A Supertax on Individual Incomes Above $25,000
Summary
Individual incomes, after taxes, could be limited to
$25,000 by a 100 percent supertax on net income remaining
after the regular income tax. The personal exemption for
this purpose would be $25,000.
The supertax would not affect persons whose income
before deductions did not exceed about $60,000 under the
Treasury proposed rates or $40,000 under present rates.
The tax is estimated to yield $211.8 million (over and
above the revenue from the Treasury proposed rates) from
approximately 19,500 persons if joint returns are
mandatory and $174.3 million from approximately 17,000
persons if separate returns are permitted.
The effective application of such a tax would raise a
number of problems.
DEFINITION OF THE TAXPAYER
(a) Under the present option to file separate returns,
every member of the family would be allowed $25,000. If
joint returns were mandatory, the husband and wife would
together the limited to $25,000, but each child could
receive and additional $25,000. This could be presented
by making consolidated returns mandatory for the whole
family for purposes of both the income tax and the
supertax.
(b) At present, trusts and estates are in some cases
subject to the individual income tax, regardless of the
number of beneficiaries and the income of each from other
sources. The application of the $25,000 limit to trusts
and estates would work serious injustice, particularly in
the case of beneficiaries whose total income (including
their share of the trust) is relatively small. The
exemption of trusts and estates, on the other hand, would
permit tax avoidance. The present tax treatment of
pension trusts would have to be revised. Otherwise an
avenue of escape would remain.
(c) The individual income tax now applies to
proprietorships and partnerships. The application of the
$25,000 limit to these groups would interfere with
business incentives and encourage wasteful expenditures.
DEFINITION OF TABLE INCOME
A $25,000 limit would aggravate the problem of
defining taxable income. Defects which can be tolerated
under the income tax would be magnified under the
supertax, and in some cases could defeat the whole
purpose of the tax.
(a) To present avoidance by the conversion of ordinary
income into capital gains, taxable income could not
exclude such gains. The inclusion of gains would
encourage the taking of losses and the postponement of
the realization of gains and, therefore, would lead to an
artificial market.
(b) The supertax would encourage the retention of
profits by corporations unless provision were made for
the taxation of undivided profits either to the
corporation or to the stockholders. Section 102, which
now imposes a penalty on corporations improperly
accumulating surplus, could be implemented to prevent the
more glaring evasions.
(c) The application of the supertax to unincorporated
business would prevent the accumulation of reasonable
surpluses for normal capital growth and business
contingencies. The option of incorporation offers little
relief. The supertax would be confined to owners'
withdrawals from the business, with provision for
reasonable surplus accumulations.
(d) The application of the supertax to State and local
interest would amount to the taxation of such interest
under the regular income tax. In the absence of similar
treatment of wholly-exempt Federal securities, present
holders would enjoy a windfall, either in the form of
exemption from the supertax or in the form of capital
gains, resulting from the sale of their securities to
those subject to the supertax.
(e) For all those subject to the supertax some
charitable contributions would be costless; they would be
made at Government expense. Unless such contributions
were limited (for example, to amounts contributed in
preceding years) the resulting income tax revenue loss
might exceed the yield of the supertax.
(f) Since State income taxes are deductible in
arriving at taxable income, States could increase their
tax rates applicable to the upper income brackets at the
expense of the Federal Government, without burdening
their residents. The limitation of deductions to taxes
due under laws in effect on January 1, 1942, may be
desirable.
(g) Special provisions would be required to prevent
abuse of depletion allowances and to minimize injustice
to persons receiving high incomes for services rendered
over a period of years.
RELIEF FOR FIXED COMMITMENTS
The supertax would make it difficult for some
individuals to meet such fixed commitments as life
insurance premiums mortgage amortization non-business
leases, contributions pledged to charity, subscriptions
for stock, installment purchases of business property,
and obligations to make payments for alimony, support of
relatives, and for annuities to servants.
The case for granting special relief for fixed
commitments is weak. Present law permits interest on debt
to be deducted in computing taxable income; therefore,
those subject to the supertax could refinance their fixed
commitments without a net interest cost to themselves.
The problem of heavy insurance premiums could be met by
the re-arrangement of insurance contracts. To cases of
real hardship, a Government lending agency could be
authorized to extend credit facilities.
I. PURPOSE AND NATURE OF THE TAX
The purpose of this supertax is to implement the
President's statement in his April 27 message to Congress
when he said:
". . . . . I therefore believe that in time of
this grave national danger, when all excess income should
go to win the war, no American citizen ought to have a
net income, after he has paid his taxes, of more than
$25,0000 a year.
This objective may be reached by: (a) a surtax scale
that (with normal tax) imposes 100 percent rates above
the point that will leave the amount desired or (b) an
additional supertax taking 100 percent of taxable income
above $25,000 after other-taxes. Because of the
differences in exemptions and credits the first method
would not give the precise result desired; a scale that
would leave just $25,090 to single person without
dependents would leave somewhat more to a married person
with dependents. Therefore, it is assumed here that the
tax will be a supertax, but for most of the discussion
the form of the tax is of little significance.
II. YIELD AND NUMBER OF TAXPAYERS
The tax is estimated to yield $211.8 million from
approximately 17,000 persons if joint returns are
mandatory and $174.3 million from approximately 15,000
persons if separate returns are mandatory. /1/
FOOTNOTE
/1/ If loopholes referred to below are not closed, the
revenue would be much less than estimated.
END OF FOOTNOTE
Under the Treasury's proposed rates a net income of
about $60,000 and under 1941 Act rates about $40,000
would be needed to leave $25,000 after taxes. The lower
the rate scale imposed by the 1942 Act, the larger the
number of taxpayers affected by the supertax.
III. DEFINITION OF THE TAXPAYER
A. INDIVIDUAL VERSUS FAMILY
The $25,000 limit could apply to individual taxpayers,
collectively to both spouses, or collectively to the
family unit including minor (and perhaps adult) children.
If the limit applied only to individuals, the
discrepancies among families would be glaring. A husband
and wife together could receive $50,000, and each child
could receive $25,000.
Income from property which can be divided by transfers
would become more valuable relatively to income from
salary, professional practice, or business. The value of
residence in community property States would increase
still further. Enactment of the mandatory joint return
proposal will solve part of the problem. Some taxpayers
could still avoid some of the 100-percent tax by
transferring income- producing assets to their children,
especially minors, and to others upon whom they can
depend to use the income as they (the donors) desire.
This problem could be met most satisfactorily by
following the Australian practice of not recognizing such
gifts for income tax- purposes and taxing the income to
the donors. The application of this technique to the
supertax would automatically involve its simultaneous
application to the regular income tax.
Another, but less satisfactory, approach would be to
impose the supertax on the basis of the family unit,
including both spouses and minor children. Consolidated
returns would be mandatory for the family. Additional
exemptions might be allowed for each member of the family
--$25,000 for the head, $5,000 for a wife, $3,000 for
each child, etc. This practice would increase the
effectiveness of the limitation in that it would apply to
that part of the income of minor children not derived
from assets transferred to them by the parents; it would
be less effective in that it would exclude the income
from assets transferred to others than the spouses and
minor children. It would mark a large and not necessarily
desirable departure in income taxation. Conflicts with
State law might arise, and search for methods of
avoidance would spread widely. Artificial units could be
established.
B. ESTATES AND TRUSTS
Since the $25,000 limit is directed towards the
"American citizen", it would be desirable for
purposes of the supertax to overlook estates and trusts,
artificial legal entities, and relate the tax to the real
persons concerned. Otherwise the door is open both for
evasion and unintentional hardship.
Ordinarily estates should not present a serious
problem because they are allowed to deduct amounts
distributed to beneficiaries, and it should be possible
for them to make distributions of most of the income that
would otherwise be subject to the supertax. However,
estates may remain unliquidated for some time either
voluntarily or because of circumstances beyond the
control of the parties involved. Litigation or other
legal impediments may make it impossible to distribute
income, and in such cases the application of the supertax
to the estate may work serious injustice since several
persons, none of whom receives anything, may really own
the income. But to exempt unliquidated estates having
incomes comparable to the incomes of individuals subject
to the supertax would make delay in settlement an
effective method of tax evasion.
Trusts create a still more serious problem. On the one
hand, there are trusts over which the grantor has no
control but the income from which is taxable to him.
Funded life insurance trusts fall into this category; one
solution would be to tax the real owner of the insurance
policy, but this would run counter to the treatment under
the regular income tax and would not always be possible.
On the other hand, trusts create possibilities of evasion
because they make possible the splitting of income. To
exempt trusts would open a wide loophole; to exempt
existing trusts only would grant a large and unmerited
windfall. The issues involved are primarily legal, and
for most practical purposes the economic issues are of
secondary importance. It would probably be impossible to
devise a tax that would effectively limit to a specific
figure the increase in economic power of persons with
varied interests in trusts.
However, complicated and arbitrary rules for the
taxation of trusts and estates have been developing, and
it would be impractical to revise the system on short
notice to make the adoption of the supertax the occasion
for substituting a new set of rules. It is often
impossible to determine currently the individuals who
will ultimately receive the income of a trust or estate.
The logical goal -- taxing the person whose interests are
really increased by the income -- cannot be easily
followed in practice.
C. PENSION TRUSTS
Imposition of the supertax would make more imperative
revision of the treatment of pension trusts, The
Treasury's suggestion that maximum benefits from the
employers contributions be limited should be adopted.
Otherwise corporation executives could take the marginal
portions of their compensation in the form of
contributions to the pension fund rather than current
salary. Normal and surtax yield as well as supertax yield
would be lost. The Bureau of Internal Revenue may have
sufficient power to prevent obvious avoidance, but even
if existing plans remain undisturbed, some officers would
receive handsome; bounties in the form of exemption of
income that would otherwise be taxed at 100 percent.
Some further provision may also be needed to limit the
tax-free accumulation of income on the assets of the
pensions trust. Many plans permit participants to
contribute to the fund substantial amounts in addition to
their normal contributions. The income earnings are then
exempt from current taxes. Transfer from other
investments to the fund could increase their yield after
tax from zero to whatever the fund earned. Purchase of
life insurance with a large saving element offers the
same opportunity for avoidance.
D. UNINCORPORATED ENTERPRISES.
The application of the supertax to the income of
proprietor ships and partnerships would raise problems
that are discussed in IV- D below.
IV. DEFINITION OF TAXABLE INCOME
The attempt to construct a tax that then superimposed
upon the regular income tax would place a ceiling of
$25,000 on individual incomes, makes the development of a
fair definition of taxable income indispensable.
Inclusion, exclusion, hardship cases, and loopholes are
magnified and may negate the objective of income
limitation.
A. CAPITAL GAINS AND LOSSES
1. ARGUMENTS FOR INCLUSION /1/
(a) Unless capital gains were included in the base,
tax avoidance would be possible through the conversion of
ordinary income into capital gains (for example, low
interest boating bonds sold at discount). Those with
large incomes would be given one form of activity which
could yield income not subject to the limit --
speculation.
(b) Capital gains represent an important source of
income to individuals with incomes of the sized to which
the limitation would be applicable, and to exclude
capital gains from the base would provide an obvious
means of tax avoidance for persons with large incomes.
For 1940, not long term capital gains reported by
individuals and taxable fiduciaries with net incomes of
$50,000 or more, accounted for over 6 percent of their
total income.
(c) It might be assumed that the portion of the
realized capital gain includible in net income; for
purposes of the supertax is the portion which accrued
within to the current year, and therefore properly
subject to all taxes imposed for the current year.
2. ARGUMENTS AGAINST INCLUSION
(a) The realization of capital gains may be postponed
if the tax rates become too high. An individual subject
to the supertax could delay taking his gain and risk the
market dropping substantially. Under Treasury proposed
rates, an individual subject to the limitation would have
about as much left from a $1 capital gains (50 cents
left) as a person not subject to the limitation who had a
capital gain of 71 cents (49.7 cents left). The inclusion
of capital gains in the base of the supertax will disturb
the normal flow of transactions in the capital market.
FOOTNOTE
/1/ The maximum tax on actual long-term capital gains
under the supertax would be 50 percent under the present
law and the Treasury proposal both of which provide that
only one-half of the actual gain be included in taxable
net income.
END OF FOOTNOTE
(b) The inclusion of capital gains in the tax base
will encourage the taking of losses to the fullest extent
possible in order to offset gains and also to derive the
benefits of the carryover. /1/
3. CONCLUSION
If the $25,000 limit is to be effective capital gains
must be included. Inclusion of gains could necessitate
see allowance for losses. The Treasury's proposals with
respect to capital gains and losses are generous and
equitable, and the supertax should not necessitate
revision of the basic recommendations. Nevertheless,
arbitrary market influences must be expected.
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