December 1, 1950

Financing Defense: Is An Excess Profits Tax the Solution?

Executive Summary

The excess profits tax rests on a basic philosophy which is fallacious. Its two general concepts—that average earnings in the past or a percentage of capital employed in the business can be used to measure what are “normal” profits and what are “excess” profits—are both theoretically unsound. Neither concept can be implemented practically because of wide variations among different industries and among individual companies within each industry. The use of a “base period” is unrealistic, and the attempt to establish a “fair” rate of earnings leads to results which are greatly inadequate in some cases and excessive in others.

Aside from the unrealistic and fallacious nature of the concept of a “standard” for measuring “normal” or “‘excess” profits, attempts to put these standards into effect in a tax law lead to specific inequities and evil consequences. These arise from the nature of the tax itself, and the principal ones are:

(1) The excess profits tax strangles productive effort. (2) It penalizes small and growing corporations. (3) It contributes to inflation. (4) It is difficult to administer. (5) It is difficult, if not impossible, to grant relief in cases where the tax has a particularly harsh impact.

These patent inequities and indeed absurdities are readily perceived when an attempt is trade to apply the standards to individuals.

The United States has had poor experiences with the excess profits tax in World Wars I and II. After each war, the tax was denounced as unsound and promptly repealed. Its revival now is an attempt to take out of mothballs past methods which have worked badly, without due consideration of the real needs of our present situation.

Our present situation is entirely different from a war emergency. We apparently face a long-range defense period which may well extend for a decade or even beyond. Our real needs are the encouragement of industrial efficiency, the conservation of resources, and the preservation of every incentive to produce, not merely for this year, but for years to come. Our greatest weapon is our productive strength. In addition, we must at all cost avoid further inflation and should follow a policy of pay-as-you-go finance. Under these circumstances, tax policies that unduly restrain the economy, that are inaccurate and inequitable among taxpayers, that depend on administrative devices that break down, have no place in our tax planning.

We believe that excessive profits accruing directly from defense production should be prevented or taxed away. Renegotiation, as developed in World War II, with refinements and adjustments growing out of our experience with it in that period, adequately, directly, and certainly transfers this type of “excess profits” to the government.

Business profits will have to bear their share of the burden of the heavy costs of our defense. The better alternative to an excess profits tax is to spread over the whole of business earnings an additional “defense tax.” The economy is operating at a high level, and there is no slack of unemployed labor or plant. Any extra burden of defense taxation will be damaging. By spreading the burden as broadly as possible, we may avoid excessive damage to any particular sector of our productive operations.

Our fundamental need is to maintain a strong, healthy, active economy, and an efficient, productive industry. A moderate defense tax will meet our revenue needs far better than an excess profits tax, with fairness and without the administrative difficulties, the glaring inequities, the excessive waste and irregularities, and the restraints and dangers of an excess profits tax.

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