Date 2 February 1943
Author Randolph Paul; General Counsel, Treasury Department
Title Statement of Randolph E. Paul, General Counsel for the Treasury, before the Committee on Ways and Means of the House of Representatives Revision of Income Tax Payment Methods
Description Congressional Testimony
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.
 

Statement of Randolph E. Paul, General Counsel
for the Treasury, before the Committee on Ways and Means
of the House of Representatives
Revision of Income Tax Payment Methods

February 2, 1943

I. Introduction

In response to the request of your Committee, I am here to discuss the income tax payment problem. The problem of putting income taxes on a pay-as-you-go basis was emphasized by President Roosevelt in his recent Budget Message in connection with his request to Congress for $16 billion of additional collections for the fiscal year 1944. It is my understanding that the committee desires at this time to consider the pay-as-you-go question, and my statement today will, therefore, be limited to this subject. It will not deal with other phases of our tax problem.

I should like to say in passing, however, that what the Congress does in solving the payment problem will have a direct bearing on the overall revenue program. The method employed to put the income tax on a pay-as-you-go basis will directly affect the dollars-and-cents yield of the tax and the timing of the flow of revenue into the Treasury. Over-all revenue needs, therefore, should be kept clearly in mind in drawing up the specific provisions of a new income tax payment plan.

Owing to the great expansion of the individual income tax how taking place in response to war needs, the strengthening of our system of income tax payment has become a first order of business. The 39 million individual taxpayers required to pay income taxes of almost $10 billion for 1942 under the present law must be afforded a way of meeting their tax obligations with a maximum of convenience and a minimum of hardship. In addition, the Treasury should be protected from taxpayer delinquency and resultant loss of revenue. And, finally, the Government needs a flexible instrument of fiscal policy under which revenues will react speedily to changes in tax rates and exemptions and in the national income.

The Treasury department and the Congress have been acutely aware of these needs. During the course of the Revenue Revision of 1942 there was general agreement that it would, be highly desirable to put a substantial part of the income tax on a current basis by means of collection at source. The purpose of my statement today is to review the income tax payment problem and to analyze briefly methods which may be helpful in its solution

II. DEFECTS IN OUR PRESENT SYSTEM OF PAYMENT

The income, tax is the most direct and equitable method of reaching taxpaying ability. Since it is, and must remain, the backbone of the federal tax system, every attention should be given to improving its structure and application. For the great masses of taxpayers the present method of collecting the income tax payment has the basic defect that tax payments are not, synchronized with the receipt of the income on which the tax is based. This defect arises partly because installment payments are not timed to fit the receipt of income and partly because the taxes on a given year's income are not payable until the following year.

A. POOR ADAPTATION TO TAXPAYER'S BUDGETS AND FLOW OF INCOME.

A system of equal quarterly installments ignores the basic fact that most people budget on a weekly, semi-monthly, or monthly basis according to the interval between pay-checks. Such a system also ignores the wide variations in the income receipts from one quarter to the next for such persons as farmers and seasonal workers. Equal quarterly installments are accordingly ill-adapted both to prevailing budget habits and to the flow of income.

This defect was not serious when income tax rates, were low and the tax reached only the minority of our population with relatively large incomes. But in recent years the defect has been greatly magnified. The tax has been broadened to reach many millions of additional taxpayers with small incomes and little experience in planning their finances to meet large bills at infrequent intervals. Moreover, the burden of the tax has been greatly increased for all taxpayers. A suitable pay-as-you-go method will be of great assistance to millions of persons.

B. THE LAG IN PAYMENTS.

Another difficulty of our existing method of payment, from the standpoint of the vast majority of taxpayers, is that this year's tax payments are based on last year's income. The resultant lag caused no serious payment problem as long as the income tax burden was relatively low, and the persons principally affected by the tax were accustomed to saving and budgeting for various obligations, including taxes. But with the expansion of the income tax the payment lag has become a vital problem. To be sure, the lag does not cause the taxpayer difficulty as long as his income continues at a steady pace. If, however, his income-varies from year to year, his taxes will be poorly geared to his receipt of income. And if his income declines sharply or ceases entirely, as at unemployment, retirement, disability or death, the overhanging tax debt may cause real hardship.

III. THE PAYMENT PROBLEM AS IT AFFECTS SPECIFIC TAXPAYER GROUPS

The problem faced by taxpayers in meeting their tax bills and the nature of the solutions that can be provided depend in large part on the size and source of their incomes. For present purposes the estimated 44 million individuals obligated to pay taxes on 1943 income may be classified into three distinct groups: (1) 30 million wage and salary earners whose incomes after exemptions do not go above the first surtax bracket of $2,000; (2) 10 million taxpayers whose income also do not go above the first surtax bracket, but who receive more than a nominal amount of income from sources other than wages or salaries; and (3) 4 million persons whose incomes from all sources exceed the first surtax, bracket, (Table 1).

A. WAGE AND SALARY EARNERS.

1. THE PAYMENT PROBLEM

The overwhelming majority of the 44 million taxpayers for 1943 will be wage and salary earners whose incomes after exemptions and credits will not exceed the first surtax bracket of $2000. This group covers, for example, single persons with net incomes up to $2500, married couples without dependents with net incomes up to $32000, and married couples with two dependents with net incomes up to $3900. It is this group which hit hardest by the defects in our present payment system.

Taxpayers in this group are accustomed to weekly or monthly budgeting under which expenditures are directly governed by the pay envelope. They are under considerable pressure to use their income as soon as it becomes available. They find it extremely difficult to make adequate provision for meeting lump-sum tax bill which fall due a year after the receipt of the income being taxes. Because of uncertainty of employment, they can not escape uncertainty about future income. Moreover, if their incomes stops because of unemployment, entrance into the armed forces, sickness, or death, the income tax debt for the last year of income may become a crushing burden.

2. A PAY-AS-YOU-GO METHOD FOR WAGE AND SALARY EARNERS.

Under these conditions collection at source provides the only adequate answer to the income tax payment problem. Under such a system the income tax on these wages and salaries would be paid by withdrawing it week by week and month by month when the pay envelope is handed to the employee. The wage and salary earners' taxes would be automatically budgeted because tax payments would coincide with the receipt of income. At the same time the problem of income tax debt would be eliminated for these taxpayers. If the normal tax and the first bracket surtax, that is, the "basic liability" were
collected at source in this manner, 30 million of the 44 million taxpayers estimated for 1943, or nearly 70 percent, would be current. (Table 1) No pay-as-you-go plan is adequate unless it makes current at least this group of wage and salary earners.

It should, be kept in mind that collection at source does not in itself increase or decrease the tax liability of the taxpayer,
Collection at source is merely a device designed to help the individual pay his income tab currently as he earns his income. The individual receives full credit for the amounts collected at source when he files his tax return at the end of the year. The amount of the tax liability is determined by the rates imposed on everyone, whether the liability is collected at source or not. Consequently, it is the rate of tax liability that determines the rate of collection at source.

A collection at source system must be framed with these criteria in view: The current collections must approximate as closely as possible the employee's liability for the year; the employee must not be required to make quarterly or other unnecessary returns; the machinery of collection must be made as adaptable as possible to the accounting and business methods of the employer. The principal elements of a collection at source plan that would meet these criteria may be summarized as follows:

FIRST. As stated any pay-as-you-go plan should currently discharge as much as possible of the taxpayer's liabilities; it
should also be so adjusted as not to collect more than the liabilities. This objective, can be readily achieved by collecting at source only on amounts of income in excess of an allowance for exemptions and deductions. In other words, the amount of each wage or salary, payment subject to collection at source would be determined by subtracting from the gross payment an allowance for personal exemptions and normal deductions. These allowances would, be prorated according to the length of the pay period, that is, weekly, semi-monthly, monthly, or, other period. For example, under existing exemptions the weekly allowance might be $11.00 for a single person, $26.00 for a married couple, and $8.00 additional for each dependent. These amounts are made somewhat larger than the prorated annual exemption in order to incorporate an allowance for average deductions. The allowance for personal exemptions would be based on a simple statement furnished by the employee to his employer.

It is important to note that any system of withholding income tax which does not allow exemptions, or which allows only a uniform exemption for all employees without regard to their marital or dependency status, would not meet the need. Substantial under-collection with resulting large deficiency payments, or substantial over-collections with resulting large refunds, or both, would result in numerous cases under a withholding system not geared to actual income tax exemptions.

SECOND. The rate applied to the wage and salary payments after these allowances would be set so as to collect approximately the basic tax liability, that is under present law the normal tax of 6 percent plus the minimum surtax rate of 13 percent. However, the rate would be slightly lower than the sum of the normal tax and the first bracket surtax in order to make further allowance for deductions and to allow for vacations without pay, occasional periods of unemployment, and possible fluctuations in income above and below the taxable limit. In this way, refunds for over-payment at the source would be held to a minimum.

THIRD. After the close of the year, these taxpayers would file returns showing their actual income and final liability for the year. Adjustments of actual collections at source to the final liability would be made by means of additional payment or refunds. For the vast majority of wage earners, such adjustments would involve a deficiency or refund of only a few dollars.

FOURTH. Apart from the allowance of exemptions according to marital and dependency status, the essential mechanism for such a method of collection at source is already established under the withholding machinery adopted for collecting the Victory Tax on wages and salaries. Such collection at source of the Victory Tax should be integrated with collection at source of the regular income tax. However the Committee may wise to consider the possibility of absorbing the Victory Tax into the regular income tax system.

The Committee may wish to consider the desirability of collecting at source the basic liability on dividends, as well as, on wages and salaries. In the case of dividends the normal and first bracket surtax could be collected on the gross amount. The administrative problems will of course, have to be weighed, but since dividend receipts represent a sizable portion of the income of millions of taxpayers for 1343, collecting the tax on such income at the source would be, a considerable contribution to a pay-as-you-go system, of tax collection.

B. PERSONS SUBJECT ONLY TO FIRST BRACKET RATE, WITH INCOME FROM SOURCES OTHER THAN SALARIES AND WAGES.

The incomes of many taxpayers do not readily, fit into a system of collection at the source. By far the largest group of such taxpayers consists of those who receive more than a nominal amount of income from sources other then wages or salaries, and whose total income is not in excess of the first surtax bracket. For 1943 it is estimated that 10 million of the 44 million taxpayers will be in this group. Their problem is different from that of wage and salary earners, and the system of current collection which is set up for them must differ accordingly.

1. PAYMENT PROBLEM

The incomes of several million small taxpayers consist of business profits, professional fees, rents, and far, receipts. The flow of income from most of these sources fluctuates widely from year to year, and frequently even from season to season. Under our present system these taxpayers often find that their tax payments are badly out of step with income. The result in many cases is difficulty and even hardship. Moreover, the tax payments of such persons on a quarterly basis may not at all coincide with the receipt of cash income, which may be lumped in one quarter or two quarters of the year. And when income drops off or stops entirely, these taxpayers are faced with the same difficulties as small wage and salary earners. The need for a pay-as-you-go system of tax collection is fully as pressing for them as for wage and salary earners.

Since the incomes of these people come in irregular amounts and from many different payors, the need for current payment can not be met by collection at the source. If persons with sell incomes from non wage sources are to be put on a current basis, one of two alternative methods may be employed. One method would base tentative current payments on prior-year income. The other method would base tentative current payments on simple quarterly statements of income received in the current year. A further discussion of these two methods may be helpful.

2. ALTERNATIVE APPROACHES TO A SOLUTION

a. TENTATIVE PAYMENTS BASED ON LAST YEAR'S INCOME.

Under the first of the two methods for collecting taxes on non-wage incomes the taxpayer would be required to make tentative payments in the CURRENT year on the basis of the PREVIOUS year's income and to make an adjustment in the following year for overpayment or underpayment. For example, the tentative tax for 1944 would be based on the income of 1943 as reported on March 15, 1944. After the end of the year, on March 15, 1945, a final calculation of 1944 income would be made. If the tax payments in 1944 proved to be too small, the deficiency would be paid at this time. If the payments proved to be too large, the taxpayer would receive a credit or refund of the excess payment.

Under this system the tax payments made in each year would depend not only on what the income had been in the previous year, but also on how much, the income of that previous year differed in turn from the income of the year prior to it. If a person's income were stable from year to year, his tax payments under this plan would be substantially current. If, however, his income were not stable, he might be very far from being current since his tax payments in any year would not be geared to the income of that year. Thus, a person whose income increased from year to year would have deficiencies to
make up each year, while a person whose income decreased from year to year would have credits or refunds due him each year. If the fluctuations in income were such that increases and decreases alternated, the deviation from current payment would be all the greater.

To illustrate the inadequacy of this method wit,h an extreme example, let us assume that a taxpayer in four successive years had income of $2.000 in Year 1, $4,000 in Year 2, $8,000 in Year 3, and $2,000 in Year 4.

          Example of tax payments under a system of current
           collection based on previous year's income /1/

                   Married person  No dependents:

                                          Deficiency      Total
Year       Net income    Tentative tax   due to under-   payments
              /2/             /3/         payment in      during
                                          prior year        year

Year 1        $2,000         /4/              /4/           /4/

Year 2        4,000        $ 140              /4/         $ 140

Year 3        8,000          538          $   398           936

Year 4        2,000        1,562            1,024         2,586
FOOTNOTES TO TABLE
 
/1/ Under rates and exemptions of the Revenue Act of 1942, excluding Victory tax.

/2/ Assumed to be derived from items not subject to collection at source; minimum earned income assumed.

/3/ The tentative tax is the same as the tax payable under the present method of payment on the income received in the previous year.

/4/ It is assumed that the taxpayer had no taxable income for years prior to Year 1. Therefore, there is no tax payable in Year 1 and no deficiency or credit in Year 2.

This taxpayer's tentative payment in Year 3 at present tax rates would amount to $538 based on the $4,000 income for Year 2. In addition, he would also in Year 3 have to pay a deficiency of $398 in taxes for Year 2, because in that year he had paid a tentative tax based on an income of only $2,000, his income in Year 1, whereas his actual income in Year 2 was $4,000. Thus, the payments which the taxpayer must make in Year 3 depend upon what his income was in Years 1 and 2. Going on to Year 4, when the taxpayer's income is actually $2,000, he will pay a tentative tax of $1,562, based on the $8,000 income of Year 3, and, in addition, he will also have to pay a deficiency of $1,024 for Year 3 because in that year he had paid a tax measured by the Year 2 income of $4,000, while his actual Year 3 income was $8,000. He is thus required in Year 4 to pay a total of $2,586, or $586 more than his income in that year. Thus, when incomes either rise or fall, the tax payments in a given year are based on the income of the two preceding years and are net related to the income of the current year.

As has been pointed out, this method works well for stable incomes, but without further refinement does not work well for fluctuating incomes. It should be noted that stability is the exception rather than the rule. Most incomes are characterized by fluctuation up one year, down the next, or up for several years, and then down for several years. It is estimated that the incomes of about two-thirds of the taxpayers for 1943 will vary substantially, either up or down from their 1942 incomes,

To base the tentative payments on last year's income when that income will generally be something higher or lower than this year's income, is not pay-as-you-go but pay-as-you-went. It is just this pay-as-you-went aspect of our present system that we seek to avoid.

It may be suggested that the defects of such a system can be patched by a relief provision which would permit adjustments in the tentative tax when the current year's income is expected to differ from the prior year's income. But since fluctuation in income is the rule, a provision designed to handle exceptions would to the extent it was followed actually became the rule. Taxpayers might be expected to take advantage of a permissive provision when their incomes were declining, but they could scarcely be expected to make the correction when their incomes were increasing, unless the provision were made mandatory through severe penalties for understatement of income.

b. TENTATIVE PAYMENTS BASED ON QUARTERLY STATEMENTS OF THIS YEAR'S INCOME.

Since corrections to take care of fluctuations in incomes would depart in so many cases from the prior year's income, it may be helpful to consider a method which would go more directly to current income. Thus, a system of quarterly payment based on quarterly statements of current income might be put into effect. Such a quarterly statement and payment system would be a supplement to collection at source on wages and salaries. It would enable taxpayers with seasonal incomes -- for example, farmers and many types of businessmen -- to gear their tax payments much more closely to income than is possible under the present system of equal quarterly installments. The quarterly statement of current income would be simple in form, as shown in Table 2. It should be noted that similar statements would be necessary under the method of basing payments on last year's income.

 
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