Comparison of estimated individual income tax liabilities based on calendar year 1938 incomes under the provisions of the Revenue Act of 1936 and those of the August 1937 tax proposals of the Division of Research and Statistics for a Revenue Act of 1938 (Millions of dollars) Estimated liabilities Revenue Act of 1938 $2,672.0 Estimated liabilities Revenue Act of 1936 1,727.8 Increased liabilities due to Revenue Act of 1938 $ 944.2 Percentage increase-in tax liability 54.6%
The following tabulation shows the estimated increase (+) or decrease (-) in these total individual income tax liabilities made by each proposed revision, assuming that the specified revision in each case is the last revision made in the law (i.e., if adjustments have been made for all other revisions.) In other words the amounts shown are the amounts of revenue which will be lost (+) or gained (-) if all proposed provisions are adopted except the one indicated. /1/
(Millions of dollars) New surtax rated $ + 575.0 Separate returns taxed at joint return rates + 297.0 New method of taxing capital gains and losses + 138.6 Reaction in personal exemptions + 98.5 Increase in earned income credit - 31.6 Limitation of deductions for contributions + 14.9 Carry-over of net deficits - 5.6 Foreign income of nonresident citizens + 5.0 Increase in maximum age of dependents - to "under 20 years of age" - 3.0 Reporting of loss of worthless stock as a regular capital loss + 1.0
FOOTNOTE TO TABLE
/1/ If two or more of the suggested proposals are not enacted into law the amount by which the revenue estimates must be reduced is not the sum of the amounts shown opposite each of the specified provisions. It will be less than that amount and will require a new estimate due to the interdependence of the estimates.
END OF FOOTNOTE TO TABLE
Comparison of estimated estate tax liabilities for returns estimated to be filed during fiscal year 1939 computed under the provisions of the Revenue Act of 1936 and under the August 1937 proposals of the Division of Research and Statistics for a Revenue Act of 1938 (Millions of dollars) Estimated estate tax Revere Act of 1936 $ 401.8 Estimated estate tax Revenue Act of 1938 1.084.9 _______ Increased liabilities due to Revenue Act of 1938 $ 682.7 Percentage increase in tax liability 169.9%
The following tabulation shows the estimated increase in these total estate tax liabilities made by each proposed revision, assuming that the specified revision in each case is the last revision made in the law (i.e., if adjustments have been made for all other revisions.) In other word. the amounts shown are the amounts of revenue which will be lost if all proposed provisions are enacted into law except the one indicated. /1/
(Millions of dollars) Revision of tax rate $425.1 Revision of Specific exemption 175.0 Tax on capital gains 125.0 Revision in deduction of charitable charitable bequests 50.2 Revision in deduction of insurance 33.5 Revision in deduction of property taxed within 5 years 14.1
FOOTNOTE TO TABLE
/1/ If two or more proposals are not enacted into law the amount by which the revenue estimates must be reduced is not the sum of the amounts shown opposite each of the specified provisions. It will be less than that amount and will require a new estimate due to the interdependence of the estimates.
END OF FOOTNOTE
TAX REVISION STUDIES, 1937
SUMMARIES OF FINDINGS AND RECOMMENDATIONS
In the following section there are presented collectively, for purposes of convenient reference, the summaries of the findings and recommendations respecting each of the taxes examined. These summaries, copies of which are included also at the beginning of the separate volumes of the Tax Revision Studies, outline briefly the criteria which governed the examination of the tax structure. They indicate also the major considerations affecting the recommendations and state the specific recommendations themselves.
The detailed treatment of the various taxes will be found in the several volumes, as follows:
Volume II - Income, Capital Stock, and Excess-Profits Taxes.
Volume III - Capital Gains Tax.
Volume IV - Undistributed Profits Tax.
Volume V - Estate and Gift Taxes.
Volume VI - Excise Taxes.
TO: Mr. Magill FROM: Mr. Haas Subject: TAX REVISION STUDIES, 1937: INCOME, CAPITAL STOCK, AND EXCESS-PROFITS TAXES
SUMMARY OF FINDINGS AND RECOMMENDATIONS
In the accompanying memorandum consideration, viewed primarily from an economic standpoint, has been given to certain features of the Federal income, capital stock, and excess-profits taxes. The proposals contained herein are predicated upon three objectives: (1) The placing of increasing reliance upon the progressive taxes, (2) the coordination of the individual and the corporate income taxes, and (3) the elimination of existing structural inequities. The more significant of the conclusions are as follows:
1. With a view to increasing the relative importance of the individual income tax in the Federal revenue structure and with a view to facilitating the elimination of less desirable regressive taxes, it is recommended that the level of the surtax rate schedule be increased. Specifically, it is proposed that the present rate schedule be replaced by a new rate schedule ranging from 3 percent on surtax net income of $3,000 to $6,000 to 75 percent on surtax net income of $5,000,000 and over. In addition to affording the individual income tax a larger role in the revenue structure, the proposed rate revisions will enable a more scientific distribution of the aggregate Federal tax burden and will impose a justifiable addition to the tax burden of the middle size incomes.
2. It is recommended that the present personal exemption of $1,000 for single persons and $2,500 for married persons, be reduced, respectively, to $800 and $2,000. This will broaden the individual income tax base, making it applicable to a substantially larger number of taxpayers and will, in addition, increase the burden upon individuals subject to surtax rates. Although a lowering of personal exemptions will increase Federal revenue, the recommendation is primarily prompted by the desirability of obtaining substitute revenue from the low income classes in a more equitable manner than is possible through the miscellaneous excise taxes. it is recognized that the eventual elimination of even the least desirable indirect taxes cannot be realized so long as the personal exemptions are maintained at a relatively high level.
3. Inasmuch as the lowering of personal exemptions to the levels of $800 and $2,000 might unduly burden the recipients of small incomes, it is recommended that the earned income credit be raised from 10 percent to 15 percent and that the limitation of the earned income credit to 10 percent of net income be eliminated.
4. The two existing corporate privilege taxes, the corporate normal income tax and the capital stock tax, are believed to be relatively high as well as defective. The corporate normal income tax allows corporations with a substantial volume of business to escape the privilege tax in years of unprofitable operation. The capital stock tax overcomes this difficulty as far as concerns the taxing of corporate privilege because it applies annually to both profitable and unprofitable business corporations. It, however, is deficient in its arbitrary determination of taxable base (adjusted declared value). In combination, the two taxes are inadequate for the taxation of corporate privilege because corporations with net income pay both taxes each year whereas corporations with no net income pay only the arbitrary capital stock tax. It is, therefore, recommended that the corporate normal income tax and the capital stock tax be repealed.
5. The present capital stock and excess-profits taxes were linked for the purpose of furnishing a base for a capital stock tax as a corporate privilege tax and for establishing a base for an excess-profits tax. Neither of these objectives were achieved. On three occasion. (Revenue Acts of 1934, 1935, and 1936) the corporate taxpayer has been enabled to determine that tax base which, considering the profitableness of its business, the fluctuations in such profits from year to year, and the prospects for repeal of these taxes, would result in the least aggregate amount of tax liability. Taxes which leave the taxpayer options of this character are undesirable. Furthermore, the present interrelationship of the capital stock and excess-profits taxes holds no promise of resolving the vexing problems associated with the establishment of an excess- profits tax base. It is, therefore, recommended that the repeal of the capital stock tax be accompanied by the repeal of the excess- profits tax. This, it is noted, will in no way jeopardize the opportunity of establishing a satisfactory excess-profits tax base for future use.
6. It is recommended that the present corporation normal income tax, capital stock tax and excess-profits tax be replaced by a new corporation privilege tax. The present corporation normal income tax favors corporations whose capitalization is made up of stocks and bonds, as against those with stocks only. Furthermore, the base for the existing corporation normal income tax favors corporations that rent business properties as against those that own them. Since a corporation privilege tax should properly tax corporations in accordance with the scope of their operations and in accordance with the return on the entire amount of capital operating in the business, but without regard to the character of the capital structure, it is recommended that for purposes of the new corporate privilege tax interest, rents, and royalties be disallowed as deductions and that the income of corporations include tax-exempt interest as well as inter-corporate dividends, rents and royalties.
7. The incomes of husbands and wives are not taxed as a unit under the present law. Husbands and wives may, at their option, file separate or joint returns. The husband and the wife may each report such income as is viewed to be theirs under State property laws. In community property States the usual division is one-half of the community income to each spouse; the practice followed in other States is less uniform. This results in interstate variations of Federal income tax burden. In addition, the use of separate returns enables wealthy husbands and wives to avoid high surtax rates, which would otherwise be applicable. If the incomes of husbands and wives be viewed as a unit, then to overcome the inequities resulting from the existing practice, it is recommended that when husbands and wives file separate returns, the tax liability should be determined on the basis of their aggregate income, prorated to each in accordance with the amounts of their separate incomes.
8. The present income tax base is determined primarily on an annual basis. Over a period of years and under existing progressive corporation and individual rates, this imposes a higher tax upon taxpayers receiving variable sources of income than upon those receiving stable sources of income, even though the aggregate amount of income received over the period is identical. This inequity might be rectified by averaging the income tax base for several years. Such a procedure, however, would produce much hardship during depression years when the average tax base exceeds the taxpayer's current income, out of which taxes for the most part must be paid. To accomplish some degree of averaging, it is recommended that the taxpayer's annual net losses be adjusted for non-statutory income items and carried forward for a two-year period.
To avoid impairment of revenue during depression years, it is recommended in the separate memorandum on Capital Gains and losses that for purposes of determining the carry-forward of capital losses, the most variable of the income items, capital gains and losses, be segregated, except with respect to the undistributed profits tax. Such segregation would tend to prevent capital losses from making inroads upon the taxes determined on ordinary sources of income.
9. The allowance of discovery value and percentage depletion is believed to discriminate in favor of oil and mining interests. These bases for depletion enable the taxpayers to recoup more than 100 percent of their investment in mining and oil properties. To limit the amount of depletion allowable to the capital invested, it is recommended that cost or March 1, 1913 value be the only allowable bases for the determination of depletion.
10. The surtax on gains from the sale of oil and gas properties prospected by individuals is limited to 30 percent of the sale price. A similar limitation had been in effect under the several revenue acts through 1932 but was eliminated under the Revenue Act of 1934, only to be restored in 1936. It 15 recommended that this limitation be repealed. This favored treatment of the oil and gas interests rests on the theory that the application of the full surtax rates to gains from such sales tends to discourage prospecting by individuals and discriminates against them by comparison with corporations. The first of these arguments can be discarded by reference to the fact that the Federal Government is finding it necessary to restrict production; the second carries little conviction since it applies equally well with respect to other capital gains.
11. The present personal holding company tax is deficient, for its overly precise definition of the personal holding company produces difficult administrative problems. This difficulty can be surmounted if holding companies receiving 80 percent of their income from specified sources of the type now included in the definition of personal holding company income (Revenue Act of 1937) are taxed on the entire amount of their undistributed profits, according to the concentration of control. Accordingly it is recommended that the rate schedule be graduated downward from 70 percent in those cases where control is concentrated in one to five individuals, to 10 percent in those cases where control is vested in the hands of more than fifty individuals.
12. The deductions on account of charitable contributions now allowable to estates and trusts seem to be excessive. The absence of limitation upon the deduction in the case of estates and trusts enables individuals to establish trusts for the sole purpose of administering charities, thereby avoiding the 15 percent limitation upon such deduction applicable to individuals. It is, therefore, recommended that the deduction for charitable contributions in the determination of the net income of estates and trusts be limited to 15 percent.
13. Partnership net income Is at present determined after the allowance of a deduction for charitable contributions up to the amount of 15 "percent of partnership income The partners, as individuals, are allowed a deduction for charitable contributions up to 15 percent of their net income, including their pro rat& shares of partnership net income. Thus, individual members of partnerships are permitted two potential deductions for charitable contributions. It is, therefore, recommended that in computing the 15 percent limitation for individual members of partnerships, such individuals include their pro rata share of the partnership contributions, and further, that instead of including their pro rata share of partnership income after the deduction for charitable contributions, their pro rata share be included before such deductions.
14. Taxpayers are now permitted to treat certain donations as business expenses under Section 23(a). By shifting the donations from allowable deductions under Sections 23(o) and (q) to expenses (23(a)), individual taxpayers and partnerships can free themselves of the 15 percent and corporations of the 5 percent limitation upon deductions for charitable contributions. To prevent such shifts it is recommended that the computation of the limitations for charitable donations be based on the total amount of donations, whether include& under expenses or under deductions.
15. Section 120 of the present law provides that if an individual donates amounts which together with certain taxes exceed 90 percent of his net income for each of ten years, then there is no limitation upon the deduction for charitable contributions made in subsequent years. In practice this provision applies to few, if any, taxpayers. In addition it would not operate equitably with respect to individuals with substantially similar but technically dissimilar records of large donations. It is, therefore, recommended that the section be repealed.
16. Employees' pension trusts, whether revocable or irrevocable, are now exempt from the income tax. Taxpayers are allowed certain deductions from the income tax base to support the employees' trust funds. In the case of revocable trusts, taxpayers are now enabled to shift income into such trust funds for the purpose of reducing current income tax liability and to recoup the amounts so shifted by subsequently canceling the terms of the trusts. Similarly, bankruptcy may intervene to make funds shifted to employees' trusts available to the general creditors rather than to employees. To prevent possibilities of tax avoidance through employees' pension trust, it is recommended that only irrevocable trusts be exempt from the income tax and only those of such trusts which, in the terms of the trust, provide for at least 75 percent of the employees of five year standing with salaries under $5,000 and provide further a plan for the distribution of the trust funds to employees in the event of liquidation.
17. At present the sale of a depreciated stock results in the realization of a capital loss, but if the depreciation is extreme so that the stock be comes worthless, the taxpayer is allowed a deduction against ordinary income to the extent of the basis for the worthless stock. This distinction between moderate and extreme depreciation in stock values is believed to be invalid for income tax purposes. It is, therefore, recommended that when stock becomes worthless, or approximately worthless, when it depreciates to, say, 3 percent of its basis, the taxpayer be allowed to include the loss among other capital losses reported for the year; and in case the worthless or near-worthless stock subsequently appreciates in value and is sold, the basis for such stock is to be the market value used in determining the capital loss.
18. Nonresident American citizens are allowed to exclude their foreign earned income from the gross income reported for Federal income tax purposes on the ground that the taxes imposed by foreign countries burden nonresident Americans to a point where any additional taxes on their earnings abroad would be unreasonable. This view is not consistent with the general framework of the Federal income tax and the system of credits allowable on account of foreign taxes paid. The basis for Federal income tax liability is citizenship, not residence. It is, therefore, recommended that so long as citizenship constitutes the basis for the tax, all citizens of the United States, whether resident or nonresident, be taxed on income from sources within and without the United States, and further, that international double taxation be voided by allowing nonresidents the same privileges as are now granted residents, e.g., afford tax credits on account of foreign income, war profits, and excess-profits taxes against the tax determined on the citizen's aggregate income. The consideration that most foreign taxes are not of the creditable type, is not germaine because resident citizens are also burdened with nondeductible taxes.
19. Building and loan associations are exempt from the Federal income tax. The exemption appears to be predicated on the assumption that these associations are nonprofit organizations and operate on a mutual basis. Actually, building and loan associations accept deposits at interest rates differing from those on capital contributed by different classes of shareholders. They may thus be said to be in competition with the banks. It is, therefore, recommended that building and loan associations be subjected to the Federal income tax, unless they can demonstrate that their operations conform to the standards of mutuality, upon which tax exemption is predicated. This recommendation will serve to make taxable all building and loan associations which accept deposits and guarantee a fixed rate of return, as well as those which pay a rate of return on founders', organization, or other special types of shares different from that paid on ordinary members' shares. In other words, a building and loan association's tax exemption is made conditional upon a test of mutuality: the payment of a uniform rate to all contributors of capital.
20. In order to relieve a liquidated subsidiary from the full impact of the undistributed profits tax on the adjusted net income accounted to date of liquidation, the Revenue Act of 1936 provided for the allowance of earnings and profits accumulated since 1913 for purposes of determining the dividends paid credit, despite the fact distributions in liquidation are not dividends and so not taxable as income to the recipients. This provision conflicts with the general policy expressed elsewhere in the law, that distributions not taxable to the recipients are not available for purposes of determining the dividends paid credit. The regulations respecting distributions in liquidation appear to lack adequate legal foundation. It is, therefore, recommended that Section 27(f) be repealed and that the law be clarified y,by making the' substance of Section 27(f) an exception to Section 27(h). This would enable the Bureau to substantially follow the present procedure with closer conformity to the explicit provisions in the law.
FROM Mr. Haas Subject: TAX REVISION STUDIES, 1937 -- TAX TREATMENT OF CAPITAL GAINS AND LOSSES SUMMARY
1. The subject ion of income derived from capital gains to the progressive income taxes is justifiable on economic, equitable and practical grounds. From the standpoint of taxation, the kind of income that is relevant and significant is the income that measures taxpaying ability. Capital gains constitute real taxpaying ability no less than equivalent income derived from other sources.
2. The tax treatment of capital gains and losses in great Britain, France and Germany provides no satisfactory model on which to build a system for the United States. In each country, the differentiation of taxable from non-taxable gains is by a process so arbitrary as to create severe inequities between taxpayers of substantially identical circumstances bait with unimportant differences in the form of income received. Moreover, there is a strong inducement to taxpayers to convert taxable income into non- taxable gains, thus making tax considerations an extremely important, influence on investment activities and policies.
3. The tax treatment of capital gains and losses of individuals in the United States has ranged from the complete inclusion of capital gains and losses in the tax base in the years 1918-1921, to the present treatment which includes in taxable income certain percentages of capital gains and losses (subject to limitation) which vary with the years assets have been held. From 1922 to 1933, the taxpayer was allowed, at his option, to segregate from his ordinary income the gains from assets hold more than two years, and subject them to a 12-1/2 percent flat rate. Losses from assets held more than two years could likewise be segregated, except for l922 and 1923, and allowed a tax credit of 12-1/2 percent subject to certain limitations. Gains and losses from assets held two years or less were included in ordinary income.
4. The existing tax treatment of individuals is inequitable as respects both gains and losses. It is not intolerable as respects capital gains, however, and in this respect is greatly superior to the treatment that it displaced. The limitation on capital losses, however, is 50 unjust as to be indefensible.
Capital gains are now given decidedly preferential tax treatment. as compared with other sources of individual income. Wealthy individuals, especially, are offered an extremely strong tax inducement to make their new investments in such manner as will permit their returns therefrom to take the form of capital gains.
The chief effect of the present system on the securities markets arises through the influence on timing. At the option of the taxpayer, income taxes on capital gains may be POSTPONED by delaying the formal realization of gains, REDUCED by deferring formal realization until one or more of the four "step-down" intervals provided in the law has elapsed, and COMPLETELY AVOIDED by foregoing formal realization, leaving such realization to be accomplished by the taxpayer's heirs.
5. Although the influence of tax considerations is real, their effects upon the movements and volume of activity of the securities markets are far less substantial than is often contended. The bulk of capital assets is relatively insensitive to the character of our capital gains taxation. This is true of the part held quasi- permanently for purposes of control and income. It is also true of the part employed in the short-term operations of traders and speculator5, operation which normally account for a large fraction of the total trading in listed securities. For intermediate-term speculators and investors, tax considerations necessarily operate among a welter of other factors which usually provide stronger incentives to action.
The available statistical evidence, though by no means conclusive, does not support the contention that the tax treatment of capital gains since 1922 has been of more than modest influence upon the level and activity of the securities markets. The underlying business situation and the related speculative temper of the times are primarily responsible for stock market booms and collapses.
6. The capital gains and losses of corporations have not created tax problems in any way similar to those of individuals. special treatment was not needed as long as there was a relatively low flat corporation income tax; and the enactment of graduated rates beginning in 1936 created no practical problem, because the range of graduation is relatively narrow.
Imposition of the surtax on undistributed profits has raised a new problem for corporations with respect to the tax treatment of capital gains and losses. If the capital gains of good years must be paid out currently to avoid surtax liability, but no carry-forward of the capital losses of bad years is allowed, the tendency over a period of years will be to shrink the value of capital assets. The most practicable method of minimizing or eliminating this tendency appears to be that of allowing net capital losses in full as a deduction in computing adjusted net income, with a carry-forward for two years of any excess losses.
7. It is recommended that capital gains and losses of individuals be subjected to tax treatment on the basis of what may be called the average accrual method. According to this method the amounts of gain and loss realized are averaged separately over the number of years the assets were held, and taxed at rates determined on such average amounts when added to ordinary income. The increment of tax resulting on the average gain and tax credit on the average loss are multiplied by the average number of years respectively the assets were held, and the combined products represent the tax on capital gains The objective of the plan is to recognize more adequately the fact that the realized gains and losses frequently accrue over several years.
In more detail the procedure under this method is as follows:
a. Capital gains are segregated from capital losses. The average investment period for gains and the average annual gain during this period are determined; and the average investment period for losses and the average annual loss during this period are determined.
b. The average annual gain and the average annual loss are combined to determine a net-average gain or loss applicable to the shorter of the two investment periods. The tax or tax credit on the resulting figure is computed with reference to the surtax net income, and this tax or tax credit is multiplied by the number of years in the shorter average investment period to determine the tax or tax credit on capital gains and losses during this period.
c. The tax or tax credit on the average annual gain or the average annual loss, whichever accrued for the longer average investment period, is computed with reference to the sur-tax net income, and multiplied by the number of years by which the longer average investment period exceeds the shorter, to determine the tax or tax credit applicable to those years.
d. The taxes or tax credits thus obtained are combined, the result representing the total tax or tax credits on capital gains and losses. Any unused tax credit is carried forward for two years, to be allowed only as an offset against tax liability on capital gains realized in dose years.
e. In computing the tax, no allowance is given for any portions of the personal exemption, credit for dependents, or minimum earned income credit not utilized in commuting the ordinary income tax. If there is no surtax net income, the tax or tax credit is computed, assuming surtax net income to be zero rather than a negative quantity.
If legally feasible, contribution to charitable and similar institutions should be regarded as occasioning the realization of capital gains and losses by their donor; and such capital gains and losses should be included with other capital gains and losses for purposes. If this is not feasible, it is recommended, for purpose of determining the deduction for charitable contributions, that the value of such contributions in kind be fixed at the adjusted basis (Section 113) or market, whichever is lower.
If legally feasible, transfers by inter vivos gifts should be regarded as occasioning the realization of capital gains and losses by the donor. If this proposal is not deemed feasible, it is suggested that a supplementary gift tax be levied, measured by the capital gains and losses incorporated in such transfers. In the event that this should also be unacceptable, it is recommended that, for the purpose of determining both capital gains and losses, the basis for property acquired by gift be made either the base in the hands of the donor or market value at time of transfer, whichever is lower.
It is recommended that the capital gains and losses of corporations be included in ordinary income in full, except that for purposes of determining the normal-tax net income, capital losses be allowed only to the extent of capital gains. Any excess of capital losses not allowed in the current year in determining normal-tax net income is carried forward for two years to be credited against the capital gains of those years. In determining adjusted net income capital losses are allowed in fill against income from any sources. Any excess of capital losses not so utilized is carried forward for two years for use as a deduction in determining adjusted net income of those years.
8. Next to the recommended average accrual plan, the most superior alternative would be a continuation of the present five-step system with an improved scale of percentages designed to approximate more closely the resulting taxes to taxes applicable to other sources of income; and with a liberalization of the present loss limitations.
All of the other alternative tax treatments of the capital gains and losses of individuals possess weaknesses which make their adoption unwise.
The undistributed profits tax will tend to diminish one important source of capital gains, but will leave a number of other sources unaffected. Hence it does not obviate the justification for the tax on capital gains.