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April 30, 1941


Mr. Chairman and Members of the Committee: Because of
my conviction that the impact of the present defense effort upon
our national economy will depend greatly upon the tax program now
undergoing formulation by this Committee, I particularly welcome
the opportunity to present my views to you. In doing so I shall
speak merely as an individual and not in behalf of the Board of
Governors of the Federal Reserve System. The Reserve System is,
of course, continuously engaged in the study of the workings of our
economic system as a whole and is interested, as we all are, in seeing the defense program move forward with the greatest possible speed
and with the least possible dislocation to our economic structure*
One of the most important factors in determining whether economic
dislocation will be great or small — I think we all recognize that
there must be some dislocation —» is the way in which we raise these
great sums we are spending for national defense. I mean by that not
only how much we tax as contrasted with how much we raise by borrowing but also, after we have decided how much tax revenue we ought to
have, the kinds of taxes we use to get it*
The Secretary of the Treasury has recommended that during
this emergency two-thirds of our Federal expenditure be covered by

I strongly endorse this recommendation. Yiewed in the light

of the financial history of this and other countries, this goal may


seem an extremely ambitious one. Ho great nation, to my knowledge,
has passed through a period of world disturbance like the present
without borrowing a very much larger proportion of its expenditures
than one-third. Viewed, however, in the light of our prospective
economic situation, the goal is reasonable and, indeed, a modest one.
During the past eight years I have repeatedly expressed the conviction
that a large Federal deficit is appropriate during a period of widespread unemployment and depressed national income. I have always
accompanied that statement by saying that a large Federal deficit is
inappropriate to a period of virtually full employment* There have
been some absurd exaggerations of the speed with which unemployment is
likely to vanish and I fear that anyone who expects to see unemployment disappear by the summer or fall of the present year is in for a
sad disappointment. It is true, however, that we may be very close
to a general condition of having more jobs than people to fill them
by the end of the calendar year 1943 and, of course, before that time
there will be many specific products which we shall have to ask the
civilian public to do without or to consume in greatly reduced volume
because those products use materials and machines that are needed for
defense production. At the present moment we are on the verge of this
situation with respect to a wider range of products than is generally
realized and as time goes on the needs of the defense program will
increasingly trench upon goods available for civilian consumption.


Meanwhile the national income, expressed in money terms,
is rising and will continue to rise as work proceeds on the huge
volume of defense orders now on the books. As the wages, profits, and
other incomes paid out in connection with this activity begin to be
spent, it will become difficult to provide enough goods to meet these
increasing money demands. Tlfhen this condition prevails for a sustained
period in consumer markets generally, prices are marked up and the
situation is one of inflation.
That is what is likely to happen to us unless we do something to prevent it. One way of preventing it is by adequate taxation.
The Government asks its citizens to give its money to the tax collector
instead of spending it in the stores or shops. In this way civilian
competition against Government for the use of men, materials, and
machines can be restrained. It is always important tloat taxes should
be levied in accordance with ability to pay but when taxes begin to
represent real sacrifices, as they must do if they are to perform
their function in the present emergency, when they begin to mean lard
instead of butter in the frying pan, a vacation spent on the front porch
instead of at the mountains, a college education for only the oldest
boy and not for all the children, it becomes doubly important that
they should be levied in accordance with ability to pay. When it is
necessary to tighten belts, it becomes doubly important to tighten most
the belts which are most ample.
That is why I find myself in general agreement with the main
outline of the Treasury proposals and that is why I am doubtful whether

it would be prudent and statesmanlike to raise more revenue from
excise taxes than the Treasury proposes to raise, especially when it
means heavy taxes on commodities like coffee, cocoa, tea, and sugar.
These commodities may be regarded as proper objects of taxation in
some poverty-stricken countries of the Old World where governments
must extract revenue from their citizens in any fashion that is
expedient. They are not appropriate taxes in this country where an
enlightened body of citizens is able to understand the broad policies
of its government and is prepared to support those policies by the
payment of direct taxes. Either an increase in income tax, when
applied to the lower brackets of individual income taxpayers, or a
tax on coffee will restrain consumer expenditure. But the difference
lies in the fact that the individual income tax does this frankly and
directly and does it in a fashion which adjusts the burden to the taxpayerfs ability to baar it, A tax on coffee or any other article of
mass consumption does it secretly and indirectly and in a fashion that
makes the burden proportionately heaviest on those least able to bear
it. Before democratic government came into the world indirect taxation was the only type of taxation, The history of direct taxation,
and in particular of the income tax, is the history of the expansion
of democracy,
I am therefore in general agreement with the Treasury's
program both in its aggregate amount and in the general type of taxation it implies. I believe, however, that it could be improved by
certain changes in emphasis with respect to the revenue sources on


which it draws. I shall devote the remainder of my testimony to
describing these changes.
I. Excess Profits Tax
In my opinion an effective excess profits tax is not only
the keystone of a well balanced tax program; it is an essential element
in solving the economic difficulties which are beginning to confront
the nation over a very wide field. Any tax program that you gentlemen
may frame, whether it follows the exact lines of the Treasury proposals
or not, will have to include a substantial increase in the rates of
taxation for corporate incomes in general and for individual incomes.
Tou cannot reasonably ask the great numbers of business concerns of
small and moderate size who are not participating in defense contracts
to assume the additional tax burden involved in an increased normal
corporation rate (or in the special surtax on corporate net income),
and you cannot ask millions of individual taxpayers to assume the
additional burdens involved in increased individual income tax rates
until you have given them every reasonable assurance that the funds
they are being asked to provide will not go to swell the excessive
profits of a few favored corporations.
It is an open secret that the excess profits tax now on the
statute books does not give any such assurance. If you allow the idea
to take root in the public mind that through these vast expenditures
a few are being made rich and a few who are already rich considerably
richer, the result is bound to endanger the success of our defense


effort. We cannot afford to let our citizens remain doubtful on this
important point. JIany of us believe that in order to prevent an
inflationary spiral of price and wage increases we ought to ask labor
to moderate the demands for increased wages which are now being heard
and which will be heard in increasing volume as employment increases
and employers find that they are bidding for labor on a seller's
market. Such a counsel of moderation to labor cannot be wholly
effective if employers are permitted to retain huge profits. Will
they forego wage increases if we permit corporate earnings after normal
tax to rise during 1941 to a level 75 per cent above 1939 and permit
many individual corporations to realize, after payment of taxes,
profits vastly higher than at any previous time in their corporate
It is often said that these corporate profits are effectively
taxed under the individual income tax. If that were strictly true they
would be effectively reached by the surtax schedules which the Committee
has under consideration. But, as you gentlemen who frame our revenue
legislation know, it is not true that corporate earnings feel the full
force of our individual income tax rates. Corporate earnings may now
be withheld from distribution without penalty; I need not recall the
Short and unhappy history of the undistributed profits tax. Since we
do not have an undistributed profits tax we must have heavier corporate
taxation along with heavier taxation of individuals. In the taxation
of corporations primary emphasis ought to be placed on the excess profits

The Treasury has suggested that an additional #400 millions
of revenue be obtained by amending the excess profits tax. I believe
$900 millions of additional revenue, or #500 millions more than the
Treasury proposes, can and should be obtained from this source. The
Treasury, I understand, plans to present specific proposals for revisions in the excess profits tax after there has been an opportunity
to analyze the current tax returns that are now being filed. For this
reason, in appearing before the Committee which played such a large
part in writing that complex and difficult piece of legislation, the
Excess Profits Tax Act of 1940, I will not venture to make specific
suggestions as to how this additional revenue should be obtained
beyond the following rather general remarks. I am sure you are all
aware of the revenue-yielding potentialities of an excess profits tax,
as shown by our own experience during the World War. The present
statute could be made to realize those revenue potentialities by
changes in a few important respects. I shall mention four. Personally
I should like to see all four of these change made but I should welcome changes in any one of them or any combination of them.
1, Restrict the use of the income method of computing the
excess profits credit, either by reducing the 95 per cent of past
average earnings now allowable to 75 per cent, or by any other method
that may recommend itself to the Committee. The technique by which
this is done is less important than the principle that favorable earnings experience in the base period should not be allowed to operate
to confer tax immunity for excess profits purposes for all future times.


I agree with Mr. Sullivan*s view that all excessive profits, as well
as profits directly or indirectly attributable to the defense program,
should be subject to special taxation.
2* Increase sharply the rates now applicable to excess
profits. In my opinion, in the light of the rates in force in this
country during the last World War, a maximum rate of 75 per cent is
not too high. It is also important that the tax brackets used in the
present law be revised to subject earnings which most .American businessmen would consider very large to reasonably high rates of tax* A corporation earning excess profits of #100,000 a year (which means total profits /)
considerably in excess of #100,000} is not a small corporation in terms
of American business as a whole and yet the highest rate which such
corporation would be called upon to pay under the present statute is
35 per cent.
3. Reduce the rate of return allowed under the invested
capital method of computing the excess profits credit from the present
figure of 8 per cent to 6 per cent. The figure of 8 per cent was used
during the days of the World War* Ideas about a number of things have
changed since that time, including the rate of return that investors
could reasonably hope to realize on investment in securities. We see
that change reflected all along the line in interest rates and we should
make a similar adjustment in our ideas about an appropriate rate of
return on equity capital.
4* Exclude borrowed money from the invested capital base.
Profits are made by people who own equity capital and it makes for


needless confusion and complication to define allowable rates of return



in other terms than rates of return on equity capital. If we wish
to help the small corporation, it should be done directly by increasing the present specific exemption of $5,000.
II. SpecjaX Defense Taj qn Corporation Inco^
If the excess profits tax is revised along the lines I have
just indicated, it will then be fair and reasonable to ask American
corporate enterprise as a whole to pay the special defense tax on
corporate net income which the Treasury proposes. The arguments for
enacting a special defense tax, instead of raising the rate of the
corporation normal tax, seem to me to be clear and convincing. Most
of the partially tax-exempt Government securities now outstanding were
issued in years when the maximum rate of normal corporation income tax
ranged between IS and 15 per cent; the Government did not expect to
grant, nor the purchaser of securities to receive, immunity from taxation at a higher rate. The maximum rate of normal corporation income
tax now stands at 24 per cent. Since we have now stopped issuing taxexempt Federal securities, I can think of no legitimate reason why we
should confer additional tax benefits upon holders of outstanding
securities by further increasing the normal corporation income tax
rate. The only way of obtaining a significant amount of Increased
revenue from corporations generally without that undesirable incidental
result is the special tax proposed by the Treasury. I am aware that
commercial banks, which have special problems I have known intimately
for many years both am an active banker and as head of the Federal
Reserve System, will be among the groups most vitally affected by the


new tax; there are many banks that, as a result of this measure,
will pay significant amounts of Federal income tax for the first
time. But I do not believe that the banks will want to seek any
special immunity from taxation when other business groups, and taxpayers generally, are cheerfully accepting their fair share of the

III. Individual Iflcc^e


The effect of the surtax rates proposed by the Treasury is
to leave many salaried workers and others living on relatively fixed
incomes in a worse position with respect to income after taxes than
they enjoyed two years ago. It should also be recognized that it is
this fixed income group that will be hit by even a small rise in the
cost of living. I suggest that the additional revenue from revisions
of the excess profits tax along the lines proposed above might well
be used to moderate the individual surtax rates which the Treasury
has proposed, especially in the lower brackets of the surtax schedule.
For this purpose I would suggest a specific schedule of rates which
I ask the Committers permission to insert in the record. In contrast
to the Treasury's proposal, no additional defense tax would be superimposed on the tax resulting from the application of these rates.


It also seems to me an appropriate time to correct the rather
illogical relationship between the exemptions for single persons and
for married persons. We allow an exemption for married persons of
more than double the single exemption. It seems to me that in so far
as we attempt to measure by this method the increase in minimum necessary


household expenses that occuis at the time of marriage a serious error
in measurement has been made*

I propose the lowering of the exemption

for married persons to $1500, leaving the present $800 exemption for
single persons unchanged*

It se


ne making over $30

a week — and this applies to a

of the millions

of persons now being added to industrial payrolls and of the millions
of others receiving increases in remuneration as a result of increased
wage rates, overtime pay and promotion to better jobs — ought to make
a significant direct contribution to the support of his government*
We need revenue from this group of our population as well as from better
paid groups and if we can obtain it in this way rather than from the
inequitable and cumbersome device of a sales tax, we shall have made a
significant achievement in democratic finance and in good government*
17* Jjslpate apd Ojft ffftxes
The strengthening of estate and gift taxes is the most needed
reform in our whole tax structure. In a message to Congress in June
1935, the President said:
"The transmission from generation to
generation of vast fortunes by will, inheritance
or gift, is not consistent with the ideals and
sentiments of the American people* Such inherited
economic power is as inconsistent with the ideals
of this generation as inherited political power
was inconsistent with the ideals of the generation
which established our government*w
The task of bringteg law into conformity with our American ideals, begun
in the Revenue Act of 1935, should be completed now*



Tor this reason I am thoroughly in accord with the Treasury
proposals, but for this reason I believe also that we should go a
great deal farther. Even a lowering of exemptions and a considerable
increase in the rates of estate and gift taxation are only a part of
the task. The avenues for tax avoidance are both broad and numerous
under our existing system of estate and gift taxes, and so long as
these avenues are allowed to remain open, the task of bringing transfers
of wealth within the framework of a progressive tax structure will remain
incomplete. A rather extensive redrafting of existing statutes is,
therefore, essential.
Since detailed recommendations on methods of closing existing
loopholes can be furnished only by qualified legal experts, I shall try
merely to indicate the general principles which, in my judgment, should
guide the revision of our estate and gift tax laws. I think there is
little disagreement regarding the underlying purpose of estate and gift
taxes. It is to subject the passage of wealth — from individual to
individual andftromgeneration to generation — to an effective system
of taxation at graduated rates. The amount of tax ought not to depend
in any significant degree upon the form in which wealth is transmitted —
whether directly or through life insurance or through tax-avoidance
trusts — nor upon the time of transfer — whether during life or at
death. With this in mind, I hope the Committee will give consideration
to the following proposals:

1. For the present exemptions of #40,000 under the
gift tax, #40,000 under the estate tax and an
additional #40,000 for life insurance — a total
of #120,000 — there should be substituted a single,
consolidated exemption of #259000 applicable to the
sum of gifts and estate, including insurance proceeds.


2. Because the gift tax schedule is 75 per cent of
the corresponding estate tax rates$ many people
hare inferred that the net saving through transfers
by gift is only 25 per cent. This inference is incorrect. At present tax liability at the highest
estate tax rates to which an estate would he
subject can be avoided by Incurring tax
liability at the lowest gift tax rates. This
type of avoidance can be prevented only by
combining gift and estate taxes into a single
tax on transfers of wealth. I prefer to leave to
lawyers the explanation of the several possible
methods of effecting such a consolidation. If
consolidation were effected the taxpayer would be
free to choose how much of his property to dispose
of during life and how much at death, but his tax
liability would not be influenced by his decision.
Until this step is taken, the opportunity to save
a great deal on estate tax by payment of a small
gift tax will remain open.
3. Under existing statutes estate and gift taxes can
frequently be either entirely avoided or substantially reduced through the use of various devices
involving long-term trusts. To close this avenue
of avoidance, the legal concept of "gifts* and
"transfer at death* ought to be broadened to
include all transfers of property that transmit
wealth from one generation to another.
Consumer Taxes
I am in general agreement with the Treasury proposal to
raise a substantial amount of additional revenue from taxes bearing
directly on consumer expenditure, including in this term taxes on
liquor and tobacco as well as the manufacturer1s excise taxes. Within the range of articles upon which it is proposed to levy increased
rates or new taxes, much heavier taxes than are proposed by the
Treasury should be applied to articles that use materials, skills,
QBd facilities that could make a significant contribution to defense
production and lighter taxes on articles whose decreased production


will release men, materials, and&cilitles for which there is no
important military use. The Treasury has proposed to obtain only
$80 millions of additional revenue from new automobiles as contrasted
with #855 millions additional revenue from gasoline. The automobile
industry has already committed itself to curtailing production by SO
per cent in its next model year, at a time when the national income,
and the civilian demand for new cars, are rising rapidly. I do not
know what would happen in the automobile industry if people wanted to
buy five or six million cars at a time when only four million were
available, but in other industries with which I am familiar this situation would lead to a rise in prices, a rise of considerably greater
magnitude than could legitimately be attributed to the increase of
3 1/2 per cent of the manufacturer's price which the Treasury is
proposing. If the situation is to be handled by an increase in prices —
and up to the present moment I have heard no feasible suggestions as
to how automobiles could conceivably be rationed — I know no reason
why the Government should not take a considerably greater share of the
increased price people will be paying for automobiles than the Treasury
proposes. In my opinion a tax of 20 per cent would be more appropriate
than the rate of 7 per cent which the Treasury has suggested.
In contrast to this situation we have proposed a very considerable increase in the tax on gasoline. VIth some minor exceptions petroleum and its products are not commodities which are in scarce supply.
They are commodities which are in over-abundant supply. No significant
contribution will be made to the immediate problem of curtailing civilian


demands for steel — and I think it is an immediate problem — by


encouraging people to re strict the use of cars which they already
The same general principle applies to the proposed check
tax. The people who work in banks are admirable people, but I am
afraid few of them would be of any use in an aircraft factory or a
shipyard. If you encourage people to restrict their use of banking
facilities by using currency instead of checks you will be releasing
resources which have no significant contribution to make on the production lines of our defense effort. The people who will in fact avoid
the use of checks by withdrawing their bank accounts will be for the
most part individuals of small means who will thus be deprived of a
safe and convenient method of making money payments which will continue
to be enjoyed and utilized by wealthier depositors. In so far as checks
are issued by business concerns, businessmen will find it easy in this
period of general economic expansion to pass on the small addition to
their costs of doing business to consumers in one way or another. Moreover, during our earlier experiment with the check tax many corporations
found a wholly satisfactory method of tax avoidance through the use of
drafts drawn on themselves. In the Federal Reserve System we have for
many years been trying by every means at our disposal to make the process
of transferring funds by check easier, safer, and less costly for the
ordinary citizen as well as for business enterprise, and we naturally
regret to see any measure adopted that would represent a backward step in
the development we have tried to encourage* For these reasons I propose


that additional revenue of about $300 millions be obtained from
automobiles; that the gasoline tax be increased by only half a
cent instead of a full cent; and the proposed check tax should be
eliminated from the list of excise taxes presented by the Treasury*
The following table, which I would like to insert in the
record, rather than to read at this time, summarizes the differences
between yields from various revenue sources under the suggestions I
have made and the Treasury proposals. There is no significant difference in the aggregate yield of the two sets of proposals*


(Yield In millions of dollarsj


Corporation incomes:
Excess profits tax (lever credits,
higher rates)
Surtax as proposed by Treasury
Indiridual incomes:
Surtax increases (lover schedule)
Reduction in married person's exemption
to $1,500
Estates and gifts (apply estate tax rates
to gifts)
Excise taxes:
Gasoline (1/2 cent instead of 1 cent per
gallon additional)
Passenger automobiles, parts and
accessories (SO per cent instead of
7 per cent)
Checks (eliminate proposed 2 cents tax)
Other excise taxes as proposed by Treasuiy
Summation of items
Less: Allowance for interrelated tax


| Treasury





















Til. Loopholes
Because I understand that the Treasury intends at a later
time to submit proposals dealing with loopholes, I have not emphasized
that topic in my testimony, except in so far as the whole structure
of the estate and gift taxes may be considered a loophole. That is
not because I think the subject is unimportant. Every time the
individual surtax rates are raised, it increases taxpayers1 incentives
to make use of tax-avoidance devices that are available under existing
law and it increases the Treasury's loss of revenue from tax-avoidance.
No list of such devices could be comprehensive but the following items
would surely appear in any lists

1. Transfers by corporations to pension trusts for
their high-salaried executives, Instead of direct
cash bonuses, serving the double purpose of avoiding payment of individual income tax on the amount
so transferred and of shifting income from years
of high salaries to years of retirement when income
may be much reduced and hence taxable only in the
lower brackets.
2. ¥se by husband and wife of the privilege of filing
joint or separate returns.
3. Investment in tax-exempt securities, especially in
State and local securities exempt from both normal
and surtaxes.
4. Retention of corporate earnings or distribution of
non-taxable stock dividends.
5. Transferring income-producing property to members of
the family or others in lower tax brackets, either
by outright gift or the creation of irrevocable trusts.
6. Making charitable contributions not in cash but in
property which has enhanced in value, deducting the
current value of the property, thus avoiding taxation
of the capital gain.


I do not wish to dwell at length on these matters, but
I hope that the Committee at a later date will undertake to deal
comprehensively with them*