ments of a sound tax. Two defects characterize the tariff in this country when considered from the fiscal standpoint. One defect is its inelasticity. The proceeds of the tariff are likely to fall off just at the time when the government is most in need of revenue. This defect was acutely felt during the World War, for the falling off in imports reduced the customs receipts to a minimum. The government had to rely almost wholly upon other sources of revenue. This defect of the tariff has been clearly stated by R. F. Hoxie:

Throughout the history of the customs revenue system in the United States, the income from this source has been determined, not by the government need, but, almost wholly, by the character of temporary industrial, and more especially temporary commercial conditions. As a consequence, in war the current public income has proved utterly insufficient, unstable, and inflexible; in peace it has shown itself extremely uncertain, fluctuating with every crisis and even with the changes in the policy and condition of foreign nations; in times of prosperity it has forced upon the treasury embarrassing surpluses, leading to extravagant expenditure, speculation and crisis; in adversity it has left the treasury empty, necessitating the lavish use of the public credit.3

A second defect has been lack of simplicity. The Fordney-McCumber tariff contains duties for approximately 1,500 different articles. A force of 8,204 employees is necessary to administer the act. Upwards of two hundred pages are necessary to write the act, and several hundred additional pages are necessary for constructions of the act and for regulations for customs officers. England's pre-war tariff, mainly for revenue, which concentrated on ten leading articles, was simplicity itself in comparison with the intricacies and complexities of the American schedules. Classifications recommended by the Tariff Commission have been incorporated in the present Act, but they still leave the law an enormously complex affair.

Both on the grounds of elasticity and simplicity, the modern protective tariff falls short of a satisfactory form of revenue. Its main justification must be found in its effect upon protected industries.*

Income Taxes.-Income taxes are applicable both to individual incomes and to corporation incomes. Taxation of corporation incomes has already been discussed, and hence only taxation of personal incomes need be considered here. The first federal income tax was passed as an emergency measure during the Civil War. Owing to faulty administration, this tax was repealed after the war. In 1894, an income tax was revived, but was soon declared unconstitutional by the Supreme Court. Article I, Section 9, of the constitution states:

No capitation, or other direct, tax shall be laid, unless in proportion to the census or enumeration herein before directed to be taken.

3 See C. J. Bullock, Selected Readings in Public Finance, 3rd edition, p. 774. 4 This phase of the tariff has been discussed in detail earlier, in sections dealing with international trade.

The Civil War tax had been construed as an indirect tax, but the 1894 tax was construed as a direct tax. It therefore violated the constitution. In 1913, the constitution was amended as follows:

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 or enumeration.

Congress promptly passed a revenue act employing the income principle, and the income tax in one form and another has remained on the statute books ever since. The rates became extremely high during the World War and the years immediately following, but were readjusted to a more permanent basis in 1924. The following analysis refers mainly to the 1924 law.

Numerous state governments have also adopted the income tax principle. The turning point in state adoption came in 1911. Prior to that year, all state experiments in income taxation had met with failure, due to incompetent methods of administration. In 1911, Wisconsin provided an adequate form of centralized state administration and soon demonstrated that a state income tax law could be made a success. Massachusetts, New York, and other states have taken up the principle. In 1925, fourteen states had personal income tax laws, and twelve states had corporation income tax laws.

Economics has neglected an adequate study of the meaning of income. Income tax authorities have had to develop a definition of income, suited to the specific purpose in hand. The result is a statutory conception of taxable net income.

The beginning of this conception is gross income. After gross income has been computed, net income is a next logical step in calculation. The term "gross income" includes gains, profits, and income derived from salaries, wages, or compensation for personal service of whatever kind and in whatever form paid. But gross income does not include all that comes in. Certain receipts are definitely excluded from gross income. Such exclusions would be proceeds of life insurance policies paid upon the death of the insured, dividends on life insurance premiums, the value of property acquired by gift, bequest, devise, or descent, interest upon federal and state obligations, amounts received through accident, health, or workmen's compensation insurance, alimony, and sums received for personal damages, such as libel, slander, or breach of promise.

Net income means gross income less deductions, exemptions, or "credits." Single persons have an exemption of $1,500 and married persons an exemption of $3,500, together with an exemption of $400 for each dependent person. Other exemptions include bad debts, charitable contributions and gifts, interest on indebtedness, dividends from corporations (exempt from normal tax but not from surtax), salaries of state officers and employees, and other items. The final calculation leaves See C. C. Plehn, "Income as Recurrent, Consumable Receipts," American Economic Review, Volume XIV, March, 1924, p. 1 ff.

the taxable net income, or statutory net income. According to the regulations issued by the Treasury Department, statutory net income is substantially identical with accounting net income."

The rate structure rests upon a distinction between normal taxes and surtaxes. The normal tax under the 1924 law is 2 per cent on the first $4,000 of net income, 4 per cent on the next $4,000, and 6 per cent on all above $8,000. The surtaxes apply only to net incomes in excess of $10,000. The rates begin at 1 per cent and rise to 40 per cent on net incomes in excess of $500,000. The surtaxes are in addition and not in lieu of the normal taxes, so that a net income of $12,000, for instance, would pay a normal tax on the full amount plus a surtax on the amount in excess of $10,000. In 1918, the normal tax was 12 per cent and the surtaxes ran as high as 65 per cent for the largest incomes. These rates were excessive, and were only justified, if they were justified at all, on the ground that war emergency required extreme measures.

The argument has been strongly urged that high surtax rates are destructive of capital. They are said to take away capital from the wellto-do, which would otherwise be used for productive enterprise. Also, they are said to drive capital into tax-exempt bonds of states, municipalities, and other local units of government, and to encourage wasteful and extravagant expenditures on their part, particularly in the cities. Difficulty comes in agreeing at what precise point surtax rates should fall, without destroying private capital and discouraging initiative. The 1924 act reduced surtax rates mildly, but not enough to satisfy many groups. The final determination of rates will doubtless remain the center of further political controversy and experimentation.

Even though surtaxes be reduced, few people would advocate that the principle of progression be abolished altogether. At first, progression was bitterly fought, but now it is pretty generally conceded that progression is necessary if income taxation is to square with the canon of ability to pay, or equality of sacrifice. This accepted principle does not apply with equal force to corporation income taxation. There, the proportional method is often adhered to and was adopted in the 1924 legislation.

The income tax presents serious problems of duplication, or multiple taxation. Many of the states tax non-residents, who are also subject to income tax in their states of domicile. Their incomes, in addition to being subject to tax in two states, are also subject to the income tax of the federal government. The federal government, moreover, faces the problem of taxing alien residents and resident citizens who derive income from foreign countries. The international duplication has been in part remedied by applying the principle of reciprocity. For instance, alien residents of the United States may deduct from taxes payable to this country the amount of similar taxes paid to a foreign country, if the

See above, p. 203, footnote.

7 Non-citizens and non-residents must pay a straight 6 per cent normal tax on all net income.

foreign country of which such alien residents are citizens, in imposing such taxes, allows a similar credit to citizens of the United States residing in such country. In spite of such reciprocal treatment, however, international comity in taxation still presents many problems. The problem of inter-state duplication would be greatly simplified by adoption of the principle of taxing only residents of the state. Many states are unwilling to make this concession, however, because they believe that well-to-do outside investors in property of the state drain income out of the state without returning anything to the state.

A distinction is now drawn between earned and unearned income. The British were first to adopt the principle that earned income, derived from wages, salaries, etc., should be taxed less heavily than unearned incomes, derived from ownership of property. For purposes of tax administration some rather arbitrary methods of measuring the two kinds of income were introduced into the 1924 law in the United States. If the taxpayer's net income is not more than $5,000, his entire net income shall be considered earned, regardless of where it comes from. But not more than $10,000 can be counted as earned income, even if income above that is solely in the form of personal salary. A deduction of 25 per cent of the normal tax is allowed on the earned income. Although we may well agree with the principle that certain forms of earned income should be taxed less than unearned income, nevertheless we can scarcely approve of the cumbersome method of administration of this principle. Unless a better method can be devised of applying the principle, it is doubtful if the principle will continue as a part of income tax procedure.

The British income tax employs the method of stoppage at the source in collection of the income tax. The tax is deducted from income before the taxpayer gets the income. The government, for instance, deducts the tax from interest on its own bonds before disbursing interest to bondholders. Private debtors likewise must deduct the stated tax from all debt payments, so that creditors receive only the net debts after the tax is out. Corporation shares must pay the tax before dividends are disbursed. Tenants of real property deduct the tax from the rentals due the landlords. Numerous forms of income, however, cannot be reached by stoppage at the source, and hence each taxpayer is required to make out a declaration of income. The American system has not made stoppage at the source a method of collecting the income tax, although certain forms of it have crept in. The most conspicuous form is the exemption of dividends from the normal tax on individual incomes, and the taxing of the corporation income directly at the source. The American system does, however, gather information at the source, by requiring all employers to report their salary and wage disbursements to the internal revenue bureau. The bureau can check back over the individual declarations to make sure that incomes have not been understated.

Centralized administration is the keynote of effective enforcement of

the income tax. The original fear that evasions would be universal has not been warranted in fact, because centralized state and federal administration has been reasonably efficient in ascertaining the proper amount of taxable income. State administration has particularly to face the problem of relating the income tax to the property tax. In some states, the income tax has taken the place altogether of the property tax in state revenue. In other states, the classified property taxes, in moderate forms, are used in conjunction with the income taxes. In many states, the receipts of the income tax are not used exclusively for state expenditure, but are apportioned in part among the local communities. In general, the adoption of income taxes has lessened reliance upon the general property tax.

At first, it was assumed that complete secrecy about income tax returns was indispensable. However, certain authorities advanced the doctrine that publicity of returns would help in preventing individuals from understating income and escaping taxation. In 1924, the principle of publicity of returns was established. It is questionable whether publicity is of any material advantage.

The fiscal adequacy of the federal income tax is shown in the following table:

32.

1 Returns reporting net income of $3,000 and over.

* Statistics of Income, Bureau of Internal Revenue, 1922, p.

2 Determined on the basis of the number of returns filed and the average net income in each class. 3 Returns reporting net income of $1,000 and over.

The income taxes, both individual and corporation, are among the most flexible sources of revenue. By careful adjustment of rates from