Date 9 January 1941
Author Unknown
Title Collection at Source of the Individual Normal Income Tax
Description Staff memo, Division of Tax Research, Treasury Department
Location Box 54; Collection and Payment; Records of the Office of Tax Analysis/Division of Tax Research; General Records of the Department of the Treasury, Record Group 56; National Archives, College Park, MD.
 
      Collection at source of the individual normal income tax

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  Summary                                                  

  I.  Introduction                                         

 II.  Collection at source of current year's               
       normal income tax liabilities                       

      A.  Collection at source in the United               
           States                                          

          1.       Prior to 1913                           
          2.       Revenue Acts of 1913-1916               

                   (a) Sources of income subject to        
                        withholding                        
                   (b) Exemption and deduction certificates
                   (c) Refunds                             
                   (d) Reasons for discontinuing           
                        collection at source               

          3.       Income tax payment plans after 1916     

      B.  Collection at source in Canada                   

          1.       General income tax payment plan         
          2.       National Defence Tax                    

                   (a) Basis of withholding                
                   (b) Exemption certificates              
                   (c) Taxability of wages and             
                        salaries                           
                   (d) Reporting                           
                   (e) Refunds                             

          3.       Problems involved in instituting the    
                    Canadian system into the United States 

                   (a) Refunds                             
                   (b) Coverage                            
                   (c) Administration                      

      C.  Plans presented to the Committee on              
           Ways and Means in connection with               
           Revenue Revision for 1941                       

          1.       Testimony of William J. Schiefflin, Jr. 

                   (a) Plan                                
                   (b) Problems involved under the         
                        Schiefflin plan                    

          2.       Testimony of Professor Albert G. Hart   

                   (a) Plan                                
                   (b) Problems involved under the         
                        Hart plan                          

III.  Collection at source of past years' normal           
       tax liabilities                                     

      A.  Collection at source in Great Britain            
          1.       Prior to 1940                           
          2.       Under current law                       
          3.       Problems involved in instituting the    
                    British system into the United States  

      B.  Collection at source in Australia                

          1.       South Australia                         

                   (a) Basis of withholding                
                   (b) Exemption certificates              
                   (c) Administration                      

          2.       Commonwealth of Australia               

                   (a) Basis of withholding                
                   (b) Exemption certificates              
                   (c) Use of tax stamps                   

          3.       Problems involved in instituting the    
                    Australian plan into the United        
                    States                                 

                   (a) Uniform exemption under the         
                        South Australian plan              
                   (b) Exemptions varied with marital      
                        status under the Commonwealth      
                        plan                               

 IV.  Collection at source as an inflation control         
       measure                                             

  V.  Suggested tax at source                              

      A.  Plan                                             

      B.  Alternative procedures under the plan            

          1.       Exemption certificates                  
          2.       Salaries and wages of persons not       
                    covered by social security or other    
                    Federal retirement plan, and business  
                    income                                 
          3.       Returns by employers                    

      C.  Responsibilities of employers, employees and     
          the Treasury under the suggested plan            

          1.       Responsibilities of employers           
          2.       Responsibilities of employees           
          3.       Responsibilities of the Treasury        
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                             APPENDICES

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App. 1.  Description of income tax payment plan by Dr. Carl Shoup.

App. 2.  Refund procedure                                         

         Summary of statistical information                       
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                               TABLES

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Table 1.    Estimate of number of part-time employees in industries  
            covered by the old-age provision of the Social Security  
            Act, January, 1938-June 1940.                            

Table 2.    Employments not covered by the old-age provisions of the 
            Social Security Act or other Federal retirement plan:    
            number of workers, amount of earned income and number of 
            employers, 1940.                                         

Table 3.    Employments not covered by the old-age provisions of the 
            Social Security Act or other Federal retirement plan;    
            frequency distributions of income.                       

Table 4.    Individual returns with net income, 1937; Selected       
            sources of income, frequency of each source, and percent 
            each source is of total income.                          

Table 5.    Individual returns with net income, 1937, by net income  
            classes; Selected sources of income, frequency of each   
            source, and percent each source is of total income.      

Table 6.    Individual income tax returns with statutory net income, 
            Forms 1040 and 1040A, for 1936: Number of returns showing
            only one or two sources of income with salaries and wages
            as a source of income, classified by size of salaries and
            wages and by source of income.                           

Table 7.    Individual income tax returns with statutory net income  
            Forms 1040 and 1040A for 1936: number of returns showing 
            salaries and wages, and one other source of income of    
            less than (A) $100 and (B) $500.                         

Table 8.    Individual income tax returns with statutory net income, 
            Forms 1040 and 1040A, for 1936: Total number of returns, 
            and number of returns showing only one source of income, 
            classified by size of total income and by source of      
            income.                                                  

Table 9.    Farm operators: Frequency distribution of income. Family 
            income 1935-1936.                                        

Table 10.   Self-employed other than farm operators: Frequency       
            distribution of income. Family income 1935-1936.         

Table 11.   Individual income tax returns, Form 1040 for 1936, sole  
            proprietorships reporting only farming business: Number  
            of returns, total receipts from farming, net profit from 
            farming and net loss from farming, by total receipts     
            classes.                                                 

Table 12.   Individual income tax returns, Form 1040, for 1936, sole 
            proprietorships reporting two or more businesses: for the
            farming business reported, number of businesses, total   
            receipts from farming, net profit from farming, and net  
            loss from farming, by total receipts classes.            

Table 13.   Individual income tax returns, Form 1040, for 1936, sole 
            proprietorships reporting only one business, exclusive of
            those reporting farming business: number of returns,     
            total receipts from business, net profit of business, and
            net loss of business, by total receipts classes.         

Table 14.   Individual income tax returns, Form 1040, for 1936, sole 
            proprietorships reporting two or more businesses,        
            exclusive of farming business for those returns reporting
            farming business; number of returns, total receipts from 
            business, net profit of business, and net loss of        
            business, by total receipts classes.                     

Table 15.   Number of agricultural and other partnerships in the     
            United States, 1936, by size of net income or deficit.   

Table 16.   Covered employment: Workers, earned income, and          
            employers, 1940, 1941.                                   

Table 17.   Estimate of number of individuals in the income brackets 
            $750 - $5,000 who are not subject to income tax due to   
            the personal exemption and credit for dependents 1935-36.

Table 18.   Distribution of families and single individuals and of   
            aggregate income received, by income level, 1935-36.     

Table 19.   Personal exemption, credit for dependents, and earned    
            income credit expressed as a percent of net income for   
            all returns, 1934-1939.                                  

Table 19A.  Aggregate expenditures of American families and single   
            individuals for main categories of consumption and total 
            income by income levels, 1935-36.                        

Table 20    Illustrative table of weekly exemptions and deductions   
            allowed for purposes of the special withholding tax on   
            salaries and wages.                                      
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Collection at source of the individual normal income tax

SUMMARY

I. INTRODUCTION

The collection of the normal income tax at source may be with respect to either CURRENT year's or PRIOR year's tax liabilities.

Collection of CURRENT YEAR'S TAX LIABILITIES at source was attempted in the United States during the Civil War and 1894 income tax experiments and under the Revenue Acts of 1913-16. It is now in effect in Canada in connection with their National Defense Tax. During the Hearings before the Committee on Ways and Means on Revenue Revision for 1941, the revival of this system was suggested by Mr. William J. Schiefflin, Jr., Chairman of the Committee on Taxation of the Chamber of Commerce of the State of New York, and Professor Albert G. Hart, of Iowa State College, for purposes of currently preventing inflation and easing income tax payments.

Collection of PRIOR YEAR'S TAX LIABILITIES at source is now in effect in Great Britain and Australia. The main purpose of this system of collection is to ease tax payments.

II. COLLECTION AT SOURCE AS AN INFLATION CONTROL MEASURE

The largest portion of consumer incomes in the United States is not subject to income taxation. Likewise, only a small proportion of the population of the United States is covered by the income tax. For 1936, taxable income tax returns filed represented only 3.9% of the population. Only about 35% of the total flow of income to individuals was reached by the income tax and only about 25% was reported on taxable returns. The coverage of the income tax is narrowest where the greatest amount of income is concentrated, that is for individuals with incomes of less than $5,000.

In view of this, any payment system based upon the present levels of exemptions and credits would be inadequate as a means of price control. A tax at source on behalf of current year liability would, however, have an appreciable effect as an inflation control measure through withdrawing the tax compulsorily from current income.

As an alternative to a tax at source, consideration should be given to lowering personal exemptions as a means of controlling price increases. To an indeterminate extent, many individuals would curtail expenditures for consumer goods if their prospective tax liabilities were increased. For purposes of controlling inflationary price increases, it may be adequate to reduce the exemptions for heads of families to $1,500 since expenditures of those in the lower income classes are not likely to be made for articles, the supply of which is limited by Defense needs. Such lowering of personal exemptions, together with the popularization of tax anticipation certificates, may serve to control inflationary price increases in a manner similar to an income tax at source, though perhaps less effectively.

III. SUGGESTED TAX AT SOURCE

If the price situation develops in a way which requires tax measures designed to facilitate the control of inflation, a special income tax collected at source of the following type is suggested. This tax could be instituted promptly and without the need for any elaborate administrative machinery.

1. The special tax would be separate from the regular income tax and, in the interests of equity, would be imposed on all sources of income at graduate rates. The withholding of tax at source would, however, apply only with respect to salaries, wages and commissions. A flat rate of tax would be imposed for withholding purposes and this would be credited against the total tax liability determined on the basis of an annual return reporting all sources of income.

2. For the purpose of determining total tax liability, the gross income, deductions, credits and exemptions would be the same as for the regular income tax. For the withholding tax, only personal exemptions, credit for dependents and a tentative deduction allowance of 10% of the amount of personal exemptions and credits would be recognized. /1/ Employers would accept the statement of employees as to marital and dependent status.

3. The tax would be withheld at source on a weekly basis. The allowance for personal exemptions, credit for dependents and allowable deductions would be on the basis of a 50 week year.

4. Each week or wage payment period the employer would purchase tax stamps and turn over to the employee stamps equivalent to the amount withheld at source. The stamps would be obtainable at local post offices or from the collectors of internal revenue. Employees would be required to countersign the stamps in order to discourage thefts.

5. Employees would accumulate stamps received as evidence of tax payment until the end of the year. At the close of each year employees would report their income from all sources if such income exceeded the annual personal exemption or, irrespective of the amount of income, if any tax had been withheld during the year. Total liability would be determined on the basis of the graduated rates imposed for the special tax. The tax at source would be credited against the total tax and all stamps submitted with the return in support of the credit claimed. Any tax liability in excess of the credit would be payable in cash. Any stamps accumulated by the employees in excess of total tax liability would be cashed by the Bureau of Internal Revenue and paid over to the taxpayer.

IV. OTHER TAX AT SOURCE PLANS

A brief discussion of various collection at source plans which have been used in this country or abroad or have been suggested to the Committee on Ways and Means in connection with the 1941 Revenue Revision follows

A. Collection at Source of Current Year's Income Tax Liabilities

1. Collection at Source in The United States, 1913-16

Under the Revenue Acts of 1913-16, the normal income tax on interest, rents, salaries, wages and all other fixed and determinable annual or periodic income, except dividends, was subject to withholding at source. Dividends were exempt from normal tax during these years and consequently not subject to withholding. The tax was withheld on the gross amount of the specified source of income without taking into account exemptions and deductions unless the recipients of the income filed exemption and deduction certificates with withholding agents setting forth marital status and amounts of exemptions and deductions claimed. Where such certificates were filed, the withholding agent had authority to refrain from withholding on the amounts claimed as exemptions or deductions. The certificates were not notarized but penalties were imposed for their fraudulent use.

The exemption and deduction certificates were objectionable to employees, employers and the Treasury. Employees changing jobs did not wish to submit to their new employers exemption certificates which would disclose the amounts they had received during the year from former employers. Unless they did so, however, the tax was withheld on a gross basis and a refund had to be claimed from the Treasury at the close of the year. Either procedure was objectionable. The handling of exemption and deduction certificates, the record-keeping necessary for determining the amount of tax to be withheld and the reporting to the Government all imposed a vexatious burden on employers. From the Treasury standpoint, millions of exemption and deduction certificates were accumulated for audit purposes. It did not, however, prove practicable to make a complete check of the certificates against the returns.

The collection at source system broke down soon after its inception. For the fiscal year 1915 only $5.5 out of $16.6 million, or less than one-third of the individual normal tax for that year, was collected at source, and in his annual report for that year, the Secretary of the Treasury recommended the discontinuance of collection at source. This recommendation was acted upon in the Revenue Act of 1917.

2. Collection at Source in Canada

The Canadian National Defense Tax is based on total net income (before donations) if such net income is in excess of $660 for a single person and $1,200 for a married person. The tax is collected at source on salaries, wages, dividends and bond interest. The tax on dividends and interest is on a gross basis. The tax is withheld on salaries and wages on the basis of the RATE of pay. If the rate paid to employees is such that its continuance throughout the year would result in the employee receiving income above the exemption level, the amount so paid is subject to tax deduction at source. The employer need not be concerned with the question of how much income will in fact be earned by the employee during the year. At the close of each taxable year definitive returns are required of all persons with total incomes exceeding the personal exemption levels. The sums withheld at source are credited against the total National Defense Tax as determined on the basis of the return. Where the amount withheld during the year exceeds total liability as shown by the return, a refund is made.

Refunds would constitute the prime difficulty in instituting the Canadian system into the United States. Since the taxability of wages and salaries is determined by the RATE of pay, there may be many instances where, due to unemployment or shifts from more to less remunerative employment, total earnings during the year would not exceed personal exemptions. /2/ In such cases refunds would result.

Under present American practice, refunds are slow and costly. The minimum cost per refund is estimated at between $3 and $4. Refunds take from 6 weeks to many months to complete and must be passed by both the Bureau of Internal Revenue and the Office of the Comptroller General. The present refund procedure could not be changed substantially without an act of Congress which would revise the auditing standards of the Office of the Comptroller General. Any system, such as the Canadian, which contains the possibility of a considerable number of refunds annually is, therefore, not practicable.

3. Plans Presented to The Committee on Ways and Means in Connection with Revenue Revision for 1941.

(1) TESTIMONY OF WILLIAM J. SCHIEFFLIN, JR. /3/ - Mr. Schiefflin suggested a gross income tax at a flat rate on salaries, wages, dividends, bond interest and "every form of income paid to individuals". This is an endorsement of the suggestion made by Prof. Harley L. Lutz.

Aside from the fact that such a gross income tax would bear more heavily on the poor than the wealthy and runs counter to equitable taxation on the basis of ability to pay, the main problems involved under the Schiefflin plan are (a) it is not possible to withhold a tax at source with respect to all types of income and (b) it is not possible to apply withholding to some types of income recipients.

Salaries and wages constitute about 58% of total income received by individuals. The tax could be withheld on this source with a minimum of difficulty. The tax could also be withheld on dividends. Dividends represent 14% of total income. On the remaining sources of income, representing 28% of total income, withholding would not be practicable.

To attempt to collect the tax at source on rents, for example, would require most persons in the country to become tax collectors as well as taxpayers, for every person renting living quarters or business premises would be required to withhold the tax on each payment of rent. Similarly, borrowers would have to become withholding agents with respect to the tax on loan transactions. The tax on income from business could not be withheld at source since there can be no withholding agent for such income. The tax on capital gains could not be withheld at source since information relating to the amount of the gain is not available to the purchaser of the capital asset.

While, as noted, the tax could be withheld on salaries and wages generally, serious problems would be involved in attempting to reach agricultural, domestic and casual workers. These workers represent about 15% of the working force. The difficulty in taxing such workers at source arises primarily for the number of employers involved. For example, agricultural and domestic workers numbering between 5.5 and 5.8 million are employed by between 4.6 and 5.1 million persons, or almost as many employers as employees. To check whether the tax has been withheld properly, where so many potential withholding agents exist, would be extremely difficult. Further, since no end of year return is required under this plan, not only these workers, but all others who escaped withholding, would be freed from tax. In addition, proprietorships and partnerships, which represent over 16% of total national income produced, could likewise escape tax.

Mr. Schiefflin's plan would, therefore, fall primarily on workers in industrial employment and recipients of dividends and bond interest. Such a discriminatory tax would be highly inequitable.

(2) TESTIMONY OF PROF. ALBERT G. HART. /4/ - Prof. Hart suggested that the normal tax on all wages and salaries, interest and dividends in excess of exemptions should be collected at source.

The main problem under Prof. Hart's plan relates to allowing personal exemptions and dependent credits. Under his plan, books of weekly exemption certificates, in denominations based on marital status and the number of dependents, would be issued to individuals. This would involve the issuance of approximately 2-1/2 billion exemption coupons annually. Aside from the cost of printing and distribution, a considerable amount of time would be needed to set up such a system. Further the sheer handling of so large a number of coupons would be burdensome to employers and the Government and also to employees insofar as they had to fill in and mail applications for exemption certificates.

B. Collection at Source of Past Year's Income Tax Liabilities

Great Britain and Australia collect the income tax at source on behalf of prior year's tax liabilities.

In Great Britain the tax assessor informs the employer of each employee's tax liability for the past year. The employer is then charged with the responsibility of deducting during the year, in equal installments from wage payments, the amount of the tax.

In Australia, the tax is withheld on salaries and wages at a fixed rate /5/ until a sufficient amount has been withheld during the year to meet the prior year's tax liabilities. Exemption certificates are issued to employees as soon as they show that their liabilities have been met. These certificates exempt employees from further withholding for the balance of the year.

The collection of past year's tax liabilities at source is primarily a method of facilitating payment. Its efficacy as an inflation control device is nullified by virtue of the time lag between the derivation of the income and the payment of tax thereon.

 
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