The Excess-Profits Tax

DURING the past three years of rising prices, merchants and manufacturers have made large profits, whether they did business efficiently or inefficiently. The state of the market, rather than ability, has been of first importance in securing a high percentage of earnings. The corporation excess-profits tax has met with favor because it forces a corporation which has profited by abnormal conditions arising out of the war to divide a share of its gains with the government.

Although conditions which have given rise to widespread ‘ profiteering ’ are changing, certain other objectionable practices make possible extraordinary profits, or, presumably, business men would not adopt them. Those who support the continuance of the excessprofits tax find in it, not only a very convenient method of collecting taxes, but a permanent means of discouraging the maintenance of sweatshops, cut-throat competition, and practices of like nature, by making them less lucrative.

The excess-profits tax is, however, fashioned rather for carving unsound fruit than for pruning a source of decay. And even if, by making them less profitable, the tax bids fair to discourage objectionable business methods, it will, for the same reason, discourage able management.


But if those who support the tax have credited it with an illusory virtue, those who condemn it have charged it with an evil for which it is only limitedly responsible, namely, the high cost of living.

A federal tax which produces a revenue measured in billions of dollars will reflect itself in increased prices. It is doubtful whether any other type of business tax would have added so little to the cost of living as has the excessprofits tax. A simple analysis of the factors which underlie the fixing of prices will show that most corporations are able only to a limited extent to shift a tax on profits.

If the production of an article is controlled by a monopolist (the owner of a patent, for example), the price will be regulated, not primarily by the cost to the producer, but by the maximum amount which the average prospective purchaser is prepared to pay. The maximum which the purchaser is prepared to pay is only slightly affected by the amount of profits tax or any other cost which the producer has been forced to bear.

If the production (including distribution) of a commodity is subject to competition, and only some competitors are taxed, they cannot add the tax to the price of the commodity which they offer for sale, because their competitors would undersell them. Perception that those subject to the profits tax will seek to shift the tax by continued high prices unquestionably tends to encourage all business men to maintain inflated prices; but, as is being presently demonstrated, prices in competitive lines of business seek irresistibly the level established by a normal margin of profit for the untaxed dealer.

The percentage of profits tax varies greatly with the rate of profit on the investment, and corporations whose profits are less than 8 per cent pay no profits tax. Furthermore, persons doing business as partners or individuals are not subject to the excess-profits tax and may be subject to only a low rate of individual income tax. It is obvious that a taxed corporation, forced to compete with corporations and individuals, that have paid little or no profits tax or its equivalent, will find it impossible to shift the tax to any great extent.

The revenue substitute commonly offered for the excess-profits tax is some form of sales tax. If the excess-profits tax actually were largely passed on to the general public, it would, in effect, be a tax on sales. To substitute an untried sales tax for a tax proved to be productve would be unwise.

But the excess-profits tax is not generally shifted to the buying public; and its inequalities, only irregularly effaced by diffusion, affect chiefly the common stockholders, out of whose profits the tax is paid.


The law levying the corporation excess-profits tax is inequitable in four outstanding particulars.

First: ‘Profits’ taxed under the law are often only apparent profits. Close corporations, in which substantially all the stock is held by employees, had, prior to 1917, made no attempt to pay salaries commensurate with the value of services rendered by officers and other employees who were also stockholders. Increased return on the stock roughly offset deficiencies in salary. After the enactment of the first law levying a tax upon corporation profits, salaries of stockholding employees were increased in order to reduce the taxable profits of the corporation, and the increase has in some cases been far beyond the actual value of the services.

It is obviously impossible for the Commissioner of Internal Revenue to judge the good faith in each of the multitude of these cases, and general limitations have been laid upon allowable increase in salary. The limitations have, in many instances, forced corporations to pay taxes on profits which are fictitious, because they arise from the government’s refusal to allow, as an expense, salaries that constitute just compensation for the services of stockholding employees.

Second: In some lines of business, earnings in isolated years exceed 20 per cent, although the average of profit is less than 8 per cent. Corporations whose profits fluctuate are subject to tax in the peculiarly prosperous year; while the corporation whose average of profits is equally great, but whose income is stable, will never be subject to the profits tax.

Third: Investors are entitled to a high return from a successful enterprise which involves a considerable risk of loss; but the excess-profits tax is levied without regard to the nature of the business in which the corporation is engaged. The rate of profit fixed as a fair return is applied equally to the profits of a mining company and those of a national bank! A plan was proposed to establish a sliding scale of ‘excess profit,’ based on the element of risk involved in various lines of business; but this was rejected as impracticable.

Fourth: The excess-profits tax is based, not solely on the amount of profit, but on the ratio of profit to invested capital. We have already noted that this tax is unjust, in that it sometimes taxes a corporation on an amount of profit which is really fictitious. But even when the correct amount of profit is determined, if the full amount of capital is not allowed for, the ratio will be false and the tax excessive.

A corporation can usually more accurately determine the cost than the present value of its capital assets, since the cost will have been entered in the corporation’s books of account, while the value of most assets is subject to a wide range of opinion. Because of this fact the present law bases the excessprofits tax, not on the value, but on the cost of a corporation’s assets.

Let me illustrate the inequality which this may entail. In 1900, corporation A bought an office-building in a growing city for $100,000. The property now is worth not less than $300,000, as evidenced by offers of purchase at that price. The corporation’s net income from rentals is $30,000. It is subject to an excess-profits tax based, not on the rate of 30 to 300, but on the ratio of 30 to 100.

In 1920, corporation B purchases an adjoining building for $300,000, the net income from which is $40,000 a year. B is subject to an excess-profits tax based on the ratio of 40 to 300. Although neither its income nor the proportion of income to actual capital is as great as B’s, corporation A will have to pay more than tw ice the amount of profits tax payable by corporation B.

Increase of value is not limited to tangible assets. By honorable dealing and persistent advertising a corporation may have built up a highly valuable asset of good-will for which it receives no credit in computing the tax. Patent rights, too, become worth, in some cases, much more than cost.

The hardship which this provision of the present law entails was called to the attention of Congress, and consideration w7as given to a proposal to make value rather than cost the basis of the tax. The administrative difficulties of the plan required its abandonment. In auditing returns based on an estimate of the current worth of the corporation’s assets, the Bureau of International Revenue would have been forced each year to appraise, not only a large proportion of the tangible property in the United States, but the good-will and patent rights of almost all domestic corporations.

The law provides limited measures of relief applicable to certain cases of outstanding hardship; but, in spite of the efforts of the Treasury Department to apply these measures liberally, the operation of the excess-profits tax is resulting in gross inequalities.


Even if the chief defects of the excess-profits tax were not (as they are) inherent; and if a law could be drawn which would remove the inequality of the present law, nevertheless, the tax should be repealed because of its lack of harmony with the individual income tax.

The federal tax on individual income is not levied solely at a flat rate, like a state or city tax on property. There are two flat rates (4 per cent and 8 per cent) of ‘normal tax’; but, in addition, there is a scale of so-called ‘surtaxes,’ beginning at the rate of 1 per cent on income which exceeds $5000. Successive tiers of income are taxable each at a higher rate of surtax. By the time income reaches $50,000 it becomes subject to a surtax of 24 per cent; and an income of over a million dollars is made up of fifty-four layers or tiers; the top one, composed of all income over a million, being subject to a surtax of 65 per cent. To the surtax must be added, in each case, the flat 8 per cent (or, in the lower tiers, 4 per cent) rate of ‘normal tax.’

Turning to the tax on corporations, we find that the excess-profits tax is a kind of surtax, levied, not according to an unrelated amount of income, but according to the percentage of profit on the investment; that the tax is 20 per cent of profits exceeding 8 per cent, and 40 per cent of profits exceeding 20 per cent, on the investment; and, finally, that the profits tax is supplemented by a corporation income tax levied at a flat rate of 10 per cent, without regard to the percentage of profit. This income tax (unlike the individual normal income tax) is levied only on the amount which remains after the profits tax has been deducted from the income; so that the highest tier of corporation tax is subject to a maximum tax of 46 per cent — 40 per cent profits tax and 10 per cent income tax on the 60 per cent of income left after deducting the profits tax.

Since, however, that portion of the profits which does not exceed 8 per cent on the investment is subject merely to the income tax, and since profits amounting to an additional 12 per cent on the investment are subject to a profits tax of only 20 per cent, the tax on the corporation’s income as a whole will necessarily be less than the tax of 46 per cent on its topmost layer of profits. In fact, the combined income and excess-profits taxes rarely exceed 33 per cent of a corporation’s entire net income. The normal range of corporation taxes is therefore from 10 per cent to approximately 33 per cent.

Bearing in mind that a corporation is essentially only a sort of hoop for holding together an association of real persons, — the stockholders, — let us now examine the effects of the excess-profits tax on these persons.

If a corporation which has paid a 33 per cent tax out of income distributes the remainder of the income in dividends, a part of this may go to a stockholder whose other income has reached $100,000 and who is subject to a surtax on additional income at the rate of 52 per cent. The tax on the stockholder would, in this event, be 33 per cent, advanced by the corporation, plus 52 per cent of the 67 per cent left after the payment of the corporation tax; or 34.84 per cent, making a total of 67.84 per cent.

If the corporation had paid a tax of only 10 per cent, the stockholder’s combined tax would be 10 per cent plus 52 per cent of the 90 per cent left after payment of the corporation tax, or about 56.8 per cent.

Had this same person received an equal amount of profit from a business which he conducted individually, he would have been subject to the normal tax of 8 per cent (from which dividends from a corporation are exempt), and to the surtax of 52 per cent, making a total of 60 per cent. If the corporation tax is heavy, the combined corporation and individual taxes of stockholders of large taxable income will be somewhat higher than would be the tax on profits from an individual business. But if the rate of the corporation’s tax is low, a stockholder of large taxable income will pay less tax by having profits drain through a corporation than by having them come to him directly.

For a stockholder to save tax by paying an additional corporation tax appears to present a paradox. It is, however, explained thus: the corporation tax is greater than the normal individual income tax (from which dividends are exempt), and so would inevitably result in an increased aggregate tax, were it not for the fact that the corporation tax is deducted from the stockholder’s income before the individual surtaxes are assessed, while the amount of normal individual income tax is not deductible from income in computing the surtax. This saving in individual surtaxes sometimes more than offsets the amount by which the corporation tax exceeds the normal individual tax.

Turning to a stockholder whose income is $5000 or less, we find a very different situation. The fact that the corporation tax is deducted before the individual surtax is assessed is of no significance to him because his income is not subject to surtax. He saves, it is true, the normal individual income tax of 4 per cent, but at the expense of 10, 20, or even 33 per cent tax paid by the corporation. It is only as the amount of a person’s income increases, and he becomes subject to the higher 8 per cent normal tax and to increasing rates of surtax, that the exemption from the normal individual tax and the saving in surtax approaches or exceeds the corporation taxes.

The excess-profits tax does not bear harshly on wealthy stockholders since, in paying this tax, they escape other and possibly even heavier taxes. The tax seriously affects only stockholders of comparatively small income.

While the present method of corporate taxation is unfair in forcing stockholders of small income to bear a burden of tax grossly in excess of the tax paid by persons whose income is even greater but arises from other sources, it is equally iniquitous in affording shrewd stockholders of large income an avenue of escape from individual income tax.

We have thus far assumed, you will recall, that the corporation distributes the profits left after payment of taxes. As a matter of fact, many, if not most, corporations distribute only a fraction of their profits. The rest are reinvested in liquidating indebtedness or expanding the business. Stockholders are not taxed on income thus reinvested.

A person engaged in trade or farming, individually or in partnership, is taxed on profits which are retained for developing the business or the farm, as well as upon profits actually withdrawn. A professional or salaried man may immediately invest a portion of his income in stocks; but the income so invested is not exempt from tax.

This escape of accumulated corporation profits from the individual surtaxes which are payable on all other forms of income, except interest from tax-free bonds, affords no relief to the stockholder of comparatively small income. Subject as he is to little or no individual surtax, and with dividends exempt from the normal tax, he is unconcerned (from the standpoint of taxes) whether the profits of the corporation are distributed or not.

It is the stockholder of large means, comparatively lightly affected by the corporation income and profits taxes even on profits which are distributed, who finds this accumulation of corporation profits an effective agency for escaping federal taxation.

A person whose taxable income has reached a million dollars will be taxable at the rate of 73 per cent on additional income, consisting of undivided profits of an unincorporated business.

A person of like income holding stock in a corporation will be taxed on undivided profits of the corporation only to the extent of the corporation tax, which may be as low as 10 per cent. Thus a stockholder may avoid 63 per cent of the 73 per cent tax which the law contemplates that he shall pay. The accumulated profits will, it is true, probably be reflected in the value of the corporation stock; and hence will increase the taxable gain, or decrease the deductible loss, upon a sale of the stock. But if the stock has materially increased in value, a thrifty investor, whose income is large, will hold on to it.

Whatever your attitude toward progressive taxation may be, I am sure you will agree with me that such inequality in the application of a progressive tax is intolerable.


It is often easier to find powder with which to blow up an existing system than to provide material for a new one. Fortunately, those who would wipe out the excess-profits tax have a constructive plan of replacement. The proposed law is roughly as follows. Retain the fiction that a corporation is a separate person. Levy a flat rate of tax on the profits of a corporation. Add a proviso that profits which are distributed to stockholders within six months of the close of a corporation’s business year shall be exempt from the corporation tax. And make the tax so high that a corporation will be forced to seek the exemption by distributing all of its profits. The stockholders will then be subject to the income tax on these distributed profits as on any other income. The corporation tax will be simply a goad to drive corporation profits under the shears of the personal income tax.

Corporations will be permitted to distribute profits, either in cash dividends or, with the approval of the Commissioner of Internal Revenue, in promissory notes bearing a rate of interest sufficiently high in respect to the corporation’s credit, to make the notes worth approximately par.

It is true that stockholders may thus be taxed on ‘profits’ not received in cash; but so is a person conducting an unincorporated business, who has been unwilling or unable to withdraw the profits from his business.

Stockholders of closely held corporarions will, in most cases, return to the corporation a considerable part of the dividends as paid-in surplus. Corporations whose stock is more widely distributed will employ a method for tempting the scattered profits back into the corporation fold, under which, if the common stock is worth more than par, additional common stock will be issued and stockholders given the right to buy the stock at a figure less than its actual value. If a stockholder does not himself wish to reinvest, he may sell his ‘ rights ’ to others. ‘ Rights ’ are at present bought and sold on the stock market. If the corporation’s common stock is worth not more than par, so that its sale at par or higher would offer no irresistible attraction to investors, preferred stock, having a sufficiently high rate of dividend to ensure a value above par, may be offered to common stockholders.

The revision of the tax on corporation profits must, however, go hand in hand with an amendment to the individual income tax. The present rates of individual income surtax are so high that they defeat their purpose and are unjust.

The individual surtaxes fall most heavily upon those whose income is derived chiefly from personal services and those who happen to receive an unexpectedly large amount of income in a single year.

The highest rates of surtax, added to the normal income tax, will reduce the yield of stock paying 10 per cent to less than 3 per cent. Under the present law, an alert investor whose income is consistently high either holds stock in a corporation that distributes only a small percentage of its profits, or has invested in non-taxable government bonds. If the possibility of avoiding the prohibitive surtaxes by holding appropriate corporation stocks is removed, wealthy stockholders will inevitably transfer their capital from stock to tax-free bonds. The rates of surtax should be reduced to a point at which a stockholder of large income may anticipate a net return, after payment of taxes, exceeding the return from non-taxable securities. The maximum rate of surtax should not exceed 20 per cent.


A taxing policy which is not fair is not sound; but the excess-profits tax is an unsound method of permanent taxation, aside from the inequality which it creates. The excess-profits tax is exceedingly complicated. The preparation of a return which will satisfy the government’s requirements and protect the corporation’s interests requires the services of expert accountants and an attorney. Former Commissioner of Internal Revenue Daniel J. Roper has established the immediate cost of the preparation of the returns last year at not less than $100,000,000. The value of the time and thought devoted by corporation officers to tax matters, that should instead be applied to problems affecting production and sales, is very great. The government machinery for administering the income tax is choked by the mass of audits and contests incident to the excess-profits tax.

Furthermore, the excess-profits tax ignores the mass of income below a fixed percentage on the investment, and depends for its harvest upon cutting deeply into profits when they emerge from the established safety zone. A decrease in earnings will, of course, unfavorably affect any tax based upon income, but a general curtailment of corporation income would reduce revenue from the excess-profits tax to a tithe of the present yield.

Business men and citizens generally are entitled to demand that Congress take thought for the future. Next year, unless all signs fail, there will be a very material reduction in corporation incomes.

Failure to act, in the forthcoming session of Congress, not only will result in the continuance of an unjust and needlessly burdensome tax, but may disrupt our national finances.

In closing, I want to emphasize these four points: —

The corporation excess-profits tax cannot fairly be condemned as a method of taxation which has a peculiar tendency to aggravate the high cost of living.

The present system of corporate taxation should, nevertheless, be revised, because it unduly burdens stockholders of small income, and because it permits stockholders of large income to escape the surtaxes, which are payable by persons whose income is no larger but is derived from personal services, from profits of an unincorporated business, or from rents and taxable interest.

Congress should adopt a system of taxation which will cause stockholders to be taxed individually upon corporation profits.

Abnormal profits generally are subsiding, and excess-profits taxes will be diminished; replacement of the present corporation taxes by a tax on the stockholders probably will entail no material loss of revenue, and will ensure a source of revenue more constant than that provided by the excess-profits tax.