Half a century later, Donald Regan walked into the Oval Office to talk about tax reform.
“President Reagan liked to start every meeting off with a story or a joke,” recalls Regan, who was his Treasury secretary at the time. “So, as a way of introducing the subject, I asked him a question about his old employer, the General Electric Company: ‘What does General Electric have in common with Boeing, General Dynamics, and fifty-seven other big corporations?’”
“I don’t know,” said the President. “What do they have in common?”
“Let me tell you, Mr. President,” Regan said. “What these outfits have in common is that not one of them pays a penny in taxes to the United States government.”
“What?”
“Believe it or not, Mr. President, your secretary paid more federal taxes last year than all of those giant companies put together.” This was wrong, the Treasury secretary argued.
The President agreed. “I just didn’t realize that things had gotten that far out of line,” he said.
The man responsible for the President’s realization was Robert S. McIntyre, a public-interest lawyer who wrote a bombshell report in 1984 documenting 128 out of 250 large companies that paid no federal income taxes in at least one of the previous three years. Every one of the companies earned a profit in those years. Seventeen of them paid no taxes in every single year.
Americans were outraged, especially when they learned a year later that 30,000 individual taxpayers were earning over $250,000 a year and paying less than 5 percent in taxes — and 3,000 of them were millionaires.
Clearly, the tax code had changed in the half century since its height of progressivity. The question was, How?
It began innocently enough. The nation’s new tax collector wanted to know how to define “net income.” Daniel Roper was his name. His agency, the Bureau of Internal Revenue, was the precursor to the IRS, and it had the unenviable job of interpreting the Revenue Act of 1913.
Congress had instructed the Treasury to collect taxes on “net income,” or the profits leftover after business operations. The idea was simple. You can only pay taxes with the money you have. If you spend it to generate income, you can’t spend it on taxes. That’s why even this simplest of all tax codes allowed eight deductions: consumer interest, business expenses, state and local taxes, losses, bad debts, depreciation and depletion of business property, dividends, and taxes already paid.
There was only one problem: No one could agree on a definition for any of these things. That’s where Daniel Roper came in.
The biggest challenge Roper faced was the oil industry. They had been arguing, since the advent of the corporate income tax in 1909, that they were being treated unfairly. Every time they pumped oil out of the ground, they said, the well became less valuable. Eventually, the oil would be gone, and the well would be worthless. Little by little, they were losing money. But who could say how much?
The Revenue Act of 1913 allowed oil companies to deduct 5 percent of their revenue as a “depletion allowance.” This was unorthodox. The revenue had no direct relation to the size of the well. They could wind up deducting a lot more than they were actually “losing” in asset value — or, as the oil companies argued, a lot less.
So Congress gave Roper more leeway. They instructed the BIR to determine “a reasonable allowance,” as long it wasn’t more than the total amount of money that the company had invested in the well.
The oil industry wasn’t satisfied. They argued that a successful well cost a lot more than the money invested in it. Oil companies typically had to drill multiple wells before they found a profitable one. They were investing a lot of money in the ground that the tax code wasn’t giving them credit for. Instead of deducting their investment in a well over time, they wanted to deduct the entire value of their oil, regardless of how much they paid for it.
This was unprecedented. No other industry was treated this way, yet in February 1919, Congress gave the oil lobby their wish.
Daniel Roper was now in charge of deciding how much every oil well in the United States was truly worth.
Roper hired Ralph Arnold, a renowned palaeontologist and geologist, and together they recruited a team of scientific experts to estimate the size of reserves under every oil field. In a few short years, the Treasury collected production records on over 10,000 tracts and 5,000 wells.
They called it “scientific taxation.”
Unfortunately, it wasn’t nearly as scientific as they had hoped. The experts disagreed often, making it seem more art than science. Even when the scientists did agree, a Congressional investigation found that they were often overruled by BIR administrators who allowed oil companies to take more generous deductions. The leader of the investigation, Senator James Couzens, concluded that they should scrap the whole system and treat oil like any other industry.
Congress agreed to a compromise. They would send Arnold and his merry band of scientists home, but they would still allow companies to deduct up to 27.5 percent of each well’s gross income. “Percentage depletion” was back, and this time, it was here for good.
Percentage depletion has become less generous over time. Nowadays, it’s 15 percent instead of 27.5, but it still counts as a tax expenditure. If oil companies depreciated their capital investments like other industries, they would pay approximately $1 billion more in taxes every year.
The oil depletion allowance is not the biggest tax expenditure — not by a long shot — but it is one of the oldest, and therefore one of the most outdated.
There are many reasons why the tax code lost its simplicity over the years. Some are economic. Some are political. For the oil depletion allowance, it was definitional. But there’s one thing they all have in common: Once in place, they’re nearly impossible to get rid of.
It’s a lesson we should have learned from tariff battles in the nineteenth century. Once they’re entrenched, special privileges are hard to undo. The people who stand to lose — the ones who enjoy the special privilege — are always more concentrated than the ones who stand to gain. Getting rid of the oil depletion allowance might mean a few more bucks in the pockets of the average American, but it’s worth tens of millions to a big oil company. So they naturally have more motivation to fight for it — and the higher tax rates go, the stronger their motivation grows.
By the end of World War I, they were begging for relief.
Andrew Mellon picked up where Daniel Roper left off. The new Treasury secretary came into office in the midst of the worst economic downturn in a generation. He immediately diagnosed the problem as a lack of investment. Corporations were starved of funds. Wealthy taxpayers like Mellon were putting their money into municipal and state bonds instead, where they could earn interest tax-free. It never seemed to occur to Mellon that investors might have turned to these safer investments because the economy was weak, not the other way around.
The interest exemption dated back to 1895, when the Supreme Court ruled that the Tenth Amendment — “powers not delegated to the United States…are reserved to the States” — prohibited the federal government from imposing “a tax on the power of the States and their instrumentalities to borrow money.” The Sixteenth Amendment seemed to overrule them, but legislators didn’t want to challenge precedent when they wrote the Revenue Act of 1913. So they kept the exemption alive.
Now, eight years later, Secretary Mellon argued it was distorting investment decisions and holding the economy back. He tried to eliminate the exemption, but local and state governments fought back and won.
Fortunately, the Treasury Department had a Plan B. They brokered a deal with Congress to cut the top tax rate on income from investment sales, formally known as “capital gains,” from 65 percent to 12.5 percent. If investors didn’t have to pay as much taxes on capital gains, they wouldn’t have as much reason to avoid taxes by investing in municipal and state bonds. They could fund corporations again.
Capital gains tax rates remained lower than ordinary income tax rates for the rest of the 1920s. When the Great Depression struck, legislators questioned whether the bankers who drove the stock market to its breaking point had deserved this tax “preference” after all. Senate hearings revealed that the government had been subsidizing the very duplicitous behaviour that wound up crashing the economy.
But the capital gains preference, like the oil depletion allowance, had attracted a powerful coalition of supporters who profited from it. The New York Stock Exchange began a “decades-long campaign against capital gains taxes” that succeeded in keeping the top rate at 25 percent, even as Congress raised ordinary income tax rates over three times as high. Rather than closing the loophole, they opened it wider.
And so, loopholes begat loopholes. A reasonable depreciation allowance led to an unreasonable oil depletion allowance. The constitutional exemption of state interest led to the banker’s preference for capital gains.
And one day during World War II, a temporary wartime emergency measure led to the largest permanent loophole in the entire tax code.
The story begins in 1926, when Daniel Roper was trying to define “net income.”
Roper and his team discovered that workers were being penalized for receiving pensions from their employers. The way pensions worked, the company would put money into a trust, which would invest it until the workers retired and withdrew it. Because the income tax only applied to the rich, most workers didn’t pay it, but they did get hit with the corporate income tax on any income the pension trust earned. The workers were better off getting the money as untaxed current income.
Legislators eliminated this bias by exempting pension trusts from the corporate income tax in the Revenue Act of 1926, but in so doing, they set an important precedent.
The tax base expanded over the next two decades, as the government taxed more and more workers to pay to fight first the depression and then the war, but the pension exemption remained impervious. Slowly, the imbalance began to tilt in the other direction, with workers paying higher taxes on current income than on pensions.
World War II put an extraordinary strain on the labor market. Workers were drafted and sent overseas, and the ones who were left had to multiply production to meet needs on the home front and the war front. Firms competed for scarce labor by raising wages, which consumers paid in rising prices.
Congress created the Office of Price Administration to stop inflation with wage and price controls. Following precedent, they exempted pension and insurance benefits. They argued, in fact, that pension and insurance benefits were not inflationary since they were future income — and therefore unlikely to be paid to workers until after the war was over.
Over the next four years, pension plans more than tripled, as firms used the only monetary incentive they had left to attract workers.
But the biggest beneficiary in the long run was the nascent health insurance industry, which had only recently begun offering group plans to large firms. The timing was opportune. Medical education reforms over the past two decades had improved the quality of physicians, and pharmaceutical and technological breakthroughs began to convince Americans of their efficacy.
When the IRS ruled in 1943 that employees didn’t have to pay income taxes on their health insurance benefits, they inadvertently created the centrepiece of the US health care system as we know it. Health insurance benefits became so valuable to workers that the National Labor Relations Board ruled in 1949 that unions could bargain for them along with wages.
The IRS tried to retract the exemption after the war, but they were no match for the millions of Americans who had come to benefit from it in the meantime. Congress promptly made the exemption permanent in the Internal Revenue Code of 1954.
It became the single most expensive expenditure in the tax code.
Year after year, president after president, the tax code became a veritable Swiss cheese of loopholes. Congress added an investment tax credit for purchases of business equipment in 1962 and a special tax break for export companies in 1971. They subsidized the mining industry and the savings-and-loan associations and independent oil producers, who got a loophole on top of a loophole when Congress narrowed the depletion allowance to privilege even fewer firms. But the largest expenditures were mostly in place by the end of World War II.
For decades, tax expenditures were safe from elimination for the simple reason that the nation could afford them. Tax rates on the rich were high — much higher than they are today — and as a result, budget deficits were low. The government didn’t need more money, so they left most of the loopholes alone.
Then, Ronald Reagan became president.
The first major achievement of the new administration was the Economic Recovery Tax Act of 1981. It slashed the top income tax rate from 70 percent to 50 percent, pushed the top capital gains tax down from 28 percent to 20 percent, and allowed companies to deduct the depreciation of their investments much faster, when the money was more valuable. Budget deficits exploded.
As the government went deeper into debt, the president refused to raise tax rates, which only left one way to collect more revenue. And that’s when Donald Regan walked into the Oval Office carrying a report on all the corporations that didn’t pay income taxes.
This is the fifth in a series of Substack posts that will show how the United States can raise trillions of dollars in revenues to reduce inequality. Come back next week for Part 6…
The taxing system has certainly been cyclical. Even in simple terms it has to be difficult to determine the value of oil wells. Tax allowances are disputed among all levels of society. One can perhaps look at scientific taxation as mind shaping. It has to be molded among the masses. Look forward to following more Swiss cheese.