the moment pass. “Now wait a minute,” he responded. “You are going over the heads of all of us.”

Roosevelt’s steadfast, if somewhat confused, opposition to the Ruml plan seemed to bolster the spirits of congressional Democrats, who were starting to soften in their own fight to hold back the proposal. Robert Doughton, a North Carolina Democrat who chaired the House Ways and Means Committee, had been fighting to slow Ruml’s momentum, and he was glad to have FDR enter the fray.

Fighting Forgiveness

In a letter to Paul, Doughton called the Ruml plan “the biggest outrage ever attempted to be perpetrated upon the people of the United States.” And resisting that plan was ultimately its own reward. “Win or lose, we will have the satisfaction of knowing that we stood up in battle for a just cause against a most iniquitous proposal.”

As it happened, Doughton had already advanced a compromise plan for partial tax forgiveness. Treasury preferred no forgiveness at all, instead suggesting delayed payment schedules to help ease the transition. But Doughton — closer to the political realities of 1943 — understood that Ruml had already sold cancellation to the public. The only question was how much cancellation might be necessary to escape the voters’ wrath.

In its report on the Current Tax Payment Act of 1943, Ways and Means had dismissed Ruml’s call for total forgiveness. “While the objective of providing for taxpayers to become current in the payment of their Federal income taxes is desirable, yet we do not believe that the country at this critical time can afford to forgive $10,000,000,000 of tax liability already due and owing by the taxpayers to accomplish this purpose,” the majority wrote.

Republicans on the panel, however, were happy to embrace full cancellation. And when the fight moved to the floor of the House, many rank-and-file Democrats joined them. On March 30, by a vote of 199 to 188, the House adopted the Ruml plan — only to revote the same day and reject it 215 to 198. A close call, and a bad sign for anyone hoping to defeat cancellation entirely.

Meanwhile, all the talk about cancellation had apparently left taxpayers confused. Treasury Assistant Secretary John Sullivan warned lawmakers of “the misapprehension in the minds of many taxpayers who have a feeling that perhaps something will be done by the Congress which will relieve them of the necessity of filing their returns and paying their quarterly tax.” That expectation was already having a real-world effect; as the 1943 tax deadline drew near, the Bureau of Internal Revenue reported a sharp decline in expected filings.

Senate Struggle

The House eventually approved legislation featuring 60 percent forgiveness of 1942 tax liabilities. But the Senate Finance Committee had more expansive plans, rejecting the House compromise and adopting the Ruml scheme intact. On May 14 the full Senate approved Ruml’s plan for total cancellation by a vote of 49 to 30.

On May 17 Roosevelt intervened. In a letter to congressional leaders, he made his position clear. “I am eager, as I am sure the whole country is eager, to see our taxes put on a pay-as-you-go basis at the earliest possible moment,” he noted. Among other things, such a move was vital to help contain inflation.

But the Senate bill, featuring complete forgiveness, was unacceptable. “This cancellation would result in a highly inequitable distribution of the cost of the war and in an unjust and discriminatory enrichment of thousands of taxpayers in the upper income groups,” Roosevelt wrote. “Such groups would be enriched by the cancellation of taxes already owing by them.”

FDR dispensed with arguments that cancellation would leave revenue flows unharmed. “The fact that the upper income groups may pay just as many dollars into the Treasury in 1943 on account of their liability for 1943 does not detract from their enrichment nor change the result that they would have permanently escaped tax on 1942 income,” the president argued.

Total forgiveness would also create new burdens for those least able to pay. “Others, including those now on the battle fronts, would later be obliged to shoulder the burden from which our most fortunate taxpayers have been relieved,” Roosevelt wrote.

The president concluded on a note of compromise — and warning. “I believe that there should be substantial adjustments to ease this transition” to current collection, he told lawmakers. “But there are limits beyond which I cannot go.”

A House-Senate conference committee eventually settled on a compromise: To make taxpayers current, Congress would forgive 75 percent of 1942 or 1943 tax liabilities, whichever was less. To ease future compliance burdens, a new withholding system would take 20 percent from most paychecks, easing the task for inexperienced taxpayers.

It was an imperfect compromise, especially from Treasury’s perspective. But it was an important and probably unavoidable one. Tax forgiveness was simply too popular to resist entirely.

And ultimately, the introduction of withholding and current collection was probably worth the sacrifice. Both were necessary components of the new fiscal regime introduced during the war. And they provided for the survival of this regime long after the war had ended.

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