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Personal Taxes

PERSONAL TAXES § 1. Inheritance-tax laws. § 2. Fiscal and social aspects. § 3. In come taxes; general nature. § 4. Income taxation by the states. § 5. Obstacles to federal income taxation. § 6. Federal taxation of individ ual incomes. § 7. Important features. § 8. Development and yield. § 9. Corporate income and excess profits. § 10. Defective theory of corporate income taxation. § 11. A system of taxation.

§ 1. Inheritance-tax laws.

There remain to be consid ered at least two important forms of taxation that are essen tially personal in their unit of assessment, in contrast with the foregoing, which are (or should be, if consistent) essentially impersonal.' There are the inheritance and the income taxes. Property received by bequest or intestate inheritance for taxing purposes is usually viewed as essentially income ac cruing but once under peculiar conditions, and therefore taxable to the individual beneficiary. However, inheritance taxes still retain some traces of a legal origin in feudal times, when the estate reverted to the overlord until released upon the payment of certain dues, and the tax is collected in the course of the probating of wills under the direction of court officials.

of the American states had inheritance tax laws in 1921 (all but South Carolina, Florida, Alabama, Mississippi, and New Mexico). These laws apply generally to property passing either by will or under the interstate laws of the state. The tax is for state purposes. These laws differ in many ways, but are nearly all alike in certain respects: I See ch. 18. § 3. note, and § 5. on this distinction. The poll tax also is personal: see cb. 17, § 9.

(1) In applying to the separate legacies rather than to the estate as a whole.' (2) In taxing legacies to relatives in the direct line at a lower rate (or even exempting them entirely) than those to collateral relatives.' (3) In exempting legacies below a certain amount.' (4) In having rates progressing with the size of the legacy; (this feature is less general, but is prominent in most of the later laws).

The federal government has until lately made little use of an inheritance tax. The law passed in 1862 in the midst of the Civil War yielded little and was soon repealed. But in 1916 was enacted an "estate tax" (amended and increased in succeeding years) which is imposed upon every estate (as a whole, not on the several shares) on the excess over $50,000, at progressive rates from 1 to 25 per cent, the maxi mum being on estates exceeding ten million dollars.

§ 2. Fiscal and social aspects. The fiscal importance of inheritance taxes in the states has been comparatively not very great, but has rapidly grown. In 1903 the receipts from this source (in twenty-seven states) were more than $7,000,000; in 1913 they were (in thirty-five states) $26, 000,000, and are doubtless now much greater. In New York state alone the receipts range between ten and fifteen million dollars a year. The yield of the federal estates tax by fiscal years has been as follows: 1917 $6,000,000 1918 47,000,000 1919 82,000.000 1920 104,000,000 The spread of inheritance taxes and the higher and progressive rates applied are an expression in part of the In Utah the tax is 5 per cent on all estates over $10,000.

• Exception, Utah.

+ Exceptions are Missouri, New Hampshire, Vermont, Virginia.

need of additional revenues and in part of the growing popu lar concern regarding the concentration of wealth. Yet the actual legislation is something of a compromise between fiscal policy (to get revenues) and social policy (to reduce or to dis tribute the larger fortunes. In New York legacies of more than $1,000,000 are now taxable at 4 per cent to relatives in the direct line and to all others at 8 per cent. In Washing ton the tax to relatives in the direct line is from 1 to 5 per cent, according to the amount of the share, but to others it may go as high as 15 per cent. In Wisconsin, somewhat simi larly, the tax may rise to 15 per cent on the excess above $500,000. These taxes are of considerable importance, not only fiscally, but as the means for reducing large inherited fortunes. For this latter purpose, however, it would be more consistent and effective to make the progressive rates apply to the distributive shares rather than to the estates as wholes.

§ 3. Income taxes ; general nature. All taxes, whether assessed upon the capital value of goods or not, come out of (reduce) the incomes now or later available for individuals. But there are various ways of attacking incomes, i. e., of ap portioning the tax burden. Income taxation is that form in which the basis of the assessment and levy is the income of the taxpayer as it arises (not accumulated wealth, or capital, or business processes, or expenditures). Of the various concep tions of the one mainly employed in income taxation is monetary income arising in the course of business, supple mented occasionally (but not consistently) by some items of material income that are expected to come to the person.

There is not in the long run such a contrast between wealth taxation and income taxation in their ultimate burden and effect as is usually supposed. Indeed, wealth (or capital) taxation as applied to accumulated wealth is more far-reaching than income taxation, for it falls upon the present worth alike of monetary and of psychic 5 See Vol. I, p. 26.

incomes (e. g., the value of a house, whether it is let to a tenant or occupied by the owner). But, on the other hand, income taxation attacks directly the monetary incomes from labor, coming as wages, salaries, fees, and profits in busi ness (unfunded as distinguished from funded incomes). This feature goes naturally with the fact that the income tax is essentially a personal tax, grouping the items of assessment about a person, whereas the "property" taxes are mainly (though not consistently) impersonal, making the piece of wealth the primary object of assessment. This summation of each person's income makes income taxation peculiarly suit able for progressive taxation with the social-welfare motive of equalizing the distribution of wealth. It is doubtless this technical assessment feature, rather than any essential ad vantage as a mode of taxation, that has led to its recent growth in popular favor.

§ 4. Income taxation by the states. Income taxes have been used widely in European countries, but until 1913 very little in the United States. Numerous attempts have been made by the states to tax incomes, but with small results. Personal incomes, when sought by local assessors, proved to be most elusive. There were (in 1913) but seven states with any thing resembling a personal income tax.° These are Virginia, North Carolina, South Carolina, Mississippi, Oklahoma, Mas sachusetts, and Wisconsin. Of these states Wisconsin has the most recent law, and one the widest in its application and the most important fiscally. The law applies a progressive rate to all incomes (with exemption of $700 from wages and salaries) and contains elaborate provisions for corporate tax ation. The proceeds are distributed 10 per cent to the state, 20 per cent to the country, and 70 per cent to the municipality in which the tax is collected. In the six other states the tax s In addition, certain items of receipts of companies or incomes of individuals are arbitrarily defined as property for purposes of taxation in a few cases in about fifteen other states. See Wealth, Debt, and Taxation, Report of the Bureau of the Census, 1907, p. 622.

III is on incomes only exceeding a certain amount (North Caro lina, $1000, the other states from $2000 to $3500 exemption) ; some apply to incomes from any source, but others do not apply to incomes from property otherwise taxed. The total receipts from these state income taxes in 1913 were but $314,000.

In 1919, four states, Alabama, New Mexico, North Dakota and New York adopted a general income tax. In New York the rate is 1 per cent on incomes up to $10,000, 2 per cent on the next $40,000, and 3 per cent on all over $50,000. The yield the first year was $20,000,000.

§ 5. Obstacles to federal income taxation. The income tax has now come to play a most important part in the fiscal system of the federal government. Until 1913, however, it had been used only in a small way under the law passed in 1861, frequently amended, and finally repealed in 1870, to continue in force until the year 1872. The rate was 3 per cent on the excess of incomes over $600, and 5 per cent on the excess over $10,000. This law was re peatedly upheld by the United States Supreme Court as not in conflict with the Constitution. Its fiscal results were not large, as it was never effectively administered.

The next income-tax law was that of 1894, enacted in con nection with the tariff revision of that year. It was declared unconstitutional before it had gone into effect. The main ground for the decision was that a tax on incomes from rent of land as well as on incomes from personal property was direct, and must therefore, according to the Constitution, be apportioned among the states according to population.

In the active discussion of social legislation in the years fol lowing this decision public sentiment developed, favoring an amendm,ent to the Constitution. It is a remarkable fact that, when the bill for the sixteenth amendment to the Con stitution was finally passed, it was voted unanimously by the Senate and almost unanimously by the House. It was ratified by three fourths of the states, and became a part of the Constitution February 25, The Democratic party, which had passed the law of 1894, was pledged to the passage of an income-tax law when it came into power again in 1913. The reduction of the tariff, as well as growing expenditures, moreover, made necessary the development of new sources of revenue for the national government. In other countries the income tax had been found to be a part of a system of taxation especially valuable as a "balance wheel" to equalize the revenues and expenditures. It was deemed by some to be an additional advantage of an income tax that it would make the richer citizens better realize the nature and burden of public expenditure. Most other federal revenues, being derived from the tariff and from taxes on merchandise, are borne mainly by the purchasers and con sumers.

An income tax was opposed as sectional taxation by many in the eastern states, where the owners of most of the larger fortunes reside. But to this Senator Elihu Root replied that the states where there was the greatest ownership of wealth pay the largest taxation under any scheme, and ought to.

§ 6. Federal taxation of individual incomes. The law as first enacted constituted section 2 of the tariff act of 1913 entitled, "An act to reduce tariff duties, and to pro vide revenue for the government and for other purposes." The development of this law, and the growth of taxation under it as it was successively amended between 1913 and 1919 to meet new needs, is one of the most remarkable chap ters in our financial history. The law of 1913 applied both to individuals and to corporations. As "incomes" in these two cases are so different in nature, and as these two features in the law have had somewhat different developments, we may do well to treat them separately, beginning with the tax upon individuals.

Article XVI. The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census enumeration.

The law of 1913 imposed upon individuals a "normal" tax of 1 per cent (on the excess above exemption), and an "additional tax" (in later amending laws called a surtax) ranging from 1 to 6 per cent on individual incomes of larger amounts than $20,000. There were thus eight classes of persons: those entirely exempt; those paying only at the normal tax rate; and six different classes paying a surtax, which on the portions of income exceeding a half million dollars was at the maximum rate of 7 per cent. This law applied retroactively to the last ten months of the calendar year 1913 (beginning March 1), and continued to apply for the calendar years 1914 and 1915. The act was then succes sively amended (or superseded by new laws) beginning in 1916. These changes will be tabulated below to simplify as far as possible the somewhat complex Let us note first, however, some important new features of taxation in volved in this act.

§ 7. Important features. There were various exemptions, $3000 on every individual income and $4000 on the aggregate income of husband and wife living together (this distincton, it will be observed, offers a reward of $20 per annum to make marriage a failure). Among allowable deductions are sums paid for taxes (except assessments for local benefits), necessary business expenses, losses sustained, and (for the normal tax only) those parts of individual incomes derived from corporations that have paid the tax on them.

The difficulty of getting an honest and complete assessment of incomes is great. All taxation is deemed by the taxpayer to be "inquisitorial" in some degree, and this is particularly true of an income tax. In England had been developed the plan called "stoppage at source," by which corporations and other businesses were required to deduct taxes before paying dividends, salaries, etc., to taxable persons. The taxation of corporations at the rate of the normal tax, while requiring them to report the names of those receiving dividends and interest payments, gave an ingenious way in our law of checking up the returns of individuals in respect to a class of investments that is steadily increasing in importance. By

amendment, stoppage-at-source was in many cases changed to the requirement of reporting-at-source, as less troublesome and equally efficient.

The most disputed feature of the income tax probably was the principle of graduation, called also progression. It is up held in part because in this case it but offsets regression, that is, relatively heavier taxation on the smaller incomes, in the case of the other kinds of taxes (tariff, property taxes, etc.). It is urged further that those of larger incomes, especially the largest, have marked advantages over others in making in vestments. Further it is urged that the higher the income the less does a certain rate cut into the "amount necessary for good living" (as was said in Congressional debate). This is in accord with the psychological principles of choice, of value, and of diminishing gratification. Finally, there is a wide spread approval of the progressive rate just because it in so far acts as a leveling influence upon fortunes. The "addi tional" tax is already important fiscally, yielding more than one half of the total paid by individu,als and one fourth of the total from corporations and individuals.

§ 8. Development and yield. The income tax was made retroactive to include incomes accruing from March 1, 1913, to the end of the year, and continued to apply to December 31, 1915, and the personal income tax yielded approximately $28,000,000 in the ten months of 1913, $41,000,000 in 1914, and $68,000,000 in 1915. In September, 1916, the law was changed by doubling the normal rate and increasing the sur tax rates to a maximum of 13 per cent. This law also was applied retroactively to incomes accruing from January 1, 1916, and continued in force during the calendar year 1916, yielding more than $173,000,000.

After our entry into the war was passed the act of October 3, 1917, called the War Revenue Act, reducing the normal ex emption from $3000 to $1000 ($4000 to $2000 in case of mar ried persons living together), imposing under the name of an "additional normal tax" a new surtax of 2 per cent on all in comes of more than $3000 for single persons and $4000 for married persons, increasing the surtax maximum rate to 63 per cent and reducing to $5000 (taxable income) the point at which it began. The number of returns (that is, taxable per sons) was thereby increased to nearly three and one half millions, and the yield of the calendar year 1917 was more than $675,000,000.

The war tax legislation of February 24, 1919, attempted to meet the financial needs of the government when they were at the maximum. The principal changes in the individual income-tax law were in the normal and the additional normal rates, both being trebled to apply retroactively to incomes in the calendar year 1918, and the increase of the surtax by rearranging the classes and applying the maximum rate of 65 per cent to all incomes of more than $1,000,000 (half the amount previously paying the maximum). Under this act there were nearly four and one half million tax able persons, and the yield for the calendar year 1918 was $1,128,000,000. The act provided for the reduction of the normal rates (regular and "additional") each from 6 to 4 per cent for the calendar years 1919 and 1920.

§ 9. Corporate income and excess profits. Along with the federal taxation of individuals under the income tax has since 1913 been closely linked a new and special form of taxation of corporations. Important legislative changes in the one have been nearly always accompanied by equally important changes in the Before the adoption of the sixteenth amendment, the need for new revenue in the Taft adminstration led to the en actment, August 5, 1909, of an "excise tax" on corporations, measured by net profits within the taxing period. This yielded in the four years that it was in force an average of about $32,000,000 annually.

This excise-tax feature was abandoned in 1913, or it may be better to say that it was incorporated into the income-tax law of that year, by which net corporate profits ("incomes") were made subject to a normal rate of 1 per cent, as were those of individuals. This yielded between 1914 and 1916, between $30,000,000 and $60,000,000 a year. In 1916 this normal rate was increased to 2 per cent, at which the yield in creased to $180,000,000 in the fiscal year 1917. At the same time a tax of per cent was laid upon net incomes de rived from the manufacture of munitions (a business then most prosperous through enormous sales to the Allies) ; and the capital stock of certain large classes of corporations was subjected to a tax of 50 cents (soon doubled) on each $1000 par value in excess of $99,000. These various taxes on cor porations in the aggregate were capable of yielding nearly a quarter billion dollars. But this was only the beginning of corporation taxation. While continuing the normal income rates on corporations, the law of March 3, 1917, laid the first excess profits tax (8 per cent on corporate profits exceeding 8 per cent of actual capital invested) ; but this law was superseded by the War Revenue Act of October 3, 1917, which levied war excess profits taxes upon incomes alike of individuals, partnerships, and corpora tions. The details are too complicated for discussion here, but a few features may be noted. A distinction was drawn between incomes derived chiefly from personal or pro fessional service (taxed at a flat rate of 8 per cent, after the exemptions)and incomes derived primarily from invested cap ital (taxed at progressive rates in accordance with the per centage that profits bore to "invested capital" value). In the case of the latter the lowest rate, 20 per cent of profits, was applied on "net income" not in excess of 15 per cent of the invested capital; and the highest rate, 60 per cent on "net income" in excess of 33 per cent of invested capital. The amount of income exempted was $3000 for corporations and $6000 for partnerships and individuals, and also, in all cases, an amount of new income equal to a specified percentage of the invested capital during the "pre-war period," defined as the years 1911, 1912, and 1913. The yield from this tax was enormous, the total from corporate incomes and excess profits (mostly the latter) in the calendar year 1917 being nearly $3,000,000,000 and in 1918 more than $4,000,000,000.

§ 10. Defective theory of corporate income taxation. There is apparent in all this legislation the attempt to treat corporations and individuals on the same principles, especi ally in applying to both of them alike exemptions and pro gressive rates. There is much confusion of thought here, for (1) "income taxes on individuals" and (2) "income and ex cess profits taxes on corporations" are very different in their nature and their sources. The term "net income" as applied to individuals is charged with psychological meaning. The whole modern theory and justification of progressive rates as applied to income taxation assumes that the income on which the rates are imposed is a total of the various income items (real and monetary) of an individual. His net income within the year is available for spending and enjoyment, or to add to his capital as a net addition. If this net income total is small, it should not be taxed at all, for that would take away part of what is conceded to be necessary for the minimum of comfort. Hence, exemptions are granted not only to the poorer citizen, but to all citizens, for even the richer taxpayer should not be taxed on that portion of his income necessary to existence or minimum comfort. Hence, also, progressive rates on larger incomes, since the sacrifice, the psychic cost, of giving up the marginal portion of in comes is assumed to become progressively less to the indi vidual as his income increases. The second reason for pro gressive taxes, namely, the social benefit of leveling somewhat the larger fortunes, is likewise applicable only to individuals, or at most to large corporations owned by one or by few men.

In truth, the concept of income is not applicable at all to corporations without confusion of thought. Only indi viduals have net incomes, enjoyable or available for rein vestment. Corporations have receipts and expenditures, have net profits (or losses), at the end of the year, the equitable title to which belongs to various individuals, as evidenced by the securities they hold. But a moderately small cor poration may have virtually but one owner, and• he very rich, whereas an extremely large corporation may have many par tial owners, most of them with very modest incomes. Ex emptions and progressive rates, varying in accordance with the total of the profits ("income") of corporations, have therefore no relationship in principle to those in the ease of individuals.

Nor can taxation of corporate profits at progressive rates in accordance with the ratio of profits to invested capital be justified on the same grounds as progressive income taxa tion. "Invested capital" is a term that in practical busi ness has a wide range of meanings, and the excess profits tax, when first imposed, caught the corporations with the most varied book values of capitalization. In general, the more recklessly they have been financed and the larger the amount of watered stock they had issued, the smaller the rate of profits on which they were taxable, and vice versa. The im perative necessities of war finance may relatively justify any measure of taxation that produces the results immediately desired; but the fundamental defects soon produce grave abuses and widespread protests, and will compel revision of our federal corporate taxation. The income tax is here as a permanent feature of our tax system. Eventually it should be reconstructed on the sound principle that only individuals have incomes. In various ways increments in capital value and undistributed profits of partnerships and corporations might be periodically assessed as income to the individual owners, thus verging into one simple whole the many diverse elements in our present complex of income and excess-profits taxation.

§ 11. A system of taxation. The task of reforming and developing the various kinds of taxes and of uniting them into a just and consistent plan for each of the divisions of government in the United States is a vast and difficult one. There are many conflicting interests among states, between states and nation, among the various minor political divisions, and among individuals and classes. There are also conflicting opinions regarding many features of the possible practical plans. Because of these it is safe to predict that progress will not be made quickly, steadily, nor always directed toward a clear ideal. If progress is to be rapid, the public must, how ever, have consistent principles by which its steps may be guided. In the foregoing kinds of taxation are the various elements that may be united into a system of taxation. It is useful to consider how this might be done.

At the basis of the whole tax structure is taxation, by value, of concrete wealth at the place where it is situated (in situ). This should be regardless of the distribution of owner ship or of the residence of the owner. The present misnamed "general property tax" already presents the main outlines of this form of taxation, and the general changes necessary in law and method of assessment have been indicated Cor poration taxation may be adjusted to this either by separate treatment and assignment to state purposes only, or more sim ply for most states, by assimilating it with the general taxa tion of wealth and allotting due shares of the proceeds to the various taxing divisions." The national government can, be cause of its exclusive power of levying tariff duties and also because of its exclusive control over interstate commerce, reach the tax-paying ability of the nation effectively by a combina tion of tariff and internal duties levied upon business acts. These mostly become merged into business costs, and are diffused over the whole population through general prices.il This system of impersonal wealth taxation may then be supplemented by personal taxation, applied through inherit ance and income taxes. These forms of taxation extend over and reach many of the same persons and incomes as do ulti mately the impersonal taxes. But the summation of personal incomes gives the necessary condition for applying the prin ciple of progression as far as this is, by public opinion, deemed desirable either for fiscal or for social reasons.

9 See above, ch. 18, 4 5.

is See ch. 18, § 15, and § 16.

ii See eh. 16, 12 and § 14, first paragraph.

income, tax, taxation, incomes and cent