Book Review: Bank’s From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present

Steven A. Bank, From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present (Oxford University Press, 2010)

The U.S. corporate income tax is under attack. The right calls it “the most growth-inhibiting, antitcompetitive tax of all.” Some on the left argue that “canceling the corporate income tax” and replacing it with a value-added tax would “reduce[] the cost [of corporate goods] to all consumers.

But at the same time the corporate income tax is being excoriated in some circles, it is unlikely to be repealed.  Although it only accounts for approximately 12 percent of the government’s tax revenue, Americans say that increasing the corporate income tax is one of their preferred methods of fixing the fiscal straits in which the United States finds itself.

Absent from the arguments over the proper role of the corporate income tax is any consideration of its provenance. If the corporate income tax is such an anticompetitive, expensive, and insignificant source of government revenue, why was it enacted in the first place?  And why did it evolve into the form in which it exists today?

Steven A. Bank’s excellent From Sword to Shield: The Transformation of the Corporate Income Tax, 1861 to Present provides answers to these questions. Ultimately, Professor Bank paints a picture of an undeliberate, though not-quite-accidental, tax, the design and underlying purpose of which changed regularly, and the consequences of which were poorly understood, even by the business interests that lobbied for legislation that would ultimately prove problematic for corporations and their shareholders.

In the early years of the United States, forming a corporation required a special legislative charter. As such, corporations were rare, and their taxation relatively unimportant. Corporations were generally taxed only when the corporate for could otherwise be used to evade some non-corporate tax. Moreover, in the early Republic, taxes were more likely to be imposed on industries than on entities. As such, a state may have imposed a tax on the capital stock of banks, or on insurance companies or transportation companies. But generally, taxes were imposed on the basis of the corporation’s industry rather than merely as a result of being the corporation’s being incorporated.

Fast-forward to the post-Civil War era. As states began to adopt general incorporation statutes, more and more businesses began to incorporate.  At the same time, there was rampant tax evasion; the property tax, especially, was hard to collect, as people began to own more intangible property.  States began to see corporate taxes as a substitute for property taxes on these intangible assets.

Although there was no federal property tax, state corporate taxes influenced federal thinking.  There was a general concern on the federal level that the nouveau riche were not paying their fair share of taxes.  The government began to focus on taxing income at its source, and corporate income had to be part of this focus.  But after Americans’ generally negative experiences with tax collection during the Civil War, a corporate income tax was more palatable than a broad-based individual income tax.  Still, the 1894 corporate income tax was meant to function as a proxy for taxing shareholders’ income.

Struck down as unconstitutional, the corporate income tax of 1894 was never implemented.  In need of revenue, Congress enacted a targeted excise tax which was repealed as the need for revenue diminished (and which was ultimately found unconstitutional).  But by the early 20th century, tarriffs were not generating sufficient revenue for the government and, in 1909, Congress again looked at taxing corporations.  Because of questions about the constitutionality of a corporate income tax, Congress enacted a corporate excise tax.

And then, in 1913, came the Sixteenth Amendment and the modern income tax.  Both individuals and corporations were now taxable on their income at the same normal rates.  The income tax avoided double taxation, though, by exempting dividends from the personal income tax on the theory that the money distributed to shareholders as a dividend had already been taxed when earned by the corporation.  But the design of the personal income tax presented a new problem: although corporate and personal income were subject to normal income tax at a flat rate, there was also a progressive surtax on individual income.  As an individual’s income rose, the surtax would reach rates as high as six percent.  The progressive surtax on individuals presented an opportunity for tax evasion: corporations did not face the surtax and corporate income was only taxable to shareholders when the shareholders received the income as dividends.  To the extent corporations retained their earnings, wealthy shareholders could defer their surtax payments almost indefinitely.

The potential use of corporations as vehicles for tax evasion turned the corporate income tax into Professor Bank’s metaphorical sword: it was intended to cut off tax evasion.  Congress tried several methods to counteract evasion, from undistributed profits taxes (where corporations would be taxed on any profits that they did not pay out as dividends to their shareholders, interestingly, an idea closely related to the current taxation of mutual funds) to excess profits taxes (imposed during World War I, putatively on entities that profited from the war).  Unsurprisingly, business interests disliked these various measures, and fought aggressively against them.

As the difference between individual and corporate income tax rates increased, arguments over the best approach toward taxing corporations became more intractable, and the policies underlying the corporate income tax began to change.  In 1936, the debate over corporate taxation came to a head as the government needed an addition $620 million in revenue to, among other things, fund veterans’ bonuses.  President Roosevelt made a radical recommendation: to use an undistributed profits tax, set at a high rate, not just to supplement the corporate income tax, but to replace it.  In addition to raising additional revenue, the undistributed profits tax would prevent evasion of surtaxes.

The business community was horrified.  The rate necessary for the undistributed profits tax to subsume the corporate income tax, they argued, would force corporations to distribute all of their profits, interfering with the decisions of boards of directors and managers.  If corporations could not retain earnings, they would be unable to grow, and would not have reserves to get them through unexpected difficult times.  Ultimately, Roosevelt’s proposal was gutted, leaving in its place a corporate income tax and an undistributed profits tax set at a relatively negligible rate.  However, individuals lost the exemption from the normal personal income tax for dividends received from corporations they had previously enjoyed.  Dividends would now be taxable at ordinary rates.  Suddenly, corporate income, even if it was distributed immediately upon receipt, was subject to double taxation.  The corporate income tax had transformed from a sword against tax evasion to a shield against interference with corporate decisions (specifically, the decision of whether to retain earnings or pay them out as dividends) by the government.

Interestingly enough, the debate that has consumed corporate income tax policy arguments in the recent past–the debate over double taxation–was entirely absent in the wake of the 1936 changes.  Business was more concerned about eliminating the excess profits tax entirely and about getting preferential capital gains rates enacted.  Business itself had fought for double taxation, as a lesser evil than what President Roosevelt wanted to enact.

Professor Bank continues through the present, discussing the latter half of the 20th century, as well as President George W. Bush’s reduction of the tax rate on dividends in 2003; he sees arguments over the corporate income tax, including arguments over tax rates and over the double taxation of corporate income, as continuing into the future.

From Sword to Shield is a fascinating read on several levels.  It is, of course, a history of the corporate tax.  And it offers a broad history the last 150 years or so of business in the United States.  But it is also a history of the legislative sausage-making process: in tracing one legal regime for over a century, Professor Bank shows the interaction between the President, legislators, the Treasury Department, parties affected by the legislation, and even newspapers and public perception.  The various sides’ discourse is thought-out, passionate, but measured.  Every new iteration of the corporate income tax was a compromise, and sometimes the consequences were unexpected.  As messy as the process was, though, it succeeded in producing a functional corporate income tax.

Which is to say, if you have any interest in tax, you need to read this book.  And even if you don’t have any interest in tax, if you are interested in the legislative process or in economic history (or even on the impact of war on fiscal policy), this book is for you.  Although the tax law has an unfortunate (and inaccurate) reputation for dryness, From Sword to Shield is anything but.  The prose is accessible and compelling; the policy issues are well-explained and cogent.  And the history will help give more depth and context as you listen to or participate in debates about the future of corporate taxation.


Samuel D. Brunson is an assistant professor of law at Loyola University Chicago School of Law.  He would like to thank Jeffrey Kwall, Matthew Jennejohn, and Jamie Brunson for their thoughtful comments on earlier drafts.

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1 Response

  1. John McConchieq says:

    This is an interesting and well-written review. I am looking forward to reading the book. There is no doubt that it will inform our thinking in the next few years while governments work hard towards dealing with their deficits.