Collection at source -- proposals for meeting criticisms

Three proposals have been made to meet the criticism that have been leveled at collection of the individual income tax at source; (1) That the collection at source be eliminated altogether from the bill; (2) that, instead of the collection at source on a net basis, an additional tax should be imposed on gross income before the allowance for personal exemption and dependent credits; and (3) that the collection of the income tax should be placed on a current basis by the adoption of the Ruml plan and that coupled with this change, part of the income tax should be collected at source.

I. ELIMINATE COLLECTION AT SOURCE

If collection at source were eliminated, there would be no danger of interfering with the savings bond program. It would reduce the employers' difficulties arising from the shortages of payroll personnel and equipment and also the Bureau's problems of administration. Further, the total tax payments in 1943 would be substantially reduced and the taxpayers would no longer feel that they were being called upon to pay two years taxes in one.

There are, however, a number of important reasons why collection at source should not be eliminated from the present bill. In the first place, the income tax with a lower exemption has become a mass tax. Over 30 million people will be required to file returns for 1942. many of these _____ (insert figure) will be called upon to file an income tax return for the first time. As the national income has grown and the unemployed have been reabsorbed, many individuals who formerly made incomes below the exemption levels will now make incomes substantially in excess of the lowered exemptions. Aside from the question of personal honesty, it is almost inevitable that a considerable number of these people will fail to make income tax returns. Collection at source is necessary, therefore, to protect the revenue.

It is also necessary to protect the taxpayer from the full impact of income taxes that are substantially higher than Americans have even been called upon to pay over to the Government. Standards of living offer great resistance to shrinkage. The present war emergency calls for a universal shrinkage of the standard of living. To the extent that the people fail to impose self discipline and contract their expenditures for the necessaries and ordinary convenience to which they have become accustomed, they will find it extremely onerous to meet the tax bill when due if the tax bills are left as they are at present on a quarterly basis. Many will need to borrow the tax money; others will need to apply for extensions. There is grave danger that unless a substantial portion of the ordinary American's income tax liability can be discharged out of his current earnings before the money reaches him through a system of collection at source, the entire income tax might be jeopardized to wholesale delinquencies. Even if the delinquencies do not develop, it is still highly undesirable to subject the great majority of the people to the drastic periodic pressures of quarterly tax payments under a systems of high rates and low exemptions.

If it were a matter of tiding over one year or two, a substantial case might be made for delaying collection at source during the war emergency on the grounds that while collection at source is extremely important as an anti-inflationary device, it nonetheless introduces a new administrative feature of great importance at an inopportune time when business people are preoccupied with maximizing war production and harassed by many vexing problems such as labor shortages, material and equipment shortages, and other unusual disturbances. The prospect is, however, one which almost certainly will call for very high levels of income taxation from very many millions of taxpayers. To defer the decision for 1943 and even for 1944 will not be very helpful for sooner rather than later, the urgency of instituting the collection at source device will become so great as to force it upon us or else force the abandonment of the income tax for the majority of the people. Without collection at source, the income tax must remain a class tax, limited to the upper income groups.

The savings bond program itself involves collection at source. Our field investigation disclosed that the employers are making many other deductions at source for non-governmental purposes. (Heller or Hellborn fill in some facts here). This survey also shows that the savings bond program would not be jeopardized by the simultaneous introduction of collection at source. (Heller or Hellborn fill in facts here from the employer and employee field survey).

Once the machinery and the habit of making deductions at source is firmly established as they are already being established even without collection at source through the bond savings program and the various other types of deductions made by the employer, the techniques can be perfected and the over-all costs reduced. It is true that with the personnel shortages and restrictions on the manufacture of payroll equipment, some of the concerns may experience considerable difficulty during the war period in making the necessary adjustments for the expansion of the collection at source technique. Such an expansion will, however, become necessary in case, other measures failing, it is found desirable to institute a compulsory saving plan. If we are to be ready for such an eventuality later, it may be helpful to initiate the necessary expansion now by recommending in the 1942 bill collection of part of the income tax at source, then when compulsory savings are needed, it would be a simple matter to absorb the additional work since the groundwork would already have been laid for the expanded program.

Finally, it should be pointed out that if the Treasury were at this late date to recommend against the retention of collection at source in the 1942 bill or even if it were to take such a weak stand in favor of collection at source as to make it clear to the public that it no longer favored it, the Treasury's prestige with the Congressional committees and with the other governmental agencies straining to stop inflation would be materially damaged. This point alone should not, however, weight heavily if their reasons for retention of collection at source were clearly without foundation and weak or inadequate. On the contrary, all the facts bearing on the issue appear to point in the opposite direction.

Treasury Department, Division of Tax Research

                                             August 19, 1942

MATERIAL FOR STATEMENT ON TREASURY POLICY

Collection at source -- proposals for meeting criticisms (Continued)

3. FORGIVENESS OF TAX

The collection at source plan incorporated in H.R. 7378 has been criticized on the one hand because it creates a tax hump or a doubling up of taxes in the transition years 1943 and 1944 and on the other hand because the 5 percent rate seems entirely inadequate either for the purpose of having a material effect upon inflation or for the purpose of pulling the taxpayer out of debt to the Government. Thus, in 1943 the taxpayers in the lowest/taxable income groups would be required to pay a rate of approximately 24 percent -- 6 percent normal tax (reduced by 6 percent for the earned income credit); 13 percent surtax, both applicable to 1942 incomes; and 5 percent collection at source tax on his current 1943 income. In effect, however, the entire 24 percent would have to be paid out of current 1943 incomes, unless the taxpayers had been foresighted and provided through tax anticipation certificates or otherwise for the payment of their 1942 liabilities. At the same time, the 5 percent collected at source on 1943 incomes would constitute only 5/19th of the liability in the lowest income brackets and a much smaller proportion of the 1943 liabilities for all other taxpayers. The two criticisms in conjunction constitute a formidable barrier against a favorable ultimate consideration of the collection at source plan which is incorporated in the House bill.

To surmount the doubling up or the hump problem, it has been suggested that some of the past year's liability might be forgiven. If some of the past year's liability were forgiven, then it would be possible to make the amount collected at source very much more substantial then 5 percent without at the same time increasing the total amount to be paid out of the current 1943 year's income as to run about of the doubling up objection.

The most popularized plan for placing the income tax on a current basis is one advanced by Mr. Beardsley Ruml, Treasurer of R.H. Macy and Company and Chairman of the Board of Governors of the Federal Reserve Bank of New York.

He stresses the importance of getting the taxpayers out of debt to the Government during the war period because may persons have gone into the war services with 1941 and in some cases 1942 tax liabilities awaiting/their return and after the war period because if unemployment should develop, many may find it crushing to meet the taxes that have accrued on incomes of earlier and more prosperous days. It is generally agreed that only a small percentage of the population have formed the fixed habit of accruing their tax liabilities and that the majority of the people pay their taxes when due out of their current year's earnings. It would seem reasonable, therefore, to time the tax payments in such a manner as to have them move up and down with the flow of income. Although this general objective is readily accepted, it is not easy to devise a plan to accomplish it. Since the Ruml plan is reported to have gained considerable support in the Committee, it would seem desirable to describe this plan briefly and to indicate in what respects it does and in what respects it does not meet the requirements.

THE PLAN (To be filled in from the last Ruml plan memorandum)

A. With collection at source.

B. Without collection at source.

C. The plan serves to place income tax collection on a current basis in the following situations:

D. The plan fails to place income tax collections on a current basis in the following situations:

E. The plan has the following equity and other defects:

F. The plan can be improved with respect to the above by doing the following:

Treasury Department, Division of Tax Research

                                             August 19, 1942

MATERIAL FOR STATEMENT ON TREASURY POLICY

Collection at source -- proposals for meeting criticisms (Continued)

II. SUBSTITUTE TAX ON GROSS

It has frequently been suggested that collection at source should be on a gross basis before the allowance of personal exemption and credit for dependents rather than on the proposed net basis after much allowances. It is claimed that such a tax would be easier to administer; would be simpler both for the employer and the employee, involving each in less record keeping and bookkeeping expenses; and would yield substantially more revenue than collection at source on a net basis.

A more careful examination of the administrative and compliance aspects of a gross tax as distinguished from a net tax collected at source reveals that the simplification is largely illusory. Our field investigation disclosed that collection at source on a gross basis would be almost as expensive as a net tax for employers. The saving in personnel and machinery would, for the most part, be negligible. Machinery employed in the payroll departments of large concerns is now loaded substantially to capacity. Any additional item will involve a certain amount of re-arrangement and adjustment of the current procedure. These re-adjustments will involve about the same expense, irrespective of whether the tax is imposed on the gross or a net basis. (Perhaps Mr. Heller or Mr. Harriss can fill in something more here. Nothing technical should, however, be included, such as for example, the number of spaces on cards, etc.).

The administrative problems of a gross withholding tax would undoubtedly be much more serious for the Bureau of Internal Revenue than a net withholding tax. Every income recipient would become liable to tax. Instead of some 30 million taxpayers, the Bureau would did itself dealing with some 55 million taxpayers. Millions of these taxpayers with incomes less than the exemption levels under the income tax would have no income tax liability against which the offset the amounts collected at source and many millions more would have amounts withheld from them in excess of their ultimate liabilities. Thus, the volume of refunds would be greatly multiplied. Under the proposed tax, not only is an allowance made for personal exemption and dependent credits, but some allowance is also made tentatively for the deductions ordinarily allowed under the income tax as finally determined. Without these allowances, the volume of refunds would literally swamp the Bureau's strained administrative machinery. Aside from the administrative difficulties, it seems unduly harsh to withhold from millions of individual switch small incomes below the exemption levels, small amounts of funds only to refund them at a later date. Many of these individuals are in urgent need of receiving currently their entire income. Further, it should be pointed out that while millions of these employees with small incomes are being deprived of the current use of part of their income, many millions of self-employed would be favored in comparison, since it would be folly on grounds of equity alone to compel some type of tentative collection of tax, only to be refunded later. Thus it would appear that a gross tax might easily be at least as complex as a net tax collected at source and that it is entirely unsuitable as a collection device for a net income tax.

It has sometimes been suggested that a gross tax might be introduced as an additional or separate tax rather than for the purpose of pre-paying part of the regular income tax. There are a number of serious objections to this proposal. In the first place, an additional gross tax, for all practical purposes, amounts to an additional payroll tax. Imposed at a uniform rate on all wage earners, it would be likely to provoke demands for wage increases and would thus weaken the forces against inflation. Secondly, a substantial gross tax would be prejudicial to the maximum war effort. The maximum war production can be maintained only if the nation's workers are permitted to maintain an efficient standard of living. Despite the rapid rise in the national income, it has been estimated that millions of workers ar still receiving incomes below the standards necessary for health and efficiency. (Perhaps some figure should be inserted here from the 1942 O.P.A. data).

Further, a gross income tax would distribute the tax burden inequitably among income classes in such an obvious manner as to undermine the morale of the population and its faith in a fair allocation of the burdens which inhere in the war emergency. From the viewpoint, then, of inflation, war production, and war morale, there is little to be said in favor of a gross income tax. In the plan which the Treasury recommended, and which is now incorporated in the bill, collection at source would be on the gross basis with respect to interest and dividends. Individuals with small amounts of income chiefly from these sources, are however, exempt from the withholding tax if their incomes are below the exemption levels of the regular income tax. This provision is made to avoid undue hardship to some 500 million people that rely almost exclusively upon their interest and dividend receipts for a livelihood. It seems unfair and unnecessary to deprive these individuals from the use of part of their small income for some substantial period. They will have no liability under the regular income tax and should be asked to give up the use of a portion of their available resources pending a final settlement and refund of the tax collected at source. Thus, from our viewpoint a gross tax is undesirable even if restricted to some of the income items, interest and dividends, it is intolerable if made general.

Strong representations have been made for the elimination of collection at source for interest and dividends. This type of suggestion has been made not only by those opposed to collection at source altogether but also by some of the friends of collection at source on grounds that the administrative and the compliance burdens are especially great with respect to interest and dividends.

It is highly desirable to extend collection at source to as large a segment of the income stream as possible. Narrowing the scope of collection at source greatly increases the danger that collection a source will be regarded as or converted into a tax on wages alone, entirely independent of the personal income tax. Any such separation of the tax collected at source form the regular income tax would be likely to lead to a far less progressive tax structure, probably to a gross wage tax without exemptions. Such a tax would not only be discriminatory and inequitable, but would also give rise to demands for wage increases. Further, each narrowing of the scope of collection at source increases the discrimination between persons who are subject to collection at source, and hence must pay their taxes currently, and persons not subject to collection at source, and hence able to make use of the money for a considerable period.

It is particularly desirable to subject bond interest to collection at source, precisely because so large a part of such interest consists of Government bond interest. We shall be in a far better position to get cooperation from industry in administering collection at source if it is clear that the Federal Government is willing to undertake its share of the task.

The elimination of collection at source entirely for dividends and interest would unduly reduce the scope of collection at source and seriously undermine its anti-inflationary effectiveness. Our estimates are that about $40 million would be collected from bond interest at the 5 percent rate provided in the bill for 1943 and about $80 million at the 10 percent rate provided for 1944 and thereafter. The corresponding figures for dividends are $220 million and $440 million, respectively; and for wages and salaries, $1 billion and $2 billion.

While collection at source unquestionably raises serious compliance problems for employers and payors of dividends and interest, they do not seem to justify the complete exemption of coupon bond interest from withholding.

Treasury Department Division of Tax Research

August 19, 1942