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BOARD OF GOVERNORS
DF THE

FEDERAL RESERVE SYSTEM

Office

Date j*** m, m o .

C o r r e s p o n d e n c e

To

Chairman Sccles

From

Brails Despres




Subject:

The attached memorandum, prepared by Mr. Krost of
this section, outlines a national defense tax program for the
period before full employment is reached. We plan to proceed
further with work in this field.
Attachment

June 3, I9I4O

FINANCING NATIONAL DEFENSE
The basic task involved in an expanded national defense program
is one of mobilizing and directing productive resources to national defense purposes.

The problem of financing is not an isolated problem, but

is merely one aspect of this more general task.

The choice of financing

methods should, therefore, be governed largely by the total economic
situation, and, in particular, by the degree to which available productive
resources are being utilized.
There is a widespread disposition to believe that we cannot
expand our defense activities without an offsetting general curtailment
in other sectors of the economy. As an outgrowth of this approach, the
problem of financing is therefore concerned largely with the maimer of
apportioning the sacrifices which are made necessary by an expanded
defense program.

This view of our present financing problem completely

ignores the most important fact of our present economic situation. Full
utilization of our available productive power would result in an expansion
in the output of goods and services of at least one-third.

In this

economic environment, the objective of financing policy should not be expansion of the defense program and curtailment elsewhere, but expansion of
the defense program and expansion elsewhere.

This objective is dictated

not only by general social and economic considerations, but also by the
broader requirements of the defense program itself.
In the years since 1929 the important industrial countries of
the world have been able to approach full employment only after embark-




ing on large scale armament programs. In every instance — in Germany,
Italy, Japan, Prance and England — these programs have been financed in
large part by borrowing and by taxes on funds that would otherwise not
have been spent. In no case have taxes tending to restrict consumer demands been the predominant source of funds; it is only now, after the
virtual elimination of unemployment, that drastic measures of this nature
are being imposed in England and France.
Military and Naval Expenditures and Industrial Production
1939 Relative to 1929 l/
(Index numbers; 1929 = 1075)

Country
Japan
Germany
United Kingdom
Italy
France
United States

Military
expenditure
736
4,690
580
260
187
166

Industrial
production
175
129
115
103
81
81

1/ Fiscal years ending in the indicated years. Sources: for production
""
statistics, Monthly Bulletin of the League of Nations; for expenditure statistics, League of Nations World Economic Survey, 1938/39,
except Germany, Barron's, October 9» 19^9.




In the United States unemployment will not disappear until the
national income has increased by about |30 billion.

The income derived

from the national defense expenditures that have been proposed during the
past few weeks, together with private capital and consumer outlays that
may be generated by these expenditures, will not remotely approach this
figure.
Although the existing plans for national defense expenditures
involve amounts that are small in terms of our capacity to produce, these
expenditures are unlikely to remain small. It is altogether possible
that they will ultimately rise to levels which will strain our productive
capacity to its limits.

The best preparation we can make to meet future

strains is to increase our productive power now. The productive efficiency
of our working population will be raised through rapid expansion of
general employment and incomes.

The expansion of capacity in basic indus-

trial fields, such as railroads and electrical utilities, can best be
hastened by increasing our demands for current output from business as a
whole. Full employment is vitally connected with public health and other
aspects of our social preparedness. It should not be forgotten that I4.7




-3per cent of the men called up under the draft during the last war were
found to have physical defects. Recent studies have shown the close
connection of sickness with low income, of which unemployment is perhaps
the most important cause*
The continued existence of unutilized capacity in industry as
a whole is likely to be overshadowed by the attention devoted to the
bottlenecks in the production of airplane engines, armor plate and machine
tools which are now preventing rapid growth in the production of essential
items of armament equipment. It has been suggested in some quarters that
these situations should be dealt with by measures of taxation and more
broadly that the solution of these minor and temporary difficulties
requires important sacrifices on the part of the general consuming public.
Taxation is an instrument too blunt for effective use in situations of
this kind. These problems should be dealt with by appropriate measures
of industrial policy such as programs of apprenticeship training to remedy
scarcities of skilled labor and the setting up of priority schedules to
insure the allocation of machine tools and scarce raw materials to those
uses which are most vital from the point of view of the national defense
program, rather than by over-all curtailment of private expenditure through
taxation.
The elimination of unemployment is also a necessary condition
for the creation of the sense of unity required for the effective mobilization of the national efforts.

The experience of other countries has

shown that parties devoted to the overthrow of democratic forms of govern-




ment recruit their members most easily from the ranks of the unemployed.
Moreover, it is equally important to prevent the growth among the broad
masses of the people of the cynical view that our national defense expenditures are directed, not toward a truly national objective, but toward
the creation of excessive gains for a few.

The only effective method of

implementing the President's pledge that our defense program will not
create a new group of millionaires is to impose effective excess profits
taxation and other taxation measures designed to recapture an appreciable
part of the profits and capital gains that will be created by thes expenditures.

The necessity for measures of this type is shown by the

following tabulations




Annual Rate of Return on Het Worth on the
Basis of Earnings During the First Quarter of 191+0
Rate
(per cent)
Machine tool companies
A
B
C
D
E
F
Aircraft manufacturing companies
A
B
C
D
E
Automobile company

66.8

6k.Q

lt.6.0

10.6

30.1.1
2U.8
52.li-

38.8
37.1+

29.2
28.0

JUU.7

-5-

From the foregoing discussion the conclusion may be drawn that,
so long as large-scale unemployment persists, it is desirable to rely on
borrowing for a substantial part of the funds required to finance additional
national defense outlays*

To avoid the excessive growth of incomes swollen

by profits and capital gains derived from the armament industries and to
make preparations for a future period when it may be desirable to secure
greatly increased tax revenues, the following proposals are advanced:




Proposals relating to the individual income tax:
1. Disallowance of the personal exemption and credit for
dependents in the computation of net income subject to
surtax. Reduction of surtax rates in the lowest brackets
in order to avoid a sharp increase in taxes for those who
are now exempt from surtax by only a small margin and for
those who now pay small surtaxes.
This proposal represents a return to the procedure in
effect before 193k. The present procedure represents in
effect a system of grants from the Federal Government
made in the form of tax remissions to taxpayers with
incomes of $1±9000 and over* For married taxpayers with
three dependents, the grant ranges from zero for taxpayers with incomes of 14,000 to $2,775 for taxpayers with
incomes of $5*000,000 and over. If grants of this type
were made by the Treasury in the form of cash outlays,
the unjustified expense would be generally condeimri^dj
in their present form these grants are just as costly and
just as little justified as if they were made in cash*
2#

Revision of the surtax rate schedule to secure additional
revenue from incomes between 15,000 and $100,000,
The surtax rate schedule embodied in the proposed Revenue
Act of I9I4O now before Congress would serve this purpose,
although that schedule in combination with the lowering
of the personal exemption produces an abrupt increase in
taxes on incomes of #5*000 to |8,000 that might have been
avoided in a more carefully drafted plan.
Its effect is to move the American rate structure a short
distance in the direction of the British rate structure.
The United Kingdom1s reliance on the income tax as a




-6-

principal source of revenue has been an important
factor in moderating the severity of industrial fluctuations and in keeping industrial activity at a high
level in that country.
The following table compares tax liabilities under
existing legislation in the United States, under the
proposals now before Congress, and under existing
British legislation.
Married person, no dependents

il.,000
8,000
20,000
80,000
1+00,000

3«

Present
rates

Congress
proposals

21+8
1,589
21,269
232,190

70
317
2,336
30,650
255,392

British
rates
872
2,21+8
8,220
52,072
323,072

Introduction of a compulsory joint return for husband
and wife. Introduction of a compulsory joint return
for "financial families", including the income derived
from assets received by gift from the head of the family.

Ij* Inclusion of undistributed corporate earnings in income
subject to individual income tax through the issue by
corporations of certificates of participation in undistributed earnings.
A repeal of the provision allowing taxpayers to elect
to be taxed on capital gains at a maximum rate of
15 per cent.
6. Removal of tax exemption from future issues of Federal
Government securities*
The four measures listed above are designed to close
loopholes through which large amounts of income now
escape taxation. A high proportion of the forms of
income that escape through these loopholes is typically
saved. Proposals 3 BXid I4. are probably unconstitutional
under past rulings of the Supreme Court, but there is
some prospect that present Court might reverse these
rulings.

-7-

Proposals relating to the estate and gift taxes:
Inclusion of gifts during the life of the donor in the
computation of the taxable estate; that is, assessment
of the estate tax on the total of estate passing at
death plus gifts during life, with a credit for gift
taxes previously paid.
Under existing law the initial transfers made under a
tax-avoidance program designed to transfer an appreciable
part of an estate by gift avoid taxation at the highest
rate of estate tax to which the estate would be subject
by incurring taxation at the lowest rates of gift tax.
For example, a gift of #10,000 from an estate that will
amount to slightly more than #1,000,000 at the death of
the donor avoids a prospective estate tax of #3,200 by
paying a gift tax of only $150. The proposal is designed
to equalize the tax treatment of property passing by gift
and by bequest.
8. Substitution for the present specific exemptions of
U\O9000 under the gift tax and |I|£),000 under the estate
tax of an exemption of |10,000 to be applied to the
total of estate passing at death plus gifts during life.
9«

Elimination of the insurance exemption.

10. Increase of estate tax rates to raise more revenue from
estates of moderate size.
By making use of the flj.0,000 specific exemption under
the gift tax, the flj.0,000 specific exemption, and the
flj.0,000 insurance exemption under the estate tax, an
estate of $120,000, or #120,000 of any estate, no matter
how large, may be transferred to heirs free of tax. An
additional |80,000 may be transferred by gift subject to
taxes of only f5,100. Under the British estate duty,
the transfer of $200,000 would be exempt from tax to the
extent of only fljOO and would involve taxes of §2lj.,000.
Proposals relating to the corporation income tax:
11.




Taxation of insurance company income in the same manner
as other corporate income.
Life insurance companies had almost a billion dollars of
gross income in 1937 but paid only $392,000 in Federal
income taxes. Favorable tax treatment for the insurance
companies, justified in some measure by their position
as custodians for individual savings, has been carried
so far as to confer virtual tax exemption on an important
sector of .American business.




-8-

12. Imposition of an excess profits tax designed to recapture for the Government a considerable part of the
profits resulting from armament expenditures and the
general business expansion that may result from armament expenditures#
The technical problems of measuring capital investment for purposes of determining the profit ratio and of
preventing hardship for enterprises with special
operating characteristics, though difficult, are not insoluble. The basic feature of the excess profits taxes
now in force in Canada and the United Kingdom is the
use of average profits over a short period of years as
a standard from which to measure excess profits. To
prevent hardship on enterprises with exceptionally low
profits in the base years, an amount equal to 5 V er cent
on invested capital in the base years might be set as a
minimum for "standard profits". To secure adequate
treatment of enterprises with exceptionally high profits
in the base years, an amount equal to 15 per cent on
invested capital in the base years might be set as a
maximum for "standard profits". Special deductions for
rapid amortization of investments in defense industries
would be allowed.

The additional revenue yield from the measures proposed may be
roughly estimated as follows:
(in millions of dollars)

!•

At 19l|.0
income
levels

At full
employment
income levels

Individual incomes - surtax:
a) disallowance of personal
exemption and credit for
dependents for surtax purposes

100

170

t) increase in surtax rates

300

550

c) introduction of compulsory joint
return for husband and wife

200

3ko

d) inclusion of undistributed
earnings in tax base

200

1,000

100

100

500

1,000

50

80

e) repeal of optional Vj% rate on
capital gains
l/
2#

Corporation taxes:
aj revised treatment of insurance
company income
t) excess profits tax
Estate tax:
aJ lowering of exemptions
b) inclusion of gifts in taxable
estate 2/

—

c) increase of rates

200

450

1,650

3,690

Summary
Increa.se in revenue from proposals
Increase in revenue from rise in incomes to
full employment levels
a) income and estate taxes

k,&5

3,22!>
1,100

b) other budgetary receipts
c) net non-budgetary receipts
(primarily excess of payroll
taxes over unemployment and
old-age insurance benefits)
Total

300
1,650

l/ Effect on revenue uncertain because of possible effects of the change in
""
tax treatment on the realization of capital gains.
2/ Effect on revenue faoectjato*



-10-

The most significant fact brought out by this table is that the
additional revenue yield from the measures here proposed, besides being substantial at present income levels, would rise with extreme rapidity as national income increased.

The revenues furnished by these proposals would be

over 120 per cent higher at full employment levels of national income than
at present income levels. Moreover, these tax increases would not impede
the cumulative expansion of national income in response to increased
defense outlays. In both these respects the taxes here proposed differ^ significantly from taxes on consumption.

Consumption taxes offer a superfi-

cially easy and attractive way of increasing present revenue.

Their future

revenue-producing power is far inferior, however, to that of the taxes
proposed in this memorandum both because the yield of consumption taxes rises
less than in proportion to national income and because the very existence of
such taxes impedes the expansion of incomes.
At a full employment level of national income the tax structure,
revised in accordance with proposals in this memorandum, would yield
aggregate revenues of flij. billion.

The present non-military expenditures

of the Federal Government now amount to about $6 billion.

This means

that military expenditures could increase to the total of $8 billion
without occasioning any permanent increase in the national debt if at the
same time national income rose to the full extent permitted by our productive capacity.
If expansion of defense activities continues after conditions of
full employment have been reached, taxes on mass consumption may be required
as a part of a set of measures designed to reduce civilian consumption and
the utilization of labor and equipment in non-essential industries. Sjich




-11taxes might be based on some variants of the "deferred wages11 proposal
put forward by J, M# Keynes, adapted for collection purposes to the
available administrative machinery already set up for the payroll and income taxes.
In the interest of equity, it is important that such taxes should
be imposed when they become necessary but in the interest of the effective
use of productive resources the imposition of taxes of this type should be
avoided until full employment has been reached.