Passive Versus Active Income

Today’s installment concludes The United States Adopts the Income Tax,
our selection from The Income Tax of 1913 from The Quarterly Journal of Economics, Volume 28 by Joseph A. Hill published in 1913.   For works benefiting from the latest research see the “More information” section at the bottom of these pages.

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Previously in The United States Adopts the Income Tax.

Time: 1913
Place: Washington, D.C.

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 practice. 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.

This ends our series of passages on The United States Adopts the Income Tax by Joseph A. Hill from his book The Income Tax of 1913 from The Quarterly Journal of Economics, Volume 28 published in 1913. This blog features short and lengthy pieces on all aspects of our shared past. Here are selections from the great historians who may be forgotten (and whose work have fallen into public domain) as well as links to the most up-to-date developments in the field of history and of course, original material from yours truly, Jack Le Moine. – A little bit of everything historical is here.

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