REDUCTION OF SUR-TAX RATES NEXT STEP IN LIGHTENING WAR TAXES

The following article was written for the Crimson by Mr. L. W. McKernan '13, of the Treasury Department in Washington. For the past few years Mr. McKernan has been connected with the Treasury War Loan Staff.

The high surtax rates are a product of the war. They came with the War Revenue Act of 1917. In 1918 they were increased to their highest point. The Revenue Act of 1921 reduced them to a maximum of 50 per cent, or a combined normal and surtax of 58 per cent, but even this approximates the war levels.

The outstanding feature of the high surtax is their marked tendency to become unproductive. The high rates are defeating their purpose. Statistics of income for the years 1916-1920 prove this in the clearest fashion. There has been a remarkable decline in the larger taxable incomes, while taxable incomes generally have been increasing. The following statistics show this for taxable incomes in excess of $300,000 a year: Number of Returns Year  All classes  Incomes over $300,000 1916*  437,036  1,296 1917*  3,472,890  1,015 1918*  4,425,114  627 1919*  5,332,760  679 1920*  7,259,944  395 *Net income of $3000 and over. *Net income of $1000 and over.   --Net Income-- Year  All classes  Incomes over $200,000 1916  $6,298,577,620  $992,972,986 1917  13,652,383,207  731,372,153 1918  15,924,639,355  401,107,868 1919  19,859,491,448  440,011,589 1920  23,735,629,183  246,354,585   Dividends and interest on Investments Year  All classes  Incomes over $300,000 1916  $3,217,348,030  $706,945,738 1917  3,785,557,955  616,119,892 1918  3,872,234,935  344,111,461 1919  3,954,553,925  314,984,884 1920  4,445,145,223  229,052,039

These figures show that while net incomes of all classes during the period from 1916 to 1920 increased from $6,298,577,620 in 1916, to $23,735,629,183 in 1920, and the number of returns from 437,036 in 1916 to 7,259,944 in 1920, the number of returns of incomes over $300,000 decreased during the same period from 1,296 in 1916 to 395 in 1920, and the amount of incomes over $300,000 from $992,972,986 in 1916 to $246,354,585 in 1920. During this same period investment of all classes increased, while in incomes over $300,000 investment income shrank from $706,945,738 in 1916 to $229,052,039 in 1920. While the number of returns and the total income reported for all classes, has steadily increased from year to year, there has, since the adoption of the higher surtax rates in 1917, been a very marked decrease in the number of returns, the total net income reported, and reported income from dividends and interest-bearing investments for taxpayers reporting net incomes in excess of $300,000. Obviously these figures show not a reduction in the number of individuals in the country actually having excess of $300,000 a year, or in the total actual net income for such individuals, but that individuals actually enjoying such income have, by various methods of reducing net income under the law (including investment in tax-exempt securities), translated themselves from the upper to the lower surtax classes, and in some cases probably avoided the payment of income taxes altogether. In this way the surtaxes are gradually defeating their own purpose and the high rates are becoming ineffective because of the steady disappearance of the taxable incomes to which they were intended to apply.

The tendency to become unproductive of revenue, is not confined to the very highest surtax rates. The tendency is characteristic of all the surtax classes where the rate is high enough to induce evasion of the burden by investment in tax-exempt securities and availing of other methods of avoiding payment of the higher rates. The following table, which, while not official, is compiled from the official Statistics of Income published by the Bureau of Internal Revenue, shows clearly the dwindling of taxable incomes of $100,000 a year or more, and the tax derived from them. *Percent  *Percent  *Percent 1916  1.52  29.47  73.11 1917  .67  17.60  54.26 1918  .32  9.84  44.07 1919  .30  8.84  44.64 1920  .18  4.38  32.34

*Ratio of number of returns from incomes of $100,000 and over to number of returns from incomes in excess of $3000.

*Ratio of total net income from incomes of $100,000 and over to total net income from net incomes in excess of $3000.

*Ratio of tax paid on net incomes of $100,000 and over to total tax paid on net incomes in excess of $3000.

It is apparent from this table that the surtaxes on taxable net incomes in excess of $100,000, while constituting between a quarter and a third of the total taxable net income in 1916 and yielding almost three-fourths of the total income tax paid by persons having taxable net incomes in excess of $3,000 in that year, in 1920 constituted little more than one-twentieth of the total net income and yielded less than one-third of the total tax: and this in spite of an increase, up to 1918, in the rate of surtax imposed.

The explanation is that since 1917 the rates have been so high that the inducement to see tax exemption of income has been controlling, and taxable net income reported has been reduced, although the actual income of taxpayers in the higher classes has for most years increased.

The ways of escape from the surtaxes, which are many and well known, all lead to the same end, the reduction of taxable net income. Among them may be mentioned the use of corporation and be mentioned the use of corporations and trusts to avoid payment of surtaxes directly, or by dividing income; the division of property among members of the taxpayer's family by gifts inter vivos; the taking of losses on capital investments in such fashion and at such times as to accomplish a maximum reduction of taxable income; the exploitation of certain features of the law such as the provision contained in Section 202 of the Revenue Act of 1921 relating to exchanges of securities; but finally and most important, investment in tax-exempt securities.

Legislation Can Help

Certain of these practices can be corrected by legislation. Evasion by exchange of securities has already been prevented for the future by amendment of Section 202 of the Revenue Act of 1921 at the last session of Congress. Legislation preventing undue reduction of net income by deduction of losses is equally possible and even more desirable as it is estimated that there is a heavy loss of tax revenue from this cause. But in this matter, as in other matters, legislation is no panacea. Ways of escape will persist, in spite of legislation, and will be availed of, as long as there is sufficient inducement. No matter what gaps are stopped by acts of Congress, the output of tax-exempt securities by states and municipalities will continue to afford an easy escape from all federal income surtaxes. This broad highway to exemption from taxes can only be closed by a constitutional amendment.

Many Tax-Exempt Securities

There are now outstanding approximately $11,000,000,000 of wholly tax-exempt securities. Of these about $8,500,000,000 are state, county, and municipal bonds. It is estimated that state and municipal securities are now being issued at the rate of one billion dollars a year. Here is a ready refuge from surtaxes. A taxpayer in the highest surtax class can now invest in a tax-exempt state or municipal bond paying 5 per cent interest and obtain the same net return as from a surtaxable stock paying dividends of 10 per cent. The average commercial bond, which is subject to normal tax as well as surtax, must pay slightly more, about 10.40 per cent to yield the same, after payment of taxes, as a 5 per cent state or municipal bond to the taxpayer in the highest surtax class. There is every inducement and ample opportunity to the taxpayer in the higher surtax class to transfer his investment funds from railroad and industrial securities to state and municipal bonds. The tax-exempt security is the occasion for the evil, but the high surtax is the moving cause.

Surtax Must be Reduced

The vice of the situation lies in the existence of high surtaxes in conjunction with the continued issuance of tax-exempt securities. Adoption of a constitutional amendment to restrict further issues of tax-exempt securities, coupled with legislation closing the gaps in the income law, is a final but far from immediate solution. And it will not eliminate tax-exempt state and municipal bonds now outstanding. Awaiting their retirement will postpone the date of complete solution. Only reduction by Act of Congress of the surtax rates to a level at which the inducement to invest in tax-exempt securities becomes negligible will destroy immediately and completely the tax-exempt evil, and reduction is logically the net step in the lightening of the tax burden imposed upon the country by the war.

These figures show that while net incomes of all classes during the period from 1916 to 1920 increased from $6,298,577,620 in 1916, to $23,735,629,183 in 1920, and the number of returns from 437,036 in 1916 to 7,259,944 in 1920, the number of returns of incomes over $300,000 decreased during the same period from 1,296 in 1916 to 395 in 1920, and the amount of incomes over $300,000 from $992,972,986 in 1916 to $246,354,585 in 1920. During this same period investment of all classes increased, while in incomes over $300,000 investment income shrank from $706,945,738 in 1916 to $229,052,039 in 1920. While the number of returns and the total income reported for all classes, has steadily increased from year to year, there has, since the adoption of the higher surtax rates in 1917, been a very marked decrease in the number of returns, the total net income reported, and reported income from dividends and interest-bearing investments for taxpayers reporting net incomes in excess of $300,000. Obviously these figures show not a reduction in the number of individuals in the country actually having excess of $300,000 a year, or in the total actual net income for such individuals, but that individuals actually enjoying such income have, by various methods of reducing net income under the law (including investment in tax-exempt securities), translated themselves from the upper to the lower surtax classes, and in some cases probably avoided the payment of income taxes altogether. In this way the surtaxes are gradually defeating their own purpose and the high rates are becoming ineffective because of the steady disappearance of the taxable incomes to which they were intended to apply.

The tendency to become unproductive of revenue, is not confined to the very highest surtax rates. The tendency is characteristic of all the surtax classes where the rate is high enough to induce evasion of the burden by investment in tax-exempt securities and availing of other methods of avoiding payment of the higher rates. The following table, which, while not official, is compiled from the official Statistics of Income published by the Bureau of Internal Revenue, shows clearly the dwindling of taxable incomes of $100,000 a year or more, and the tax derived from them. *Percent  *Percent  *Percent 1916  1.52  29.47  73.11 1917  .67  17.60  54.26 1918  .32  9.84  44.07 1919  .30  8.84  44.64 1920  .18  4.38  32.34

*Ratio of number of returns from incomes of $100,000 and over to number of returns from incomes in excess of $3000.

*Ratio of total net income from incomes of $100,000 and over to total net income from net incomes in excess of $3000.

*Ratio of tax paid on net incomes of $100,000 and over to total tax paid on net incomes in excess of $3000.

It is apparent from this table that the surtaxes on taxable net incomes in excess of $100,000, while constituting between a quarter and a third of the total taxable net income in 1916 and yielding almost three-fourths of the total income tax paid by persons having taxable net incomes in excess of $3,000 in that year, in 1920 constituted little more than one-twentieth of the total net income and yielded less than one-third of the total tax: and this in spite of an increase, up to 1918, in the rate of surtax imposed.

The explanation is that since 1917 the rates have been so high that the inducement to see tax exemption of income has been controlling, and taxable net income reported has been reduced, although the actual income of taxpayers in the higher classes has for most years increased.

The ways of escape from the surtaxes, which are many and well known, all lead to the same end, the reduction of taxable net income. Among them may be mentioned the use of corporation and be mentioned the use of corporations and trusts to avoid payment of surtaxes directly, or by dividing income; the division of property among members of the taxpayer's family by gifts inter vivos; the taking of losses on capital investments in such fashion and at such times as to accomplish a maximum reduction of taxable income; the exploitation of certain features of the law such as the provision contained in Section 202 of the Revenue Act of 1921 relating to exchanges of securities; but finally and most important, investment in tax-exempt securities.

Legislation Can Help

Certain of these practices can be corrected by legislation. Evasion by exchange of securities has already been prevented for the future by amendment of Section 202 of the Revenue Act of 1921 at the last session of Congress. Legislation preventing undue reduction of net income by deduction of losses is equally possible and even more desirable as it is estimated that there is a heavy loss of tax revenue from this cause. But in this matter, as in other matters, legislation is no panacea. Ways of escape will persist, in spite of legislation, and will be availed of, as long as there is sufficient inducement. No matter what gaps are stopped by acts of Congress, the output of tax-exempt securities by states and municipalities will continue to afford an easy escape from all federal income surtaxes. This broad highway to exemption from taxes can only be closed by a constitutional amendment.

Many Tax-Exempt Securities

There are now outstanding approximately $11,000,000,000 of wholly tax-exempt securities. Of these about $8,500,000,000 are state, county, and municipal bonds. It is estimated that state and municipal securities are now being issued at the rate of one billion dollars a year. Here is a ready refuge from surtaxes. A taxpayer in the highest surtax class can now invest in a tax-exempt state or municipal bond paying 5 per cent interest and obtain the same net return as from a surtaxable stock paying dividends of 10 per cent. The average commercial bond, which is subject to normal tax as well as surtax, must pay slightly more, about 10.40 per cent to yield the same, after payment of taxes, as a 5 per cent state or municipal bond to the taxpayer in the highest surtax class. There is every inducement and ample opportunity to the taxpayer in the higher surtax class to transfer his investment funds from railroad and industrial securities to state and municipal bonds. The tax-exempt security is the occasion for the evil, but the high surtax is the moving cause.

Surtax Must be Reduced

The vice of the situation lies in the existence of high surtaxes in conjunction with the continued issuance of tax-exempt securities. Adoption of a constitutional amendment to restrict further issues of tax-exempt securities, coupled with legislation closing the gaps in the income law, is a final but far from immediate solution. And it will not eliminate tax-exempt state and municipal bonds now outstanding. Awaiting their retirement will postpone the date of complete solution. Only reduction by Act of Congress of the surtax rates to a level at which the inducement to invest in tax-exempt securities becomes negligible will destroy immediately and completely the tax-exempt evil, and reduction is logically the net step in the lightening of the tax burden imposed upon the country by the war.

*Ratio of number of returns from incomes of $100,000 and over to number of returns from incomes in excess of $3000.

*Ratio of total net income from incomes of $100,000 and over to total net income from net incomes in excess of $3000.

*Ratio of tax paid on net incomes of $100,000 and over to total tax paid on net incomes in excess of $3000.

It is apparent from this table that the surtaxes on taxable net incomes in excess of $100,000, while constituting between a quarter and a third of the total taxable net income in 1916 and yielding almost three-fourths of the total income tax paid by persons having taxable net incomes in excess of $3,000 in that year, in 1920 constituted little more than one-twentieth of the total net income and yielded less than one-third of the total tax: and this in spite of an increase, up to 1918, in the rate of surtax imposed.

The explanation is that since 1917 the rates have been so high that the inducement to see tax exemption of income has been controlling, and taxable net income reported has been reduced, although the actual income of taxpayers in the higher classes has for most years increased.

The ways of escape from the surtaxes, which are many and well known, all lead to the same end, the reduction of taxable net income. Among them may be mentioned the use of corporation and be mentioned the use of corporations and trusts to avoid payment of surtaxes directly, or by dividing income; the division of property among members of the taxpayer's family by gifts inter vivos; the taking of losses on capital investments in such fashion and at such times as to accomplish a maximum reduction of taxable income; the exploitation of certain features of the law such as the provision contained in Section 202 of the Revenue Act of 1921 relating to exchanges of securities; but finally and most important, investment in tax-exempt securities.

Legislation Can Help

Certain of these practices can be corrected by legislation. Evasion by exchange of securities has already been prevented for the future by amendment of Section 202 of the Revenue Act of 1921 at the last session of Congress. Legislation preventing undue reduction of net income by deduction of losses is equally possible and even more desirable as it is estimated that there is a heavy loss of tax revenue from this cause. But in this matter, as in other matters, legislation is no panacea. Ways of escape will persist, in spite of legislation, and will be availed of, as long as there is sufficient inducement. No matter what gaps are stopped by acts of Congress, the output of tax-exempt securities by states and municipalities will continue to afford an easy escape from all federal income surtaxes. This broad highway to exemption from taxes can only be closed by a constitutional amendment.

Many Tax-Exempt Securities

There are now outstanding approximately $11,000,000,000 of wholly tax-exempt securities. Of these about $8,500,000,000 are state, county, and municipal bonds. It is estimated that state and municipal securities are now being issued at the rate of one billion dollars a year. Here is a ready refuge from surtaxes. A taxpayer in the highest surtax class can now invest in a tax-exempt state or municipal bond paying 5 per cent interest and obtain the same net return as from a surtaxable stock paying dividends of 10 per cent. The average commercial bond, which is subject to normal tax as well as surtax, must pay slightly more, about 10.40 per cent to yield the same, after payment of taxes, as a 5 per cent state or municipal bond to the taxpayer in the highest surtax class. There is every inducement and ample opportunity to the taxpayer in the higher surtax class to transfer his investment funds from railroad and industrial securities to state and municipal bonds. The tax-exempt security is the occasion for the evil, but the high surtax is the moving cause.

Surtax Must be Reduced

The vice of the situation lies in the existence of high surtaxes in conjunction with the continued issuance of tax-exempt securities. Adoption of a constitutional amendment to restrict further issues of tax-exempt securities, coupled with legislation closing the gaps in the income law, is a final but far from immediate solution. And it will not eliminate tax-exempt state and municipal bonds now outstanding. Awaiting their retirement will postpone the date of complete solution. Only reduction by Act of Congress of the surtax rates to a level at which the inducement to invest in tax-exempt securities becomes negligible will destroy immediately and completely the tax-exempt evil, and reduction is logically the net step in the lightening of the tax burden imposed upon the country by the war.