Let the annual net income be                   $ 1.00
         Let the capital stock be declared at            10.00

There will be no excess-profits tax since net income equal to 10 percent of the value of the capital stock, that is, $1 is exempt.

The capital stock tax is 1/1000 x $10 = $0.01

If the value of capital stock were made 10.1 x net income, the excess-profits tax would still be zero but the capital stock tax is increased to $0.0101.

If the value of the capital stock were made 9.9 x net income, then:

         The capital stock =                        $0.0099
         Excess-profits tax = 6/100 x ($1 - 0.99) =  0.0006
              Total tax                             $0.0105

In other words, if fixed annual earnings are assumed, the combined tax will be a minimum when the declared value of capital stock is ten times earnings.

Because earnings are not fixed but fluctuate, each taxpayer may be tempted to enter upon a more complex computation based upon his prediction of the irregularity of the income peculiar to his own business. He has now entered a hazardous no-man's land in the realm of estimates. The significance of the venture can be demonstrated by an example:

                                           Company A      Company B
                                           ---------      ---------

Declared value of capital stock
 year ending June 30, 1936                $1,000,000     $1,000,000
Annual income each of the first
 nine years                                  100,000         none
Income in the tenth year                     100,000      1,000,000
Average annual net income for
 the ten-year period                         100,000        100,000
Capital stock for the ten-year
 period                                       10,000         10,000
Excess-profits tax for the
 ten-year period                              none          105,000
                                          ----------     ----------
Total of both taxes for the
 ten-year period                          $   10,000     $  115,000

It is true that such inequities due to variations in the stability of net income among business firms would be characteristic of any excess-profits tax imposed on a yearly basis rather than on some base that averaged the profits of several years. Further, it may be argued that the present procedure has the merit of giving the taxpayer an opportunity to surmount the inequities of an excess-profits tax imposed on a yearly basis by allowing him to declare that value for his capital stock which for the peculiar distribution of the profits of his business over the years will reduce the aggregate of the taxes to a minimum. Such argument is not convincing, however. What is more likely is that the taxpayer's efforts to accomplish such a reduction in the aggregate tax load will result either in a staggering burden of taxes or at least in a burden disproportionate to the taxes which would have resulted if less discretion had been allowed him in establishing the value of his capital stock.

Some taxpayers will make an honest effort to declare the true value of the capital stock. Others will perhaps just as honestly match their wits with the lawmakers in an effort to reduce the combined load from the two taxes to a minimum, taking into consideration the probable life of business. Obviously between the two broad groups of taxpayers, those who seek to establish true capital value and those who seek to establish a capital value with an eye towards reduced taxes in the future, there is apt to be a wide gap.

Then, as for the latter group, there will be great differences among the taxpayers themselves or among their hired experts in their efforts to forecast the fortunes of their business so as to declare a capital value which over the life of the business will keep the two taxes in combination down to a minimum. Temperamental differences alone, aside from variations in sheer forecasting capacity, would account for substantial inequalities in the tax load.

The link between the two taxes was forged to avoid the heaping up of litigation and to avoid extremely difficult administrative problems that would have emerged had the Government undertaken a valuation of all business assets, either through direct appraisal or through review of accounts submitted on tax returns for the purpose of showing the original amount of capital paid in and all subsequent adjustments on the invested capital of business.

Although the objective of the present combination of capital stock and excess-profits taxes can easily be understood, it is doubtful whether taxes that induce taxpayers to strain not merely with valuation problems but with the prospects for the repeal of the taxes, the prospects for business profits and the probable nature of the distribution of business profits over the years, can be anything less than whimsical. Some taxpayers will rely more largely than others on repeal of the taxes within a given period; some will prognosticate the future profits of their business better than others; some will guess or estimate the distribution of the profits over the years more accurately than others; but many, with or without the hire of experts, will have blundered into declarations of value for their capital stock which will penalize them for many years to come. It is extremely difficult to justify taxes with a base so lacking in objectivity as are the existing capital stock and excess-profits taxes. For this reason it is recommended that they be repealed.

c. The Proposed Corporation Privilege Tax

To achieve coordination between the personal and corporate taxes it is proposed that the present corporation normal income tax, the capital stock tax and the excess-profits tax be replaced by one corporation privilege tax. Corporate privilege can best be measured by taking into consideration the TOTAL CAPITAL employed in the business irrespective of whether derived from bond or stock issues and irrespective also of whether the corporation owns or rents its business properties. Accordingly for the purposes of the new privilege tax it is proposed to modify the base employed in conjunction with the present corporation normal tax in the following respects:

(i) Disallow the statutory deductions for interest, rent and royalties;

(ii) Disallow the credit to the extent of 85 percent of dividends received from other corporations; and

(iii) Include tax-exempt interest in the taxable base.

The present base for the corporation normal income tax appears to be unsatisfactory, primarily because it results in discrimination in favor of corporations whose capitalization includes bonds and against those whose capitalization is made up entirely of stock. If the corporation tax is to be a privilege tax, then the tax should relate to a base which reflects the return upon the corporation's entire capital and which is more closely related to the scope of its operations than the statutory net income employed for the present corporate normal income tax. The base should be such as to make the tax apply equally to corporations with similar scope of operations irrespective of whether such corporations own their business properties or operate rented properties.

The disallowance of the deduction for interest, rent and royalties will not altogether attain this latter objective because if rent and royalties are disallowed, then it would seem proper to disallow the deduction of at least a portion of taxes and depreciation. Such procedure, however, is not feasible because it is impossible to arrive at any satisfactory solution of precisely what proportion of taxes and depreciation should be disallowed in order to be equal to the component of such items in the disallowed rent. This component is known to vary for different types of property and as between properties in the same type of industry but situated in different parts of the country. Altogether, however, the failure to achieve complete parity between the owners and renters of business property does not detract seriously from the proposal.

Such changes in taxable basis as are here proposed, it should be noted, are fully within the competence of the legislature. The Supreme Court has consistently sustained the power of Congress to specify allowable deductions in computing net income. It only remains therefore to appraise these proposals in the light of economic considerations.

The proposal raises two serious problems. The first of these concerns the period of transition. The present procedure, followed from the beginning of the Federal income tax, has unduly favored the indebted corporations. A sudden reversal of policy, by disallowing the deduction of interest, may seriously hamper the operation of companies with substantial amounts of outstanding debt unless, in the transition period at least, the tax rates were made moderate. Similarly, companies with outstanding long-term rental and royalty contracts might become seriously embarrassed if the new base were adopted in combination with a high rate. In other words, during the period of transition from the present normal income tax base to the proposed corporation base, it is necessary to take some precautions lest the dislocation occasioned by the change in base seriously disrupts business equilibrium.

The second problem involved in the proposal concerns the taxation of inter-corporate items. The proposed tax would, in effect, bring much pressure to bear upon holding companies and other types of affiliates because the proposal is to include interest, rents, royalties and dividends in full as sources of corporate income. Dividends received by corporations prior to 1936 had always been excluded completely from the sources of corporate income. Under the Revenue Act of 1936, 85 percent of such dividends were excluded. Under the proposal none of such dividends will be excluded. In other words, inter-corporate dividends, rents, etc., will be taxed at least twice within the system of the proposed corporation tax and possibly several additional times if there are intermediary corporations. Furthermore, dividends will be taxed in full under the individual normal and surtax rates.

The proposal to tax inter-corporate items in full and to continue the practice adopted in 1936 of taxing dividends under the normal individual income tax is entirely consistent with the view that the new tax is a corporate privilege tax. So long as the rates are kept moderate, it would seem perfectly proper to disregard the fact that the intercorporate income items might be taxed several times and will be taxed at least twice. If, however, the rate is not moderate, then it will be difficult to disregard this fact. In other words, irrespective of the name of the new tax, if the rate should be high, then it would be necessary to invoke the conduit view of the proposed tax and to look to the interests ultimately affected. On this basis the tax will not bear analysis. It has merit only as a corporate privilege tax and it would cease to be such unless the rate is moderate.

Since the basis for the new tax is corporate privilege, it would seem proper to include among the sources of income, tax-exempt interest because failure to include it makes it impossible for some companies, principally banks, to reflect adequately the scope of their operations -- and so the corporate privilege. It is interesting to observe that a few States, including New York State, tax what is otherwise regarded as tax-exempt interest as part of the corporation income tax base. The proposal to include such interest in the new tax is not, therefore, without any precedent. The advisability of including such interest would depend upon factors other than taxation, namely, upon legal considerations and especially upon the probable effect of the change upon the Federal Government's bond market. If this tax-exempt interest cannot be taxed for one of several reasons suggested, then it is recommended that at least expenses incurred in connection with the receipt of such tax-exempt interest be disallowed as a business expense.

The proposed new corporation tax base will serve likewise for purposes of the undistributed profits tax and the tax liability under the proposed corporate privilege tax will be allowed as a deduction for purposes of establishing the adjusted net income in the same way as the corporate normal tax is now allowed. Similarly, all the amounts paid out by the corporation, such as interest, rents and royalties, will be credited in the same way as dividends are now credited for purposes of determining the undistributed net income. The proposed treatment of corporate enterprise should result in a rational relationship between the taxation of the individual and the taxation of corporate enterprise.

The base for the corporate privilege tax would not reflect satisfactorily the corporate privilege in the case of companies whose income is almost exclusively investment income. The income of investment trusts (and to some extent also of insurance companies) comprises almost exclusively intercorporate sources. To treat investment companies in the same way as other corporations would impose upon them an undue burden not commensurate with corporate privilege. To treat such companies equitably by comparison with others it is necessary to consider part of their income purely on a conduit basis. It is suggested, therefore, that the technique now employed with respect to mutual investment companies be adopted. In other words, all the income received, whether in the nature of intercorporate items or not will be included in the corporate privilege tax base of investment companies. To relieve them from the full impact of the corporate privilege tax they may be allowed to credit against the base not the full amount of dividends paid, as is the case with mutual investment companies at present, but some percentage which, if desirable, could be made to vary according to the types of investment companies.

3. Joint And Separate Returns

It is proposed that if a husband and wife living together file separate returns, the total tax of the husband and wife shall be computed on their aggregate net income and assessed to each in accordance with the ratio of their separate net incomes to the aggregate net income.

Section 51(b) of the Revenue Act of 1936 provides that:

"If a husband and wife living together have an aggregate net income for the taxable year of $2,500 or over, or an aggregate gross income for such year of $5,000 or over -- (1) Each shall make such a return, or (2) the income of each shall be included in a single joint return, in which case the tax shall be computed on the aggregate income."

Assessment of the income tax upon husbands and wives has presented a perplexing problem of equitable administration throughout the life of the income tax system. The problem has been to determine whether or not joint returns of husbands and wives living together should be treated as one or as two separately taxable incomes.

In practice, husbands and wives filed either joint or separate returns under the earlier revenue acts, but the option granted husbands and wives living together to file either joint or separate returns was not specifically provided in the earlier laws. Such a provision appears for the first time in Section 223 of the Revenue Act of 1918. The procedure under the earlier acts indicates that the returns of husbands and wives living together presented difficult problems regardless of the type of return that they chose to file. These problems centered on the question whether the returns of husbands and wives living together constituted a unit or whether they were returns of two incomes, taxable separately, even if reported on a single return. There was some confusion. At the very beginning, the procedure for determining tax liability in some respects leaned away from the recognition of separation of interests of husbands and wives living together and in other respects seemed to recognize such a separation of interests.

Thus, under the Revenue Act of 1917, the graduated normal income taxes were assessed against the aggregate amount reported by the husband and wife WHETHER JOINT OR SEPARATE RETURNS WERE MADE. A consistent procedure would have required that the graduated surtax under the Revenue Acts 1913 to 1917 should have been assessed in a similar way, namely against the aggregate amount of income reported by the husband and wife living together, REGARDLESS OF WHETHER JOINT OR SEPARATE RETURNS WERE MADE. However, the procedure was not consistent.

The surtax under the earlier acts was assessed against the separate income of each except when joint returns were made by husbands and wives living together, in which case the surtax was usually assessed against the aggregate amount reported. However, the assessment of the surtax on the aggregate income did not seem to derive from any clear conception that a joint return is a taxable unit; it seemed merely to be more convenient in some instances to assess it in this manner. In instances where the income and deduction items reported by the husband and wife were carefully segregated in the joint return, the surtax was assessed separately for each.

The procedure now followed seems to have been moulded during the period 1918-1920 under the Revenue Act of 1918. The practice of joining the returns of husbands and wives for purposes of the graduated normal income tax, even though made separately, was discontinued and the practice of computing the surtax on the separate incomes when separate returns were filed, but on the aggregate income when joint returns were filed, was definitely established during this period. The practice was established that the tax should be computed on the separate incomes when separately reported and on the aggregate income when jointly reported.

Upon reexamining the implications of the procedure thus established the Federal Government has come to the view that the incomes of husbands and wives constitute a unit and should be taxed as such. The problem in its present form emanates from a United States Supreme Court decision /1/ in which it was held unconstitutional to impose a tax upon one person measured by the income of another. The law of the State in which a person resides determines the rights to income as between husbands and wives. Differences in State laws, therefore, have necessitated different treatment of the incomes of husbands and wives for Federal income tax purposes and have resulted in discriminatory treatment of such taxpayers living in different States, i.e., if their incomes are viewed as a unit.


/1/ Hoeper vs. Tax Commission, 248 U. S. 206.


The present practice in Federal income tax administration is to recognize the basis prescribed by State statutes for the separation of interests of husbands and wives. Eight States, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas and Washington, hold to the system of community property. In substance, the system of community property existing within these States allocates one-half of the community property and income to the husband and the remaining one-half to the wife. Some other States have adopted the common law which does not recognize any separation of property interests between husbands and wives. The wife's property at date of marriage, and all property and income that she might acquire after marriage, belong to the husband. Still other States have adopted variations of one or both of these legal systems.

The accompanying Table 7 indicates the extent to which husbands and wives avail themselves of the option to file separate returns. The income reported in community property returns added to the income reported by husbands and wives making separate returns in 1935 amounted to $2.4 billions out of $14.9 billions or 16 percent of the total income reported for purposes of the Federal income tax. It is apparent that the problem under consideration is of substantial importance.

 Table 7: Individual Returns for 1935 by Net Income Classes, Showing
       Number of Returns and Net Income by Family Relationship

                     Joint returns of husbands,
                     wives, and dependent
                     children and returns of
                     either husband or wife
                     if no other return           Community property
                     is filed                        returns /1/
                                        Number of returns

Under 5 (Est.) /2/          1,348,761
Under 5                       460,989
      5-6 /2/                   4,937                     108
      5-6                      88,484                   7,599
      6-10                    130,572                  12,874
     10-25                     57,316                   8,343
     25-50                      7,327                   1,632
     50-100                     1,396                     496
     100 and over                 244                      96

   Total                    2,100,026                  31,148

                                  Net Income (Millions of dollars)

Under 5 (Est.) /2/              3,254
Under 5                         1,726
      5-6 /2/                      27                       1
      5-6                         483                      42
      6-10                        973                      97
     10-25                        817                     122
     25-50                        242                      55
     50-100                        91                      33
     100 and over                  44                      22

   Total                        7,657                     372

                                                          Single men
                             Separate       Separate      and single
                             returns        returns       women --
                                of             of         heads of
                             husbands        wives        families
                                       Number of returns

Under 5 (Est.) /2/            31,063         27,737         427,029
Under 5                       37,865         52,725          29,469
      5-6 /2/                    493            374             867
      5-6                      5,278          3,665           5,946
      6-10                    16,785          8,766          11,192
     10-25                    20,996          8,523           6,925
     25-50                     7,719          2,545           1,278
     50-100                    3,026            880             378
     100 and over              1,130            344             126

   Total                     124,355        105,559         483,210

                                  Net Income (Millions of dollars)

Under 5 (Est.) /2/                65             42             751
Under 5                          120            130             110
      5-6 /2/                      3              2               5
      5-6                         29             20              32
      6-10                       131             67              84
     10-25                       328            130             101
     25-50                       265             88              43
     50-100                      203             59              25
     100 and over                248             77              30

   Total                       1,392            615           1,181

                              Single men
                              and single
                              women -- not     Estates
                              heads of           and         Grand
                              families         trusts        total
                                        Number of returns

Under 5 (Est.) /2/              606,396        16,166      2,457,152
Under 5                       1,024,483        12,214      1,617,745
      5-6 /2/                       174            17          6,970
      5-6                        13,418         1,282        125,672
      6-10                       24,119         2,892        207,200
     10-25                       18,631         2,830        123,564
     25-50                        4,615           913         26,029
     50-100                       1,517           340          8,033
     100 and over                   564           143          2,647

   Total                      1,693,917        36,797      4,575,012

                                  Net Income (Millions of dollars)

Under 5 (Est.) /2/                  709            17          4,838
Under 5                           1,863            28          3,977
      5-6 /2/                         1               /3/         59
      5-6                            73             7            666
      6-10                          184            23          1,559
     10-25                          280            43          1,821
     25-50                          157            32            882
     50-100                         102            23            536
     100 and over                   115            36            572

   Total                          3,484           209         14,910

                         FOOTNOTES TO TABLE

     /1/ The community property returns exclude separate returns of
husband and wife showing community property income where the net
income is under $5,000; joint returns of husband and wife on which
the net income is under $10,000; and returns of net income of $10,000
and over not designated as returns of community property income. The
returns excluded are classified, according to the status shown, as
joint returns of husbands and wives or separate returns of husbands
and wives. In tabulating joint returns showing community property net
income of $10,000 and over, the data are divided to represent two
community property returns, the net income of class for each of the
separate returns being one-half of the combined community income.
Separate returns of husbands and wives showing community property
income of $5,000 and over are classified as community property
returns by net income classes according to the net income on each

     /2/ Nontaxable returns. Specific exemptions from normal tax and
surtax exceed net income.

     /3/ Less than $500,000.

                          END OF FOOTNOTES

The division of the total income between the husband and wife results in a reduction of the total tax paid to the Federal Government. As a result of the double use of the lower brackets, the surtax rates applicable to the separate parts are not as high as the surtax rates that would apply to the whole income. Furthermore, the total Federal income tax of a husband and wife residing in one State may differ from that of a husband and wife residing in another State, even if identical amounts of income were received in each instance.

Specifically, no advantage accrues to married residents (without dependents) of community property States under the existing law so long as their taxable net income before personal exemption does not exceed $6,500. On incomes in excess of that amount, a tax advantage appears which gains in significance as the size of the income increases. While it amounts to only $40 in the case of $7,500 incomes, the advantage increases rapidly with the size of incomes, reaching almost $70,000 on incomes of $1,000,000. The extent of the tax advantage accruing to married residents of community property States on incomes of specified size is presented in Table 8. The contrast is greatest between community property States than the others, but there are substantial variations among all the States -- even among the eight community property States.

                               Table 8

               Federal income tax liability on incomes
of specified size in community and non-community property States /1/

                                  Income tax liability
     Net income       ---------------------------------------------
  before exemptions                       Community property States
   (In thousands        Non-community     -------------------------
     of dollars        property States      Amount     Advantage

     $    3,500           $     26         $     26    $      -
          5,000                 80               80           -
          7,500                210              170          40
         10,500                458              278         180
         20,500              1,664            1,118         546
         52,500              9,644            6,028       3,616
         76,500             19,484           11,708       7,776
        102,500             33,944           19,288      14,656
        202,500             96,944           67,888      29,056
        302,500            163,944          129,888      34,056
        402,500            233,944          193,888      40,056
        502,500            305,944          259,888      46,056
        752,500            490,944          432,888      58,056
      1,002,500            680,944          611,888      69,056

                          FOOTNOTE TO TABLE

     /1/ Tax computed on basis of $2,500 exemption for married
persons and maximum earned income credit.

                           END OF FOOTNOTE

To remove these differences it is proposed that the tax be computed on the aggregate net income of both spouses, even though they file separate returns, and assessed to each in accordance with the ratio of their separate net incomes to the aggregate. The decision in Cole vs. Commissioner may have some bearing upon the possibility of this procedure. This proposal would impose the tax uniformly on total net income of all returns of husbands and wives regardless of the State in which such persons reside. By thus effecting uniformity of assessment, this proposal would bring about greater equity within the income tax, both by the elimination of discrimination and by eliminating the possibility of avoiding high surtax rates by wealthy families. Moreover, since the tax would be computed on aggregate net income of both husbands and wives, adoption of this proposal would result in increased income tax revenues.

4. Carry-Forward For Annual Net Losses

It is generally recognized that the income tax would be more equitable if it could be based on the average income over a period of several years. Some obvious administrative difficulties, however, render the use of an average base impractical. The most important objection, perhaps, is that its use is grossly inconvenient for the taxpayer who is confronted during depression periods with a sizeable tax liability based on a preceding prosperity.

For many years the British experimented with an average tax base, employing a different number of years for different kinds of income and taxing some kinds of income on an annual basis. They did not employ an average base for the individual surtax, however, and in general the use of the average base was relatively unimportant except with respect to Schedule D which applies to the profits of trades, business and professions. Prior to the taxable year beginning April 6, 1927, the tax in this schedule was assessed on a three-year average base.

In the Finance Act of 1926 (aside from certain provisions which were made to facilitate the transition from the three to the one-year basis) this procedure was abolished. Simultaneously, however, a provision was enacted which allows business losses to be carried forward for a period of six years. This liberal carry-forward of losses may be regarded as a substitute for the averaging procedure. In a similar manner, the net loss provisions in our Revenue Acts 1921-1932 (which were discontinued by the N.I.R. Act) gave partial effect to the averaging of income.

Under these net loss provisions (subject to certain exceptions and limitations) net loss was defined as the excess of the deductions allowed over gross income. The exceptions and limitations were designed to limit the net loss to be carried forward to the losses from trade or business. They were designed also to make a more realistic accounting of the loss sustained by the taxpayer than resulted from the computation of the excess of statutory deductions over statutory gross income. For example,

(a) The deduction for depletion, under statutory deductions, included deductions on bases that were in no clear way related to the true depletion charges to which the taxpayer is entitled, that is, they included depletion under the percentage and discovery value bases. The deduction for purposes of determining net loss, however, were more realistically limited to those based on cost or March 1, 1913 value.

(b) The gross income did not include certain tax-exempt interest. Such interest was included for the purpose of determining the net loss to be carried forward. These adjustments reflect, in a sense, what the legislators themselves thought of certain provisions of the income tax law employed in the determination of statutory net income. In the case of interest excluded from gross income, the obstacle is a constitutional one and so beyond speedy remedy. In other instances, it would seem proper to amend the laws so as to make the statutory concepts reflect more closely the true economic position of the taxpayer.

Capital losses were carried forward as a component of net loss in different ways under different revenue acts and differently as between individuals and corporations in the manner which is described in detail in the separate memorandum on Capital Gains and Losses.

Certain of the adjustments on net deficits that formerly were necessary for the purpose of establishing a net loss, which more accurately reflected the accounting of income for individuals and corporations, will not be required if the revisions suggested in this memorandum are adopted. For example, the need for the adjustment with respect to inter-corporate dividends will disappear if the proposed corporation tax base, which includes 100 percent of inter-corporate items (dividends, rents, royalties, interest), is adopted. Similarly, the adjustment for depletion will no longer be required if the bases for depletion are restricted, as herein proposed, to cost or March 1, 1913 value. The adjustment for tax-exempt interest, however, will still be necessary because it is not possible as yet to surmount the constitutional obstacles to the taxation of tax-exempt interest under the individual income tax. But even this adjustment may not be necessary with respect to corporations if it proves feasible to include tax-exempt interest in the new corporation tax base.

In addition to the carry-forward of adjusted net deficits of individuals and corporations for a period of two years, capital losses will be carried forward for a corresponding period in the manner detailed in the memorandum on Capital Gains and Losses. Briefly, in the case of individuals the capital loss is converted into a tax credit in the year realized and, to the extent not offset in the current year by taxes on capital gains, is carried forward as a tax credit against the tax on capital gains of the two succeeding years. In the case of corporations, for purposes of the privilege tax, the capital losses are allowed as an offset in full against capital gains in the current year, but not against any ordinary income. The excess of the capital losses over capital gains is carried forward to the next two succeeding years to be allowed as an offset only against capital gains realized in those years; and for purposes of the undistributed profits tax, capital losses are allowed in full to offset against capital gains plus ordinary income in the current year and any excess not so offset is carried forward for two years to offset the capital gains plus ordinary income before determining the adjusted net income for the undistributed profits tax of those years.

The enactment of the proposal to carry forward adjusted net deficits of individuals and corporations and to carry forward capital losses for two years will go far towards establishing the income tax on a more equitable basis. Variable sources of income will thereby be placed on a more equal footing with the more stable sources of income and taxpayers who are the recipients of variable sources of income will no longer be discriminated against as they are under the present system, which taxes income strictly on an annual basis without any averaging whatsoever and without any approach to averaging which results from the use of carry-forward of losses.

In the event that the revenue implications of this proposal are found to be such that for practical reasons it could not be included in the revenue revision for 1938, then it is suggested that the proposal be enacted with a limitation. It may be provided, for instance, that the carry-forward of the cumulative losses should in no one taxable year be allowed to reduce the net income of individuals or of corporations by more than 33-1/3, or perhaps 50 percent.

5. Restriction Of Bases For Depletion

It is proposed to amend Section 114 so as to limit the amount of depletion to the cost basis of the property or its 1913 value.

The general rule with regard to depletion is that provided in Section 114(b)(1) of the Revenue Act of 1936:

"The basis upon which depletion is to be allowed in respect of any property shall be the adjusted basis provided in section 113(b) for the purpose of determining the gain upon the sale or other disposition of such property***."

The exceptions to this general rule are:

(a) Discovery value in the case of mines other than those producing coal, metal or sulphur.

This basis, applicable when the market value of the property at or within thirty days of discovery is materially disproportionate to the cost, dates from the Revenue Act of 1918 and originally applied also to other mines, oil and gas wells. Its scope was restricted by the Revenue Act of 1926 which limited it to mines and again by the Revenue Act of 1932 which limited it to its present scope so that it applies only to mines other than coal, metal or sulphur. The allowance for depletion on the discovery value basis cannot exceed 50 percent of the net income computed without allowance for depletion.

(b) Percentage depletion for oil and gas wells.

This basis dates from the Revenue Act of 1926. The allowance is 27 1/2 percent of gross income not in excess of 50 percent of the net income computed without allowance for depletion.

(c) Percentage depletion for coal, metal and sulphur mines.

This basis dates from the Revenue Act of 1932. The allowance is 5 percent in the case of coal mines, 15 percent in the case of metal mines and 23 percent in the case of sulphur mines but not in excess of 50 percent of the net income computed without allowance for depletion.

In isolated instances cost or 1913 value may still be the most favorable basis for depletion but percentage depletion has come to be used most extensively.

The use of discovery and percentage depletion bases enable the taxpayer to recover more than 100 percent of his investment tax-free, although the presumption is that the taxpayer is entitled to recover his capital but that any excess over the investment should be regarded as taxable income. The income tax provisions permitting the use of discovery and percentage depletion bases are tantamount to the granting of a bounty to the oil and mining interests. Such a bounty, even if justified on general grounds, should be granted directly, rather than in the nature of an income tax relief. The latter procedure tends to destroy the equity of the income tax.

In the first place, the enactment of percentage depletion did not bring about uniform treatment as between different types of mines and gas and oil wells. The percentages vary according to the type of property, 27 1/2 percent in the case of gas and oil wells, 5 percent in the case of coal, 15 percent in the case of metal and 23 percent in the case of sulphur properties.

In the second place, there is no necessary relationship between the aggregate depletion that can be taken under the several percentages and the cost of the property.

Thirdly, the oil, gas and mining group generally is treated more favorably than other types of business since business discoveries that increase the value of the business do not result in the creation of some artificial base corresponding to the discovery value or depletion base, of which the taxpayer is permitted to take annually some arbitrary percentage as a deduction from gross income.

The Federal Government could justly remove discovery and percentage depletion bases even if some circumstance such as war or other extraordinary demand dictated the stimulation of mineral and oil production. It can certainly justify the removal of these bases in circumstances that appear to have dictated governmental restriction programs for the purpose of protecting natural resources and market prices.

Further, the bases for depletion provided for in the exceptions to the general rule as stated in Section 114(b) were, under the revenue acts that first enacted them and under all subsequent revenue acts (except as hereinafter noted), simultaneously excluded from the basis for depletion recognized for the purpose of adjusting the cost or March 1, 1913 value for the purpose of determining the gain or loss from sale or other disposition of capital assets. This meant that the tax avoidance from excessive depletion charges taken under the discovery value or percentage of income basis could not be nullified at the time when the depleted property was sold, because these excessive depletion deductions had no bearing upon the computation of gain or loss upon the sale of mines, oil and gas wells. The Revenue Act of 1932 changed this procedure for 1932 and subsequent years by making the same depletion deductions applicable for both purposes with the exception that "where for any taxable year prior to the taxable year 1932 the depletion allowance was based on discovery value or a percentage of income, then the adjustment for depletion for such year shall be based on the depletion which would have been allowable for such year if computed without reference to discovery value or a percentage of income."

This change, introduced by the Revenue Act of 1932 and continued to date, will offset some of the tax avoidance from excessive depletion bases but cannot offset the tax avoidance that had accumulated on account of excessive depletion charges prior to 1932 nor can it shut off tax avoidance in the instances where the cost of the property has been more than completely charged off. The basis for depletion can be made most uniform and equitable if the exceptions to the general rule stated in subsection (1) of Section 114(b) and the subsections (2), (3), and (4) of Section 114(b) are repealed. If these amendments are enacted, then the bases for depletion would be limited to (1) cost, or (2) March 1, 1913 value of the property; and the subsidies in the shape of tax exemption that now accrue to the mining, gas and oil interests on account of excessive depletion allowances would be discontinued.

6. Tax Limitation On Income From Sale Of Oil And Gas Properties

It is proposed to repeal Section 105 of the Revenue Act of 1936 dealing with income from the sale of oil or gas properties.

Section 105 of the Revenue Act of 1936 provides that "in the case of a bona fide sale of any oil or gas property, or of any interest therein, where the principal value of the property has been demonstrated by prospecting or exploration or discovery work done by the taxpayer, the portion of the tax imposed by Section 12 (surtax on individuals) attributable to such sale shall not exceed 30 per centum of the selling price of such property or interest."