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Public Financing and Budgeting for War

Public Financing and Budgeting for War. America's great wars—the Civil War, World War I, and World War II—have been the most important events shaping the federal government's approach to public finance. Along with the political crisis of the 1780s and the Great Depression of the 1930s, these wars created distinctive public finance regimes that were crucial not only to the war efforts but also to the subsequent peacetime expansions of the federal government. At the core of these regimes were distinctive systems of taxation, each with its own characteristic tax base, rate structure, administrative apparatus, and social intention.

To mobilize for wars of unprecedented scale required vast new revenues, and this in turn freed American leaders to reexamine the nation's financial options. In so doing, they faced issues that far transcended the technicalities of war finance. Because each great military crisis involved the meaning or survival of the nation, it stimulated debate over fundamental national values, even as it intensified ideological and distributional divisions within American society. And because each war required the sacrifice of lives as well as treasure, it provoked social division and political conflict, which often centered on issues of taxation. The politics of taxation has, therefore, both expressed contested national values and furnished a means to resolve the social and ideological conflicts intensified by war.

Within the conflicted politics of each wartime emergency, the architects of national mobilization worked to persuade Americans to accept new taxes as a necessary form of sacrifice. In the Civil War and each of the two world wars, federal leaders designed new tax programs both to implement sacrifice and to convince the mass of taxpayers that their sacrifices were fair. In the process, the new tax systems came symbolically to express the goals of American society.

Before the Civil War, a system of low tariffs, a borrowing capability that Alexander Hamilton's financial program had helped establish, and the enormous landed resources of the federal government had been adequate to finance almost all of the activities of the federal government. Only the War of 1812, because it disrupted the foreign commerce on which tariffs were based, forced the federal government to adopt temporary excise and property taxes. The financial system of the early republic would probably have remained adequate, had not a great national emergency intervened.

In no sense was the Civil War more truly a modern war than in its enormous requirements for capital. Union war costs drove up government spending from less than 2 percent of the gross national product to an average of 15 percent, close to the 20 percent level of the early 1990s. This evoked a program of emergency taxation and borrowing unprecedented in scale and scope.

The Union placed excise taxes on virtually all consumer goods, license taxes on a wide variety of activities (including every profession except the ministry), special taxes on corporations, stamp taxes on legal documents, and inheritance taxes on estates. Each wartime Congress also raised the tariffs on foreign goods, doubling the average tariff rate by the end of the war. Finally, the government levied its first income tax—graduated tax reaching a maximum rate of 10 percent.

Taxes funded about 20 percent of the Union's war costs, leaving the government to finance the rest by running deficits and borrowing money through the sale of Treasury bonds. Secretary of the Treasury Salmon P. Chase and Jay Cooke, a Philadelphia banker, marketed the bonds cleverly, by making interest on them payable in gold, and thus giving investors a hedge against inflation; they also reassured the wealthy by keeping income tax rates low. Most innovatively, they sold bonds not just to the wealthy and to financial institution, but to the middle class. Although banks and rich people in America and Britain bought most of the securities, Cooke's newspaper advertisements and his 2,500 subagents persuaded nearly a million northerners—a quarter of all families—to by them too. The administration of President Abraham Lincoln pioneered the propaganda techniques that would become essential to funding the major wars in the twentieth century.

In order to persuade Americans to make financial and human sacrifices for World War I, President Woodrow Wilson and his supporters in Congress had to introduce progressive income taxation on a grand scale. Passed in 1916 as a preparedness measure and expanded significantly after American entry into the war, the World War I income tax was an explicit “soak‐the‐rich” instrument. It imposed the first significant levies on corporate profits and personal incomes, while avoiding the extensive taxation of wages and salaries. In adopting the concept of taxing corporate “excess profits,” the United States—alone among the belligerent powers—placed at the center of wartime finance a graduated tax on all profits above a government‐specified “normal” rate of return. Excess‐profits taxation generated most of the revenues raised during the war. Taxes produced a larger share of total revenues for the United States than any other belligerent, despite the fact that by the end of 1918 the daily average of war expenditures in the United States was almost double that in Great Britain and far greater than that in any other combatant nation. Thus, wartime public finance was based on the taxation that Democratic political lenders, including President Wilson, regarded as monopoly profits—in effect, ill‐gotten gains.

Closely related to the Wilson administration's tax program was its sale of war bonds to middle‐class Americans. Rather than tax ordinary citizens at high levels, the Wilson administration sought to mobilize their savings, a strategy that Secretary of the Treasury William G. McAdoo called “capitalizing patriotism.” He attempted to persuade ordinary Americans to reduce consumption, increase savings, and become creditors of the state; so that after the war these middle‐class bondholders would be repaid by tax dollars raised from corporations and the wealthiest Americans.

Selling bonds directly to average Americans on a multibillion‐dollar scale required marketing campaigns far greater in scope than those used anywhere else in the world. Largely through trial and error, the Wilson administration devised a vast array of marketing techniques, including the sophisticated analysis of national income and savings. Financing by the new Federal Reserve system, which McAdoo turned into an arm of the Treasury, was important, but not as much as McAdoo's efforts to shift private savings into bonds. In promoting the four “Liberty Loans,” McAdoo's Treasury armed itself with modern techniques of mass communication, and succeeded in placing its loans deep in the middle class—far deeper than during the Civil War. In the Third Liberty Loan campaign (conducted in April 1918), at least one‐half of all American families subscribed. Thus the new public‐finance regime installed by the Wilson administration encompassed a revolution in borrowing strategy as well as tax policy.

While the Wilson administration and the military did not always agree on what resources were necessary, the administration never allowed political or economic concerns to influence the setting of financial objectives. By 1918, the financial commitment to the war effort had become substantial; federal military expenditures reached nearly 25 percent of national product. The pay‐off would have been even more evident had the war lasted into 1919, as the administration expected.

The most radical tax initiative—excess‐profits taxation—did not survive the postwar reaction of the 1920s, but Democratic tax politics retained its “soak‐the‐rich” thrust into early mobilization for World War II. Like Wilson, President Franklin D. Roosevelt was committed to generating the revenues required to prosecute the war through taxes that bore heavily on corporations and upper‐income groups. “In time of this grave national danger, when all excess income should go to win the war,” Roosevelt told a joint session of Congress in 1942, “no American citizen ought to have a net income, after he has paid his taxes, of more than $25,000.”

But opposition to radical war‐tax proposals strengthened in the face of the revenue requirements of full mobilization. One source of opposition came from a diverse group of military planners, foreign‐policy strategists, financial leaders, and economists. One of these was Russell C. Leffingwell, who had been Assistant Secretary of the Treasury during World War I and a partner in J. P. Morgan and Company since the early 1920s. Throughout the turbulence of the 1920s and 1930s, experts like Leffingwell had marshaled the economic lessons of World War I and its aftermath. Now they wanted to mobilize even greater resources, to do so more smoothly and predictably, and to reduce inflationary pressures. They promoted mass‐based taxation, based either on a general sales tax or an income tax that produced most of its revenue from wages and salaries. The second source of opposition to Roosevelt's radical tax proposals came from Democrats in both Congress and the administration itself; they worried that stringent corporate taxation might turn a postwar slump into another major depression.

In October of 1942, Roosevelt and Congress compromised by dropping the general sales tax, as Roosevelt wished, and adopting a progressive income tax, although a less progressive one than Roosevelt wanted. The act greatly reduced personal exemptions, enabling the federal government to acquire huge revenues from the taxation of middle‐class wages and salaries. Just as important, the rates on individuals incomes—including a surtax graduated from 13 percent on the first $2,000 to 82 percent on income over $200,000—made the personal income tax more progressive than at any other time in its history.

Under the new system the number of individual taxpayers grew from 3.9 million in 1939 to 42.6 million in 1945, and federal income‐tax collections leaped from $2.2 billion to $35.1 billion. By 1945 nearly 90 percent of American workers submitted income‐tax returns, and about 60 percent of the labor force paid income taxes, usually in the form of withheld wages and salaries. In 1944 and 1945, individual income taxes accounted for roughly 40 percent of federal revenues. Corporate income taxes provided only about one‐third, or half their share during World War I. Mass taxation had become more important than class taxation.

In making the new individual income tax work, the Roosevelt administration and Congress relied heavily on payroll withholding, deductions that sweetened the new tax system for the middle class, the progressive rate structure, and the popularity of the war effort. It was unnecessary to encourage popular support and sacrifice for the war by redistributing wealth through the tax system: Americans who believed their nation's security was at stake concluded that victory required both personal sacrifice and indulgence of the corporate profits that helped fuel the war machine. The Roosevelt administration reinforced this spirit of patriotism and sacrifice by employing an extensive propaganda program. The Treasury, its Bureau of Internal Revenue, and the Office of War Information made elaborate calls for civic responsibility and patriotic sacrifice, building on the arguments that the Wilson ad ministration had crafted during the bond campaigns of World War I.

Because of the buoyant revenues produced under the new regime, during the last two years of World War II tax revenues covered roughly half of government expenditures. The federal deficit, after increasing from $6.2 billion in 1941 to $57.4 billion in 1943, held at about the 1943 level for the remainder of the war. These were impressive feats because the wartime expenditures represented a more massive, faster, and more prolonged shift of resources from peacetime endeavors than had been the case during World War I. The average level of wartime federal expenditures, which increased from 1942 through 1945, amounted to roughly half the national product—more than twice the average ratio during World War I. Moreover, by hitching taxation firmly to expenditure needs and dramatically broadening the tax base, federal policies also restrained wartime price inflation.

Thus, during World War II, as well as in World War I and even in the Civil War, a liberal democratic state demonstrated the fiscal power of a trusting and wealthy public. That trust, nurtured by the federal government, permitted and encouraged the adoption of income taxation—one of the most coercive and statist means of raising revenue. In a fiscal sense, the adoption of mass‐based income taxation during World War II, and the victory of a taxpaying culture, represented a triumph for both the republican virtue and the national strength the framers of the Constitution had sought to advance.

Cumulatively, the two world wars revolutionized federal public finance. Policy architects had seized the opportunity to modernize the tax system, adapting it to new economic and organizational conditions and making it a more efficient producer of revenue. (The income tax, for example, enabled the federal government to utilize the financial apparatus of the modern corporation to monitor income flows and collect taxes on them.) No process of “modernization” dictated the selection of options—for example, of income taxation over consumption taxation—but in each crisis policymakers discovered that the organizational maturation of industrial society had created a new menu of feasible options. Exploiting the new tax options during emergencies provided a structure and an administrative apparatus that allowed the federal government to take fiscal advantage of postcrisis economic expansion.

By contributing to the resolution of wartime social crises, the emergency‐driven policies of progressive taxation acquired legitimacy and cultural force. The tax regimes of the two world wars did not produce a social revolution but did establish tax policy that was far more progressively redistributional than it had been before World War I, affirmed government's right to redistribute income according to ideals of social justice, and powerfully expressed the nation's democratic ideals.

By creating systems of taxation that had acquired an independent legitimacy and were administratively more robust, each crisis enabled proponents of expanded government programs to advance their interests after the emergency ended. Postwar leaders could forge new expenditure program—both direct and indirect—without raising taxes or introducing new ones. The popularity of the expenditure programs, in turn, reinforced the popularity of the tax system behind the programs.

The tax system created in World War II proved to have a great capacity for expanding federal programs after the war. Persistent inflation and economic growth helped extend the life of the World War II tax regime by making it highly elastic, allowing the federal government to create new programs without enacting politically damaging tax increases. The World War II tax system paid for the strategic defense programs of the Cold War and, without any general or permanent increases in income taxation, for the Korean and Vietnam War mobilizations as well. Because the size of the defense budget relative to the GNP tended to decline through the 1970s (except during the Korean and Vietnam Wars), post–World War II increases in federal revenues went largely for the expansion of domestic programs.

In the absence of a new national emergency, the World War II tax regime remains in place today. Beginning in the late 1970s, however, stagnant economic productivity eroded its fiscal force and an antigovernment movement undermined its political legitimacy. Whether or not Americans will devise a new tax system to replace that created during World War II, the creation of the three great wartime regimes suggests that Americans can embrace drastic changes in taxation and public finance if the right political and economic circumstances converge.

Bibliography

Robert A. Love , Federal Financing: A Study of the Methods Employed by the Treasury in Its Borrowing Operations, 1931.
Roy G. Blakey and and Gladys C. Blakey , The Federal Income Tax, 1940.
Randolph Paul , Taxation in the United States, 1954.
Milton Friedman and and Anna J. Schwartz , A Monetary History of the United States, 1867–1960, 1963.
Sidney Ratner , Taxation and Democracy in America, 1967.
Charles Gilbert , American Financing of World War I, 1970.
John Witte , The Politics and Development of the Federal Income Tax, 1985.
W. Elliot Brownlee , Federal Taxation in America: A Short History, 1996.
W. Elliot Brownlee, ed., Funding the Modern American State, 1941–1995: The Rise and Fall of the Era of Easy Finance, 1996.

W. Elliot Brownlee

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