FDR Tried To Stop A Capital Gains Tax Cut — And Failed

Presidents sometimes play an outsize role in shaping tax policy — Ronald Reagan in 1986 may be the best relatively recent example. But it’s a mistake to assume that presidents come to the job with clear ideas about specific tax issues.

To be sure, they often have strong opinions about the overall direction of tax policy: that taxes should go down, or up, or down for some people and up for others. But they don’t typically have well-formed ideas about specific elements of tax policy.

Sometimes, however, they can develop strong opinions under the tutelage of their advisers — especially when opinions about a specific issue resonate with their broader tax philosophy.

Such was the case with Franklin D. Roosevelt and the tax treatment of capital gains. While Roosevelt showed little interest in capital gains taxation during his first five years as president, he developed a passionate interest in the topic during his sixth.

Not that it did him any good: Congress ignored him entirely.

Discovering Tax Avoidance

FDR wrestled with many tax issues during the early years of his long presidency, but the treatment of capital gains was not among them. His first-term tax agenda focused on excise taxes (especially on alcohol), individual tax rates on regular income (especially in the upper brackets), the estate tax, and the taxation of corporate profits.

And while Congress made significant changes to the tax treatment of capital gains in the Revenue Act of 1934, FDR himself never engaged with the issue. (Indeed, he had little to say about any aspect of the 1934 law.)

It was not until the spring of 1937, at the start of Roosevelt’s second term, that capital gains got any serious attention from the president. Facing an unexpected shortfall in revenue collections, FDR asked Treasury Secretary Henry Morgenthau Jr. to accelerate his department’s existing project on tax avoidance among the rich.

Morgenthau explained to his staff that the president “wants to say flatly that our estimates and our method of estimating were correct, but the citizens — that’s the word he used — found a trick way of finding loopholes. And then he wants us to go into considerable detail as to what those loopholes are.”

Morgenthau’s explanation, recounted in John Morton Blum’s biography based on Morgenthau’s voluminous diaries, underscored Roosevelt’s fixation on political narrative (From the Morgenthau Diaries (1959)). When it came time to make a public case against tax avoidance, FDR wanted to tell a story — one that featured particular villains and their specific misdeeds. He expected Treasury to supply the raw material.

“The time has come when we have to fight back, and the only way to fight back is to begin to name names of these very wealthy individuals who have found means of avoiding their taxes at home and abroad,” the president told Morgenthau.

Treasury’s legal experts were uneasy with FDR’s enthusiasm for naming names. Indeed, they warned Morgenthau that those disclosures might be illegal. But neither Roosevelt nor Morgenthau was swayed by such concerns. 

Morgenthau relayed the president’s view in notably overheated language. “The question is whether we are going to have a Fascist government in this country or a government of the people, whether rich men are going to be able to defy Government and refuse to bear their burdens. Are we going to make progress in liberal government or is it going to take a revolution finally to settle the question,” Morgenthau thundered.

Roosevelt believed that a high-profile campaign against tax avoidance loopholes was crucial to the larger battle for the soul of the Democratic Party, according to Morgenthau. Many conservative Democrats wanted to move the party to the right, forcing FDR to abandon his more progressive economic reforms (including the corporate undistributed profits tax, enacted in the face of vociferous business opposition in 1936).

In 1937 FDR was in danger of losing his battle against the conservative Democrats. But the president believed that a populist campaign against tax loopholes would help deflect conservative attacks.

To be effective, however, that sort of anti-loophole campaign had to be lurid. It needed to name not just the loopholes, in other words, but the people using them.

“Let us give the president what he wants, without quibbling as to whether this or that is legal. The president is intelligent enough to decide what he can use,” Morgenthau instructed his staff.

In the face of this dubious demand, Treasury Undersecretary Roswell Magill chose to play it safe. He prepared two memos for the president, each describing important tax avoidance techniques.

The memos were identical in every way but one: The first featured the names of many rich and famous Americans; the second, sanitized version did not.

According to Blum, FDR liked the memo but asked Treasury to supply at least 25 more names for use in a radio address he was preparing. No sanitized versions for this president, thank you very much.

But Morgenthau had gotten cold feet about the vilification FDR had in mind. He was concerned that naming names would “stir up class hatred unnecessarily,” according to Blum. Magill, too, continued to urge that the avoidance data be presented anonymously, emphasizing that naming individuals was inherently unfair.

“One famous manufacturer who had incorporated a yacht might be the sole object of attack although at least twelve others followed the same practice,” Blum explained.

Ultimately, discretion proved to be the better part of valor, even for Roosevelt. When the president sent his anti-loophole message to Congress, it left the White House with no names attached.

It is likely, however, that Roosevelt anticipated what soon followed: Congress did the dirty work for him, identifying many of the same taxpayers in later hearings.

Lessons From Loopholes

The capital gains preference figured into some of the avoidance schemes outlined in Magill’s memo, as well as Roosevelt’s message to Congress and the subsequent hearings on Capitol Hill. But for the most part, it remained rather peripheral during that episode.

Neither Congress nor the White House would get serious about the issue for another year. Still, several aspects of the 1937 anti-loophole campaign make it important to understanding the capital gains debate that unfolded the following year.

First, FDR’s message to Congress in 1937 alluded to the nascent campaign among business leaders to make capital gains entirely tax exempt. Spearheaded by leaders of the New York Stock Exchange, this campaign was gaining fans on Capitol Hill. (For more on that campaign, see Ajay K. Mehrotra and Julia C. Ott, “The Curious Beginnings of the Capital Gains Tax Preference,” 84 Fordham L. Rev. 2517 (2016).) 

FDR warned lawmakers to resist the notion that “because certain individuals do not approve of high income tax brackets, or the undistributed earnings tax, or the capital gains tax, the first duty of the Congress should be the repeal or reduction of those taxes.”

Clearly, the taxation of capital gains was already getting some hostile attention in Washington.

Second, the 1937 tax avoidance debate underscored FDR’s myopic focus on wealthy taxpayers when it came to definitions of tax fairness. Many tax experts of the 1930s were eager to reduce tax burdens on the poor, principally by cutting excise taxes, which were a major component of the federal revenue structure at the time.

But FDR was always more interested in raising taxes on the rich, or at least heading off tax cuts in the upper brackets when lawmakers threatened that possibility. Even for fans of progressive taxation, FDR’s approach to achieving tax fairness was incomplete.

Third, Roosevelt’s fondness for tax storytelling — evident throughout the loophole debate — would resurface in the capital gains argument of 1938, albeit in less lurid form. While he took to heart his advisers’ concerns about illegal disclosure, he continued to frame his tax preferences in narrative form, always looking for a story with good guys and bad guys, winners and losers.

Discovering Capital Gains

In late 1937, two months after Congress had passed the antiavoidance Revenue Act of 1937, lawmakers began debating several more tax reforms, including changes to the existing treatment of capital gains.

Since 1934, capital gains had been taxed using a system of exclusions based on holding periods. For assets held a year or less, 100% of the realized gain was included in income and taxed at normal rates. For assets held between one and two years, 80% was included; between two and five years, 60%; between five and 10 years, 40%; and over 10 years, 30%.

Capital losses were recognized using the same scale and netted against capital gains. It bears repeating, however, that in all cases, the included gain was taxed using the graduated rate structure applied to regular income; this would become an issue later on.

Business leaders were never happy with this legislation, and they had been agitating for reform since the moment of its enactment. By late 1937, these critics were starting to find allies on Capitol Hill, and observers began to talk about the prospect of actual legislation. In late October, a reporter asked Roosevelt what he thought about the chatter.

“The only thing I can say about those stories is something rather interesting,” FDR said. “If you will read them you won’t find in any of the stories anything relating to changes in taxes — not a single reference — of that portion of the population which has very little money to live on.”

This was vintage Roosevelt, underscoring the class issues at play in tax policy debates. And he had a compliant press corps to help him along. A follow-up question asked if there had had been any talk about revising sales taxes (by which the reporter presumably meant excise levies, since there was no federal sales tax).

“Never, no mention of that ever,” Roosevelt said. “Never any mention of increasing the purchasing power among the 30 or 40 millions of people who have today practically no purchasing power. I think very probably it is an interesting thing for you to use your imagination on and write interpretative stories.”

New Legislation

Soon enough, idle chatter became actual legislation. By the spring of 1938, the House had drafted a bill that included a revised treatment for capital gains.

The House proposed that holding periods for long-term gains be measured on a more granular, monthly basis; rates would then be reduced in smaller increments as well, typically by a single percentage point or two.

The Senate, however, had something more dramatic in mind.

More sympathetic to business complaints about the heavy burden of the existing tax regime, the Finance Committee drafted a bill to tax long-term gains at a single rate of 15%, essentially returning to the arrangement in place between 1924 and 1932, when long-term gains were taxed at a flat rate of 12.5%.

“The committee believes that this treatment of capital gains and losses will stimulate transactions, facilitate the flow of capital into new enterprises, release frozen capital, and increase the revenues of the government,” the committee explained in its report.

By this point, Roosevelt had made his peace with the House bill. Indeed, he seems to have come around to the idea that some sort of tax cut was actually reasonable.

“The President said the existing rates of taxes on capital gains were too high,” Magill later recalled in describing a key meeting at the White House.

Magill’s recollection, recounted in Blum’s Morgenthau biography, captures a typical moment of presidential inconstancy. Roosevelt possessed a deep and abiding commitment to progressive taxation, evident throughout his career.

But his understanding of tax policy was modest, and he could lose his way when confronted with specific policy issues.

Ironically, at this crucial moment it fell to his most conservative policy adviser to bring him home. Magill was a Republican and would eventually become an outspoken champion of limited taxation and small government.

But he was also a straight shooter and respected tax expert. And like most tax experts of the 1930s, he believed that capital gains didn’t need especially generous treatment.

“I interrupted to say that I did not think they were too high,” Magill remembered of his discussion with Roosevelt. “The real objection to the existing law was that the treatment of capital gains was unfair.”

Roosevelt latched onto Magill’s final word. “The President said to put it that way,” Morgenthau wrote in his diary. “Under this bill the individual with a small capital gain of $5,000 would pay 15% and the individual with a $500,000 capital gain would also pay 15%. This was a clear violation of the principle of taxation according to capacity.”

Roosevelt’s insistence on framing the issue as a comparison between two theoretical taxpayers is illuminating. He understood that tax policy was best explained — politically, at least — when it was reduced to personal terms.

If you couldn’t name actual individual taxpayers, you could at least describe notional individual taxpayers. As a consummate politician, FDR understood that every story needs characters — even a tax story.

The Two Taxpayers

Indeed, FDR had added characters to this particular tax story even before his meeting with Magill, which occurred on May 18. More than a month earlier, during a press conference with the editors of trade papers, he had framed the capital gains debate as a fundamental issue of tax fairness.

“Today it is the national policy, whether we like it or not — it is generally accepted by the people and you will never be able to change it — to maintain a graduated tax upon personal incomes,” Roosevelt told the reporters. The capital gains tax, as the Senate proposed proposed to revise it, would undermine that principle.

“I take it that most of us in this room are fixed about the same way, financially,” Roosevelt said in a disingenuous effort to align himself with the reporters in the room. (Anyone who has visited Roosevelt’s estate in Hyde Park, New York, would find that false camaraderie laughable.) “Occasionally we can make a capital gain, through an investment or the purchase and later sale of a piece of property, we can make a capital gain of five or 10 thousand dollars. A good many of you have done it; I have done it.”

But should those gains be taxed at the same rate as truly huge gains? Roosevelt asked. Because that’s what the Senate bill would require. And he offered a story to make his point: “I have a very good friend of mine that has a profit on 10,000 shares of a certain stock, which he has held more than a year, of $500,000. He is pretty good; we are none of us in that class, I take it. Now, under the theory of taxation, he ought to pay more than 15%; under the Senate bill, he does not.”

There, over a month before he would suggest the framing to Magill, Roosevelt trotted out his archetypal two taxpayers, replete with their $5,000 and $500,000 capital gains. It wouldn’t be the last time this “good friend” would make an appearance.

Five days later, in a letter to Congress, Roosevelt used the two-taxpayer framing again. And as before, he began with a paean to progressive taxation and ability to pay:

“For many years the country has accepted without question the principle of taxation in accordance with ability to pay. This principle applies to all forms of additional wealth accruing to individuals. There is no fairness in taxing the salaried man and the merchant upon their incomes and taxing at far lower rates the profits on the capital of the speculator. Nor is it fair to subject the salaried man and the merchant to progressive surtaxes upon their earnings and at the same time to tax capital gains, large or small, at the same fiat rate, to the particular advantage of the taxpayer who otherwise would pay much higher surtax rates.”

Roosevelt noted that existing law treated capital gains “very favorably.” Without expressly attacking the preference, he opposed the Senate’s attempt to sweeten the deal.

“Under the Senate bill this preferential advantage is further increased by reducing the tax to a flat rate, no matter how large are the taxpayer’s capital gains or how large his other income,” Roosevelt said. And then he offered up his favorite illustration.

“For example, a man who makes a capital gain in a given year amounting to $5,000 would have to pay a tax of not more than 15%; while at the same time the man who makes capital gains of $500,000 in a given year will also pay a tax of not more than 15%,” Roosevelt told lawmakers. “Desirable as it is to foster business recovery, we should not do so by creating injustices in the tax system, particularly injustices at the expense of the man who earns his income — injustices to the advantage of the man who does not.”

The man with the half-million-dollar gain was no longer Roosevelt’s “friend,” but he was still the lucky beneficiary of an unjust tax break — and someone who had failed to “earn” his income, to boot.

Talk about rank injustice! Roosevelt knew how to stoke the fires of moral indignation.

Illustration or Storytelling?

Perhaps it’s unfair to make too much of Roosevelt’s two-taxpayers trope. Maybe the president was simply trying to make plain the arithmetic involved in a flat rate tax.

That would be plausible — were it not for Roosevelt’s repeated attempts to imbue his hypothetical taxpayers with flesh-and-blood qualities.

In an April 21 press conference with members of the American Society of Newspaper Editors, he began by offering reporters a long history lesson (mostly accurate!) on the development of the federal income tax and its treatment of capital gains.

Roosevelt concluded by acknowledging that the capital gains regime in place since 1934 was perhaps too onerous. “The House bill [then under consideration] recognized what was probably the fact, that the existing capital gains tax was too high,” he said.

The House bill was reasonable, cutting the rate “to what was considered a fair differential, a fair graduation of rates to be paid on capital gains,” Roosevelt acknowledged. That was the key: the rate graduation preserved in the House bill.

“I was entirely willing to go along with it as long as they maintained the principle [of graduation]. That is the principle and it is the American principle,” according to Roosevelt.

In those comments, Roosevelt finally settled on the heart of his argument. What irked him about the Senate bill was its failure to provide for graduated rates. The virtue of the 1934 arrangement, with its sliding scale of gain exclusions based on holding periods, was that it taxed included gains using the regular rate structure.

Ultimately, the principle of graduation is what mattered most to Roosevelt. To be fair, it’s probably what mattered most to his advisers, too.

But Roosevelt was especially attached to graduation, as evidenced by his consistent attention to the rate structure throughout his presidency. Like many non-experts, he was moved by the symbolism and apparent simplicity of marginal rates.

They made sense to him in moral terms. Perhaps more important, they were something he could explain to voters in political terms.

Speaking of which, Roosevelt went on to tell the newspaper editors a story that would drive home the importance of those rates. It was a story that should be familiar by now, but in this telling, the two taxpayers have real personality. They are, once again, friends of Franklin:

“The other day I had two men come to visit me, both of them old friends. One of them has got — he is about as rich as I am, which does not mean much. Last year, a few years ago, he bought a couple of hundred shares of stock and he has a nice little profit, even today. He thinks the company is doing well, but he does not want to hold it. He has a $5,000 capital gain in it and he is willing to pay his 15 percent. The other man who came in has a block of 10,000 shares of a certain stock that he bought at 20 and can sell tomorrow for 70. He has a net profit in that of $500,000. He is all for the Senate bill because the Senate bill would only tax him 15 percent on a half-million-dollar profit, just like the little fellow, who has a $5,000 profit. Therefore the Senate bill is a complete negation and abandonment of what has become an established American policy.”

You Lose Some

Roosevelt never stopped making this argument about the two taxpayers — until the larger argument was lost. Which happened rather quickly. 

Roosevelt was soon forced to acknowledge that the tax bill was going to include some version of the Senate’s flat rate capital gains provision; he simply didn’t have the votes to stop it. Indeed, the Senate carried the day in its conference negotiations with the House, winning a complicated formula that left taxpayers with a truncated form of capital gains graduation in the final bill.

As passed, the Revenue Act of 1938 taxed short-term gains (from assets held under 18 months) as regular income. But gains from assets held between 18 months and two years were taxed at a maximum flat 20%, and those held over two years were taxed at a maximum of 15%.

To be sure, Roosevelt was left with the option of vetoing the final version of the bill. And his veto would probably have been sustained.

But the cost of such a veto seemed too steep, even to Roosevelt. Ultimately, he agreed to let the bill become law without his signature. But not before one final complaint, delivered in a speech in Arthurdale, West Virginia.

After trotting out, one more time, the story of the two taxpayers (this time without the “old friends” embellishment), Roosevelt concluded with a ringing indictment of the bill’s fundamental injustice.

“This new bill, that is still before me at this moment, wholly eliminates the progressive tax principle with respect to these capital gains,” the president told his audience. “It taxes small capital profits and large capital profits at exactly the same tax rate.”

“That, my friends, is not right,” he concluded.