THE NEW INCOME TAX

The new income tax law, which is known officially as Section II of the Tariff Act of October 3, 1913, is the result of a movement that has been going on in this country for over a third of a century. The great western democratic upheaval which brought forth the many radical granger laws of the seventies and eighties dominated not only state but also national legislation and forced the enactment of the silver, interstate commerce, and anti-trust acts. It produced, also, as a part of the same general legislation, the income tax law of 1894, a law not premature in the time of its enactment, but, nevertheless, one which was soon nullified by the United States Supreme Court in a decision that the great majority of citizens considered a radical reversal of long standing precedents and an unwarranted overthrow of the will of the people. No decision during the present generation has so shaken the confidence of the masses in the fairness of this high tribunal nor has any brought forth so many assaults upon its integrity. Perhaps even more lamentable was the arousing and increasing of class prejudice throughout the nation.1

It was some time before the masses and their leaders recovered from the shock of this decision. The great western movement had been effectually checked and thwarted; the former silver legislation had already been repealed; the great trusts had succeeded in circumventing the anti-trust law; and the gold forces were soon to establish their standard upon a firm foundation. Any effort to secure an income tax seemed hopeless unless the Supreme Court could be reorganized or an amendment to the federal Constitution adopted. The former alternative was impossible so long as the opposing hosts were in political power, and the latter was almost equally hopeless because people had almost come to believe that formal changes in the Constitution were practically impossible short of civil war. The gradual relief from the prolonged economic stress of that period tended to lessen the pressure for an income tax, and before long the attention of the nation was diverted by the Spanish-American War and the great industrial revival and scramble for world markets, which followed that event.

But in spite of these facts, there were several attempts to circumvent the court's decision and to accomplish by indirection

1

Seligman's Income Tax (1911) contains an admirable discussion of this decision and of the succeeding efforts to secure a national income tax.

what had failed through direct means. During the Spanish-American War it was proposed to tax the gross earnings of corporations, but when the bill "emerged from committee, it provided for a special excise tax on the gross receipts of companies refining petroleum and sugar." Obviously, it was meant to appear as a tax upon two of the most unpopular trusts. This bill became law and the Supreme Court held it to be not in conflict with the income tax decision. A federal inheritance tax of the same period was upheld also as not being a direct tax within the meaning of the Constitution.

Various political leaders, including President Roosevelt, expressed not only the desirability of a federal income tax, but also the belief that one could be framed in such a way as to be upheld by the court. After the Democratic party had put in its platform of 1908 a demand for a constitutional amendment, Mr. Taft, as the candidate of the Republican party, expressed the opinion that no constitutional amendment was needed, but that if the protective system should fail to furnish enough revenue an income tax that would be upheld could be devised. But in his inaugural address, he said nothing about an income tax; instead, he suggested an inheritance tax if customs revenues should prove inadequate. A provision for such a tax was introduced into the new tariff bill of 1909, but the opposition by the states to a federal tax on inheritances and the western demand for an income tax were so great that the inheritance tax provision was dropped.

But in order to head off the movement for a general income tax, the Republican leaders were forced to favor a low excise tax upon corporations and to provide for the submission of a constitutional amendment, perhaps with the belief and hope that it would never receive the requisite approval of three fourths of the states. The fate of the amendment was doubtful for some time, particularly after its rejection by New York, Massachusetts, and other influential states. In fact, it did not become law until 1913, that is, not until after the leaders of the new Democratic administration had decided to enact an income tax under the guise of an excise tax if the amendment should fail or if its adoption were delayed longer. But its final ratification just at the time the new administration came in opened the way for a direct income tax, and the new law is the result.

As was to be expected, many criticisms of the bill were made while it was pending. Before it was finally passed several minor

changes were made, but few amendments involved fundamental principles. All classes of interests throughout the country conceded that it would be enacted substantially as introduced and few offered objections to the general principle of income taxation. Many did object, however, to various details, particularly to the high exemption or abatement and to the provisions for collection at the source. The life insurance companies conducted probably the most extensive campaign to modify certain provisions, and with some though not entire success.

Since the law went into effect a short time ago, criticism has broken out anew. Legal proceedings have already been begun to test its constitutionality; many bankers and holders of interest coupons have complained of its inconvenient and vexatious requirements; and the press of the whole country has been flooded with statements of lawyers, bankers, and others to the effect that the provisions of the law are intricate, inconsistent, and incomprehensible. Apparently there has been a concerted movement to force upon the whole country the impression that these characterizations of the tax are true.

As a matter of fact, there is a considerable amount both of truth and of untruth in these assertions. The income tax law as enacted is comparatively brief and for the most part is merely a framework of general principles upon which to build up the details of the structure. These main principles are fairly simple and easy to comprehend. But the act provides that the details shall be worked out by the Commissioner of Internal Revenue with the approval of the Secretary of the Treasury. Inasmuch as the law is still very new, comparatively little of the structure has been erected and fixed in final form as yet, but new rulings are being issued rapidly, and in due time points not definitely and specifically covered by the act should be intelligible and clear to all concerned. It is not reasonable to expect that a new system of the proportions contemplated by the law can be established all at once without some inconvenience and some difficulties of interpretation. Income taxes in other countries have usually provoked widespread and continued opposition at first and have later been accepted as among the most satisfactory of taxes.

The new tax has been modeled partly upon those of 1894 and the Civil War period, partly upon the recent corporation tax, and also to some extent upon the English income tax. Its adoption to meet the deficit expected from the lower tariff rates is somewhat

analogous to England's adoption of her income tax in 1842 in connection with the repeal of the corn laws. The demand of the English manufacturers for cheaper food for their employees was not without some counterpart here, and it is probable that this demand, together with the demand for cheaper raw materials, will operate with even greater force to reduce tariffs in the future.

In accepting the principle of progression, the new law departs from that of 1894 and follows the principle of the English supertax which was successfully resisted in that country for many years but finally adopted in 1910. It does not follow the English principle of differentiation between earned and unearned incomes, a reform approved there in 1907, nor does it divide incomes into schedules as does the English law. But in the fundamental administrative matters of assessment and collection of the "normal tax," it does follow the English principle of stoppage-at-the-source rather than the Prussian system of self-assessment of the lumpsum income of each individual.

Further discussion of the new tax will be clearer after an analysis of the provisions of the law. The constitutional amendment making the law possible is as follows: "Congress shall have power to lay and collect taxes on income from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration."

Chief Provisions of the New Law

Except as otherwise provided, the new income tax is to be levied "annually upon the entire net income arising or accruing from all sources in the preceding calendar year to every citizen of the United States, whether residing at home or abroad" and to every resident alien. A like tax is to be levied upon the "income from all property owned and of every business, trade, or profession carried on in the United States by persons residing elsewhere."

The term "income" includes such gains and profits as wages, salaries, interest, income from trade, business, professions, sales, and transactions of every kind, but it does not include proceeds from life insurance policies nor the value of property acquired by inheritance or gift. The inclusion of the word "accruing" makes the tax payable for the year in question, even though the income may not be actually received until later.

The income tax is really composed of three fairly separate and distinct taxes: first, and simplest, a "normal tax" of one per cent

upon the entire annual net income of every corporation; second, a "normal tax" of one per cent upon the excess above $3,000 of every individual's net income ($4,000 deduction allowed married couples); and third, a graduated "additional tax" upon the excess above $20,000 of every individual's net income. That is, corporations are not allowed the $3,000 deduction, but, on the other hand, they are subject to the "normal tax" only, not to the "additional tax," as are individuals. Insurance companies, however organized, joint-stock companies, and associations are treated as corporations. The incomes of partnerships are to be returned and taxed as parts of the incomes of the individual partners.

The rates of the "additional tax" upon parts of the net income are as follows:

In computing an individual's net income for purposes of both normal and additional taxes, the following deductions are allowed: first, necessary expenses actually paid out in carrying on any business, but not including personal, living, or family expenses; second, interest on indebtedness; third, national, state, and local taxes, but not including those assessed against local benefits; fourth, losses not compensated for by insurance or otherwise; fifth, worthless debts; sixth, depreciation, but not expenses for betterments.

Three other deductions are allowed individuals for purposes of the normal tax, but not for purposes of the additional tax: first, the $3,000 abatement already referred to ($4,000 for married couples); second, corporate dividends and earnings upon which the corporations pay the tax; and third, amounts of income upon which the tax is withheld at the source. It will be pointed out later that the second of these deductions will not always avoid discrimination when applying to this class of incomes; in its practical workings there is more difference between it and the third deduction than appears at first glance.

The deductions allowed corporations are much the same as the first set for individuals but there are exceptions worth noting.