Subject: Revenue program designed to increase the Federal revenues
and simultaneously to make a more equitable distribution
of the tax burden.
The program presented in this memorandum is not a comprehensive one. It deals only with the individual income tax, the estate and gift taxes and the miscellaneous excise taxes, and even for these taxes only the more important desirable changes are presented. The general problem of how the taxes imposed by the Social Security Act should be modified has not been touched. The big question of whether the taxes on business income, especially on corporate income, are properly aligned with the rest of the revenue system has been passed by. Likewise the stamp taxes, the liquor taxes and the tobacco taxes have been passed over. The objective of the proposals presented here is to increase the Federal revenues and at the same time bring about a simultaneous improvement of the distribution of the tax burden. To accomplish this purpose it is proposed:
(1) To change the rates, exemptions and in some respects the structure of the individual income tax. (2) To change the rates and exemptions of the estate and gift taxes. (3) To eliminate as many of the miscellaneous excise taxes as the revenue requirements of the Government will permit, but most especially to eliminate those that bear heaviest on the low income classes.
I. PROPOSED CHANGES IN THE INDIVIDUAL INCOME TAX
(1) IMPOSE A MINIMUM INDIVIDUAL INCOME TAX
The individual income tax base should be broadened for three reasons:
(a) To augment the Federal revenues; (b) To make the public more widely aware of the relationship between taxes and the costs of Government; and (c) To make possible a more equitable distribution of the tax burden.
The chief obstacle to the proposal is the problem of administration. Unless the Federal Government should undertake to increase the expenditures for administration of the income tax to accomplish a high standard in this respect, it would be extremely unwise to undertake the imposition of the proposed minimum tax or to broaden the tax base by the alternative method of lowering personal exemptions. With increases in income tax rates, whether the increases be at the upper or lower level of the scale, the pressure towards evasion is such that without increased administrative effort the income tax is likely to become the least equitable of all taxes.
The proposal is to impose a minimum tax at the following rates:
---------------------------------- Amount of Rate Total net income (percent) minimum tax ---------------------------------- 0 - 500 0 $0 500 - 700 1 2 700 - 900 2 6 900 up 3 - ----------------------------------
Against the minimum tax computed at these rates the married person or head of family would be allowed a credit of $9, or the total minimum tax, whichever is less. The $9 credit represents the tax on the first $500 of net income which becomes taxable. The minimum tax would constitute the individual's income tax liability in all instances where the tax computed at the minimum rates exceeded the tax computed under all other regular income tax rates combined; otherwise the individual's income tax liability would be the tax computed at the regular rates.
An examination of Statistics of Income data discloses that in each year there is a substantial number of individuals in net income classes reaching up as high as the $5,000 to $6,000 class that do not pay tax. For the taxable years 1934, individuals filed 4,094,420 income tax. Of these, 2,298,500 were non-taxable and 1,795,920 were taxable returns. The non-taxable returns were all concentrated in the net income classes under $6,000. The distribution of the non-taxable and the taxable returns in these income classes was as follows:
---------------------------------------------------------------- Net income Nontaxable Taxable Total classes (Thousands Number Percent Number Percent Number of dollars) of total of total ---------------------------------------------------------------- Under 1 310,401 96.9 10,059 3.1 320,460 1 - 1.5 623,136 62.0 381,773 38.0 1,004,909 1.5 - 2 303,331 50.3 299,855 49.7 603,186 2 - 2.5 321,008 72.1 124,117 27.9 445,125 2.5 - 3 433,907 81.0 101,650 19.0 535,557 3 - 3.5 196,161 59.3 134,541 40.7 330,702 3.5 - 4 71,049 35.1 131,608 64.9 202,657 4 - 4.5 22,756 17.0 111,164 83.0 133,920 4.5 - 5 10,025 10.5 85,232 89.5 95,257 5 - 6 6,726 5.9 107,136 94.1 113,862 Subtotal 2,293,500 60.7 1,487,135 39.3 3,785,635 6 and over - - 308,785 100.0 308,785 Grand total 2,298,500 56.1 1,795,920 43.9 4,094,420 ----------------------------------------------------------------
The minimum tax would apply to all the returns which at present become non-taxable because of the relatively high level of personal exemptions and credit for dependents. In addition it would apply to may more returns that are at present excluded from the scope of the individual income tax because at present no individual, with a net income of less than $1,000 if he is single or less than $2,500 if he is married or the head of a family and does not have a gross income of $5,000 or more, is required to file an income tax return.
As against the proposal to impose a minimum income tax, it would be possible to broaden the income tax by lowering the personal exemptions from the levels of $1,000 and $2,500 to the levels of say $500 and $1,000 but such procedure would seem to possess some marked disadvantages:
(a) To lower the exemptions to $500 and $1,000 would subject all individuals in the low income classes between the levels of $500 and $1,000, in the case of a single person, and between $1,000 and $2,500, in the case of a married person or head of family, to the same normal rate on their taxable balance, if any, as applied to all other individuals. For the individuals in these very low income classes, the regular normal tax rate would seem to be excessive and it is not possible by bracketing the normal tax rate to bring relief exclusively to these very low income classes. In other words, if the normal tax rate were made progressive instead of a flat rate, it would bring relief to the individuals in the upper income classes as well as to those in the very low income classes where it is desirable that the relief should be confined. To make the regular normal tax applicable to the large number of individuals that would be included in the low income classes from $500 to $1,000 or $2,500, as the case may be, would result in increased pressure to keep the normal tax at its present unduly low level relative to the surtaxes and may even possibly result in lowering it. If, instead of lowering exemptions and graduating the normal tax, the proposed minimum tax were enacted, the structure of the general income tax would not be disturbed and at the same time by enacting minimum income tax rates lower the normal tax rate, the relief could be localized in the very low income classes. (b) The method of lowering exemptions will not result in as much broadening of the tax base as can be attained by the proposed minimum tax. It is clear from the table above that the deductions and credits more often than not offset the net income in the income classes near the level of the specific exemptions. Under the proposed minimum tax, even though such deductions and credits were to reduce the taxable balance to zero or less, the returns would be taxable at the minimum rates whereas under the alternative method of lowering exemptions many, possibly the large majority, of the additional returns would be non-taxable returns. It is true that many of the returns that are now non-taxable would become taxable because of the lower exemptions. The point is, however, that around the new level of exemptions many of the additional returns filed because of the new level of exemptions would be non-taxable. Despite this fact, the lowering of the exemptions would bring in more revenue than the minimum tax if the present method of allowing the personal exemptions and credit for dependents as a credit for surtax purposes is continued. When the exemptions are lowered (in the case of individuals with substantial amounts of income), it has the effect of subjecting the amount of income which is thus added to the taxable balance to the upper surtax rates. If, however, as is proposed under (2) below, the present credit for personal exemptions and dependents is discontinued for normal and surtax purposes and a tax credit equal to the normal and surtax computed on the amount of personal exemptions and credit for dependents substituted for it, the proposed minimum tax with its lower rates but wider coverage is likely to approximate very closely the additional revenue which lower exemptions would yield.
In a certain sense the proposal to impose a minimum tax is fundamentally different from the proposal to lower exemptions even though under both procedures incomes above $500 for single persons without dependents and above $1,000 for married persons or heads of families would be tapped. The difference is that under the proposal for a minimum tax an individual with a certain amount of net income, irrespective of his marital status and credits otherwise allowed, would be liable to some income tax. In other words, the credit for dependents is in greater or less degree disallowed for the purposes of the minimum tax. In the case of an individual with say $4,000 and several dependents, the tax computed under the regular rates may be less than the tax computed under the minimum rates, in which case the tax under the minimum rates would constitute the final tax liability. The difference in tax originates because credits against net income allowable for purposes of the regular income tax do not enter into the computation of the minimum tax.
It is not proper to maintain that this minimum tax is unfair because it disallows some or all of these credits for individuals in the very low income classes whereas it does allow them for the individuals in the higher income classes. In comparing the tax liability of individuals in different income classes, it is necessary to give effect to the rates, personal exemptions, and credit for dependents taken in combination and when this is done it will be found that the minimum tax is properly aligned with the regular income tax so that the taxes bear more heavily on those with greater ability to pay. To repeat, the different treatment of the personal exemption and credit for dependents among the income classes must be combined with tax rate differentials and the net effect observed before it is possible to appraise whether the proposed minimum tax is properly aligned with the regular income tax.
(2) ELIMINATE THE CREDIT FOR THE PERSONAL EXEMPTIONS AND THE CREDIT FOR DEPENDENTS AT PRESENT TAKEN AGAINST THE NORMAL AND SURTAX BASE AND SUBSTITUTE FOR THIS CREDIT A TAX CREDIT (TAKEN AGAINST THE TOTAL TAX) EQUAL TO THE NORMAL AND SURTAX ON THE AMOUNT OF THE PERSONAL EXEMPTION AND CREDIT FOR DEPENDENTS.
Under the Revenue Acts of 1934-36 the personal exemption and credit for dependents is allowed as a credit against net income for the purposes of both the normal tax and the surtax. Under all the revenue acts prior to the 1934 Act the personal exemption and credit for dependents was not allowed as a credit for the purpose of the surtax.
The change made under the Revenue Act of 1934 seems logical on the surface, especially because the surtax under this Act became applicable for the most part at a lower level of income than under any of the earlier revenue acts. It seemed proper that individuals at the lower levels of income should not be required to pay a surtax on an amount of income which did not exceed the allowable personal exemption and credit for dependents.
The surtax became applicable under the Revenue Acts of 1913-36 at different levels of income as follows:
------------------------------------ 1913 $20,000 1916 20,000 1917 5,000 1918 5,000 1921 6,000 1924 10,000 1926 10,000 1928 10,000 1932 6,000 1934 4,000 1935 4,000 1936 4,000 ------------------------------------
The levels of surtaxable income under the Revenue Acts of 1913-32 are not comparable with the levels under the Revenue Acts of 1934-36 because the personal exemption and credit for dependents is allowed as a credit against net income under the Revenue Acts of 1934-36, whereas under the former acts such a credit was not allowed. /1/
Thus, under the Revenue Acts of 1934-36 a husband living with wife and five dependents could enjoy a net income of $8,500 without paying any surtax, whereas under the Revenue Act of 1932 such an individual would pay surtax on $2,500. Similarly, a single individual without dependents could enjoy a net income of $6,000 under the 1932 Act without paying surtax but such an individual would pay surtax on $1,000 under the 1934-36 Acts.
On the surface, the 1934-36 Acts seem more equitable than the prior acts in that they seem to take the family obligations of the taxpayer into consideration more adequately. The procedure adopted to attain this laudable objective is faulty, however, and has resulted in the introduction of greater inequity than it has removed. The enactment of the present proposal would attain the same objective but would remove the inequity which was introduced under the Revenue Act of 1934 and continued thereafter.
The personal exemption and credit for dependents is allowed for the purpose of providing relief from the impact of the normal and surtax rates to individuals with small incomes. The rate scales under any revenue act must be sufficiently high to provide adequate revenue, and at the same time must be constructed in such manner that it will conform to certain general criteria such as the principle of progression. It is impossible to construct an income tax rate scale which will conform to general principles and which at the same time will give adequate recognition to differences in the capacity to bear taxes because individuals with the same amounts of statutory net income may have substantially different family obligations. In these lower levels of income it is extremely important to provide relief from the generalized rate scale by a system of personal exemptions and credits for dependents. It is not important at all that such relief be provided for the individuals in the higher income brackets. Actually we find that the present law operates to provide greater relief to individuals with high incomes than to individuals with low incomes. The practice of deducting the personal exemption and credit for dependents from the net income before applying the progressive graduated rates accounts for this result.
The proposal is to substitute for the credit provided in Section 25 (b) of the Revenue Act of 1936 a credit against the total normal and surtax computed on the amount of personal exemption and credit for dependents.
In the following table the relief from tax on account of the personal exemption and credit for dependents resulting under the proposal is compared with the relief under the provisions of the Revenue Act of 1936.
-------------------------------------------------------------------- Assumed Relief Relief Relief from tax as personal from from tax percent of net income Net income exemption tax under the (all earned) and credit under Revenue Under for the Act of Under Revenue dependents proposal 1936 of proposal Act of 1936 1936 /1/ /2/ /3/ -------------------------------------------------------------------- $ 5,000 $4,500 $200 $ 220 4.0 4.4 25,000 4,500 200 915 .8 3.7 100,000 4,500 200 2,655 .2 2.7 1,000,000 4,500 200 3,420 .02 .3 -------------------------------------------------------------------- FOOTNOTES TO TABLE /1/ Married person ($2,500) and five dependents ($2,000). /2/ Normal and surtax on assumed personal exemption and credit for dependents. /3/ Difference between tax liability using personal exemption and credit for dependents as credit against net income (1936 Act) and tax liability computed without any personal exemption and credit for dependents. END OF FOOTNOTES (3) ELIMINATE THE PRESENT EARNED INCOME CREDIT AND SUBSTITUTE FOR IT A 5 PERCENT TAX ON "UNEARNED NET INCOME." WHICH FOR THIS PURPOSE SHALL BE THE BALANCE OF NET INCOME AFTER DEDUCTING "EARNED NET INCOME" AS DEFINED IN SECTION 25 (a) (4) OF THE REVENUE ACT OF 1936.
The effect of this proposal is not to repeal the earned income credit; in fact, the earned income credit is increased. The differentiation between earned and unearned income in the proposal is brought about by imposing a higher tax on unearned income and not as in the present law by relieving the earned net income from a portion of the regular tax. In circumstances when the revenue requirements of the Government are high, the proposed procedure for differentiation would seem to possess some advantages over the present plan.
The principle of progression is the primary principle in the taxation of individual incomes. The principle of differentiation is secondary and more debatable. The earned income credit in our present Island in the British income tax is designed for the purpose of bringing relief from the full impact of the income tax rate to the little *** In our law all income in excess of $14,000 is considered unearned *** in the British law all income in excess of $7,500 is considered unearned. In Australia, however, they differentiate between earned and property income without limitation and they have established a *** and higher rate scale applicable to property income. Certain other countries, notably France, have carried the principle of differentiation to extremes and usually have imposed higher rates on the unearned elements of income. It can be demonstrated readily that the principle of differentiation is in conflict with the principle of progression and that for this reason alone complete differentiation cannot be justified. In addition, the more extreme forms of differentiation, by splitting up the income into different rate schedules have the effect of reducing the revenue which could be raised by a single rate scale applicable to all sources of income combined.
The limited type of differentiation as practiced in this country and Great Britain can be justified because when taxes grow to be *** it is necessary to afford the individuals that derive their incomes from outlays of personal effort a certain amount of relief. The higher the tax rates, the more justifiable are differential rates between earned and unearned income. Such relief does not appear to be necessary, however, for individuals in the high income classes. The principle of differentiation in its pure form would shift the emphasis in taxation from the individual to the type of income. As *** stated, in this form, the principle is so incompatible with the principles of progressive taxation that it is not reasonable to recognize it without a limitation of the type which the British and ourselves have incorporated in the tax laws.
Put in another way, perhaps in its least favorable light, the proposed tax on unearned net income amounts to a proposal to add an additional rate of nearly 5 percent to the normal tax rate for individuals in the high income classes; to add a somewhat smaller rate to the normal tax rate for individuals in the middle and lower income classes; and to make no addition to the normal tax rate for individuals in the income classes under $3,000. The actual increase in normal tax rate would vary with the individual's composition of income and be less for those individuals that "earned" a large proportion of their income than for those that did not.
Both Canada and Australia have during this last depression imposed taxes similar to the one here proposed. The Australian rate as first imposed was a flat 10 percent. This rate was subsequently reduced to 6 percent, and again to 5 percent until the tax was eliminated completely for the fiscal years subsequent to July 1, 1936. It will be recalled that the general structure of the Australian income tax is that the rates applicable to unearned income are higher than those that apply to earned income. Their special property income tax increased the differentiation between earned and unearned income.
Unlike the Australian special property income tax, the Canadian tax (described in Exhibit 1 of the appendix) is graduated up to 10 percent. The Canadian tax is similar to the proposal in that all income in excess of $14,000 is considered unearned irrespective of the source of income. Canada did not allow an earned income credit prior to the enactment of this special tax on investment income but like Australia it seemed to recognize that when the burden of taxation is increased a greater degree of differentiation between earned and unearned income is desirable in order to bring some relief to those in the low income classes that derive their incomes from the more obvious forms of personal effort.
(4) INCREASE THE NORMAL TAX RATE TO 6 PERCENT AND ADOPT A SURTAX RATE SCALE WHICH WILL FALL MORE HEAVILY UPON INCOMES BETWEEN $3,000 AND $100,000.
In a general way criteria for rate scale making have been established. The scale that is the combination of normal, surtax and any differential taxes on special sources of income must be such as to tax the big incomes at higher effective rates than the small ones. It is possible to construct a number of scales that will conform to this criterion. The choice of scales must be determined by revenue requirements and the general, social and economic policies of the Government.
While a large measure of progression is desirable in the income tax, it is unfortunate that it is not possible to construct a system of rates which will be sharply and uniformly progressive over the entire gamut of the scale and which at the same time will bring in the requisite amounts of revenue. When matters of revenue become of paramount significance, it is necessary to forego a large measure of progression at some points in the rate scale in order to bring in the desired amount of revenue.
In the present circumstances it seems proper to raise the normal tax rate and also to flatten out the progression in the surtax rates between $3,000 and $100,000. To accomplish this it is proposed to couple a 6 percent normal tax with the 5 percent tax on unearned income (described in section (3) above) and with a new surtax rate scale as follows:
Proposed new surtax schedule ------------------------------------------- Amount of surtax net income Rate of tax Total surtax (in thousands) (percent) (cumulative) ------------------------------------------- 0 - 3 - - 3 - 5 4 80 5 - 7 5 180 7 - 9 7 320 9 - 11 10 520 11 - 13 13 780 13 - 15 16 1,100 15 - 17 19 1,480 17 - 19 22 1,920 19 - 21 26 2,440 21 - 24 30 3,340 24 - 28 34 4,700 28 - 34 38 6,980 34 - 40 42 9,500 40 - 48 46 13,180 48 - 56 49 17,100 56 - 64 52 21,260 64 - 72 54 25,580 72 - 80 56 30,060 80 - 90 57 35,760 90 - 100 58 41,560 100 - 150 59 71,060 150 - 200 60 101,060 200 - 250 61 131,560 250 - 300 62 162,560 300 - 400 63 225,560 400 - 500 64 289,560 500 - 750 65 452,060 750 - 1,000 66 617,060 1,000 - 2,000 67 1,287,060 2,000 - 5,000 68 3,327,060 5,000 up 70 -------------------------------------------
Put in another way, the proposal is to couple with the new surtax rate scale a normal tax which will vary from 6 to approximately 11 percent, the variation depending upon the amount of the taxpayer's income which is unearned.
The proposed surtax is slightly, but only slightly, less severe then the present scale is on the highest income classes but it is substantially more severe on the income classes under $100,000.
If the revenue requirements should make more moderate taxation feasible, then the other proposals outlined above could be coupled to the present surtax rate scale; if still more moderate taxes are desired, they could be coupled with the 1918 surtax rate scale. Each of these combinations would have the effect of increasing the taxes paid by individuals under $100,000 relative to the taxes paid by individuals over $100,000 net income but the increase would be greater if the 1936 surtax rates were used instead of the 1918 surtax rates and still greater if the proposed surtax rates were to be enacted in combination with the other proposals.
It should be pointed out that even if the new surtax rate scale combined with the other proposals were enacted, the effective income tax rates on individuals under approximately $50,000 would still pay relatively less taxes than they would under the British tax rates; and that the individuals approximately over $50,000 net income would pay substantially more. The relative severity of the British income tax rates, the proposed rates, and the present rates is shown in the following table and charts:
EFFECTIVE INDIVIDUAL INCOME TAX RATES IN U. S. AND U. K. Married Person and Two Dependents [graphic omitted] EFFECTIVE INDIVIDUAL INCOME TAX RATES IN U. S. AND U. K. Single Person No Dependents [graphic omitted] EFFECTIVE INDIVIDUAL INCOME TAX RATES UNDER VARIOUS PROPOSALS Married Person and Two Dependents [graphic omitted]
The present law takes a very substantial slice of the very wealthy taxpayer's income. The various combinations of proposals (as shown in the charts) would make similar inroads upon the taxpayers in the high income brackets. The high rates in the upper brackets have not been mitigated in the proposals. It is conceded that there will be a tendency for these very high tax rates to become less and less productive of revenue because they will drive the wealthy taxpayers to shelter--into tax-exempt securities and into other safe investments and away from entrepreneurs' activities. Still the existence of these very high rates will have the desirable effect of breaking down the large estates, for in this way the income from the split-up estates will fall into lower income brackets. Further, it is not at all clear that the economic process as a whole would suffer if the havens of safety were more largely occupied by the wealthier classes.