|Collection at source of individual normal income tax
In a memorandum previously submitted entitled "Some plans for easing the payment of the income tax, our preliminary conclusion with respect to collection at source was stated as follows:
The present memorandum supplies the basis for this tentative conclusion.
Some have suggested that the CURRENT YEAR'S individual normal income tax be collected at source for the purposes of preventing inflation induced by the emergency expenditures and easing the tax payments. /6/ The collection at source of PRIOR YEAR'S individual normal income tax would also facilitate tax payment. In the discussion which follows, the problems inherent in each of these two main types of collection at source plans are analyzed.
II. COLLECTION AT SOURCE OF CURRENT YEAR'S NORMAL INCOME TAX LIABILITIES
The United States and some foreign countries, including Canada, have attempted to collect at source CURRENT YEAR'S income tax liabilities. Some of the witnesses before the Ways and Means Committee on the revenue revision for 1941 have suggested the revival of this type of income tax payment plan. /7/
A. COLLECTION AT SOURCE IN THE UNITED STATES
1. PRIOR TO 1913: Under the Civil War income taxes, the tax on interest and dividends paid by railroads and on salaries of government employees was collected at source. The 1894 Act, which was declared unconstitutional before becoming fully operative, made provision for collection at source with respect to dividends and to salaries and wages in excess of $4,000 received by persons in the employ of the United States Government. /8/ No provision was made for abatements if deductions reduced the income of the recipient below the amount of personal exemption.
2. Revenue Acts of 1913-1916
(a) SOURCES OF INCOME SUBJECT TO WITHHOLDING: Under the Revenue Acts of 1913-1916, the normal individual income tax was collected at source with respect to income derived from "interest, rent, salaries, wages, premiums, annuities, compensation, remuneration, emoluments or other fixed and determinable annual or periodic gains, profits and income." /9/ Dividends were exempt from normal tax and consequently were not included among these sources of income subject to withholding.
The tax was withheld on the gross amount of the specified sources of income without taking into account the personal exemptions /10/ and deductions, unless the recipients of the income filed exemption and deduction certificates with the withholding agent.
(b) EXEMPTION AND DEDUCTION CERTIFICATES: The certificates of exemption and deduction were made available to taxpayers by the Bureau of Internal Revenue through Collectors' offices and withholding agents. Notarization of the certificates was not required. However, a penalty was provided for fraudulent use. If these certificates were not filed within thirty days preceding the due date of the annual return /11/ and an excessive amount of tax had been withheld, the excess could be remitted only on presentation of a claim for refund. If the certificates were filed with the withholding agent thirty days or more before the return was due, but not in time to prevent some collection at source on amounts of income not in excess of the allowable personal exemptions and deductions, the withholding agent was permitted to make an adjustment with the recipient of the income, the withholder paying over to the Government only the net amount of the tax withheld at source, after taking into account the certified allowance for exemptions and deductions.
With respect to the deductions, the claimant was required to submit to the withholding agent, or to the Collector, a complete statement of his income and allowable deductions thirty days or more prior to the due date of the annual return if allowance was to be made for such deductions in determining the amount of tax to be withheld at source. If this information was submitted to the withholding agent, it was authorization to him to refrain from withholding on amounts claimed as deductions. These claims were associated with the respective tax returns for audit purposes. If within the time limit the information was submitted to the Collector instead of to the withholder, the Collector immediately furnished the withholding agent (whose name and address was shown on the deduction certificate form) a statement of the amount of deductions claimed, and authorized him to refrain from collecting the tax at source on such amounts.
(c) REFUNDS: The records of the Bureau of Internal Revenue do not indicate whether collection at source under the Acts of 1913-1916 resulted in a substantial number of applications for refund. It is clear, however, that overpayment of tax at source could easily have resulted especially where multiple sources of income were involved, and also from the taxpayers' failure to make full use of the exemption and deduction certificates.
(d) REASONS FOR DISCONTINUING COLLECTION AT SOURCE: The exemption certificates under the 1913-1916 collection at source plan were objectionable to employees, employers and the Treasury.
Employees changing jobs did not wish to submit to their new employers exemption certificates which would disclose the amounts they had received during the year from former employers. However, unless such certificates were filed with the new employers, withholding would proceed on the gross amount of wages paid, even if the recipient of the wages had not received the full amount of his exempt income tax-free. The employee then had the choice of either overpaying the tax at source and applying for a refund or of disclosing to the new employer the amount of his earnings with previous employers. Both choices were objectionable.
The handling of the exemption and deduction certificates, the record keeping necessitated for purposes of determining the amount of tax to be withheld and the reporting to the Government all imposed a vexatious burden upon employers. /12/
From the Treasury standpoint, millions of exemption and deduction certificates were accumulated for audit purposes. It did not, however, prove practicable to make a complete check of the certificates against the returns.
In his report for the fiscal year 1915, Secretary of the Treasury McAdoo, recommended the discontinuance of collection at source in favor of information at source for precisely the same reasons that were initially advanced in favor of the plan. He felt that the abandonment of collection at source would result in a larger amount of revenue and elimination of a great deal of criticism of the income tax. /13/ A similar suggestion was made the following year by the Commissioner of Internal Revenue. /14/
The Treasury discovered the shortcomings of the tax at source method soon after it was put into effect. In the Annual Report of the Commissioner of Internal Revenue for 1915 /15/ it was stated that the small number of returns received from withholders would "clearly indicate that persons and organizations required to withhold the normal income tax at source . . . have failed to comply with the provisions of the law in this respect to the extent that was contemplated by its framers. It is assumed that failure of this sort was due in most cases to a lack of familiarity with the obligations imposed by the law rather than to willful neglect . . . "
The extent to which the withholding system broke down is indicated by the small amounts of normal tax collected at source. During the fiscal year 1915, only $5.5 million was collected out of $16.6 million and during 1916 $6.6 million was collected at source out of a total of $24 million.
3. Income Tax Payment Plans After 1916
Collection at source was discontinued under the Revenue Act of 1917. To ease the payment problem, provision was made for the prepayment of the income tax. Under the 1917 law, the full amount of tax was due on June 15. A 3 percent discount was allowed on amounts of tax paid prior to such due date. To receive the discount, at least one-fourth of the estimated tax was payable before thirty days after the end of the taxable year; at least an additional one-fourth within two months after the end of such year; at least an additional one-fourth within four months after the close of such year, and the remainder on or before the time fixed by law for the payment of tax, June 15.
Under all Revenue Acts subsequent to the Revenue Act of 1917, quarterly payments are permitted. Cash prepayments are also permitted but the discount has been discontinued.
B. COLLECTION AT SOURCE IN CANADA
Collection at source has never been used in connection with the general income tax in Canada. Collection at source is used in connection with the National Defence Tax which became effective July 1, 1940. This tax is based on total net income /16/ and is additional to the general income tax. The rates and exemptions were amended effective July 1, 1941. /17/
1. GENERAL INCOME TAX PAYMENT PLAN: The general income tax is due on March 31, at which time one-third of the tax is payable. The balance is due within the next four months with interest charged at the rate of 5% per annum on such balance. For 1940 and subsequent years, special provision is made if a portion of the tax is prepaid. If in each of the last four calendar months of the year a taxpayer advances installments at a rate of one-twelfth of his previous year's tax computation, and after December, following calculation of his liability, makes periodic monthly payments of one-eighth of the balance between January and August, the interest which would ordinarily be applicable on amounts due after March 31 is not charged. /18/
2. NATIONAL DEFENCE TAX: The National Defence Tax is based on total net income /16/ of single persons receiving income of over $660 and of married persons receiving income of over $1,200. The rate of tax is 5 percent except for single persons having incomes of over $1,200, in which case the rate is 7 percent. A tax credit of $20 a year is allowed for each dependent.
(a) BASIS OF WITHHOLDING: While the tax is based on total net income, withholding is restricted to only certain sources of income - wages and salaries, dividends and registered interest. In determining the amount to be withheld on salaries and wages, the marital and dependent status is taken into consideration, but the tax on interest and dividends is withheld on a gross basis. The rate of withholding is 5 percent.
(b) EXEMPTION CERTIFICATES: Employees who are married or have dependents, file certificates of marital and dependent status with their employers and the Inspector of Income Tax. When such employees are engaged by more than one employer during the year, similar forms are required to be filed with each employer. The employee must also furnish notice of any change in marital and dependent status. The employer relies on the truth of the information contained in the certificate. If, however, he has a reasonable suspicion, he either requests verification from the employee or reports the matter for official investigation.
(c) TAXABILITY OF WAGES AND SALARIES: The taxability of wages and salaries is determined by the RATE of pay. If the rate paid to the employee is such that its continuance throughout the year, computed on the basis of the normal number of working hours, days, or weeks, as the case may be, would result in the employee receiving income above the exemption levels, the amount so paid is subject to tax deduction at the source. /19/ The employer need not be concerned with the question of how much income from all sources will in fact be earned by the employee during the year. His obligation is simply to deduct the tax where the RATE of pay indicates that such wages and salaries may be taxable. In general, the foregoing applies, irrespective of whether the employee is engaged on a permanent, temporary, seasonal, or casual basis.
(d) REPORTING: Employers are required to report and remit on or before the fifteenth day of each month the amount of tax withheld, together with the names and addresses of each employee, amounts of salaries and amounts of tax deducted on behalf of each employee.
On or before April 30 of each year, definitive returns are required of all persons with total incomes exceeding the personal exemption levels. The sums withheld at source are credited against the total National Defence Tax as determined on the basis of the return. Those found nontaxable are entitled to a refund.
(e) REFUNDS: In order to get refunds on amounts of tax withheld, a refund claim must be filed within a year, showing total income and the names and addresses of the payers who made the deductions in order to permit comparison and verification of the payees' and payers' statements. The Income Tax Division of the Department of National Revenue has stated that "obviously it will be some time after the deductions have been made before a nontaxable person may have his claim verified and a refund made." /20/
The Canadian tax has been in effect for too short a time for any administrative experience to have been gained with respect to the volume of refunds or other problems involved in the tax. /21/
3. Problems Involved in Instituting The Canadian System into The United States
The main problems involved in a collection at source system of the Canadian model may be discussed under three headings: (a) refunds, (b) coverage, and (c) administration.
(a) REFUNDS: Refunds constitute the prime difficulty with the Canadian system. As already noted, insofar as wages and salaries are concerned, the amount of withholding is determined by the RATE of pay. In many instances, total earnings of tax-payers during the year will not exceed personal exemptions due to unemployment or shifts from more to less remunerative employment. Thus a large number of refunds may result.
Under present American practice, refunds are slow and costly. The minimum cost per refund is estimated at between $3 and $4. This cost runs considerably higher when the refund involves any technical problems of audit. Refunds take from six weeks to many months to complete and must be passed by both the Bureau of Internal Revenue and the Office of the Comptroller General. /22/
The Bureau of Internal Revenue has indicated that, if need be, it could modify its procedure so as to reduce the time involved. The Office of the Comptroller General has, under Act of Congress, standards of its own for auditing refunds, and it is doubted whether these standards would be relaxed unless Congress authorized an extensive revision of their present procedure.
No estimate is available of the number of refunds which would be involved if the Canadian system were adopted in the United States. Some idea of magnitude may, however, be obtained from an examination of social security statistics relating to employees working for short periods of time. Such part-time employees constitute an important portion of the total number of workers in the covered industries. During the period January, 1938 - June, 1940, the difference between the number of workers employed during the quarter and on the last day or payroll of the quarter ranged from 1.6 million to 3.7 million, or from 6.0 percent to 12.6 percent of the total number of employed persons during the quarter. (See Table 1.)
Data on rates of pay for these workers are not available. The total earnings of most were, however, below the income tax exemption level. For example, of the workers in 1938 who had earnings in only one quarter of the year and are predominantly part-time employees, about 89 percent earned less than $200 during the year and only 1.3 percent earned $1,000 or more. /23/ A substantial portion of the total were undoubtedly paid at RATES which would result in withholding if a plan similar to the Canadian were enacted in this country. It is readily apparent, therefore, that under the Canadian plan the number of refunds would be considerable.
(b) COVERAGE: Between seven and nine million persons in the United States, or about 15 percent of the working force, are employed as agricultural, domestic and casual workers. (See Table 2.) Table 3 shows that on the basis of sample studies over 90 percent of agricultural and domestic workers earn less than $600 per year. All of these would be exempt for income tax. In some cases, however, the RATE of pay may have exceeded the level for withholding. In such cases withholding would be difficult. The difficulty arises primarily from the large numbers of employers involved. For example, agricultural and domestic workers numbering between 5.5 and 5.8 million are employed by between 4.6 and 5.1 million persons, or almost as many employers an employees. (See Tables 2 and 3) To check whether the tax was withheld properly, where so many potential withholding agents exist, would be extremely difficult.
It may be noted that since an end-of-year return is required for those with total incomes in excess of the exemption level, lack of precision in withholding is not a fatal criticism. However, a certain discrimination between persons exists when some are subject to withholding and others similarly situated from the income standpoint are not. Further, in many instances, those who cannot be reached for withholding may also fail to file returns at the end of the year and thus completely escape tax.
(c) ADMINISTRATION: Under present Canadian regulations, no receipt for tax withheld is given to the taxpayer. Further, it is anticipated that claims for refunds or credits for taxes withheld made by taxpayers will be checked against employers' returns to determine the accuracy of the claim. It is readily apparent that if a substantial number of claims are made, attempting a check such as suggested by the Canadians would not be practicable. /24/ Even in the absence of refund claims, checking the accuracy of amounts of withholding claimed by taxpayers as credit against tax as determined on the basis of a return would be difficult. The issuance of tax stamps or receipts for amounts withheld would facilitate administration, but unless the receipts were made (1) nontransferable or (2) readily convertible into cash, an avenue of tax avoidance would be open. /25/ Registration of the receipts would close the possibility of such tax avoidance, but, on the other hand, would increase the complexity of administration.
C. PLANS PRESENTED TO THE COMMITTEE ON WAYS AND MEANS IN CONNECTION WITH REVENUE REVISION FOR 1941
1. Testimony of William J. Schiefflin, Jr. /26/
(a) PLAN: Mr. Schiefflin suggests a gross income tax at a flat rate on salaries, wages, dividends, bond interest, and "every form of income paid to individuals." He endorses the suggestion made by Professor Harley L. Lutz in "Financing the Defense Program" published by the National Economy League. No exemptions of any kind are recommended.
Such a gross income tax would bear more heavily on the poor than the wealthy and runs counter to equitable taxation on the basis of ability to pay.
(b) PROBLEMS INVOLVED UNDER THE SCHIEFFLIN PLAN: The main problems involved in Mr. Schiefflin's plan are that it is not possible to withhold a tax at source with respect to all types of income and also that it is not possible to apply withholding to some types of income recipients.
(1) SOURCES OF INCOME: The tax may be withheld with a minimum of difficulty in the case of wages and salaries and dividends. On the basis of 1937 statistics for returns with net income, these sources constitute 72 percent of total income and for returns with net incomes under $5,000, over 78 percent of total income. /27/
As shown in Table 6, salaries, wages and dividends are the most frequent sources of income to individuals. Of a total of 5.3 million returns with statutory net income filed for 1936, 3.3 million showed salaries and wages and not more than one other source of income. Of these, 2.4 million, or 73.3 percent, showed salaries and wages only, and 2.7 million, or 81.9 percent, had no source of income other than salaries, wages and dividends. Thus salaries and wages constitute the only source of income for 45 percent of all persons reporting net income for 1936 and with dividends accounts for all sources of income for over one-half of all such persons. Salaries and wages appeared alone, or in combination with other sources of income on a total or 4.0 million, or three-fourths of all returns with net income filed during that year.
Further, where salaries and wages were combined with another source of income, the other source of income, except in the case of business profits, was generally small. Table 7 shows that while some variation existed on the basis of size of salaries and wages, 80 percent of those receiving interest and 50 percent receiving dividends, in addition to salaries, received less than $100 from these sources. 96 percent of persons receiving interest, 77 percent of persons receiving dividends, and 72 percent of persons receiving rents reported not more than $500 from any of these sources. In the case of business profits, 76.3 percent received more than $500 from such source along with their salaries. In few cases, however, did business profits exceed salaries in amount for persons receiving income from both sources.
It may appear that since salaries and wages are the most important source of income and the tax can be withheld on that source with a minimum of difficulty, collection of the tax at source for salaries and wages might be attempted. However, it should be noted that the foregoing data are based on income tax returns and represents only a portion of the total salaries and wages received by individuals. It is the difficulty inherent in attempting to reach those persons that negates the possibility of withholding on salaries and wages. As noted above /28/, severe problems of administration would be involved in attempting to withhold the tax at source even on a gross basis for agricultural, domestic and casual workers, where almost as many employers are involved as employees. It is doubtful whether a tax involving so many withholding agents could be administered.
The withholding of tax on dividends would not constitute a problem because the number of corporations is relatively small and the records, for the most part, are adequate. A similar situation exists with respect to bond interest and royalties. /29/
An attempt to collect the tax at source on interest (other than bond interest) and rents, would present greater difficulties than collecting the tax at source on salaries and wages. Data on amounts of bond interest are not separately available. As shown in Table 4, however, all interest reported on individual income tax returns for 1937 amounted to only 3.7 percent of total income. Rents represented about 3 percent of total income. To attempt withholding on interest (other than bond interest) and rents would require most persons in the country to become tax collectors as well as taxpayers. For example, every person renting living quarters or business premises would be required to withhold the tax on each payment of rent. Similarly, borrowers would have to become withholding agents with respect to the tax on loan transactions. It is readily apparent that an adequate check on a tax of this type would be administratively impossible.
The tax could not be withheld on income from business, the professions, self-employment and capital gains. These sources constituted about 21 percent of total income reported on individual returns with net income in 1937. While capital gains represent a relatively small proportion of the total income of individuals, business income is second in importance to salaries and wages, and amounted to over 10 percent of total income reported on individual income tax returns for 1937. It constituted the only source of income on almost 13 percent of all single source returns and was the only source of income for at least one-half of the persons reporting total income of not more than $1,000 in 1936. /30/ The tax could not be withheld on business income or the income from the professions and self-employment because there can be no withholding agent for such income. The tax on capital gains could not be withheld at source because information relating to the amount of the gain is not available to the purchaser of the capital asset.
The foregoing indicates that the tax could not be held at source on some types of income and on others it could be withheld only after surmounting serious obstacles.
(2) COVERAGE: It has been indicated that certain types of persons receiving salaries and wages could not be reached by tax at source. /31/ Since under Mr. Schiefflin's plan no return is required, such persons would be freed from tax. In addition, all partnerships and proprietorships could escape the tax with ease.
Tables 9-15 present information relating to the number and incomes of farmers and nonagricultural proprietorships and partnerships. Of approximately 6 million farm operators, only 54,000 farm proprietors and 19,000 partnerships, or a total of about 73,000 farmers filed income tax returns for 1936. Analysis of a sample of the returns of farm proprietors shows that for about 46 percent total receipts of less than $5,000 and for 70 percent total receipts of less than $10,000 were reported. About three-fourths of the farmers reporting for income tax purposes showed net profit from business. An equal percent of farm operators reported family incomes of not more than $1,500. Of the farm partnerships reporting net income, over three-fourths reported less than $5,000.
About 699,000 proprietorships and 211,000 partnerships, or 810,000 of the 2.7 million proprietorships and partnerships other than farm operators filed income tax returns for 1936. Analysis of a sample of the returns of such proprietorships shows that about 19 percent reported total receipts of less than $5,000, and 44 percent reported total receipts of less than $10,000. About 90 percent of the proprietorships and partnerships other than farm operators reporting for income tax purposes showed net profit from business. Forty-five percent of the self-employed other than farm operators reported family incomes of not more than $1,500. About 80 percent had $3,000 or less. Of the partnerships other than farm operators which reported net income, about two-thirds reported less than $5,000.
The foregoing indicates that farm and nonfarm proprietorships and partnerships represent small individual amounts of income. In the aggregate, however, they represent an important part of the national income. In 1940, it is estimated that the net income of unincorporated business amounted to $12.4 billion, or 16.4 percent of national income produced. /32/ This amount, in addition to amounts of salaries and wages and other sources on which tax could not be withheld would escape tax. Mr. Schiefflin's plan would, therefore, fall primarily on workers in covered industries /33/ and recipients of dividends and bond interest. Such a tax, it is obvious, would be highly inequitable.
2. Testimony of Professor Albert G. Hart /34/
(a) PLAN: Professor Hart suggested that the normal tax on wages and salaries, interest and dividends in excess of exemptions should be collected at source. /35/
He recognized that the allowance of personal exemptions and dependent credit presents serious problems. He also indicated that it would be impracticable to collect the tax at source from farmers and the self-employed.
With respect to the problem of exemptions, Professor Hart suggested several possibilities as follows:
(1) Allow personal exemptions and credit for dependents in determination of the amount of tax to be withheld.
(2) Allow a uniform exemption for all taxpayers against salaries and wages only and give refunds to those filing end-of-year returns who are entitled to more than the minimum exemptions.
To keep down the burden of numerous refunds, the following possibilities are suggested:
(1) Allow monthly and weekly exemptions on wages and salaries which are higher than the prorated annual exemptions.
(2) Require annual returns only of persons with gross incomes of a certain size and permit such returns for persons with smaller incomes claiming refunds.
(3) Assess additional taxes and grant refunds only where the significant amounts are involved.
With respect to the incomes of business men, farmers and professional men, it is suggested that they might be required to pay in quarterly installments on estimated current year incomes. For others, however, Professor Hart feels that "the nucleus of the necessary administrative machinery for the system of collection exists in the present income tax system and the system of collecting contributions under the Social Security Act."
(b) PROBLEMS UNDER THE HART PLAN: As Professor Hart has indicated, the main problem under his plan relates to allowing personal exemptions and the dependent credit. If the plan is not to require a large number of refunds, these allowances must be made when determining the amount of tax to be withheld. For this purpose, he suggests that exemptions and credits be allowed on a weekly or monthly basis.
The plan for weekly or monthly exemptions and credits is as follows:
Exemption coupons would be issued to employees in different denominations according to marital status and number of dependents. Single persons' coupons might be green; married with no dependent, red; married with one dependent, yellow, etc. /36/ Individuals would apply to the Treasury for these coupons, setting forth their names, addresses, dependents, and social security numbers. Responsibility for determining the type of coupons to be issued would fall entirely upon the agency set up to issue them. Each coupon would carry its owner's social security number, and would be negotiable only through the owner's employer.
With each payroll, employers would have to classify employees into two groups--those whose coupons had a face value exceeding the amount which was to be deducted, and those whose coupons had a face value equal to or less than the deduction. For the first group, pay checks would be issued as though there were no source-deduction. For the second group, the tax would be deducted from the amount payable above the face value of the coupon.
The difficulties with this plan are;
(1) Exemption certificates are of no value to the unemployed or partially employed. Unless made nontransferable, such persons could sell their coupons to those with larger incomes.
(2) The plan as outlined considers only those covered by Social Security or other Federal pension plans. As indicated above, /37/ severe difficulty would be experienced in withholding the tax for persons in uncovered industries, and also with temporary employees in industries covered by Social Security or other Federal pension plans.
(3) Refunds would be involved where the total income of the employee during the year did not equal the value of the exemption certificates available to him.
(4) If exemption certificates were issued on a weekly basis, some fifty certificates would need to be issued for each of some fifty million workers, /38/ or 2-1/2 billion vouchers. Aside from the cost of printing, the handling of so large a number of vouchers, if at all possible, would be extremely burdensome to both employers and the Government.
(5) Employers would need to compare the employee's earnings with the personal exemption and credit for dependents and withhold the tax on the difference, that is, handle each employee's account separately.
(6) Checking for fraud would be difficult since persons could (1) work under different names at different times and receive thereby multiple personal exemptions, (2) falsely report marital status or dependents, (3) claim multiple exemptions where husband, wife and children were all employed.
(7) If the exemption is on a weekly basis, those who work part-time and earn more than the exemption during the week, but not in any one place of employment, would escape taxation. If the exemption is at a rate equivalent to a weekly basis, then refunds would need to be made for those who received wages at a rate in excess of the exemption but whose total income was less than the exemption. If the exemption were on the basis of a longer period of time than a week, the flow of revenues would be affected, e. g., if on an annual basis, little tax would be collected until more than the annual exemption had been earned by each worker, or not until, in most cases, the latter half of the year.