At the close of 1941, Henry Morgenthau had the toughest job any treasury secretary ever faced — finance the Second World War. The United States government confronted the daunting task of building the largest army, navy, and air force in its history, as well as supplying lend-lease arms and munitions to allies around the world. In the slang of the times, Secretary Morgenthau needed “dough” and plenty of it.
War bond drives helped raise cash, but bond sales were voluntary and the money raised fell far short of the government’s massive needs. Some suggested a national sales tax, but the Roosevelt administration opposed a sales tax because it would hit the lowest wage earners hardest. The only means of raising the enormous sums necessary to fight the war was the income tax.
The income tax amendment was added to the Constitution in 1913, but in the law’s first quarter-century only the wealthiest Americans paid income tax. That changed in October 1942 when Congress placed a flat 5% gross income tax on all annual incomes over $624. (Approximately $6,500 in 2017 dollars) The new income tax added millions of people to the tax rolls and brought billions of dollars to the treasury.
Nevertheless, income tax payments, whether by millionaires or industrial workers, were not required until March 15 of the year after the money was earned. Moreover, the tax could be paid in quarterly installments throughout the year. The treasury needed money immediately. Therefore, in early 1943, Morgenthau, with President Roosevelt’s backing, put forward a plan known as “current collection at the source”: The Federal Government would take taxes from the workers employer before the money was paid to the worker. This withholding tax would help the war effort in two ways: The Treasury would receive a steady stream of tax money, and workers would have less money to spend, thereby slowing the inflation rate of the overheating wartime economy.
A withholding clause appeared in the first income tax law in 1913, but most Americans at that time viewed withholding, even for the wealthy, as oppressive government meddling. Congress dropped authority for withholding in 1917. By early 1943, in the middle of a world war, most Americans realized the treasury needed money quickly and agreed that current collection at the source would provide the needed revenue. But even with public acceptance of withholding, a serious problem remained concerning how to changeover from the old tax system to the new withholding scheme. If Congress agreed to begin withholding in 1943, taxpayers would pay 1943 taxes out of each paycheck and also owe their 1942 taxes on March 15, 1943. A chorus of howls rose up across the country and across the economic strata. “Unfair” and “double taxation” rebounded back to Washington.
Beardsley Ruml was an economist, treasurer of R.H. Macy & Co., and the chairman of the New York Federal Reserve Bank. The Ruml Plan, as it became known, proposed that the United States Government forgive the 1942 tax debt of all Americans. Taxpayers embraced Ruml and his plan like the second coming of Santa Claus. Acting like a typical parent in such a situation, the Federal Government thought the idea was terrible. Congressmen Robert Doughton, House Ways and Means Committee chairman, labeled Ruml’s plan “the biggest outrage ever attempted.”
The administration was dead set against Ruml’s plan; FDR spent an entire press conference denouncing it. Morgenthau’s treasury staff pointed out that Ruml’s plan would benefit businessmen who made large sums in 1942 because of new war contracts. On February 11, 1943 Morgenthau wrote to FDR that under the Ruml Plan, 60 taxpayers who made more than a million dollars in 1942 would earn a windfall of at least $864,000 — more than they could save on their millionaire salaries in six years. Meanwhile, a worker making $2,000 per year would be forgiven only $140 ($1,400 in 2003 dollars) in 1942 taxes. Even Ruml admitted his plan was a windfall for the wealthy. Nevertheless, the regular worker, new to the income tax rolls, liked Ruml’s tax forgiveness plan, even if the rich got richer.
Morgenthau went on the attack, calling tax forgiveness a psychological blow to servicemen who viewed it as a lack of sacrifice by the home front. The secretary thought Congress should make taxpayers suffer one year of double taxation as a contribution to the war effort. Congress was somewhat willing but they also heard the protests of their constituents.
Meanwhile, Ruml continued to push his plan on the radio and in the press. Ruml noted that many of his Macy employees who made a good wage in 1942 but were then drafted would pay their 1942 taxes based on the higher wages made at Macys, while receiving a much lower private’s pay in 1943 — a pay subject to the new withholding tax.
The House and Senate tossed the hot potato back and forth until they finally compromised. Congress approved a plan to begin withholding on July 1, 1943 and to forgive 75% (100% up to $50 of tax liability) of each taxpayers 1942 or 1943 taxes, whichever was lower. Taxpayers were allowed to pay in two installments: March 1944 and March 1945. The lawmakers also allowed special tax relief for service men.
And so, the tax man did cometh for the tax year 1942, but his bite was severely limited. The wartime legacy of withholding, however, remains at our paycheck windows; Americans continue to pay their federal tax before they are paid for their work. Here’s hoping you get something back on April 15.