348. The Federal Income Tax15

BY EDWIN R. A. SELIGMAN

The enactment of the income-tax law of October 3, 1913, marks a new stage in the history of American finance. The American tax was designed from the very outset as an integral and permanent part of the fiscal arrangements.

The chief argument which was responsible for the passage of the Sixteenth Amendment and for the enactment of the law was that wealth is escaping its due share of taxation. Again and again in the course of the discussion attention was called to the fact that our federal system of taxes on expenditure puts an undue burden on the small man; and when the objection was made that the principle of ability to pay is recognized in state and in local taxation, the ready answer was found that in actual practice our state and local revenue systems fail almost completely to reach those taxpayers who can best afford to contribute to the public burdens.

Under the provisions of the statute the tax is imposed upon the entire income of every American citizen, whether residing at home or abroad, as well as upon that of every person residing in the United States although not a citizen thereof. In the case of non-citizens of the United States residing abroad, the tax is assessed upon the income from all property owned, and from every business, trade, or profession carried on, in the United States.

The law applies not only to individuals but to corporations. The income tax is payable by every corporation, joint-stock company, or association, and every insurance company organized in the United States, with a few exceptions.

It is easy to say that income should be taxed, but it is not so easy to define what is meant by income. The law of 1913 states that net income shall include gains, profits, and incomes derived from salaries, wages, or compensation for personal services of whatever kind, and in whatever form paid; or from professions, vocations, businesses, trade, commerce, or sales or dealings in property, whether real or personal, growing out of the ownership or use of, or interests in, real or personal property; also from interest, rents, dividends, securities, or the transaction of any lawful business carried on for gain or profit, or gains or profits and income derived from any source whatever, including the income from, but not the value of, property acquired by gift, bequest, devise, or descent.

15 Adapted from "The Federal Income Tax," in the Political Science Quarterly, XXIX, 1-4, 11, 13–18. Copyright (1914).

In discussing the question of tax rates the two chief problems are those of exemption and of graduation.

The most important point to be noted under the head of exemption is the fact that the tax applies to individual incomes only when they exceed $3,000. In this bill, as originally drafted, the exemption was put at $4,000. In the course of the discussion, however, and partly as a concession to the feeling that the limit was excessive, it was reduced to $3,000, with additional exemptions of $500 or $1,000 for children. In the final draft, while the figure of $3,000 was retained, the exemption for children was eliminated and was replaced by an additional exemption of $1,000 for a married couple. A total exemption, however, of $4,000 only is permitted in the case of aggregate income of husband and wife when living together. It is to be noted, moreover, that the exemption applies to the first three or four thousand dollars respectively of any amount of income; that is to say, three or four thousand dollars respectively are always to be deducted from the net income, in order to reach the taxable in

come.

The consideration of tax rates involves not only the question of exemption, but that of graduation. It is significant that the principle of progressive taxation evoked almost no discussion. The legitimacy of the theory was taken for granted. In considering the question of graduation, only two difficulties confronted the framers of the bill. The one was how to make a workable system of progressive taxation harmonize with the administrative methods employed; the other how to oppose with success the demands of the radicals.

The former difficulty is connected with the principle of stoppage at source, to be discussed below. It is clear that if a tax is paid at the source by the income-payer, rather than by the income-recipient, it is not easy to introduce a graduated scale. The bonds of a corporation, the tax on the income of which is withheld by the corporation, may be owned by a person of very small or of very large total income.

This problem had, however, recently been solved in England, where a uniform rate is imposed upon all taxpayers, and is assessed on the principle of stoppage at source. This remains the backbone of the tax. Then on all individual incomes above a certain figure, a so-called super-tax is levied upon the income as a whole. The same plan has been adopted in the new American law. The uniform tax levied upon all incomes, primarily by the method of stoppage at source, is called the normal tax, and is assessed at the rate of 1 per cent. The extra tax is called the additional tax or surtax and is assessed on the entire income of individuals, according to a graduated

scale. The advantage of this ingenious scheme is that the constituent parts of the income of any individual will be reached in large measure by the normal tax, and in such a way that the government will be able to ascertain the facts. The returns made by individuals for the additional tax can, to a considerable degree, thus be checked up, and the fiscal interest of the government be protected. The protection is, however, not complete; for, the principle of stoppage at source does not apply to all incomes within the United States, and implies only in an imperfect way to incomes received abroad. To a very large extent, however, the protection is undoubted. Thus it may be said that the old problem of the incompatibility of graduated taxation with stoppage at the source has been attacked with a fair prospect of success.

The other difficulty with which the framers of the bill had to cope was the danger of an exaggerated application of the progressive scale. In the original bill, the clause relating to the "additional” tax was so framed as to impose I per cent on incomes from $20,000 to $50,000, 2 per cent on incomes from $50,000 to $100,000, and 3 per cent on incomes above $100,000. In the course of the discussion, however, many amendments were introduced calling for much higher scales. The general feeling was that the graduated scale contained in the bill was not high enough. For instance, Senator La Follette proposed a scale which ran up to 10 per cent. As a result of the discussion the Finance Committee of the Senate saw that some concession was inevitable. Under the law as it was finally enacted, the rates of the "additional" tax are as follows:

The maximum rate of the income tax as a whole, therefore, 'under the new law, is somewhat under 7 per cent. This is somewhat lower than either the English maximum or that of the recent German Wehrsteuer.

The provisions in the new law which deal with the methods of assessment and collection involve a fundamental departure from the theory of all preceding income taxes in the United States. As has been frequently pointed out, the two chief types of income tax

are the personal or lump-sum tax, where everyone is compelled to make a return of his entire income from whatever source derived, and the stoppage-at-source tax, the theory of which is that it should be collected from the person or agency paying the income, rather than from the individual who receives it. The argument in favor of payment at source is the double one of protecting the honest taxpayer, and of safeguarding the interests of the Treasury. There is little doubt that a purely personal lump-sum income tax resting primarily on the declaration of the individual would be as much of a failure in the United States as was the original income tax in England or the American income tax in the years subsequent to the Civil War. It was to avoid these evils that England adopted the principle of stoppage at source to a certain extent at least, and that some other countries have in a minor degree followed this example. It was reserved, however, for the United States to apply the principle in a more thoroughgoing fashion than is the case anywhere else.

The law provides that "all persons or firms, co-partnerships, companies, corporations, joint-stock companies or associations, in whatever capacity having control, receipt, disposal, or payment of fixed or determinable annual or periodical gains, profits, and income of another person, subject to tax" are required to deduct and withhold the annual tax of 1 per cent from all "interest, rent, salaries, wages, premiums, annuities, compensation, remuneration, emoluments, or other fixed or determinable annual gains, profits, and income of another person exceeding $3,000 for any taxable year." In the case of payment of interest on bonds and mortgages or of trusts or similar obligations of corporations, as well as in the case of collections of interest and dividends on foreign bonds and stocks not payable in the United States, the tax is to be deducted on all sums irrespective of whether or not the payments amount to $3,000. The obligation to withhold the tax is not applicable to three cases. First, it does not apply to the dividends on the stock of corporations for the reason that all such corporations are subject to the tax on their net income, irrespective of whether they pay out this income as dividends or allow it to accumulate as surplus and undivided profits. Secondly, the obligation to withhold the tax does not apply to the interest on bonds, mortgages, equipment-trust, receivers' certificates, or similar obligations of which the bona fide owners are citizens of foreign countries and residing abroad. Thirdly, it does not apply to the payments to a corporation, the reason for this obviously being that all corporations are required to file a complete return of all of their income, and that the books of the corporation are open to inspection by the revenue authorities.

349. Public Capitalization of the Inheritance Tax1

BY ALVIN S. JOHNSON

There are new burdens to be assumed, and tremendous ones, just over the present horizon of the state. Pensions for the superannuated and disabled, relief for the sick, reformation of the outcast, subsidies for indigent motherhood, conservation of child life and of the human resources we now neglect through parsimony in educational effort are among the burdens which the state will in the end be forced to assume. Whether we approve or disapprove of the state assumption of responsibilities of this nature, as dispassionate observers of historical tendencies we are compelled to admit that in every modern state the party of "social reform" is making rapid headway. There is in the existing social constitution no opposing force powerful enough to prevent the ultimate realization of part, if not of the whole, of the program of the social reformers. With the new fiscal burdens that will have to be assumed, new sources of revenue must be found, or old sources must be made more fruitful. It is a realization of this situation that fixes the eye of the democracy upon the vast mass of wealth passing each year from the able hands of its accumulators to the hands of all but passive heirs. What profit shall the democracy fix for itself on death's turnover?

To Adam Smith and his immediate successors the inheritance tax presented one serious defect: it is an unthrifty tax, falling, not upon "revenue," but upon capital, and hence tends to deplete the national stock of parent wealth. If this view of the matter is valid, the progress of inheritance taxation as a source of ordinary revenue cannot be regarded as an unmixed good. Admitting, as we must, that the maintenance of the capital stock is not in itself the highest end of social policy, and that we must at times accept capital depletion as the legitimate cost of a higher good, we are yet not justified in overlooking the fact that the dissipation of accumulated capital is a social cost which should be reduced to a minimum, so far as this is possible. This point, I assume, scarcely needs argument, as the social-economic value of thrift is one of the best-established values of economic theory.

The inheritance tax rests upon the entire mass of wealth, including that which originates in unearned increment as well as that which originates in saving. But the state does not take from a given inheritance proportionate shares of the lands, reproducible goods,

16 Adapted from "Public Capitalization of the Inheritance Tax" in the Journal of Political Economy, XXII, 160-180 (1914).