Reflections on the Income Tax

THE national debt on March 31, 1920, was $24,698,000,000, as contrasted with a pre-war debt, March 31, 1917, of $1,435,000,000. The expenditures of the federal government for the fiscal year ending June 30, 1919, were over fifteen billion dollars, the revenue less than five billion dollars. The income tax, including excess-profits taxes, produced over half of this revenue — almost three billion dollars; beside which the customs duties of one hundred and eighty-three millions shrink into comparative insignificance. During the calendar year 1919, the income tax yielded four billions. The tax is to-day the mainstay of our national revenue; conservation of this revenue resource has become a national problem of the first magnitude.

In England, where the income tax has been successfully administered since 1842, the tax was, until the Great War, collected largely at the source. A borrower, for example, under the system of collection at the source, must withhold a percentage of the interest payable to his creditor, determined by the rate of income tax in force. The debtor remits directly to the government the amount withheld as tax. Thus, except in so far as there may be collusion between the creditor and debtor, the possibility of tax-evasion by the creditor is eliminated. If the income of the creditor is below the minimum income subject to tax, the government will, upon substantiation of this fact, pay to him the amount which has been withheld.

In the United States a large proportion of the persons subject to income tax derive all or a considerable portion of their income from trade or farming. Collection at the source obviously cannot be applied to income of this character. The fact that a person has received income from sales does not necessarily indicate profit: net income, or profit, arises only if there is a gross income in excess of business expenses. Furthermore, the backbone of our present federal income tax is the principle of progressive taxation. The rates of surtax under the act of 1918 mount from one per cent to 65 per cent. Collection at the source cannot be applied to the collection of surtaxes, since the aggregate income, which alone determines what rate of surtax shall apply, frequently arises from many sources.

The government is attempting to secure, so far as possible, the benefits of a system of collection at the source, by requiring that information be furnished at the source concerning certain payments. Information must be furnished the government by persons making payment of wages, rent, interest, and income of like nature, to the amount of $1000 or more, to any individual in one year; and the collection of coupons from taxable bonds is subject to an information-return. The government proposes to employ the information so obtained to detect those who evade the tax. Four million personal income-tax returns were filed last year. The clerical difficulties involved in correlating the millions of informationreturns with the millions of tax-returns limits the efficacy of the check. Furthermore, the income of many persons, though sufficiently large in the aggregate to be taxable, is chiefly or entirely received in amounts of less than $1000. And a system of information at the source, as noted of collection at the source, is inapplicable to income from trade and farming. It is evident, therefore, that successful administration of the income tax in the United States depends upon a voluntary filing of truthful returns by persons subject to the tax.

I

There exists to-day a national state of mind favorable to the truthful reporting of income for purposes of federal taxation. This results, in part, from a lingering glow of the patriotic fervor that floated the Liberty Loans and in part from a wholesome belief that punishment inexorably attends fraud practised upon the federal government. The most important element of this state of mind is, however, the conviction that the tax is being fairly administered. ‘The other fellow is bearing his share of the burden and it is only square that I bear mine’ — this is the attitude that has called forth an honest payment of federal income tax by a nation which is justly notorious for its evasion of state and municipal taxation. The average tax-payer does not instinctively seek to evade taxes. It is the suspicion that his neighbor is evading the spirit or letter of the law and shifting an inequitable share of the burden to him, or that the government is unfairly administering the tax, which turns the tax-payer into a tax-dodger. The absence of this suspicion has been largely responsible for the successful administration of the federal income tax. Anything that arouses apprehension of lax or discriminating administration strikes a serious and possibly fatal blow at the efficiency of the tax.

As a maximum penalty for willfully failing to file a return, or for filing a false return, the law provides an addition of fifty per cent to the tax which would have been payable had an honest return been filed, a fine of $10,000, and imprisonment for one year. The law affords adequate punishment for detected tax-evasion; but prosecution has rarely followed the discovery of fraud.

There are tax-payers who make honest returns only because they fear the penalty for dishonesty. The failure to prosecute willful evasion is weakening the reasoned fear of punishment which has been the chief factor in causing such persons to file accurate returns. Moreover, whereas there are few persons who are moved to file a false return by downright dishonesty, there are many who will perjure themselves in order to counteract unfair advantages which they conceive that others have seized. It is essential to a permanently successful administration of the law that the imagined necessity for self-help be prevented from gaining currency; and the chief preventive of this lies in a rigorous enforcement of the penalties for evasion of the law.

II

The Treasury Department has a two-fold function — executive and judicial. The department must issue rules of procedure, and instruct tax-payers in the application of these rules. It must provide a staff for collecting, for auditing, for refunding. The department’s purely executive activities are comparable in magnitude to those of the Post Office Department. On the other hand, the law itself is only an outline, the development of which is left to the Treasury Department. In this development, the department is exercising a judicial function. Almost every paragraph of the Revenue Act requires interpretation. What is a ‘reasonable’ allowance for depreciation? What are ‘necessary’ expenses incurred in a trade or business? At what point may a corporation be said to hold ‘substantially all’ the stock of another corporation? It is true that the department’s decision will be subject to court review; but the same is generally true of the decision of any court of first instance.

The department has ably performed its executive duties. There have been complaints of ambiguity in instructions, of inflexibility, and of tardiness in redress; but those in a position to appreciate the magnitude of the task of administering the recent revenue acts have been sparing of criticism. In the exercise of its judicial function the department has, however, laid itself open to merited criticism. In construing the Revenue Act of 1918, it has persistently ruled against the tax-payer. The following illustration of this tendency is chosen because of the large number of persons who have been affected and antagonized by the ruling.

The law provides that, in determining its taxable net income, a corporation may deduct from gross receipts ‘all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.’ Advertising is, of course, recognized as an ‘ordinary and necessary’ expense of doing business. Corporations engaged in retail business are called upon to contribute to various charities. There are merchants who refuse to make such contributions. There are, moreover, merchants who refuse to advertise. But just as the majority of merchants advertise in other ways, so the majority of corporations engaged in retail business contribute to local charities, regarding the donation as advertising. Yet assessments of additional tax have been extensively made, based on a ruling that these contributions are not a necessary business expense, and have been improperly treated as deductions in determining taxable income.

The department appears to have adopted a policy that all moot points shall be decided against the tax-payer, so that he will be compelled to carry all questions to the courts for review. If, in the exercise of its best judgment, the department decides unfavorably to the tax-payer, he can appeal to the courts, and the decision may be reversed. The government, on the other hand, cannot take an appeal from its decisions. In order, it would seem, to share the advantage which the tax-payer enjoys, of having rulings reviewed by the courts, regulations of a nature to challenge appeal have been issued. In pursuing this policy, the department ignores its judicial function, occasions the expense of litigation, and promotes an unwarranted contest. To provoke such a contest invites the chicanery and fraud which must be discouraged if the income tax is to be administered with continuing success.

III

Inequitable administration is likely to entail more immediately disastrous consequences than unequal laws; yet, in order to preserve an efficient administration of the income tax, it is imperative that the law itself be just.

The most strikingly inequitable feature of the present law is the Corporation Excess-Profits tax, which is levied at the rate of 20 per cent on earnings which exceed 8 per cent of the corporation’s invested capital, and of 40 per cent on earnings which exceed 20 per cent of the invested capital.

Privileges incident to the corporate form of organization form a legitimate basis for an excise tax. The corporation excise tax of one per cent, levied upon corporate income under the Tariff Act of 1909, and the present capital-stock tax of one mill levied annually upon the corporation’s net worth, provide rates consonant with the privileges which form the basis of the tax. But a tax is unjust which in many cases consumes a third of the income of a business conducted by a corporation, whereas the same business, if conducted by an individual or a partnership, is not subject to the excess-profits tax.

Furthermore, the burden of tax thus thrown exclusively upon corporations is unequally distributed between them. Although two corporations may have equal invested capital and equivalent average earnings, the one may have to pay heavy profits taxes while the other pays nothing.

Fluctuation in profits is responsible for this anomaly. In many lines of business, profits fluctuate greatly, and earnings in isolated years may exceed twenty per cent, in spite of the fact that the average of profit is less than eight per cent. A corporation whose earnings rise and fall will be subject to a heavy excess-profits tax on the earnings of the peculiarly prosperous year; whereas a corporation whose average earnings are equally great, but are stable, will not be subject to the tax. An individual whose income fluctuates must pay a somewhat higher income tax than one whose income is stable. Absolute justice cannot always be attained. But the excess-profits tax magnifies the inequality so greatly that the tax is utterly unfair.

Efforts to avoid the unequal burden of the excess-profits tax by neutralizing the fluctuations in annual net income have caused and will continue to engender waste. Prodigality has been made manifest in the advertising columns of our magazines. Before the excess-profits taxes were levied, the Saturday Evening Post, for example, carried less than two hundred columns of advertising per week. This magazine now carries over four hundred and fifty columns. Other periodicals show a similar increase. After allowance for the growth of a successful magazine, and for the increase of advertising normally incident to a period of business expansion, there remains a large residue which is attributable to the artificial stimulation of the excess-profits tax.

Stimulation is produced in the following manner. The directors of a corporation forecast that profits for the corporation’s fiscal year will substantially exceed 20 per cent of the invested capital. Profits in excess of 20 per cent will be taxable at the rate of 46 per cent, under the combined corporation excessprofits and income-tax laws. One of the directors proposes that the corporation remodel and enlarge its plant; but this fails to solve the problem, because expenditures for this purpose do not reduce profits. The Treasury Department has properly ruled that such expenditures simply constitute an investment of one kind of assets — cash — in another kind of assets—buildings. A second director suggests that the corporation distribute additional wages and salaries to its employees, or reduce the price of its wares for the benefit of customers. The application of this suggestion would indeed result in increased current expense and consequent reduction of profits; but the board sagaciously decides to retain 54 per cent of the suggested bonus, and permit the government to take the remaining 46 per cent, rather than to give away the entire hundred per cent. The only solution of the dilemma is one which will permit the corporation to keep its cake and yet appear to eat it. Expenditure upon advertising holds out this twofold possibility.

If a corporation has carried its advertising to a point at which it appears likely that a dollar spent in advertising will bring a return of less than a dollar, the corporation, normally, would forego further commitments for advertising. The excess-profits tax makes it profitable to push advertising far beyond this point; for if a corporation’s prospective earnings exceed 20 per cent of its invested capital, the excess may be spent at a possible cost to the corporation of only 54 cents on the dollar.

If the corporation were to derive benefit from advertising solely during the year in which the expense is incurred, no advantage would be obtained, because the tax on profits from the increased sales would offset the saving in tax from augmented expenditures. But benefits from reiterated coupling of the corporation’s name with its product will presumably continue to flow in succeeding years. Profits next year may be so meagre that no income tax and excess-profits tax will be payable, and increase in income will be derived in that year free from tax. Thus, in expending a dollar upon advertising for which it receives a return of only seventy-five cents, the corporation may be the gainer, by reason of the fact that the entire benefit is received in the lean year, free from tax, while the burden of the expenditure in the fat year will be divided: 54 per cent borne by the corporation, and 46 per cent by the government in the taxes which would have been imposed and which the government loses by reason of the additional expense incurred by the corporation. The government must recoup its loss by further taxation; but unless tax-payers generally have been equally successful in shifting the tax, only a limited portion of the burden will be reimposed upon the corporation.

The present critical shortage of paper, unlike many other deficiencies, has arisen from unprecedented consumption, and in spite of increased production. Wasteful advertising incident to the excess-profits tax is partly responsible for the accelerated depletion of our pulp-wood forests which increased production has entailed.

The Treasury Department might curb prevailing wastefulness by a ruling that expenditures upon advertising be regarded as an investment and not as current expense, in so far as benefits from the advertising extend to future years. Fair allocation of the expenditure to the years which will receive benefit therefrom appears, however, to be a task beset with insuperable difficulties. Congress could limit the amount which may be deducted as current expense to a sum equal to the average outlay for advertising prior to the enactment of the excess-profits tax (the deduction of payments for repairs was so limited under one of the Civil War income-tax acts); but such an amendment would add another inflexible limitation to a law already bristling with arbitrary provisions.

The excess-profits tax is based on artificial provisions relating to ‘invested capital’ which are difficult to administer, and requires the services of a lawyer and an expert accountant to construe and apply. The law breeds waste, and its inequalities are creating antagonisms which, if unabated, will ultimately destroy the present effectiveness of the income tax.

Many of the defects of the excessprofits tax are congenital and cannot be corrected by a revision of the law. The excess-profits tax was supportable during the period of rapid war-inflation of commodity prices. Merchandizing businesses were making enormous profits. The public temper demanded that the abnormal profits arising out of the war contribute heavily to its financing. To meet an emergency, inequalities affecting those who were reaping war profits were ignored. But now that the factors which condoned its inequitable character have disappeared, or are disappearing, the law must be repealed. The revenue lost by the repeal of the law may be recouped by a general extension of the sales tax, now limited to certain luxuries, or by an increase in the rates of income tax.

IV

Interest on certain federal, and on all state and municipal, bonds is exempted by the law from income tax. Interest on these bonds unquestionably is income, but the law does not include it in ‘taxable income.’ A person subject to tax whose ‘taxable income’ exceeds $5000 must pay a surtax of one per cent on the amount of income between $5000 and $6000. If his taxable income is over $6000, he is subject to a surtax of two per cent on the amount of income which exceeds $6000, and does not exceed $8000. The surtax thereafter increases one per cent on each additional unit of $2000 of taxable income, until such income exceeds $100,000; thereafter the rates increase at irregular intervals, until the taxable income reaches $1,000,000, all in excess of which is subject to a surtax of 65 per cent. To this surtax must be added the normal tax of eight per cent; so that a person with a taxable income of over $1,000,000 is assessed at the rate of 73 per cent on the portion of this income which exceeds the million-dollar mark.

Municipal bonds, and railroad and industrial bonds of equivalent security, yield roughly four and a half and six per cent, respectively. The combined rates of normal and super-tax on taxable income which exceeds $38,000 is 25 per cent; so that at this point the net yield from the six per cent taxable bonds, after allowance for the income tax, will just equal the yield of the nontaxable four and a half per cent bonds. At $40,000, an increase in the supertax raises the rate to 26 per cent; and the net yield of non-taxable four and a half per cent bonds exceeds the net yield of the taxable six per cent bonds. The increasing tax rate so diminishes the yield from taxable securities that the tax of 73 per cent on income exceeding $1,000,000 reduces the net yield of a taxable six per cent bond to 1.62 per cent. It is obvious that the higher the taxable income mounts above $40,000, the greater will be the inducement to convert investments the income from which is taxed into investments the income from which is not taxed. And by reason of the exemption of the bonds from state taxation, it may be advisable to convert taxable investments into certain non-taxable bonds, even though the taxable income is much less than $40,000.

The demand thus created by the federal income tax for tax-free securities has made it possible for municipalities to borrow at substantially below the market rate of interest. A subsidy of this sort inevitably leads to unessential municipal undertakings; and industrial enterprise is correspondingly crippled by inability to procure capital. The exemption is, furthermore, squarely opposed to public opinion. In so far as the public is favorable to any differentiation, it favors a lightening of the burden, not upon income from investment, but upon income from personal services.

In opposing the exemption from tax of income from state and municipal bonds, I shall be charged with inconsistency. My critic will take the position that the most palpable discrimination embodied in the law is the feature of progressive rates; and that, inasmuch as the exemption of income from certain securities tends to neutralize this discrimination, the exemption makes for justice rather than for injustice.

In so far as taxes are simply an assessment for services rendered by the government, the present income tax is discriminatory. If my house costs twice as much as my neighbor’s, and each of us fully covers his house with insurance, it is inconceivable that — the houses being of equal risk — the insurance company should attempt to charge me a premium, not twice, but four or six or ten times the premium paid by my neighbor. A municipality paves a street and proposes to apportion the cost among the abutting property-owners. Will it assess the owner of an eighty-foot lot five times the amount assessed to the owner of a fortyfoot lot, or only twice as much? Twice as much, of course. Admittedly, general taxes cannot be so nicely adjusted; but the same principle of apportionment must govern. This conclusion follows from the premise. But the premise itself is not absolute; it presents only one alternative.

Taxation may constitute the collection of a quid pro quo. Taxation may, on the other hand, take the form of an obligation incident to citizenship or domicile, without regard to the relative advantages which may flow from the status to which the tax is incident. This form of obligation is most strikingly disclosed in the duty to render military service. The test of liability to the draft was not the measure of benefit which the drafted man had received, or was likely to receive, from the government, but rather his ability to serve. The income tax applies the same test. It may be inexpedient to press the logic of this test of ability to pay to the limits of the present law; but the drastic nature of the existing rates of super-tax should not be unequally tempered by providing a means of escape, open to those whose income is derived from liquid investments, but closed to those whose income is derived from personal services or from investments which are not readily convertible into tax-free securities.

In criticizing its exemption from the income tax, I appear to have assumed that the interest from state bonds and municipal bonds may constitutionally be taxed by the federal government. The Supreme Court of the United States has not decided whether, without a constitutional amendment specifically authorizing a tax on the obligations of a state, Congress is entitled to levy a tax on interest on state and municipal bonds.¹ If the defect in the law arises from constitutional limitation, this does not make the law any the less obnoxious; it signifies that the cure lies, not primarily in a modification of the law, but in an amendment to the Constitution which will specifically empower Congress to levy a tax upon the income from obligations of a state and its subdivisions.

There are elements of great strength in the federal income tax. The tax is enormously productive. The cost of collection has been only one half of one per cent of the taxes collected. The burden is imposed on those who are best able, on the whole, to support it. Permanently successful administration is, however, dependent upon the voluntary filing of truthful returns; and truthful returns will be voluntarily filed only so long as just opposition to the tax is not provoked.

I do not pretend to have canvassed all the inequities of the law or of its administration. But with such evidence as has been introduced, I hope to have brought home the fact that

there are certain inequalities in the structure and administration of the law, which, if uncorrected, will seriously impair the effectiveness of the federal income tax.