The supertax would encourage the retention of profits by the corporation unless provision were made for the taxation of undivided profits either to the corporation or to the stockholder. Section 102 appears to offer the only approach to the handling of this difficulty. At least in the more glaring cases somewhat more effective enforcement of section 102 could prevent the deliberate withholding of corporate earnings from stockholders in the top surtax rate groups. For this purpose the penalty tax rates imposed under Section 102 will need to be increased from 25 percent and 35 percent to 100 percent to conform with the rate of the supertax. The latitude necessarily allowed in interpreting "unreasonable accumulation" will make it difficult to prevent some withholding under present unsettled conditions; plausible and perhaps meritorious cases can be made for retention of profits.

C. PROFITS OF UNINCORPORATED ENTERPRISES

Some of the difficulties encountered in applying the existing high surtax rates to proprietorships and partnerships, now subject to the individual income tax, become acute under the new supertax proposal. /2/ Problems of "loophole" and "relief" varieties are involved, see of which nay be indicated briefly:

FOOTNOTES

/1/ Under the Treasury proposal capital losses could be allowed to the extent of $1,000 plus capital gains. A five-year carryover is proposed for the excess of capital losses over Capital gains.

/2/ For instance, the loophole under Section 23 whereby the loss of "loss-producing" enterprises is taken at Government expense.

END OF FOOTNOTES

1. Business survival may be treated by the inability to accumulate reasonable surplus from earnings. /1/

2. In some cases, a $25,000 limit will be inadequate to permit reasonable capital growth and business reserves in addition to entrepreneurial withdrawals for personal expenditures. An unincorporated enterprise finds it difficult to borrow new capital. Corporations enjoy considerable latitude under Section 102 with respect to reasonable surplus additions before becoming subject to penalty taxes and relief may be necessary to place unincorporated enterprises on a position of parity. Where practicable, the right to incorporate may be exercised as a body of relief but the double taxation of corporate earnings bill reduce the advantage.

In any case, the problem here is not different in kind from that of the corporation subject to a high excess profits tax (94 percent.).

3. If a relief provision is made available to protect the internal capital supply, a loophole of tax evasion is open in the for of excessive ploughing back of profits. Experience with enforcement of Section 102 in the past suggests difficulties in effectively closing this door to tax evasion.

4. The difficulty of assuring proper control of costs becomes acute in the unincorporated enterprise where in effect the individual supertax amounts to a 100 percent profits tax above a "breaking-point" (a) that is not closely geared to capital invested and (b) that is made erratic by the possible existence of the taxpayer's other income. Waste, inefficiency, and spurious costs are probable. Various loopholes through the use of "dummy" partners are conceivable; on the other hand, errors, such as may arise in estimating depreciation, could produce extreme hardship.

Application of the supertax to entrepreneurial withdrawals, coupled with a provision for reasonable surplus accumulation may be desirable. Surplus accumulation might be allowed on the basis of some percentage of taxable income of the enterprise. This percentage feature would seem preferable to a flat amount in that it would offer some incentive to business efficiency and tax integrity.

Any incentive-maintaining automatic enforcement device of the above type would however, go awry where "other income" accruing to the proprietor or partner complicates the picture. Direct control and scrutiny would inevitably be necessary to prevent waste, spurious costs, and inefficiency.

FOOTNOTE

/1/ Section 122 loss carryover provisions could not be adequate to meet this.

END OF FOOTNOTE

Something of the magnitude of the problem from the administrative standpoint is indicated by proprietorships and partnerships profits data from STATISTICS OF INCOME 1936. /1/ In 1936 the number of single proprietorships with net income, of $50,000 /2/ and over was 656. In 1936, 3,608 individual incomes above $50,0O0 included some income from partnerships and in many cases the partnership component itself was above $50,000.

D. UNUSUAL INCOME

The person who receives an unusually high income in one year as the result of a fee, patent right, commission, etc., was given special treatment under Section 220 of the Revenue Act of 1939 (Section 107, Internal Revenue Code, as amended). The same type of provision might well be applied to the supertax.

E. EXEMPTIONS AND DEDUCTIONS UNDER ORDINARY INCOME TAXATION

1. WHOLLY TAX EXEMPT FEDERAL OBLIGATIONS OUTSTANDING

Several billion dollars of wholly tax-exempt. Federal securities are now outstanding and in the hands of private investors (corporations and individuals). Many of these will mature in the next three years, but several hundred millions will not be callable until after 1945 and the last installment not until 1970. If these issues continue to be tax exempt, they will become almost priceless to those in the very high income groups. The Federal Government faces the alternatives of (a) repudiating or appearing to repudiate its commitments, or (b) leaving a loophole. It might be possible to devise some method of disguising the repudiation, but it is difficult to see how the problem can be met otherwise.

One possibility would be to consider the imposition of a super- tax on such interest as a forced loan to be returned after the war. It might be, possible (a) to check the transfer of bonds from institutions to individuals and from individuals who now own these bonds to individuals in the very high income brackets by the imposition of a high transfer tax and (b) by the use of strong social pressure to induce present holders to redeem their bonds.

FOOTNOTES

/1/ Statistics since 1936 do not give the type of data used here.

/2/ The $50,000 "breaking-point" is taken as the income which will yield $25,000 net of tax at rates roughly halfway between present and proposed schedule. The number of firms would probably be considerably larger under 1942 conditions of business.

END OF FOOTNOTES

2. TAX-EXEMPT STATE AND LOCAL INTEREST

If the $25,000 limit is adopted, there can be no question that presently tax-exempt State and local interest must be taxed.

The outstanding supply of state and local securities is so large that those in brackets affected by the supertax could replace the larger part of their taxable securities with tax exempts. Non- inclusion of State and local interest would greatly accelerate the concentration of tax exempts in the higher brackets and would nullify the supertax for those with substantial incomes from property.

On the other hands the inclusion of State and local interest in the supertax base will amount to full taxation in the case of those affected by the supertax.

The supertax proposal in connection with state and local interest raised the following points:

1. The supertax is not a tax on tax-exempt interest per se.

2. It does tax existing to-exempt-interest in brackets above the "breaking point."

3. It had the effect of checking the existing tendency toward consolidation of state and local securities in upper bracket portfolios.

4. The supertax would have conflicting effects on the market for State and local securities;

(a) The market would lose some of the buoyancy resulting from the "consolidation" process.

(b) The market would in future tend to depend more on buyers in brackets below the "breaking point."

(c) Some higher bracket holders or buyers may be influenced by anticipation off post-emergency repeal of the super- tax and the "revival" of tax exemption.

(d) To the extent security rather than income becomes the chief object of investors affected by the supertax some state and local securities may retain a premium over riskier industrial investments.

(e) The whole security market would tend to reflect the value of factors other than income, i.e., control, security, etc.

3. CHARITABLE CONTRIBUTIONS

While the effect of high surtax rates on charitable contributions is problematical -- the reduction in cost to the donor being weighed gains the pressure of the tax on disposable income, -- under the supertax the cost to a donor of the contributions oat of income subject to the tax will be nil. It may be assumed, therefore, that contributions will be increased to the allowed maximum.

If the 15-percent allowance is retained and charitable contributions increase from the present average level of about 5 percent to the 15 percent maximum, the revenue, from the supertax plan will probably be negative.

The assumption that contributions, a form of "costless consumption", would be increased to the permissible maximum rests upon the following considerations:

1. The donor would receive good will and social prestige.

2. The donor nay retain some control over the disposition of the charitable funds.

3. Actual benefits nay accrue directly or indirectly to the donor or his descendants.

Sample computations for incomes at different levels show that while supertax revenue will appear, it will be more than off set by decreases in normal tax and surtax receipts.

The effect therefore may be to limit individual incomes to $25,000 net of taxes and charitable contributions, but the limitation will result in greater charitable contributions and smaller net tax payments. Either the supertax plan must not be regarded in any sense as a revenue measure or it must be coupled with a revision of existing charitable deductions permissible under the income tax.

To meet the situation it might be feasible to limit charitable deductions to the average percentage of income the taxpayer has deducted in the previous five years.

4. PERCENTAGE DEPLETION

Individuals may benefit from the favorable treatment accorded owners of certain depletible natural resources. Unless the income from much property is put on a parity with that from other sources, the $25,000 limit will must be universally effective. The percentage depletion question, like others discussed in this memorandum is one of the more highly controversial refused during the current revenue hearings. The Treasury's recommendations offer a reasonable basis for dealing with the problem.

5. RELATION TO THE STATE TAXES

Since State income taxes are allowed as a deduction in computing net income subject to federal tax, states could impose much greater income taxes upon their residents subject to the supertax without adding any burden because the Federal tax would be reduced by a similar count. A possible solution would be to allow ad a deduction for Federal taxes only state taxes due under laws in effect on January 1, 1942, or on the day, when the supertax is adopted.

Limits might have to be placed on the deduction of overdue real estate taxes, but so far as other State and local taxes are concerned there appears to be no problem.

V. FIXED COMMITMENTS: A TRANSITION PROBLEM

A. THE TYPES OF FIXED COMMITMENTS

The imposition of a $25,000, limit would make it difficult for some individuals to meet fixed commitments such as:

1. Contractual obligations of taxpayers with heavily mortgaged property who have agreed to make: "(a) annual payments each year towards reduction of the debt, or (b) a lump sum payment at the end of a stated period, the repayment date falling within the taxable year of the new supertax.

a. Contracts that provide for the payment of a stated sum of money over a period of years. The taxpayer may have:

(a) Bought a business, or a fractional interest in a business, payment to be spread over a period of years.

(b) Borrowed to finance a business enterprise.

(c) Agreed to pay a stated sum annually to a hospital, college, or for stock subscriptions.

(d) Assumed the obligations to pay alimony or a separation allowance or make other cents to relatives, former servants, etc. (If the Treasury's proposal that alimony be taxable to the recipient is adopted, alimony would present no problems in this connection.)

(e) Signed a non-business lease requiring large outlays.

3. Payment for securities bought on margin or with the assistance of a commercial bank loan.

4. Premiums on insurance policies.

B. The case for special relief

The case for granting special relief for fixed commitments is weak. Relief is already implicit in the present provision permitting interest on indebtedness to be deducted in computing taxable income. Consequently, no difficulty can arise because of interest charges on outstanding indebtedness. Moreover, the taxpayer's ability to service the interest charges on loans incurred to meet his fixed commitments is in no way impaired and such interest charges would not reduce the income left for meeting living expenses.

Under these circumstances, few taxpayers will have any real difficulty in meeting their fixed commitments. Where the commitment arises from the necessity of repaying a loan on property, the taxpayer has the property as a basic on which to refinance his loan, and he can do so with the government in effect paying the interest on the loan. There may be difficulties in maintaining the loan where the collateral is impaired and the remaining security is (a) the income of the borrower and (b) the continuance of the interest deduction.

If the commitment arises from the necessity of paying a heavy insurance premium, the taxpayer has several alternative methods of readjustment: (i) If he has been allowing his dividends to accumulate, he can withdraw them. (2) He can borrow on the reserve already accumulated with the government paying the interest. (3) He can change the form of insurance to one involving less saving and more pure insurance. (4) He can change the face amount of the policy. In none of these cases is there any substantial hardship; the taxpayer merely SAVES less than he otherwise would. Loss might occur if cancellation were necessary, and replacement could only be made with more costly policies.

Some cases will doubtless remain where adjustment will be difficult. An obligation may have been made that does not imply the ownership of capital assets upon which a loan may be made, e.g., an agreement to pay a pension to an age dependent. The taxpayer may have made a contract to buy into a partnership by the payment of annual sum over a period of years. In the latter case there is serious doubt that any permanent abatement of liabilities would be justified since such a policy would discriminate in favor of persons who have made commitments as against persons who were careful to avoid commitments to retain flexibility. Relief for the first type of case might be justified upon broad social grounds. However, in either situation it would be unfair to give special relief to persons with large incomes while none was being given to persons with smaller incomes whose position is fully, as difficult.

C. POSSIBLE SOLUTIONS

If it is decided to give special relief, several solutions are possible:

1. Special deduction in computing tax liability might be allowed for imperative obligations assumed before the first suggestion of the limit by the President.

2. A government lending agency could be set up to lend back taxes or give relief to creditors indirectly hit by the plan.

3. A moratorium might be provided to protect the equity of the taxpayer under commitments. Provision must be made under this plan to provide (1) for relief of creditors affected by the $25,000 limit and (2) for the demands of all persons in financial difficulties due to the war situation from whatever cause.

Neither the first nor the third of these solutions is fully acceptable. The first would confer a permanent advantage that is not in general justified. It might, however, be acceptable for agreements to contribute a specified sum annually to a charity such as a hospital or college. In these cases a deduction might be allowed to the amount of the commitment despite any other limits that may be placed on such contributions. Payments to servants who are unable to obtain other jobs might be partially deductible as charitable contributions, but pressure to enter war employment should not be reduced.

The third device -- a moratorium -- would make necessary the extension of relief to the creditor class and, therefore, appears to have little advantage over direct loans to the taxpayer. A political issue would be raised by the demands of other taxpayers in financial difficulty from other causes growing out of the war situation.

The second solution -- a Government lending agency -- seems the best if one is to be adopted. It gives no permanent advantage but merely assists the taxpayer in refinancing hid obligations and can be limited to cafes of merit. Aid would not have to be restricted to persons subject to the supertax. This solution might take the following form:

1. Establishment of a Government lending agency to which taxpayer would be required to demonstrate a need for relief.

2. Loans granted would carry a low interest rate, payable at maturity of the loan and not deductible in computing taxable income.

3. The privilege of reducing the loan would be granted on application.

4. All loans would be repayable over a period following the end of the war.

Administrative problems must be expected, and under conditions in prospect for the next year or two, the burdens added by such a plan should not be ignored.

VI. CREDIT FOR INVESTMENT IN GOVERNMENT BONDS

It has been suggested that a tax credit be allowed not to exceed 10 percent of the supertax for the investment of income received during the year in non-negotiable Government bonds not subject to repayment until after the war. To receive the allowance the taxpayer must demonstrate that the investment was made from his current receipts and not through the reduction on the liquidation of other assets. The suggestion has the following merits:

1. The $25,000 limit would be more acceptable politically.

2. The natural tendency of the taxpayer to sell negotiable investments to maintain his living standard when faced with the $25,000 limit, would be discouraged. Reduction of servants, expensive entertainment, etc. would be a source of gain to the taxpayer.

3. The area of non-inflationary government borrowing would be increased.

The following disadvantages of the allowance can be cited:

1. The limit of $25,000 is lost. A net income after regular income taxes of $1,000,000 would be reduced to $125,000.

2. If other forms of relief are also granted hardship cases, the taxpayer would be able in practice to recover a Considerable proportion of the loss intended under the original ceiling plan.

3. A compromise might be made by requiring the taxpayer applying for hardship relief, to surrender the non-negotiable bonds to the governmental agency in amount equal to the relief sought, i.e., relief demands would reduce the recoverable savings of the taxpayer after the war. A natural restraint on the taxpayer's application for relief would thereby be created.