On Taxing ‘Excess’ Profits

November 20, 1950

Though Congress has pledged itself to enact an excess-profits tax, it is fortunate that an interlude for sober thought—and a sobering election—has occurred between pledge and passage.

The term “excess” profits is ambiguous. It may refer either to the excess of wartime over peacetime profits or to the excess of profits over a so-called “fair” return. We must distinguish at the beginning, therefore, between what Senator George (Democrat, Georgia) has called a “true war-profits tax” and “establishing a precedent for a permanent [peacetime] excess-profits tax.”

To penalize high profits as such is basically hostile to private enterprise. Any standard of “fair” profits must be purely arbitrary and is based on complete ignorance of how the private-enterprise system works. For it is precisely the differences between profit margins that bring about a dynamic balance of production among thousands of different items, that reward efficiency and foresight and penalize inefficiency and poor judgment. To destroy profit differentials, to punish high profits per se, is to destroy the productivity foundation of the free-enterprise system.

But even the attempt to take away only the so-called “windfall” profits that accrue as a result of war, desirable as this goal may seem from a moral standpoint, faces formidable practical difficulties. Unfortunately there is no certain way of identifying specifically “war” profits and segregating them from “normal” profits.

The usual method has been to regard the average profits of the three to five years before the war as “normal peacetime profits” and to apply the war-profits tax to any excess above this. What we are really trying to tax in wartime is not the excess of wartime profits over past peacetime profits but the excess over what present profits would have been if there had been no war. This must at best be guesswork.

It is easy to see how unfair such a standard could be in many cases if applied to the individual income tax. Paul, let’s say, had a salary in 1949 of $5,000. Today he has a better job and a salary of $7,500. The increase may or may not be the result of the fact that the country is at war. Peter had a salary of $8,000 in 1949 and has the same salary today. Are we to take Paul’s increase of $2,500 away from him as “war profiteering” or tax it at such a rate that Paul would be paying a higher total tax on his $7,500 than Peter pays on his $8,000? Are we to penalize Paul for his $7,500, simply because he is not used to getting that much?

Yet this is the principle that an excess-profits tax applies to corporate earnings—which are merely pooled individual earnings. The presumption that the excess of any particular corporation’s earnings today (or in 1951) over those of 1946 to 1949 can be wholly attributed to war or rearmament is no more reliable than in the case of an individual’s earnings. The earnings of a new industry, such as television, would in any case have shown a spectacular growth. Even a company now working on direct wartime orders might conceivably have had bigger peacetime orders instead.

An excess-profits tax, in short, rests on a hit-or-miss presumption. And there is a more serious objection to it, especially when the rate is excessive. In the second world war “excess profits” were subject to a tax of 95 percent (with a refund of 10 percent of the tax after the war). This meant that the government took 85 to 95 cents out of every dollar that a company saved by economies, leaving only 15 cents to a nickel of it for the company itself. This all but destroyed the normal incentives for economy and efficiency. It led to inflated expense accounts and caused companies to hoard labor and materials without worrying about costs. In short, it reduced total civilian and war production at the very time when it was most essential to maximize such production.

Under a high excess-profits tax the government loses more on the side of expenditures than it gains on the side of revenues. If we must have an excess-profits tax, let the rate be moderate; and let us get by other means the further revenues we may need.