|Comparison Of Different Proposals
The proposal just mentioned apparently would require one person to pay tax on another's income and in some cases might raise the tax liability of one spouse because of the assessments' being affected by another person's income, and thus it would fall under the condemnation of the Hoper case and the fifth amendment. Moreover, it would not remove so many discrepancies as would the "B" /26/ proposal, inasmuch as many married couples in both community-property and other States would still be taxed on variously divided, instead of equally divided, aggregate family incomes.
The doubtful constitutionality of the Treadway proposal has been mentioned above (page 108). If upheld, it would lessen the existing discrimination in favor of certain citizens of community-property States as compared with those citizens making joint returns in non-community-property States. But discriminations would still exist if "property of a marital community" means common property of husband and wife exclusive of property owned independently by each spouse, because the taxable incomes of different couples who have the same aggregate income would not be the same owing to various sizes of independent incomes intering into the equal total. There would be other disparities also between couples in community-property States and those reporting separate incomes in non-community-property States, because of different divisions of income between husband and wife. If "property of a marital community" is inclusive of property owned independently by one spouse, the Treadway proposal creates a new discrimination, namely, one against citizens of community-property States in favor of those in the other States who would still be permitted to file separate returns and thereby reduce their tax liability. This disparity may be more than common though usually not so great as, the one that would be removed by the Treadway bill. It is of real significance however, and would cause much protest. The disparities of the two proposals mentioned above, or similar disparities, are involved in all the proposed solutions of the community-property income tax problem that the writer has examined. The "B" proposal appears to avoid all such discriminations, though it raises the question of proper relative treatment of single persons. Any desired solution of this latter question can be attained, however, by proper adjustments, as suggested above (pages 119-120). Moreover, it is believed that the optional provision of the "B" proposal overcomes the constitutional difficulties involved in all of the other solutions.
A Common Misconception. -- A point mentioned earlier that is persistently overlook is that the real issue is not one between the eight community-property States and the forty other states, as most of the witnesses from the community-property States and some others would make one believe. The great majority of taxpayers both in community-property States and in other states are not and would not be subject to surtaxes and would not be affected by the "B" proposal if the relative status of single persons were preserved by the adjustments suggested. The great majority of married persons would not be affected even without these adjustments for single persons. As a matter of fact, all taxpayers, except those in community-property and other States who have been securing discriminatory advantages heretofore, would stand to gain slightly either through reduced taxes or through increased Government services, because those previously favored would now pay on a parity with other couples -- that is, relatively more than in the past.
In summary, it may be said that those appreciably affected would be relatively few; those seriously affected would be still fewer because they would be found only in those cases where husband and wife each had a relatively large income and each filed a return. So it is this small group of large income receivers-many but probably not most of whom live in non-community-property States -- and not all the people nor even more than a small fraction of the taxpayers in any State that would be much affected by these proposals. Most of the proposals for joint-return solutions would have relatively small effect upon taxpayers in any but community-property States. The modifications would increase the taxes of a few rich citizens, but they are so few in number that the relief spread over the much greater numbers in those and other States would not be great. The total revenue to the Government, under certain proposals, however, might be of some significance, and important personal discriminations of various magnitudes -- some quite large -- would be removed.
SECTION VIII VARIOUS MATTERS
1. Consolidated Returns 2. Carrying Forward Losses 3. Capital Gains and Losses 4. Depletion and Depreciation 5. Improving Administration 6. Tax Appeals 7. Various Matters
1. Consolidated Returns.
Consolidated Returns. -- In the preparation of the 1934 Revenue Bill, the Ways and Means subcommittee recommended the abolition of the permission for affiliated corporations to file consolidated returns. This subcommittee argue that the filing of consolidated returns conferred substantial benefits on large groups of corporations by allowing, them to deduct the losses of one subsidiary from the gains of another and also by permitting the postponement of tax payments because "the profits on the product of the consolidated group passing through the hands of the different members of the group are not taxed until the product is disposed of to persons outside the group." The subcommittee said, further, that in the past the consolidated group did not have such a great advantage over the separate corporations, but that now, with the net loss carry-over denied, it would have a much greater comparative advantage. As explained in the section on the carrying forward of losses, this latter point is really a sounder argument for the permission to carry forward losses than for the prohibition of consolidated returns.
Mr. Magill appeared before the Ways and Means Committee and presented the Treasury arguments for the retention of consolidated returns (these were based mainly upon administrative considerations). Following this, the Ways and Means Committee recommends the retention of the privilege to file such returns, but coupled therewith the provision that corporations filing such returns should pay a tax of 15 3/4 per cent as compared with 13 3/4 per cent levied upon other corporations. This recommendation was accepted by the House and also by the Senate Finance committee, but on the floor of the Senate Messrs. Borah, Couzens, Norris, and others objected so strongly that the 1934 Law as enacted permits consolidated return with the differential rate for railroad companies only. A question that has already given difficulty is whether this provision applies to all railroads, electric and other, under the regulation of the Interstate Commerce Commission or not. This problem of consolidated returns has long been a matter of controversy. It was first made a requirement by the Government in connection with the administration of the excess profits tax. Such returns are necessary in order to get a true picture of the financial situation of most affiliated corporations. The elimination of them will result in various mergers, the substitution n of branches for subsidiaries, and the manipulation of inter-company transactions to shift gains and losses in order to reduce tax liability, though State tax and other laws will prevent some changes that might otherwise be made.
The proper auditing of the thousands of subsidiary returns will be a great additional burden upon the administrative personnel, which is already inadequate for the work that it now has. This means, in effect, that much of the needed auditing, cannot be done unless the staff is increased. Whether this law will have beneficial or injurious effects on business organization and management is uncertain. It is entirely possible that one of the purposes of those who sponsored this provision was to lessen the number of holding companies. Probably the new law will also lessen some undesirable tax avoidance, but at the cost of disturbance to business management, administrative difficulties, and an inequitable method of determining income. It is true, however, that many separate or independent business concerns are at a disadvantage as compared with the large group of affiliated concerns if the carrying forward of losses is denied. If a properly revised provision for the carrying forward of losses is restored, as recommended in another section of this memorandum, there will be comparatively little reason for prohibiting consolidated return -- in fact, there is much reason for requiring them.
The retroactive aspect of the new provision of the 1934 Act irritated numerous corporation officials, because many of them could not make promptly the changes that they wanted to make on account of this provision without reorganizing their systems of accounting. Consequently the full effects of the change will not be clear the first year.
Because frequent changes in the law are very annoying and upsetting, there is some doubt as to the advisability of repealing the new provision at once. Now that it has been initiated, it might be tried for two or three years, but, unless the results of the change are shown to be much more advantageous than seems probable, the permission or the requirement to file consolidated returns should be restored, coupled with the permission for all corporations and others to carry forward looses. The carrying forward of losses should, however, be provided for at once, and not be postponed while waiting for results under the new consolidated returns provision.
The fiscal aspects of this change are of some interest, even though the change may have been unwise on other grounds. At the time the bill was passed it was estimated that it would results in additional revenue of $20,000,000 in the current fiscal year and $35,000,000 in a full year of operation. Perhaps no one will ever know very exactly just what the fiscal or other effects might be because of the changes that will be made in organization, methods of accounting, etc., but Mr. White of the Statistical Section of the Income Tax Unit has assisted in the preparation of this memorandum by making a very interesting investigation of consolidated returns that throws light on the matter.
From an analysis of nearly 6,000 consolidated returns for the years 1930 and 1933 he ascertained for those years the losses of subsidiaries that had been deducted from the net profits of the several affiliated groups that could not have been deducted under the Act of 1934. Calculating the corporation tax upon that base, he estimated that the total extra revenue would have amounted to $118,402,500 in 1930 and to $58,525,000 in 1933; that is, those figures represent the estimated amounts of revenue that would have been gained in those years if the affiliated corporations had not changed their forms of organization, accounting, etc., because of not being permitted to file consolidated returns.
More details of Mr. White's estimates are given in the Appendix, pages 235-253.
2. Carrying Forward Losses
Carrying Forward Losses. -- The irregularity of income, the taxation of capital gains, the definition of the time of "realization", the handling of depreciation and appreciation, the cash versus the accrual method of accounting, the holding or distributing of corporation earnings in the form of dividends, all raise serious difficulties in the definition of income and the administration of a net income tax. For example, they raise such questions as: What is income? When is real economic income received? When is it administratively feasible to tax it? When is it legal to tax it? It makes a great deal of difference when income is "realized" for tax purposes, particularly under a system of graduated rates. The segregation of income into periods of one year each is really very arbitrary. It might be separated into periods of three years, ten years, or a lifetime, or into periods of one month, one week, one day, or one hour. To prohibit the carrying forward of losses from one year to another when income is very irregular is somewhat like prohibiting the carrying forward of losses in one quarter of the year in order to deduct them against gains in another quarter of the same year. Or, to take a more extreme case, one can conceive of taxing income on a daily basis or an hourly basis and prohibiting the carrying forward of losses.
The income tax is popularly supported primarily because it is thought to be in accord with the principle of ability to pay. To prohibit the carrying forward of losses flies directly into the face of this principle where incomes are very irregular, as they are in business and particularly as they are in connection with capital gains and losses. It is especially important to permit the carrying forward of losses, or to tax income on the basis of average years, or to follow some other method of smoothing out the irregularities. With steeply graduated rates it is obvious that it makes a great deal of difference whether an individual gets an income of $300,000 all in one year, or gets $100,000 annually for three years, or sustains losses of $100,000 in each of two years and then receives a net income of $500,000 in a third year. In each of the three cases his average is a net income of $100,000 per year. The British permission to carry forward losses for six years is fairer and goes much further than our practice at any time in the past.
If it is necessary for the Government to obtain more revenue, the proper way to do it is by some direct method such as the raising of rates or the reduction of personal exemptions, not by some inequitable and devious device that nullifies the foundation principles of income taxation and that causes general resentment among taxpayers whose sense of fairness cannot be outraged with impunity if the administration of a tax is to be reasonably successful. The main points suggested above apply forcibly to capital gains, a brief discussion of which is given on pages 133-136, and also to the problem of consolidated returns discussed on pages 125-130 /27/ and 235-253.
3. Capital Gains and Losses
Capital Gains And Losses. /28/ -- It is not desirable to ignore capital gains and losses in defining taxable income. Even the British are making some small modifications in the direction of American practice. The fluctuating yields of income taxes argue for improved policies with respect to the current expenditure of abnormal revenues and with respect to debt redemption or reserves. rather than for abolition of the taxation of capital gains.
The present restriction on the allowance of net losses is one of the worst "sore spots" in recent income tax legislation. It outrages the ordinary man's sense of fair play and serves to deter enterprise in the case of hazardous undertaking. This is of more importance now than usually because at the bottom of a depression entrepreneurs are too timid anyway.
Capital losses should be deducted if capital gains are taxable, and provisions for carrying forward losses -- both business and casual -- should be made if corresponding gains are taxed. Our present law violates these principles. The previous system of carrying forward losses, -- somewhat revised to cover other than business losses -- a system of averaging, or some other method, should be substituted for the present arrangement.
Furthermore, capital gains and losses should be distributed both more equitably and also more regularly so as not to cause such inequitable surtaxes, or such chances of tax avoidance for taxpayers having fluctuating incomes, or such fluctuations in revenue for the Government. These three purposes could be furthered by distributing gains and losses over the years of accrual and adjusting the tax for each year of accrual, say, not to exceed five, much as would be done in case a revenue agent discovered undisclosed revenue for past years -- instead of allocating all of such capital gains to the year of "realization" according to the new formula of the 1934 Act, which will cause great losses and needless fluctuations of revenue.
The plan suggested above is much like the Wood plan (See Senate Finance Committee Hearings, 1934, pp. 184 ff), though the Wood plan provides for taxing all of the "exceptional" capital gains accrued over, say, five years, at the rate that would apply to additional ordinary income of, say, one-fifth the amount. This feature of the Wood plan is somewhat less equitable than the one suggested above, which would distribute the capital gains and losses approximately over the years of accrual, but it makes the law somewhat easier to administer. There are other features of the Wood plan, including a 20 per cent limitation, that would make it virtually ineffective in actual practice.
Not only would the first plan suggested above be more equitable than the existing law, but it would also cause less manipulation with respect to years of realization. If losses were treated as negative income, as they should be, less revenue would be available than if they were disregarded, but it should be noted that the revenue results of the new graduated capital gains provision of the 1934 Act are likely to be very disappointing.
The extension of the use of the inventory method of determining income to cover all assets that can be valued reasonably well without too much difficulty is well worthy of serious study as a method of helping to solve the important problems involved in the taxing of capital gains. This method would lessen the accumulation of capital gains and losses in the years of "realization" and thus lessen the fluctuations in revenue and in surtax rates applying to the taxpayer. Income would be taxed when it accrued regardless of when the owner chose to "realize" it.
Strong administrative and constitutional objections are made to this proposal, and no doubt they are serious. But it has so much to be said for it from the standpoint of equity, from the standpoint of preventing tax avoidance, and from the standpoint of stability of revenues, that it has not been given the consideration it deserves. If this method could not be applied at once with respect to all classes of capital assets, it might be introduced gradually, first applying it to securities with ready markets and later progressively to other assets as the administrative force cleaned up such class previously undertaken. Even with the moro difficult classes of property, valuations once established could be kept up relatively easily from year to year. /29/
It is inappropriate to repeat here the substance of the Treasury's memorandum, the discussions before the Congressional Committee, and their reports concerning this subject while the 1934 Revenue Bill was being prepared; it is assumed that all serious students of this problem will examine them as a matter of course.
4. Depletion and Depreciation
Depletion And Depreciation. -- The writer has long been of the opinion that the depletion provisions of the income tax permit excessive deductions and are inconsistent with fair and sound income taxation. Proper recommendations of just what modifications should be made involve much special knowledge and a great deal of study, more than the writer has been able to give to this subject this summer. He therefore asked the Deputy Commissioner and the Assistant Deputy Commissioner if they would request the Valuation Division of the Income Tax Unit to prepare a brief memorandum on this subject. This statements, which follows(pages 254-261), is in general accord with the previous opinion held by the writer and is, of course, supported by much more extensive specialized knowledge and experience in this field.
It is recommended that this subject be given the adequate study necessary to formulate the exact terms of revisions that should be made.
It might be added that a thorough study of depreciation has not been made by the writer for reasons similar to those mentioned above in connection with depletion. Depreciation has even larger final importance than depletion, though the present law and practice do not appear to show such a large percentage of departure from sound theory and practice in the case of depreciation as in the case of depletion. Both subjects are, however, worthy of serious study by fresh minds cooperating with those who have had adequate technical and administrative training.
5. Improving Administration
Improving Administration. -- A limited inquiry among taxpayers, representatives of taxpayers, and others, such as has been possible within the time available, plus some previous observations and experience, have convinced the present writer that it would be wise for the Commissioner or the Secretary to make a rather thorough study of the possibilities of improving the administration of the income tax. It appears that the present personnel and administration are up to the standards or above those of the past, so that this is not an unusual criticism of the present situation, but it also appears that there are many on the present staff who are not up to the standard that should be maintained and that is necessary in order to secure the best results. The revenue agents in the field are key men in the administration of the tax. Though it appears that most of them are well qualified, it is unreasonable to expect that the talent and training required for the best performance of their duties can be secured for the compensation that some of them are paid. The testimony of some, both inside and outside of the administration, is to the effect that this service could be improved with much benefit to the Government. The Government could spend an appreciable amount for a more adequate force and for better talent in many cases and gain much in revenue collections. As a result of the short inquiry mentioned above, the writer requested the Deputy Commissioner to supply him with data indicating revenue results that might be expected from an addition of revenue agents to the staff, taking no account of the question of improving the quality of the staff throughout the force by weeding out the less efficient and substituting better-qualified men. The requested memorandum in letter form is appended hereto (pages 149-156). The facts stated therein, plus the results of the short inquiry mentioned above indicate that a considerable number of well-qualified men should be added to the staff. Before doing so, however, it would be well for the Commissioner or the Secretary, if not already sufficiently advised, to make a thorough canvass of the situation at once.
The application of the income tax in modern industrial society is necessarily a very complex problem. If anything like justice is to be obtained, particularly if large revenues are to be secured, it is impossible to put into the law sufficient specific provisions to cover all or even any very large fraction of the situation that will arise. Even if it were possible, it would be undesirable to do so. Rather, it is important to extend the policy of administrative discretion just as fast as the administrative personnel is qualified to accept such discretion, somewhat as is done in Great Britain. This is one of the reasons it is no important to have a well-qualified and adequate staff, which should, of course, also be free from political pressure. Moreover, it is necessary for the field and auditing staffs to do a first-class job in order to give proper support to the legal staff. Inadequate preparation of the factual background is one of the most serious weaknesses in the litigation of income tax cases as well in the preliminary conference and technical committee hearings. Moreover, properly improved handling of returns by the field and central staffs would lessen taxpayer ill will and greatly reduce the number of cases that have to be reviewed as well as expedite the reviews that would still be necessary. The extra expense, delay, and ill will occasioned by the present long-drawn-out excessive review system is inexcusable and would not be necessary with a properly improved administrative staff. The Government can make no more profitable investment than that necessary to maintain good administration.
Tax Appeals -- As is well known, the problems of review do not end in the Income Tax Unit or even in the Board of Tax Appeals. Appeals from the Board and from Federal district courts go to the Federal Circuit Courts of Appeal or courts of the District of Columbia. Decisions in different districts and even in different circuits are often in conflict.
Moreover, the artificial division of work between the legal staffs of the Bureau of Internal Revenue and of the Department of Justice is calculated to have a prejudicial effect upon tax administration. Under an executive order of June 10, 1933 all the control formerly exercised by the office of the Assistant General Counsel for the Bureau of Internal Revenue was transferred to the Department of Justice. Formerly the attorneys of the former office represented the Government not only before the Board of Tax Appeals but in civil tax cases up to and through the Circuit Courts of Appeal. The Department of Justice has always had jurisdiction over all criminal prosecutions and the preparation and argument of tax cases before the Supreme Court. Now their connection ceases after the cases leave the Board of Tax Appeals, except as they may be called into consultation by the Department of Justice or are requested to assist in the preparation of briefs.
This difficulty is overcome only in part by recruiting Department of Justice Tax attorneys from the Bureau staff, and the division of jurisdiction seems quite artificial and inefficient from several points of view. It vests in the Department of Justice, for instances, the determination of what decisions of the Board of Tax Appeals adverse to the Government shall be taken up to the Circuit Courts of Appeal or the courts of the District of Columbia for review. The point of view of the Department of Justice in this matter is apt to be influenced by different consideration from those that insurance the Bureau. The attorneys of the Department naturally desire to make as good a record as possible in the matter of cases won or lost. So does the legal staff of the Bureau, but it is also conscious of the fact that efficient tax administration often demands that controversial questions be clarified or put at rest as quickly as possible by authoritative judicial decision. It would, therefore, frequently favor appeals for this reason even in cases where the chances are great that the Government may lose.
The attorneys in the Appeals Division of the Bureau regard it as virtually futile to recommend to the Department of Justice that appeals should be taken from unfavorable decisions of the Board of Tax Appeals where the decisions turn upon issues largely factual in character. They appear to feel that certain members of the Board fail to give to administrative determinations the respect and that which the integrity of the revenue system demands. The Government may lose large revenues that it ought to have just as easily by looseness in determination of fact issues as by purely legal errors in the interpretation of the revenue statutes. While the cases to be appealed should be selected with great care because the statute makes the findings of the Board prima facie evidence of the fact found, an occasional successful appeal might have a very healthy moral effect upon Board members if they really have a bias either for or against the taxpayer.
Attorneys with years of experience in the Bureau have a background of understanding and information relative to our complex revenue laws and the necessities of efficient that administration it is difficult to acquire in any other way. Not infrequently it is important not only to win a particular case but also to secure, if possible, judicial approval of a particular theory upon which the result may be reached, because of its effect upon other and cognate cases that are pending or may later arise. Unless the attorneys in the Department of Justice a similar background, they may not be able to understand this fact and may insist upon trying and arguing cases in court upon theories quite different from those that the Bureau is anxious to establish. This working at cross purposes is almost certain in the long run to react unfavorably on the revenues.
Whether the remedy is to restore to the Bureau the jurisdiction of which it was deprived by the above-mentioned executive order or to go a step further and bring it under the jurisdiction of the Department of Justice is a question that admits of reasonable differences of opinion and is not free from difficulties, but the present division of control is not a permanent and durable solution.
Court Of Tax Appeals. -- There is the further question of proper courts to hear appeals. Tax law, and particularly income tax law, is so extensive and complicated that appeals could be handled much more intelligently and expeditiously by properly constituted Courts of Tax Appeals than by Circuit Courts dealing with all kinds of complex legislation covering taxes and everything else. Such courts should sit not only in Washington but also In places throughout the country convenient to taxpayers. They might be made an extension of the Board of Tax Appeals, but they should be designed to handle appeals from that Board. Doubtless there would be many difficulties in the organization and administration of such specialized courts, and, moreover, many in the legal profession are likely to be prejudiced against them, much as they were prejudiced against the establishment of the Board of Tax Appeals. A layman makes this suggestion with some hesitation and perhaps should not go into details at this point. It is believed, however, that this is a very important matter and well worthy of serious consideration.
7. Various Matters