A Supertax on Individual Incomes Above $25,000
Individual incomes, after taxes, could be limited to $25,000 by a 100 percent supertax on net income remaining after the regular income tax. The personal exemption for this purpose would be $25,000.
The supertax would not affect persons whose income before deductions did not exceed about $60,000 under the Treasury proposed rates or $40,000 under present rates.
The tax is estimated to yield $211.8 million (over and above the revenue from the Treasury proposed rates) from approximately 19,500 persons if joint returns are mandatory and $174.3 million from approximately 17,000 persons if separate returns are permitted.
The effective application of such a tax would raise a number of problems.
DEFINITION OF THE TAXPAYER
(a) Under the present option to file separate returns, every member of the family would be allowed $25,000. If joint returns were mandatory, the husband and wife would together the limited to $25,000, but each child could receive and additional $25,000. This could be presented by making consolidated returns mandatory for the whole family for purposes of both the income tax and the supertax.
(b) At present, trusts and estates are in some cases subject to the individual income tax, regardless of the number of beneficiaries and the income of each from other sources. The application of the $25,000 limit to trusts and estates would work serious injustice, particularly in the case of beneficiaries whose total income (including their share of the trust) is relatively small. The exemption of trusts and estates, on the other hand, would permit tax avoidance. The present tax treatment of pension trusts would have to be revised. Otherwise an avenue of escape would remain.
(c) The individual income tax now applies to proprietorships and partnerships. The application of the $25,000 limit to these groups would interfere with business incentives and encourage wasteful expenditures.
DEFINITION OF TABLE INCOME
A $25,000 limit would aggravate the problem of defining taxable income. Defects which can be tolerated under the income tax would be magnified under the supertax, and in some cases could defeat the whole purpose of the tax.
(a) To present avoidance by the conversion of ordinary income into capital gains, taxable income could not exclude such gains. The inclusion of gains would encourage the taking of losses and the postponement of the realization of gains and, therefore, would lead to an artificial market.
(b) The supertax would encourage the retention of profits by corporations unless provision were made for the taxation of undivided profits either to the corporation or to the stockholders. Section 102, which now imposes a penalty on corporations improperly accumulating surplus, could be implemented to prevent the more glaring evasions.
(c) The application of the supertax to unincorporated business would prevent the accumulation of reasonable surpluses for normal capital growth and business contingencies. The option of incorporation offers little relief. The supertax would be confined to owners' withdrawals from the business, with provision for reasonable surplus accumulations.
(d) The application of the supertax to State and local interest would amount to the taxation of such interest under the regular income tax. In the absence of similar treatment of wholly-exempt Federal securities, present holders would enjoy a windfall, either in the form of exemption from the supertax or in the form of capital gains, resulting from the sale of their securities to those subject to the supertax.
(e) For all those subject to the supertax some charitable contributions would be costless; they would be made at Government expense. Unless such contributions were limited (for example, to amounts contributed in preceding years) the resulting income tax revenue loss might exceed the yield of the supertax.
(f) Since State income taxes are deductible in arriving at taxable income, States could increase their tax rates applicable to the upper income brackets at the expense of the Federal Government, without burdening their residents. The limitation of deductions to taxes due under laws in effect on January 1, 1942, may be desirable.
(g) Special provisions would be required to prevent abuse of depletion allowances and to minimize injustice to persons receiving high incomes for services rendered over a period of years.
RELIEF FOR FIXED COMMITMENTS
The supertax would make it difficult for some individuals to meet such fixed commitments as life insurance premiums mortgage amortization non-business leases, contributions pledged to charity, subscriptions for stock, installment purchases of business property, and obligations to make payments for alimony, support of relatives, and for annuities to servants.
The case for granting special relief for fixed commitments is weak. Present law permits interest on debt to be deducted in computing taxable income; therefore, those subject to the supertax could refinance their fixed commitments without a net interest cost to themselves. The problem of heavy insurance premiums could be met by the re-arrangement of insurance contracts. To cases of real hardship, a Government lending agency could be authorized to extend credit facilities.
I. PURPOSE AND NATURE OF THE TAX
The purpose of this supertax is to implement the President's statement in his April 27 message to Congress when he said:
". . . . . I therefore believe that in time of this grave national danger, when all excess income should go to win the war, no American citizen ought to have a net income, after he has paid his taxes, of more than $25,0000 a year.
This objective may be reached by: (a) a surtax scale that (with normal tax) imposes 100 percent rates above the point that will leave the amount desired or (b) an additional supertax taking 100 percent of taxable income above $25,000 after other-taxes. Because of the differences in exemptions and credits the first method would not give the precise result desired; a scale that would leave just $25,090 to single person without dependents would leave somewhat more to a married person with dependents. Therefore, it is assumed here that the tax will be a supertax, but for most of the discussion the form of the tax is of little significance.
II. YIELD AND NUMBER OF TAXPAYERS
The tax is estimated to yield $211.8 million from approximately 17,000 persons if joint returns are mandatory and $174.3 million from approximately 15,000 persons if separate returns are mandatory. /1/
/1/ If loopholes referred to below are not closed, the revenue would be much less than estimated.
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Under the Treasury's proposed rates a net income of about $60,000 and under 1941 Act rates about $40,000 would be needed to leave $25,000 after taxes. The lower the rate scale imposed by the 1942 Act, the larger the number of taxpayers affected by the supertax.
III. DEFINITION OF THE TAXPAYER
A. INDIVIDUAL VERSUS FAMILY
The $25,000 limit could apply to individual taxpayers, collectively to both spouses, or collectively to the family unit including minor (and perhaps adult) children.
If the limit applied only to individuals, the discrepancies among families would be glaring. A husband and wife together could receive $50,000, and each child could receive $25,000.
Income from property which can be divided by transfers would become more valuable relatively to income from salary, professional practice, or business. The value of residence in community property States would increase still further. Enactment of the mandatory joint return proposal will solve part of the problem. Some taxpayers could still avoid some of the 100-percent tax by transferring income- producing assets to their children, especially minors, and to others upon whom they can depend to use the income as they (the donors) desire. This problem could be met most satisfactorily by following the Australian practice of not recognizing such gifts for income tax- purposes and taxing the income to the donors. The application of this technique to the supertax would automatically involve its simultaneous application to the regular income tax.
Another, but less satisfactory, approach would be to impose the supertax on the basis of the family unit, including both spouses and minor children. Consolidated returns would be mandatory for the family. Additional exemptions might be allowed for each member of the family --$25,000 for the head, $5,000 for a wife, $3,000 for each child, etc. This practice would increase the effectiveness of the limitation in that it would apply to that part of the income of minor children not derived from assets transferred to them by the parents; it would be less effective in that it would exclude the income from assets transferred to others than the spouses and minor children. It would mark a large and not necessarily desirable departure in income taxation. Conflicts with State law might arise, and search for methods of avoidance would spread widely. Artificial units could be established.
B. ESTATES AND TRUSTS
Since the $25,000 limit is directed towards the "American citizen", it would be desirable for purposes of the supertax to overlook estates and trusts, artificial legal entities, and relate the tax to the real persons concerned. Otherwise the door is open both for evasion and unintentional hardship.
Ordinarily estates should not present a serious problem because they are allowed to deduct amounts distributed to beneficiaries, and it should be possible for them to make distributions of most of the income that would otherwise be subject to the supertax. However, estates may remain unliquidated for some time either voluntarily or because of circumstances beyond the control of the parties involved. Litigation or other legal impediments may make it impossible to distribute income, and in such cases the application of the supertax to the estate may work serious injustice since several persons, none of whom receives anything, may really own the income. But to exempt unliquidated estates having incomes comparable to the incomes of individuals subject to the supertax would make delay in settlement an effective method of tax evasion.
Trusts create a still more serious problem. On the one hand, there are trusts over which the grantor has no control but the income from which is taxable to him. Funded life insurance trusts fall into this category; one solution would be to tax the real owner of the insurance policy, but this would run counter to the treatment under the regular income tax and would not always be possible. On the other hand, trusts create possibilities of evasion because they make possible the splitting of income. To exempt trusts would open a wide loophole; to exempt existing trusts only would grant a large and unmerited windfall. The issues involved are primarily legal, and for most practical purposes the economic issues are of secondary importance. It would probably be impossible to devise a tax that would effectively limit to a specific figure the increase in economic power of persons with varied interests in trusts.
However, complicated and arbitrary rules for the taxation of trusts and estates have been developing, and it would be impractical to revise the system on short notice to make the adoption of the supertax the occasion for substituting a new set of rules. It is often impossible to determine currently the individuals who will ultimately receive the income of a trust or estate. The logical goal -- taxing the person whose interests are really increased by the income -- cannot be easily followed in practice.
C. PENSION TRUSTS
Imposition of the supertax would make more imperative revision of the treatment of pension trusts, The Treasury's suggestion that maximum benefits from the employers contributions be limited should be adopted. Otherwise corporation executives could take the marginal portions of their compensation in the form of contributions to the pension fund rather than current salary. Normal and surtax yield as well as supertax yield would be lost. The Bureau of Internal Revenue may have sufficient power to prevent obvious avoidance, but even if existing plans remain undisturbed, some officers would receive handsome; bounties in the form of exemption of income that would otherwise be taxed at 100 percent.
Some further provision may also be needed to limit the tax-free accumulation of income on the assets of the pensions trust. Many plans permit participants to contribute to the fund substantial amounts in addition to their normal contributions. The income earnings are then exempt from current taxes. Transfer from other investments to the fund could increase their yield after tax from zero to whatever the fund earned. Purchase of life insurance with a large saving element offers the same opportunity for avoidance.
D. UNINCORPORATED ENTERPRISES.
The application of the supertax to the income of proprietor ships and partnerships would raise problems that are discussed in IV- D below.
IV. DEFINITION OF TAXABLE INCOME
The attempt to construct a tax that then superimposed upon the regular income tax would place a ceiling of $25,000 on individual incomes, makes the development of a fair definition of taxable income indispensable. Inclusion, exclusion, hardship cases, and loopholes are magnified and may negate the objective of income limitation.
A. CAPITAL GAINS AND LOSSES
1. ARGUMENTS FOR INCLUSION /1/
(a) Unless capital gains were included in the base, tax avoidance would be possible through the conversion of ordinary income into capital gains (for example, low interest boating bonds sold at discount). Those with large incomes would be given one form of activity which could yield income not subject to the limit -- speculation.
(b) Capital gains represent an important source of income to individuals with incomes of the sized to which the limitation would be applicable, and to exclude capital gains from the base would provide an obvious means of tax avoidance for persons with large incomes. For 1940, not long term capital gains reported by individuals and taxable fiduciaries with net incomes of $50,000 or more, accounted for over 6 percent of their total income.
(c) It might be assumed that the portion of the realized capital gain includible in net income; for purposes of the supertax is the portion which accrued within to the current year, and therefore properly subject to all taxes imposed for the current year.
2. ARGUMENTS AGAINST INCLUSION
(a) The realization of capital gains may be postponed if the tax rates become too high. An individual subject to the supertax could delay taking his gain and risk the market dropping substantially. Under Treasury proposed rates, an individual subject to the limitation would have about as much left from a $1 capital gains (50 cents left) as a person not subject to the limitation who had a capital gain of 71 cents (49.7 cents left). The inclusion of capital gains in the base of the supertax will disturb the normal flow of transactions in the capital market.
/1/ The maximum tax on actual long-term capital gains under the supertax would be 50 percent under the present law and the Treasury proposal both of which provide that only one-half of the actual gain be included in taxable net income.
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(b) The inclusion of capital gains in the tax base will encourage the taking of losses to the fullest extent possible in order to offset gains and also to derive the benefits of the carryover. /1/
If the $25,000 limit is to be effective capital gains must be included. Inclusion of gains could necessitate see allowance for losses. The Treasury's proposals with respect to capital gains and losses are generous and equitable, and the supertax should not necessitate revision of the basic recommendations. Nevertheless, arbitrary market influences must be expected.