The growth of the corporation and corporate earnings and profits was important to the development of tax systems in both countries over this period. Although United States industrial corporations were much larger than their British counterparts prior to the start of World War II, corporate profits in each country became increasingly significant over the nineteenth and early twentieth centuries. The issue for policymakers was how best to reach such profits through conventional methods of taxation. Ultimately, this turned on what corporations did with the profits they earned. In the nineteenth century, when corporations on both sides of the Atlantic had liberal dividend policies, a corporate-level tax was effectively a withholding tax on dividends. In the twentieth century, however, when corporations in the USA began to retain a higher percentage of their earnings, that characterization was no longer accurate and a new approach was inevitable.

Era of liberal dividend policies

Among most nineteenth-and early twentieth-century corporations on both sides of the Atlantic Ocean, dividends flowed freely. “It was the common practice to divide all profits in sight and to finance new construction by the issue of securities. Such policies were fully sanctioned by the public opinion of the day.” This “strong preference for debt financing in both the United States and Britain during the nineteenth century” existed “even in the absence of any substantial tax benefits.” Robert Sobel suggests that the practice of liberal dividend policies continued into the early twentieth century, explaining that “[b]efore the war, most large corporations considered earnings after taxes and payments to bondholders and preferred stockholders a ‘surplus,’ and much of this was divided among the common stockholders.” According to Sobel, “[t]his meant that such firms would have to depend heavily upon the capital markets for funds needed for expansion, and large bond issues were considered normal.”