During the year 1913 a most amazing event happened. The United States
amended its Constitution by peaceful means. Indeed the Constitution was
twice amended; for, having passed the sixteenth amendment in February,
permitting an income tax, the States, just to show what they could do
when aroused to it, passed the seventeenth amendment in May,
authorizing the direct election of United States senators by the
people.
Amending the United States Constitution is so difficult and cumbrous a
proceeding, that it had not previously been accomplished for over a
century, except by the throes of the terrible Civil War. The original
Constitution had twelve amendments added to it before it was fully
established in running order in 1804. The thirteenth, fourteenth, and
fifteenth amendments were added after 1865 to prohibit slavery. They
were forced upon the unwilling Southern States. From 1804 to 1913 no
amendment was put through by the regular process. Yet in that time
efforts to amend were made on over one hundred and forty occasions. Men
had grown discouraged at last; they said that amendment was impossible.
The cumbrous system which has thus so long blocked all change was that
Congress must by a two-thirds vote in each House agree to submit an
amendment to the States. These must then pass upon the new law, each in
its own legislature. If three-fourths of the legislatures approved, the
amendment was to be accepted. Few of the proposed changes ever won a
two-thirds vote in both Congressional Houses; and of those few not one
had ever appealed to the necessary overwhelming majority of State
legislatures. The Senatorial amendment passed Congress several years
ago, and had long been knocking rather hopelessly at legislative doors.
Then the Income Tax amendment appeared. Congress passed it almost
hurriedly in a spasm of progressiveness in 1909. Then came the great
sweep of progressive policies to victory in the elections of 1912; and
legislatures everywhere awoke to the universal insistence on the Income
Tax. All the States but six approved the amendment; and one of the last
acts of President Taft during his administration was to proclaim its
adoption. The popular amendment swept along in its train the Senatorial
change; and the latter, though still opposed by most of the old South,
was ratified by all the rest of the States except Rhode Island and
Utah. So it also became law.
Nothing illustrates better the "tyranny of the dead hand" in the United
States than the history of the income tax. The Constitution laid it
down that no head tax or other direct tax should be imposed except by
apportioning it among the several States on the basis of their
population. No more effective barrier to any system of direct taxation
could possibly have been devised. It would seem clear that the main
intention of this Constitutional provision was not merely to protect
the people of the smaller States, but to force the United States
Government to depend for its revenue upon indirect taxes. Such, at any
rate, has been its effect. Legal ingenuity, however, can get round
anything. The Supreme Court decided as long ago as 1789 that an income
tax was not a direct tax, and need not, therefore, be apportioned among
the States. During the Civil War, though not, curiously enough, until
every other source of taxable wealth had pretty well run dry, an income
tax was actually imposed by three separate Acts of Congress, the Act of
1864 levying a tax of 5 per cent. on all incomes between $600 and
$5,000, and of 10 per cent. on all incomes above $5,000. The tax
continued to be collected up to 1872, when it was repealed.
The constitutional character of the tax, when levied without
apportionment among the States of the Union, was once more fully argued
out in the Supreme Court, which in 1880 reaffirmed its decision of
1789, that a tax on incomes was not a direct tax. Some fifteen years
later, however, the question emerged again, and in a crucial form. The
Democrats came into power in 1893, and proceeded to reduce the tariff,
relying upon a tax of 2 per cent. on all incomes of over $4,000 to make
good the expected loss of revenue. The Supreme Court in 1895 shattered
all their fiscal plans and policies by pronouncing the income tax to be
a direct tax, and therefore incapable of being levied, except in strict
proportion to the population of the various States, and therefore, in
effect, incapable of being levied at all.
That decision, in all its absurdity, has stood ever since. Its
consequences were to deny to the United States Government the right to
tax incomes, to restrict it still further to customs duties as
virtually its sole source of revenue, to deprive it of a power that
might one day be vital to the safety of the Union, and to exhibit it in
a condition of feebleness that was altogether incompatible with any
rational conception of a sovereign State. It is true that the Supreme
Court has changed not only its _personnel_, but its spirit, and its
whole attitude toward questions of public policy, since 1895. It has
more and more allowed the influence of the age and the necessities of
the times and the clear demands of social and economic justice to
moderate its decisions; and had the question of an income tax been
brought before it any time in the last five years, it would probably
have reversed its judgment of 1895. But President Taft was undoubtedly
right when he urged, in 1909, that the risk of another adverse decision
was too great to be run, and that the safer course was to proceed by
way of an amendment to the Constitution.
The mere passing of the Income Tax amendment did not, however,
establish an income tax. It merely authorized the government to do this
at will. President Wilson's administration was prompt to take the
matter up. The Democrats, in conjunction with their reduction of the
tariff, needed a new source of revenue. So in October of 1913 the
Income Tax law was passed. In theory an Income Tax is obviously the
most just of all taxes. It summons each citizen to pay for the
government in proportion to his wealth; and his wealth marks roughly
the amount of government protection that he needs. In practise,
however, the working out of an income tax is so complex that every
grumbler can find in its intricacies some cause of complaint. The
present tax is therefore described here by an expert statistician, Mr.
Joseph A. Hill, the United States Government official at the head of
the Division of Revision and Results of the Census Bureau in
Washington.
Among the notable events of the year 1913, one of the most important in
its influence upon the national finances and constitutional development
of the United States is the adoption of an amendment to the Federal
Constitution giving Congress the 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." The
mere fact that an amendment of any kind has been adopted is notable,
this being the first occasion on which the Constitution had undergone
any change since the period of the Civil War, and the first amendment
adopted in peaceful and normal times since the early days of the
Republic.
It is a little remarkable, although perhaps not altogether accidental,
that the adoption of this amendment should coincide with the return to
power of the political party whose attempt to levy an income tax in
1894 was frustrated by the decision of the Supreme Court in that year.
Then as now an income tax was a component part of the program of fiscal
and commercial reform to which that party was committed. This program
included the reduction of protective tariff duties and the direct
taxation of incomes. What the Democratic party failed to accomplish in
1894, it has had a free hand to do in 1913. Indeed, the national
taxation of incomes might almost be regarded as a mandate of the people
of the United States. At any rate, it was a foregone conclusion that
the adoption of the constitutional amendment would be immediately
followed by the enactment of an income-tax law.
The law instituting the income tax was approved October 31[?], together
with the law revising the tariff, both measures being included in one
comprehensive statute entitled "An Act to reduce tariff duties and to
provide revenue for Government, and for other purposes." It is the
object of the present article to give a general description of the
income tax. This seems to be especially well worth while because the
tax can not be readily understood from a mere perusal of the involved
and sometimes obscure phraseology of the law itself. For the same
reason, however, the task of interpretation is not easy or entirely
safe. The law has certain novel features; and some of the questions of
detail to which they give rise can not be answered until we have the
official construction placed upon the language of the act by the
executive branch of the government and possibly by the courts. At the
same time, the main features of the tax become fairly evident to any
one who makes a careful study of the provisions of the act, even though
its application to specific cases may remain doubtful.
The law provides that incomes shall be subject to a tax of one per
cent. on the amount by which they exceed the prescribed minimum limit
of exemption. This is designated as the "normal income tax." There is,
then, an "additional tax" of one per cent, on the amount by which any
income exceeds $20,000. The rate is increased to two per cent. on the
amount above $50,000, to three per cent. above $75,000, to four per
cent. above $100,000, to five per cent. above $250,000, and to six per
cent. above $500,000. Therefore, under the normal and additional tax
combined, the first $20,000 of income, exclusive of the minimum
exemption, will be taxed one per cent.; the next $30,000, two per
cent.; the next $25,000, three per cent.; the next $25,000, four per
cent.; the next $150,000, five per cent.; the next $250,000, six per
cent.; and all income above that point seven per cent. This is a
rigorous application of the progressive principle.
The minimum exemption, at the same time, is comparatively high,--$4,000
for a married person and $3,000 for everybody else. The higher
exemption in case of the married is conditional upon husband and wife
living together, and applies only to their aggregate income; that is to
say, it can not be deducted from the income of each. It may be noted,
in this connection, that in England the exemption allowed under the
income tax is £160 or $800; in Prussia it is 900 marks, or $225; and in
the State of Wisconsin it is $800 for individuals and $1,200 for a
husband and wife, with a further allowance for children or dependent
members of the family.
The sharply progressive rates and the comparatively high exemption have
given rise to the criticism that this is a rich man's income tax and
disregards the principle that all persons should contribute to the
expenses of the government in proportion to their several abilities. It
is often said that an income tax ought to reach all incomes with the
exception of those which are close to or below the minimum necessary
for subsistence, and that if people generally were called upon to
contribute directly to the government they would take greater interest
in public affairs and show more concern over any wasteful or unwise
expenditure of public money. In reply it is contended that the
limitation of the tax to the wealthy or well-to-do classes is justified
because these classes do not pay their fair share of the indirect
national taxes, or of local property taxes. These debatable questions
lie outside the scope of the present article. It is evident, however,
that the income tax should not be criticized as if it were a single tax
or formed the only source of revenue for the Federal government. From
the fiscal standpoint it occupies a subordinate position in the
national finances, being expected to yield about $125,000,000 annually
out of a total estimated tax revenue of $680,000,000.
The normal tax of one per cent, is to be levied upon the income of
corporations. In effect this provision of the law merely continues the
corporation or "excise" tax which was already in existence. But that
tax now becomes an integral part of the income tax, covering the income
which accrues to the stockholder and is distributable in the form of
dividends. On the theory that this income is reached at the source by
the tax upon the net earnings of the corporation the dividends as such
are exempt. They are not to be included, so far as concerns the normal
tax, in the taxable incomes of the individual stockholders and the law
does not provide that the tax paid by the corporation shall be deducted
from the dividend.
It is perhaps a question whether under these conditions income which
consists of dividends should be considered as subject to the normal tax
or as exempt. It may be contended that a tax upon the net earnings of
corporations is virtually a tax on the stockholder's income, and in
theory this is true. But so long as the tax is not actually withheld
from the dividends, or the dividends are not reduced in consequence of
the tax, the stockholder's current income is not affected. The
imposition of the tax might indeed affect his prospective income and
might depreciate the value of his stocks. It is hardly likely, however,
that such effects will be perceptible, at least as regards the stocks
of railroads and other large corporations. If, however, it be
considered that income consisting of dividends pays the tax, it follows
that the stockholder's income is taxed no matter how small it may be.
No minimum is left exempt. On the other hand, if it be considered that
all dividends are virtually exempt, the stockholder would seem to be
unduly favored under this form of taxation in comparison with people
whose incomes are derived from other sources. Doubtless in future the
investor will look upon dividends as a form of income not subject to
the normal income tax.
In the levy of the normal income tax there is to be a limited
application of the method of assessment and collection at the source of
the income. This method is applied very completely in the taxation of
income in Great Britain. It may be well to recall summarily the
essential features of the British system. The tax is levied upon the
property or industrial enterprise which yields or produces the income.
But the person occupying the property or conducting the enterprise, and
paying the assessment in the first instance, is authorized and required
to deduct the tax from the income as it is distributed among the
persons entitled to share in it either as proprietors, landlords,
creditors, or employees. Under the English system, an industrial
corporation, for instance, pays the income tax upon its gross earnings
and then deducts it from the dividends, interest, salaries, and rents
as these payments are made. The householder pays an assessment levied
upon the annual value of his dwelling (less an allowance for repairs
and insurance) and then if he occupies the premises as tenant deducts
the tax from his rent. The income from agriculture is reached by a
similar assessment upon the farmer, based upon the annual or rental
value of the farm and with the same right of deduction from the rent if
he is a tenant farmer.
From the standpoint of the government, the main advantage of this mode
of assessment as compared with a tax levied directly upon the
recipients of the income is the greater certainty with which it reaches
the income subject to taxation. The opportunities for evasion by
concealment of income are reduced to a minimum, partly because the
sources of income are, in general, not easily concealed and partly
because, to a considerable extent, the persons upon whom the tax is
assessed are not interested in avoiding the tax. The advantages,
however, are not all on the side of the government. The tax possesses
certain advantages from the standpoint of the taxpayer, also, assuming
him to be an honest taxpayer who is not seeking opportunities to evade
taxation. One advantage is that he is relieved in almost every case
from the necessity of revealing to the tax officials the whole of his
personal income. The tax does not pry into his personal affairs.
Another advantage is that the tax is paid out of current income, being
deducted from the income as it is received. It is therefore distributed
over the year and adjusted to the flow of income as it comes in. A tax
thus collected is less burdensome in its incidence than a tax paid in
one lump sum several months after the expiration of the year to which
it related and after the income on which it is levied has been all
received and perhaps all expended.
The English system of assessing an income tax at the source, however,
has its disadvantages. It is admirably suited for a tax levied at a
uniform rate on all income or on all income above a small minimum. But
it is not well suited for the application of progressive taxation or
for the introduction of gradations or distinctions based upon the size
or character of the individual incomes. Nevertheless, the English
income tax, besides exempting a minimum, provides for graded reductions
or abatements in favor of the possessors of small incomes above the
minimum, and for a reduced rate on "unearned" income within certain
limits. All this, however, makes necessary a declaration or complete
statement of income from the persons claiming the benefit of those
provisions, and also necessitates refunding a large amount of the tax
collected at the source. Moreover, the progressive principle has
recently been applied by imposing a "super-tax" on incomes in excess of
£5,000, which also requires a declaration, the tax being necessarily
assessed upon the possessor of the income and not at the source. The
super-tax, it may be observed, occupies a position in the English
system similar to that of the additional tax in the United States,
serving to increase the tax upon the larger incomes in accordance with
the principle of progression.
Considering the various provisos and exceptions in connection with the
general rule of the act, the scope of the application of the method of
collecting the tax at the source may perhaps be safely stated thus: the
normal tax is to be deducted (1) from all interest payments made by
corporations on bonds and the like, without regard to the amount; (2)
from all other interest payments when the amount is more than $3,000 in
any one year; (3) from all payments of rents, salaries, or wages
amounting in any one case to over $3,000 annually; (4) from all other
payments of over $3,000 (excepting dividends) which may be comprised
under the designations "premiums, compensations, remuneration,
emoluments, or other fixed or determinable gains, profits, or income."
The principle of assessing income at its source, as applied in this
act, does not relieve the individual from the necessity of making a
full revelation to the tax officials of his personal income from all
sources. Though this statement needs to be qualified in one or two
particulars, the law provides in general that every person subject to
the tax and having an income of $3,000 or over shall make a true and
accurate return under oath or affirmation "setting forth specifically
the gross amount of income from all separate sources and from the total
thereof deducting the aggregate items or expenses and allowance"
authorized by the law. Although income from which the tax has been
withheld is not included in the net personal and taxable income of the
taxpayer, it must, nevertheless, be accounted for and included in his
declaration as a part of his gross income, forming one of the specified
items which are to be deducted from the gross income in arriving at the
income subject to taxation.
As already intimated, the general requirement of the full and complete
statement of income is subject to certain exceptions. One relates to
the income from dividends, the law providing that "persons liable to
the normal tax only ... shall not be required to make return of the
income derived from dividends on the capital stock or from the net
earnings of corporations, joint-stock companies or associations, and
insurance companies taxable upon their net income." It will be noted
that this proviso is restricted to persons who are "liable for the
normal tax only," _i.e._, persons having net incomes under $20,000. It
would seem, therefore, that the taxpayer claiming and securing this
privilege must in some way, without revealing the amount received from
dividends, satisfy the tax assessors that his total net income,
including the dividends (amount not stated), does not exceed $20,000.
Of course a form of statement can easily be devised to cover the
situation. But whether the law will be administered in such a way that
this provision affords some relief from the general obligation of
making a detailed and complete statement of income remains to be seen.
Another exception to the general requirement of a complete declaration
of income covers the case of the taxpayer whose entire income has been
assessed and the tax on it deducted at the source. The law relieves
such persons from the obligation of making any declaration of income;
although it is not certain that this privilege can be secured without
foregoing or sacrificing the benefits of any abatements to which the
individual taxpayer might be entitled on account of business expenses,
interest payments, losses, etc. It seems probable that where the income
is all assessed at the source the taxpayer may obtain the benefit of
the minimum exemption without making a declaration of income.
It appears, therefore, that assessment at the source does not, under
this law, operate in such a way as to afford the taxpayer any
substantial relief from the necessity of making a revelation of his
income to tax officials. Whatever basis there may be for the common
criticism or complaint that an income tax is inquisitorial remains
under the operation of this law to nearly the same extent that it
would if the tax were levied wholly and directly upon the recipients
of the income, with no resort to taxation at the source.
Regarding the assessment of the additional tax not much need be said in
the way of explanation. It is, in theory at least, a comparatively
simple matter. There is no attempt here to make any application of the
principle of collection at the source. The tax is all levied directly
upon the recipients of the individual incomes, and the assessment is
based upon the taxpayer's declaration, which for the purposes of this
tax must cover the "entire net income from all sources, corporate or
otherwise." The tax is thus largely distinct from the normal income tax
as regards both the method of assessment and the rates. It is, however,
to be administered through the same machinery, and no doubt to some
extent the information obtained as to the sources of income in
connection with the assessment of the normal tax will prove useful as a
check upon the returns of income required for assessment of the
additional tax. Every person whose income exceeds $20,000 will be
subject to both taxes, the normal and the additional, but presumably
will be required to make only one declaration. For the purposes of the
additional tax he will be required to declare his income from all
sources, and therefore any relief from the obligation of making a
complete revelation of income which may be secured to him through the
application of the principle of assessment at the source in connection
with the normal tax will be entirely sacrificed.
The administration of a direct personal income tax--using that term to
describe a tax levied directly on individual incomes--is a
comparatively simple matter, however ineffective it may prove to be in
reaching the income subject to it. Under this method of taxation it is
easy to exempt a minimum, to apply progression in the rates, or to make
any other adjustments that may be deemed equitable with reference
either to the size or character of the income or to the circumstances
of the taxpayer. But as soon as we depart from this simple method and
resort to taxation at the source, we encounter difficulties in varying
the rates, allowing exemptions, or making any similar adjustments. In
the English income tax, these difficulties are squarely met and
surmounted. As previously explained, that tax is in the first instance
levied indiscriminately on all accessible sources of income and the
adjustments are effected by refunding the tax collected at the source
so far as may be necessary. No provision is made for forestalling the
deduction of the tax, and no returns are required of the names and
addresses of persons to whom payments of incomes are made. The
exemption, however, is small ($800), and the abatements extend only to
incomes below $3,500. Above that point the entire income is taxable.
A tax which provides for the exemption of $3,000 or $4,000 from every
individual income places a formidable barrier in the way of a
thoroughgoing application of assessment at the source. It is evident
that with a universal exemption as high as this, a very large amount of
tax withheld and collected at the source would ultimately have to be
refunded. The law as enacted indicates an intention to secure in part
the advantage of assessment at the source and at the same time avoid in
part the attendant disadvantage of having to refund the tax. The
measure might be characterized as one which as regards the "normal tax"
applies the principle of assessment at the source to corporate income
completely and to other income in spots. The "additional tax" is simply
the direct personal tax. The normal tax will doubtless be successful in
reaching the large amount of income earned or created by enterprises
conducted under the corporate form of organization, much of which would
probably escape assessment under a direct personal income tax. But
beyond this it is questionable whether the method of assessment at the
source as here applied will be of sufficient advantage to justify the
administrative complications which it involves.
It seems useless, however, as well as unwise, to venture any
predictions as to how successful the tax will be in reaching the income
subject to it or how well it will work in actual practise. The law will
doubtless require amendment in many particulars, even if it does not
need to be radically revised. That the income tax in some form will be
perpetuated as a permanent part of our system of national finance may
safely be predicted. Properly adjusted and wisely administered, it
should greatly strengthen the financial resources of the Government,
make possible a closer adjustment of revenue to expenditure, and secure
a more equitable distribution of the burden of taxation.