In your memorandum of March 4, 1938 you requested the Division's views on the problem of procuring and additional $500 million or $1 billion of revenue and transmitted at the same time a memorandum from Mr. Shoup entitled "Plans for Additional Revenue." This the existing possibilities for additional sources of revenue have already been considered in my memorandum of March 10, 1938, "Possible Revenue Revision to be Considered in Connection with the Senate Finance Committee's Action on the Revenue Act of 1938," they are here briefly reiterated in conjunction with some other suggestions, for the purpose of clarifying the extent of my agreement with Mr. Shoup's proposals.

Section I below deals with possible sources of new revenue and Section II with the consideration which should govern the revision of the income tax rate structure.

I

ADDITIONAL SOURCES OF REVENUE

In the light of existing circumstances the estate and gift taxed and individual income taxes constitute the primary sources of additional revenue. In the event that time becomes an important factor, the income tax is more suitable than the death tax; otherwise estate and gift taxes should be increased before any other sources of revenue are utilized. The element of time is of particular importance because of the interval which must inevitably elapse between the increase in estate and gift tax rates and the reflection of those increases in tax collections. If, on the other hand, the element of time is of secondary importance and the objective is merely to raise the general level of normal revenue be approximately one-half billion dollars, the best course of procedure is to increase primarily the role of estate and gift taxes. If, however, it becomes necessary to raise the general level of revenue by as much as $1 billion, resource would have to be had also to income taxes as well as to none miscellaneous sources.

While, with respect to sources of revenue, I am thus in general agreement with the recommendations of Mr. Shoup, I feel that certain of the stops recommended by him for immediate action might more desirably be deferred until a later time because of the difficulties surrounding their speedy enactment. I suggest, therefore, that some of the recommendations included in Mr. Shoup's Group A be shifted to Group B. (Items 2, 6, 6.)

The following, I believe, are possible sources of revenue for near-future enactment, with indications of approximate yields for a full and normal year of operation:

(1) Reduce the combined specific estate and gift tax exemption from $40,000 to $20,000. This would produce approximately $50 million. In the event the combined exemptions cannot be so reduced, grant a $20,000 exemption for the estate tax and the gift tax separately. Such a procedure may be expected to yield $40 million.

(2) Increase the rates of the estate tax in accordance with either one of the two schedules, Proposals A and B, submitted in my memorandum of March 10. Either of these is acceptable, the choice for immediate action depending upon the amount of additional revenue required. Proposal A, which begins with 3 percent on the first $5,000 of net estate and imposes effective rates of 12.2 percent and 34.0 percent on $100,000 and $1,000,000 estates, respectively, would probably increase the estate tax yield by $250 million. Proposal B, which imposes an effective rate of 8.0 percent at $100,000 and 28.7 percent at $1,000,000, is estimated to increase to increase revenue by approximately $130 million.

(3) Increase the rates of gift tax to correspond with increases in the estate tax. This would produce probably $5 million.

(4) Eliminate the executor's option between valuation as of time of death and valuation as of one year after death. The revenue effects of such revision would, of course, depend upon the trend of security and property prices. In periods of declining prices, such as that in 1937-38, its revenue importance is substantial.

(5) Eliminate the present exemption of charitable bequests and grant instead a credit for such bequests in accordance with the proportion that one-half of the charitable bequests bears to the entire estate, as previously recommended in the Division's August, 1937, memorandum, Vol. V, page 20, and the memorandum of March 10, 1938.

(6) Replace the existing exemption of property previously taxed within five years by one graduated in accordance with the length of time intervening between the first and second transfer, as recommended in the Division's August, 1937, memorandum, Vol. V, page 15, and the memorandum of March 10, 1938.

(7) Remove the exemption new granted to non-resident aliens on transfers of Federal Government bonds.

From a long-term point of view various other revisions of the estate and gift tax structure are suggested. These include:

(1) The elimination of the present exclusion from the taxable base of $40,000 of insurance, payable to named beneficiaries, which may be counted on to produce around $8 billion.

(2) The coordination of the estate and gift tax, as proposed in the Division's August, 1937, memorandum, Vol. V, page 43, either retaining or eliminating the present three-quarters differential between the estate and gift tax rates.

(3) Impose some compensatory tax on untaxed capital gains transferred at death, possibly in the form of an additional estate tax on capital gains that have accrued to real estate, stocks and bonds, if the legal aspects of such device can be worked cut. (In a sense this proposal would be an alternative for reaching the undistributed corporate income which was intended to be reached by the Title 1B tax.)

(4) Include in taxable estate, property over which the decedent has general or limited power of appointment.

(5) Include in the taxable estate the proceeds of insurance on the decedent's life where he has retained no incidence of ownership in the insurance.

In the event that the general level of revenues has to be increased before estate tax revisions can possibly be reflected in tax collections, or if the general level of revenues has to be increase by as much as $1 billion, resort can be had to increasing the income tax rate structure. A suggested into schedule proposed by Senator LaFollette. Both of these rate schedules began at surtax net income of $3,000 instead of at $4,000 as at present. The rates in the LaFollette proposal are higher in all brackets of income up to $100,000, where the rates because identical with those in the current law. The rates incorporated in the Division's proposal are higher for all brackets of income in excess of $16,000 and lower in all brackets of income under $14,000 than those proposed by Senator LaFollette. Such rate revisions would produce about $340 million; these proposed by Senator LaFollette, about $230 million.

With respect to the principles which should govern the revision of the income tax rate scale, Mr. Shoup's recommendations rates some controversial issues. These are discussed in Section II below.

A reduction of the personal exemption from $1,000 to $800 for a single person and from $2,500 to $2,000 for a married person or head of family, independently of the increase in individual surtax rates, would probably yield $70 million of additional revenue. However, if such reductions in exemptions occur simultaneously with the upward revision of the rate structure their yield would be somewhat higher. These reductions in exemptions, together with the Division's proposed rate revision, would yield approximately $425 million of additional revenue.

With further reference to the income tax, the following present long-range possibilities:

(1) Increase the normal tax from 4 to 6 percent.

(2) Limit the deductions for charitable contributions in the determination of the net income of estates and trusts to 15 percent of the net income before such deduction. (3) Determine the tax liability of husbands and wives filing separate returns on the bases of their aggregate income, prorating to each their tax liability is accordance with the amount of their separate incomes. This would yield around $150 million.

(4) Provide by statutory enactment or by constitutional amendment for the taxation of income derived from government salaries and from future issues of government securities.

In general, I should avoid having * * * to the excise taxes unless the income, estate and gift tax suggestions have been fully exhausted, with the possible exception of (a) changing the base and increasing the effective rate of the stock transfer tax, and (b) imposing a tax on broadcasting stations measured in part by gross receipts.

II

PRINCIPLES GOVERNING THE REVISION OF INDIVIDUAL INCOME TAX RATES

In order to raise required additional revenue from income taxes, Mr. Shoup indicates that it may be desirable to raise the rates in the lower-middle rather than in the upon-middle brackets. He evidently has in mind short-run considerations and states that in the current circumstances it is not desirable to impose taxes which might have a deflationary effect upon business. The proposal springs from the belief that it is the marginal or top bracket rate and not the effective rate which influences the investment policy of individuals and that, therefore, it is possible, especially for short-run periods, to raise the bracket rates applicable to the lower segments of an individual's income without affecting his * * * to acquire additional income. When considered in conjunction with long-run requirements, there is inherent in such a program a resultant need for flexible surtax rate scales. Some of the economic and tax considerations with relation thereto are indicated below.

SACRIFICE OF EQUITY.

In the first place, to great a sacrifice in equity appears to be involved. To illustrate, make the simplified assumption that incomes shrink uniformly throughout the income scale by 33-1/3 percent and that simultaneously the purchasing power of the dollar increase by 50 percent so that all individuals remain in the same relative purchasing power position as before the depression. The change in the purchasing power of the dollar has the effect of decreasing the progression in the lower and middle brackets and increasing the progression in the highest bracket of the present rate scale. This may be soon from the effective rates in the following table which compares the effective tax rates on equivalent amounts of purchasing power.

           Effective Individual Income Tax Rates under the
       Present Law of for a Married Person with No Dependents

_____________________________________________________________________
                             Effective rate            Decrease in
     Net income                    On net income      effective rate
       before           On       reduced 33-1/3%      on equivalent
     exception /1/  net income   assumed to have        purchasing
                                   equivalent           power
                                 purchasing power
_____________________________________________________________________
$     3,000              .3              -                   .3
      6,000             1.9            1.1                   .5
      8,000             3.1            1.7                  1.4
     10,000             4.2            2.2                  2.0
     16,000             6.5            4.4                  2.1
     20,000             7.9            5.5                  2.4
     22,000             8.7            6.0                  2.7
     28,000            11.1            7.4                  3.7
     34,000            13.2            9.0                  4.2
     40,000            14.9           10.7                  4.2
     56,000            19.4           14.2                  5.2
     80,000            26.6           18.6                  8.0
    100,000            32.5           22.5                 10.0
    200,000            47.7           39.8                  7.9
    300,000            54.1           47.7                  6.4
    400,000            58.0           52.3                  5.7
    500,000            60.8           55.7                  5.1
  1,000,000            67.9           64.1                  3.8
  2,000,000            72.5           70.2                  2.3
  5,000,000            75.6           74.7                  1.1
_____________________________________________________________________

FOOTNOTE TO TABLE

/1/ A maximum of $14,000 of income is assumed to be earned.

END OF FOOTNOTE TO TABLE

It is more realistic, of course, to assume that the decrease in the lower levels of income up to $20,000, say, is less than the decrease in the middle and higher brackets. The comparison of effective rates on equivalent amounts of purchasing power is not, however, effected by differences in the rate of shrinkage of income at different levels. These differences result only in placing the individuals more or less adversely affected in a different position on the rate scale so long on the comparison is made on equivalent amounts of purchasing power. These shifts in the relative position in the income tax paying group are important but seen to me to be largely irrelevant for this analysis. It is not practically possible to adjust the rate scale to changes in the fortunes of specific taxpayers or even groups of taxpayers from one year to the other. Any adjustments of this type must made not through a flexible rate scale but through averaging the tax base, carrying forward losses, or in some other way. The basic factor in appraising should take into account the consequences of a general change in the purchasing power of the dollar and not upon simultaneous changes in the distribution of income.

If, in addition to the automatic reduction in the progressive effects of the rate scale over the lower and middle bracksts attending increase in the purchasing power of the dollar, the scale is modified by raising the lower bracket rates, the loss in progression in that portion of the scale at least is accumulated. On grounds of equity alone, it would * * * that if circumstances require a rise in the surtax rates, the scale should be raised throughout the lower and middle brackets and not only in the lower and lower-middle brackets.

EFFECT ON INVESTMENT RESTRICTED.

A substantial sacrifice in equity may nevertheless be justified if the incentive to enterprise can be counted upon to initiate a propriety wave. It does not appear that limiting the surtax rate increases to the lower and lower-middle brackets is likely to accomplish this result, because the relief granted to individuals in the upper-middle and the highest brackets is only a relative one. While their brackets rates have become lower in relation to those situated in the lower part of the rate schedule, in absolute terms they still remain uncharged. If they were reluctant to embark upon venturesome business before, they are as likely to be reluctant to do so after the surtax rates have been raised in the lower and lower- middle brackets. It is true that no additional restraints would have been imposed on them but, short of an absolute relief, there does not seen to be any reason why they should appraise their prospects for a favorable not return more optimistically than before.

Furthermore, there is the consideration that not all the income of the wealthy individuals is in any circumstances likely to be placed at the disposal of new or especially speculative business. Only a portion can is the most favorable circumstances be expected to go into such risky enterprises. The bulk of the income of wealthy persons is either spent or automatically saved and invested in securities and income-producing properties of the stabler variety. To coax a little more capital out of the wealthy into venturesome business undertakings, the tax relief in effect has to be spread over their entire income in excess of the level where the suggested rate increases terminate. This seems to be too high a price is equity for the additional boldness which might reasonably be expected to result from the relative relief in the tax burden of the wealthy.

The sources of income of the well-to-do and wealthy may be soon in Table 1, for the years 1926, 1928 and 1935. It is, of course, not possible to gauge from these figures to what extent the individuals in the higher income classes could be induced into the more risky sources of income if some tax relief were granted them. The figures in Table 2 do show that the wheels of industry probably are propelled as largely by the very classes it is proposed to burden as by the classes it in proposed to relieve. O the net income reported in 1926, 34,15 percent was reported by individuals in the net income class $5,000 to $25,000. This percentage was 32.98 in 1928 and 27.53 in 1935. The individuals in these income classes, it it true, do not have available for investment as large a portion of their income as the individuals in the higher income classes but it may be readily seem that they are far from being a negligible factor either in the investment markets or in the promotion of new and risky business ventures.

PRACTICAL CONSIDERATIONS.

From the practical viewpoint, the most important objection to a plan for flexible surtax scales is the resistance to rate increases. It is implied in the plan that in business conditions opposite to those warranting rate increases or decreases over certain portions of the scale, the rates would be decreased or increased accordingly. If, in practice, it were found that the decrease were enacted and the increases failed of enactment, then over a swing of business through different conditions of several business cycles the surtax rate scale would ten to the flattened out.

From the point of view of prospective enactment, it may well be that a proposal to increase the lower-middle brackets would meet with more opposition than a proposal to increase the bracket rates all along the line for it would be obvious to many taxpayers that they are being adversely affected while others in the higher income regions were less adversely affected, if affected at all. The danger in scaling down the top rates is that the process will be carried too far once it is initiated, and that the decreases will not be restored.

All things considered, I would recommend that if the surtax rate schedule must be raised primarily to fulfill revenue needs, them it is well that it be raised throughout the lower and upper-middle brackets.