America's Fiscal Constitution (28 page)

Germany’s military command rested its hopes on a decisive battle in France. To maximize their chance of success on that front following a peacy treaty with Russia, they planned to disrupt Allied supply lines. On February 1, 1917, Germany announced its intention to begin unrestricted submarine warfare against all ships in a zone around Great Britain, France, Italy, and the Eastern Mediterranean. Some German leaders hoped to delay an effective American military response by initiating covert schemes to influence Congress with campaign contributions and to encourage Mexico to invade the United States. German opposition leaders complained that these bizarre plots made their government an international laughingstock. Americans were not amused, and most agreed with McAdoo’s conclusion that “it was not possible to avoid war with honor.”
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The precipitous shift in American public opinion in favor of war sheds light on a perennial tension underlying American foreign policy and military spending. A majority of Americans are loath to sacrifice their tax dollars and American lives on causes not clearly related to the security of the United States itself. An influential minority, however, believes that their nation should assume the responsibility for broader international leadership, backed in part by a strong military. As Germany found out in 1917, the two groups coalesce against credible threats to the lives of Americans.

The Senate overwhelmingly passed a declaration of war on April 4, 1917. Two days later Democratic leader Claude Kitchin pleaded with his colleagues in the House to vote against a war “to which we were and are utter strangers.”
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Kitchin’s position lost by an overwhelming margin, and he immediately began working to minimize the amount of wartime debt
by raising taxes on “wealth, and not poverty.”
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Kitchin’s tax legislation permanently ended the federal government’s primary reliance on consumption taxes. From 1917 on, federal taxation would be based largely on the ability to pay.

F
INANCING THE
W
AR

President Wilson, on April 5, 1917, asked that “so far as practicable the burden of the war should be borne by taxation of the present generation rather than by loans.”
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McAdoo requested that Congress appropriate $3.5 billion for American military preparations and $3 billion for loans to the Allies.
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Congress promptly authorized debt of $5 billion, five times more than the federal government’s normal annual budget.
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McAdoo surveyed financial leaders concerning the nation’s debt capacity and set the goal of using tax revenues to pay for half of the first year’s estimated war cost of $8.5 billion.
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McAdoo observed that “one of the most fatal mistakes that governments have made in all countries has been the failure to impose fearlessly and promptly upon the existing generation a fair burden of the cost of war.”
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The treasury secretary’s analysis of the improvised early financing of the Civil War gave him “a pretty clear idea of what not to do.”
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Kitchin quickly moved a tax bill to the House floor, where he noted—to the applause of House members—that no man should protest higher taxes if he “remains at home while the boys are at the front.”
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Young males were conscripted to serve in the nation’s military, with low pay, because they were considered the most physically able to do so. Using similar logic, Kitchin’s tax bill imposed the war’s cost on profitable corporations and wealthy citizens with the greatest ability to pay.
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In October 1917 Congress passed the War Revenue Act. By then, six months after the declaration of war, the Treasury was borrowing at a rate of over $400 million a month.
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The War Revenue Act of 1917 was the most fundamental change in the federal tax system since the end of the Civil War. It lowered the threshold of income exempt from taxation, tripled corporate tax rates, and raised excise taxes and postal rates. The lowest personal income tax rate was 4 percent, and additional rates, or “surtaxes,” of 13 percent to 50 percent were imposed on higher income brackets.
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The act also taxed “excess profits” as measured by extraordinary returns on investment in an attempt to
capture some wartime profits of industrial firms with few competitors, such as US Steel and the progeny of the Standard Oil Trust.

It was difficult for McAdoo to estimate revenues generated by a tax system based largely on self-reporting of income by individual taxpayers. The idea of financing government largely by citizens who calculated their own taxable income and then mailed in checks was almost inconceivable in other nations. But most Americans complied with the law. During the months of the initial large tax payments—May, June, and July 1918—the Treasury received $2.626 billion, double the level received from all federal taxation collected previously during any fiscal year.
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The United States sorely needed those revenues. McAdoo had raised his estimate for the first year’s cost of war to $12.3 billion by the end of 1917.
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By that time he had also concluded that tax revenues could only be expected to pay for a third of the total cost of the war. McAdoo reasoned that “if you take the whole of a man’s surplus income through taxes, you cannot expect him to buy bonds, nor can you expect industry to expand.”
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The American Fiscal Tradition had sanctioned the use of debt to pay for war, but had not defined a guideline for the split between wartime taxes and debt. McAdoo’s two-thirds rule was the first attempt to do so in the twentieth century.

Kitchin’s Democrats and the remaining Progressive Party members worried about the level of wartime debt, leading them to raise taxes again even after combat ended in November 1918. The Revenue Act of 1919 also reflected congressional concerns about the high levels of wartime profits and the need to replace revenues from federal taxes on alcohol after the ratification that year of a constitutional amendment banning commerce in alcoholic beverages.

The Revenue Act of 1919 set the highest personal income tax rate at 77 percent of personal income and phased it out over two years.
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The Wilson administration warned Congress that the highest tax rates were counterproductive and encouraged tax shelters. Industrialist Andrew Mellon noted that many high-income Americans had not lawfully sought to reduce their taxes during war, but afterwards they looked on high tax rates “as a business expense” and “treated them accordingly by avoiding payment as much as possible.”
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The corporate income tax yielded far more revenue than did the personal income tax. The standard exemption from personal income taxation remained at a level above the incomes of most workers. During and immediately after the war surtaxes on high income, paid by a very small
percentage of all taxpayers, accounted for approximately 70 percent of personal income tax revenues.
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In 1919 only half of personal income tax revenue came from taxes paid on wages and salaries; the rest came from dividends, interest, and unincorporated business income. Though the nation’s partisan balance shifted significantly in the years after the war, a tax system based on the principle of ability to pay endured.

W
ARTIME
B
ORROWING AND A
D
EBT
C
EILING

The federal government borrowed $21.5 billion in five separate bond issues—four Liberty Bonds and a Victory Bond—between May 1917 and April 1919. Short-term debt at the war’s end amounted to another $5 billion. Most bonds matured in ten or fifteen years and paid interest ranging from 3.5 percent for the first bond issue to 4.7 percent for the fourth.
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Slogans used to sell bonds left little to the imagination: “You who are not called upon to die—subscribe” and “A man who can’t lend his government $1.25 at the rate of 4% is not entitled to be an American citizen.”
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Popular entertainers helped sell Liberty Bonds issued in small denominations. Each of the bond issues was oversubscribed. More than twenty-two million Americans bought Liberty Bonds, though more than 70 percent of the value of bonds sold at face values of $1,000 or more, amounts that only banks, corporations, and wealthy investors could afford.
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Congress specifically defined the amount and terms of wartime borrowing. Congress initiated the use of an overall debt ceiling when Secretary McAdoo sought to market a second bond issue before he had sold the full $5 billion authorized for the first bond issue.
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Since the Treasury could not predict exactly how much would be sold under each of the two bond authorizations, Congress allowed the Treasury to sell bonds with a ceiling on total debt from the two bonds.

A legislated ceiling on debt remained in effect after the war. It was never intended to replace the traditional requirement for congressional authorization of debt for defined purposes. The reason for borrowing up to the ceiling was crystal clear—the nation incurred debt to fund its war efforts. The final 1919 debt ceiling remained on the books even while the federal government in the 1920s steadily retired World War I debt. Federal leaders in the Hoover and Roosevelt administrations would work within this World War I debt ceiling, with minor adjustments, to offset revenue shortfalls and fund emergency relief during the Great Depression. In 1939 Congress did
consolidate the ceilings on bonds and notes into a total debt ceiling of $45 billion.
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Afterwards it raised the ceiling—eventually to $300 billion—for World War II. That level of debt was not exceeded until the Cold War’s Berlin Crisis of 1961. Federal leaders rarely differed in their perception of why the nation incurred more debt until the 1980s. Today many federal leaders appear to have forgotten the modest original purpose of the debt ceiling. Congress did not use it to control spending, since Congress could more directly cut outlays with limits on appropriations.

The World War I banking system absorbed federal debt far more smoothly than it had during prior major wars. The Treasury borrowed from banks at low rates by issuing short-term “anticipation” certificates that were paid off after the sale of each bond issue. The Federal Reserve also extended credit to support bank purchases of Treasury obligations. The Federal Reserve sharply increased the amount of circulating currency, in the form of Federal Reserve notes—modern American paper money—up to a total of $2.5 billion by 1919.
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By the end of the war, the Federal Reserve Act of 1913 required the issuance of paper money to be backed by gold reserves of at least 40 percent, but that posed no serious limit at a time when much of the world’s gold supply poured into the United States. The Federal Reserve Bank of New York alone had gold reserves greater than those of all European central banks.

The federal government wielded extraordinary wartime economic power, often at McAdoo’s direction. It guaranteed future wheat prices to secure needed supplies, assumed control of the rail system, and directly financed investments in the arms industry.

American economic and military power turned the tide of battle in France from August 1918 until the Armistice of Compiègne on November 11. German leaders, who had miscalculated the speed at which the United States could field its forces in Europe, sought a peace treaty along the lines of the plan outlined by President Wilson. The president had become a hero to many Europeans, though his relations with leaders of wartime allies soured. Allied nations that had begged for American loans protested that they could not repay them. The United States had loaned its allies $10 billion: Great Britain, $4.3 billion; France, $3 billion; Italy, $1.6 billion; and the balance to others. Interest accrued at the rate of $475 million a year, payable in gold.
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These and other war debts of Great Britain, Germany, France, and Russia reached a crippling level of more than 150 percent of their annual
prewar national income. Great Britain was the only country—besides the United States—that financed a substantial amount of war-related costs through taxation. Great Britain and France both tried to transfer much of the burden of their debts onto Germany, just as Germany had done to France after its victory in 1871 in the Franco-Prussian War. Reparations and other punitive measures angered Germans, whose nation had still occupied parts of France when it agreed to end the war. Ultimately Germany would wash away much of its domestic debt with hyperinflation. Russia simply repudiated its war debts and lost its international credit. The United States eventually recovered only 15 percent of all amounts loaned to its allies.
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Only Finland paid off its debt to the United States in full.

For twenty months, from the declaration of war until the armistice, the US government had prepared for a long conflict by ramping up its military forces and related contracts for armaments, food, and transportation. After hostilities ended, the Wilson administration seemed incapable of managing an orderly demobilization. An exhausted McAdoo resigned within weeks of the war’s end. President Wilson spent months in Europe negotiating a peace treaty and suffered an incapacitating stroke after his return.

High wartime taxes allowed the budget to return to a surplus, despite the fact that federal spending remained higher than it had been before the war. In fiscal year 1920, which began almost eight months after the armistice, the federal government spent $6.3 billion—six times the prewar level.
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Treasury Secretary David Houston warned that “we have demobilized many groups, but we have not demobilized those whose gaze is concentrated on the Treasury.”
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