Date 19 January 1940
Author Roy Blough
Title Special Defense Taxes to Raise $500,000,000 Collectible in the Fiscal Year 1941
Description Memo to the Assistant Secretary for Tax Policy, Division of Tax Research, Treasury Department
Location Box 43; Methods of Raising Additional Revenue; Records of the Office of Tax Analysis/Division of Tax Research; General Records of the Department of the Treasury, Record Group 56; National Archives, College Park, MD.
 
January 19, 1940

Mr. Sullivan

Mr. Blough

Subject: Special defense taxes to raise $500,000,000 collectible in the fiscal year 1941

I. SUMMARY OF PLANS

In accordance with your request I am outlining in this memorandum three plans for raising $500,000,000 collectible in the fiscal year 1941 from taxes that can be separately designated as defense taxes. The suggestions are tentative and are intended to serve as a basis for discussion.

The taxes involved in the following plans include the individual and corporation income taxes and the excises on gasoline, bear, distilled spirits and cigarettes.


                                   Plan 1

                                            Approximate amount of
Suggested defense taxes                     additional revenue /1/
                                                (In millions)
  Special income taxes:
    Individual /2/                                    $300
    Corporation, 2-3/4 percent                         200
                                                      ____
         Total                                         500

FOOTNOTES TO TABLE

/1/ Formal estimates have been requested from the Division of Research and Statistics and will be supplied later.

/2/ The rates for this special tax depend upon which of the several alternative methods of imposing the levy are adopted. These methods are discussed in Section III of the memorandum.

END OF FOOTNOTES TO TABLE


                               PLAN 2

                                            Approximate amount of
SUGGESTED DEFENSE TAXES                     additional revenue /1/
                                                (In millions)

  EXCISE TAXES 
    Gasoline, 1/2 cents per gallon                     100
    Beer, $2 per barrel                                100
    Distilled spirits, 25 cents per gallon)
    Cigarettes, $50 cents per 1,000                     85 

  INCOME TAXES
    Individual, 2% of normal tax base                  140
    Corporation, 1 percent                              75
                                                       ___
         Total                                         500

                               PLAN 3

SUGGESTED DEFENSE TAXES

  EXCISE TAXES
    Gasoline, 1/2 cents per gallon                     100 
    Beer, $2 per barrel                                100
    Distilled spirits, 25 cents per gallon

  Special individual income tax /2/                    300
                                                       ___
         Total                                         500

FOOTNOTES TO TABLE

/1/ Formal estimates have been requested from the Division of Research and Statistics and will be supplied later.

/2/ The rates for this special tax depend upon which of the several alternative methods of imposing the levy are adopted. The methods are discussed in Section III of the memorandum.

END OF FOOTNOTES TO TABLE

II. FACTORS CONSIDERED IN PREPARING OPTIONAL PLANS

In a memorandum of December 21, 1939 to Mr. Hanes, a copy of which is attached, six optional methods of raising $500,000,000 additional revenue annually were outlined. These were, however, based upon different considerations than the plan included in the present memorandum.

In the six optional methods outlined in the memorandum to Mr. Hanes it was assumed

(1) That the additional taxation could be in the form of general tax rate increases without the necessity of being labeled as national defense taxes.

(2) That so long as the average annual yield of the taxes was $500,000,000 it would not be necessary that such amount be collected during the fiscal year 1941.

In the present memorandum, in accordance with our discussion of the subject, it is assumed that

(1) The new taxes must be suitable for labeling as national defense taxes.

(2) They must produce $500,000,000 during the fiscal year 1941.

The new specifications require changes of the following character in the options which were submitted to Mr. Hanes:

(1) Taxes which are slow in producing revenue cannot be included. This eliminates increases in the estate tax and necessitates either retroactive application of the income taxes or provision for their collection during the first six months of 1941.

(2) Entirely new taxes should be avoided because it usually requires some time to get their administration in satisfactory shape and for business to become adjusted to them.

(3) The rate scales of the new special taxes must be shown separately and not combined with present taxes.

The defense taxes on income would be levied on 1940 income and payable on March 15 and June 15, 1941. The income tax forms could be easily adjusted to show these taxes separately.

Also, the other defense taxes suggested could readily be designated separately for the taxpayer. The cigarette tax is 1 cent additional per pack of 20 and could be levied by a special defense tax stamp. The beer and distilled spirits taxes could be stamped in a similar manner. The gasoline tax presents some difficulty. It may be possible, however, to require the distributors to indicate such a defense tax as a separate price item.

In formulating these plans it was considered desirable to make them as simple as possible and because of the temporary nature of the defense taxes it did not appear to be advisable to introduce any new tax sources. Further, the suggested defense taxes relate to the existing sources of revenue without any change in the present tax bases. Changes in tax bases are not recommended for the defense taxes because the circumstances surrounding their enactment may not be conducive for settling the treatment of debatable tax issues in our present system.

The plans are analyzed in some detail in Section III below.

III. DETAILS OF PLANS

In the following discussion, some of the technical features of the suggested plans and taxes are considered.

PLAN 1

The first plan is to derive all the defense tax revenue from the income taxes, $300,000,000 from individuals and $200,000,000 from corporations.

The rate required to raise $200,000,000 from the corporation income tax is approximately 2-3/4 percent. This added to the present 18 percent rate raises it to 20-3/4 percent, the highest in the history of the tax, with a possible exception for some corporations that paid higher taxes on their 1936 and 1937 incomes due to the surtax on undistributed profits. It is recognized that such an increase in the corporation income tax rate may be prejudicial to business and consequently to recovery.

The defense tax on individual incomes may be imposed in a number of different ways. The various methods and the effects of each follow:

(1) IMPOSE A FLAT RATE TAX OF 5 PERCENT ON EITHER (a) THE SAME BASE AS THE PRESENT INDIVIDUAL NORMAL TAX OR (b) SURTAX NET INCOME, OR (c) SURTAX NET INCOME AFTER ALLOWING A CREDIT FOR EARNED NET INCOME

If the tax were imposed on the income at present subject to normal tax, effect would be given to the earned income allowance, but interest on Government obligations which is now subject to surtax and exempt from normal tax would be exempt from the defense tax also. If the defense tax were based on surtax net income instead of income subject to normal tax, such interest on Government obligations would be taxable. Earned income under this basis would not, however, be given any special treatment, since the earned income credit is not allowable for surtax purposes. It would, of course, be possible by somewhat complicating the tax return form to provide for an earned income credit against the present surtax net income base for the purpose of computing the defense tax.

The considerations in the foregoing paragraph relate also to the other suggestions in this memorandum which involve the normal income tax base.

The effect of a 5 percent defense tax based on income subject to the present normal tax is shown in Table 1. It will be noted that the percent increase in tax is substantially higher in the lower net income classes than in the upper ones. For example, the increase for a married person with two dependents is 125.0 percent at the $5.000 level and 14.9 percent at the $100.000 level.

(2) IMPOSE A FLAT RATE TAX OF ABOUT 35 PERCENT OF THE PRESENT COMBINED INDIVIDUAL NORMAL AND SURTAX WITH A LIMITATION THAT THE ADDED TAX SHOULD NOT EXCEED 35 PERCENT OF THE INCOME REMAINING AFTER PRESENT FEDERAL TAXES

If this tax were imposed without the limitation it might in the very top classes confiscate the entire income. With the limitation, the effective rate of the combined defense and present normal and surtaxes is over 84 percent at the $5,000,000 net income level. The defense tax taken by itself ceases to be progressive at between $200,000 and $300,000. At $200,000 to combined effective rate is about 65 percent.

Other types of limitations upon a tax on tax can be devised. For example, it might be provided that in no case should the combined defense and regular income taxes exceed some stated percent of net income. If, however, the stated percent is less than the the effective rate of the present taxes, the effect is not only to relieve those with effective rates in excess of the stated rate from the defense tax, but also to lower the regular income taxes. For example, if the limitation were 50 percent of the net income, then a married person with two dependents receiving $1,000,000 net income and subject to a defense tax of, say, 10 percent would have his regular $678,436 total income taxes reduced by $178,436 to $500,000. The effects of the 35 percent tax on tax with the suggested 35 percent limitation is shown for various levels of income in Table 2. Table 3 illustrates the effects of the same proposal with a 10 percent rate. Table 4 shows the effects of the 10 percent rate with various other types of limitations and Table 5 shows the effects of a 10 percent rate without limitation. (3) IMPOSE A SPECIAL DEFENSE TAX ON THE NORMAL INDIVIDUAL INCOME TAX BASE AT RATES GRADUATED AS FOLLOWS: 2 PERCENT ON THE FIRST $2,000 OF TAXABLE BASE; 4 PERCENT ON THE NEXT $2,000; AND 6 PERCENT ON THE BALANCE, WITH THE LIMITATION THAT IN NO CASE SHOULD THE ADDITIONAL DEFENSE TAX EXCEED 10 PERCENT OF THE NET INCOME REMAINING AFTER PRESENT FEDERAL INCOME TAXES

The objective of this proposal is to relieve both the lowest and highest income brackets from the full impact of a flat rate defense tax without limitation; in other words, to throw a larger portion of the tax burden into the middle brackets.

If this proposal were adopted without the limitation, it would relieve the small but not the large incomes and would, of course, yield a larger amount of revenue. Without the limitation, the combined defense and regular income taxes at $5,000,000 income level would exceed 81 percent of net income. With the limitation, this rate would be about 78 percent.

At $5,000 the effective rate of the total tax for a married person with two dependents is 1.4 percent and at $100,000 it is 37.6 percent. The effects of the proposal with the limitation at various levels of net income are shown in Table 6 and without the limitation in Table 7.

The rates suggested for the various methods outlined above for raising additional revenue from the individual income tax could all be lower than indicated if the personal exemptions were reduced, for example, to the level suggested by Senator LaFollette. His suggestion is to reduce the $1,000 exemption for single persons to $800 and the $2,500 exemption for married persons or heads of families to $2,000.

(4) IMPOSE A FLAT 10 PERCENT TAX ON UNEARNED NET INCOME DEFINED AS ALL INCOME WHICH IS NOT AT PRESENT DEFINED AS EARNED INCOME

This proposal is in accord with a policy to favor earned income as against unearned income. The burden of this tax falls heavier on the higher incomes that normally have larger proportions of their income from property and investments and not from salaries and wages.

The imposition of such a tax would, however, tend to discourage the normal distribution of dividends and this might radically interfere with the equity of the individual income tax on the one hand and the stimulus that dividends give to consumption on the other. For that reason it may be desirable to impose this tax not on calendar year 1940 incomes, but retroactively on 1939 incomes so that the dividend distributions during 1940 would remain unaffected by the tax.

PLAN 2

It should be noted that some of the revenue which in the first plan would be raised from the income taxes on corporations and individuals is in the second plan to be derived from excise taxes on gasoline, beer, distilled spirits and cigarettes.

The corporation rate in the second plan is 1 percent instead of 2-3/4 as in the first plan. While a 19 percent corporate rate may be prejudicial to business enterprise and recovery, it should be noted that the 1 percent increase would only re-establish the 19 percent rate which corporations retaining all their earnings experienced as recently as 1938. Further, since it becomes necessary to impose defense taxes on individual incomes and on a number of excises affecting a large majority of the adult population, it may be more palatable to effect these increases if at the same time the corporation income tax rates are also increased.

The reliance upon excises in Plan 2 for approximately $285 million of the $500 million and the use of a flat individual income tax tends to make this plan less progressive than Plan 1 for in that plan approximately $300 million would be raised from the additional income tax. As has been indicated, however, some of the suggested types of defense tax on individual incomes included in Plan 1 are themselves not progressive. This is true, for example, of the suggestion to increase the normal tax, common to both plans.

The effect of the 2 percent increase suggested in Plan 2 is shown in table 8.

The cigarette and other excise taxes suggested for defense purposes will spread the burden of the emergency over a greater number of citizens than is possible by restricting the defense taxes to income taxpayers. In this connection, the cigarette tax, which is an element in this plan, which the possible exception of the tax on beer, is perhaps more regressive than the others.

PLAN 3

The distinguishing feature of Plan 3 is that none of the defense tax revenue is to be derived from additional taxes on corporate incomes. It includes the same suggestions with respect to individual income taxes as are included in Plan 1 and all the excises in Plan 2 except the cigarette tax.