This year marks the 75th anniversary of the undistributed profits tax (UPT), a short-lived New Deal fiscal innovation that nearly remade the landscape of corporate taxation. Champions of this novel and highly controversial tax hoped that it would regulate the behavior of large corporations, while curbing tax avoidance among the rich and delivering a windfall to the government.
Ultimately, the UPT did almost none of that. But it did leave lasting marks on the taxation of corporate income. In particular, it gave rise to the much derided and remarkably durable double taxation of corporate income. And here's the real surprise: That double taxation was demanded by business lobbyists.
The history of the UPT has been told by a few historians, but the leading expert is Steven A. Bank, a law professor at the University of California, Los Angeles. Bank has told the story in a series of articles and most recently in his 2010 book, From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present. (Bank and I were coauthors, along with Kirk J. Stark, of a 2008 book on war taxes.)
Bank begins his chronicle of the UPT with Franklin Roosevelt's first campaign for the White House. In a famous 1932 memo, several of FDR's closest advisers -- including Adolph Berle, Rexford Tugwell, and Raymond Moley, all of Columbia University -- suggested that retained corporate earnings might have played a key role in precipitating the slump.
Flush with profits from the go-go economy of the late 1920s, corporations had chosen to stash their cash in corporate coffers rather than pay it out to shareholders in the form of dividends, Berle wrote. This corporate hoarding prompted businesses to over-invest in productive facilities, while also reducing the money available for consumer purchasing (on the theory that some large portion of distributed earnings would have been spent rather than saved). The result? A depression.
Not content with a diagnosis, Berle and his colleagues offered a remedy, too: the UPT. A heavy tax on retained earnings would force companies to disgorge their cash, the trio insisted. "By forcing undistributed surplus into the market for capital," they wrote, "we could prevent the piling up of individual surpluses which, as we now know, can only be used in ways which are disastrous to the general economic welfare."
Strong words, but not strong enough to translate into real policy, even after Roosevelt won his landslide victory. During the early years of the New Deal, FDR shied away from ideas that seemed likely to antagonize business interests, seeking instead to cooperate with business leaders whenever possible. But by 1936, Roosevelt was done coddling Wall Street and the business community, and he returned to the notion of taxing retained earnings.
New Deal arguments for taxing undistributed profits ran the gamut from revenue to regulation. Most immediately, FDR and his advisers hoped the UPT would help close a large and looming budget gap. At the same time, however, they believed it would strike a blow for fairness by closing a giant loophole in the existing income tax.
Treasury officials estimated that corporations would retain some $4.5 billion in corporate profits in 1936 alone. By holding onto this vast sum rather than distributing it to shareholders, companies would shelter the money from high individual tax rates. Treasury estimated that retained earnings cost the government as much as $1.3 billion in lost revenue.
"The fundamental objective of this proposal is to increase the federal revenues by plugging up a major source of tax avoidance and tax evasion now existing, and thereby greatly to increase the fairness and balance of the federal income tax structure as a whole," explained one administration official during congressional testimony on the UPT.
Corporate managers played the heavy in FDR's narrative of high-end tax avoidance. Robert Jackson, then a senior Treasury official but soon to be a Supreme Court justice, offered a particularly colorful demonization. "How many [Americans] lost homes for want of a dividend to help meet interest?" he asked rhetorically. Jackson even offered up the obligatory nod to fascism: "The distress caused by this policy of regimenting all stockholders and making them goose-step to the tune of tax avoiding management cannot be fully known."
To rein in these jackbooted CFOs, Treasury suggested that Congress replace the existing corporate income tax with a new levy on retained earnings. The new tax, predicted to raise $620 million in additional revenue, would not subject corporate income to a second level of tax, at least not if that income were distributed immediately to shareholders. Only retained earnings would be subject to the UPT and then taxed again at the individual level when (eventually) paid out in dividends.
"Roosevelt's original plan was not only not intended to result in double taxation, but was designed to provide corporations with a means to integrate the corporate and shareholder-level taxes with respect to their own income," Bank wrote.
So how did double taxation enter the legislative equation? Through the vigorous effort of business lobbyists, who used it to gut the UPT itself.
Business interests hated the UPT for any number of reasons. Most obviously, it seemed likely to constitute a significant tax increase for corporate taxpayers. But it also threatened something even more precious: managerial prerogatives. Business leaders objected to the notion that government could establish an "acceptable" level of retained earnings and tax everything above it at punitive rates.
Managers worried that a high tax on undistributed earnings would drive a wedge between shareholders and managers, Bank wrote. As long as corporate income was taxed at rates far lower than individual income, shareholders were content to let companies keep the cash. But if undistributed earnings were taxed at a high enough rate, shareholders would clamor for a payout.
Business lobbyists used double taxation to fend off such a tax. In place of a high rate on retained earnings, they urged a much lower rate combined with a new low-rate tax on dividends at the individual level. The idea was to reduce the difference between what a company would pay on retained earnings and what a shareholder would pay on distributed ones.
Congress did not agree to eliminate the spread entirely, but lawmakers made it small enough to quiet objections. "The price corporate managers paid for gutting the bill of its coercive power over dividend policy was the introduction of full double taxation of corporate profits," Bank concluded. "By coupling a corporate income tax with a dividend tax to negate the undistributed profits tax, corporate profits would be subject to double taxation even if they were immediately distributed."
Some business leaders objected to the introduction of full double taxation, but Bank described their complaints as nominal. On balance, it was a good deal for corporations, and they were happy to get it.
Even the watered-down UPT that Congress eventually passed failed to stick around for long. Within a few years, business leaders convinced Congress to first gut and then repeal it. But the legacy of this failed experiment in corporate tax reform -- and business regulation -- remains with us today.