Cyclopædia of Political Science, Political Economy, and the Political History of the United States
INCOME TAX. A tax upon income has many qualities which recommend it to the economist. It accords perfectly with the first maxim of taxation as laid down by Adam Smith: "The subjects of every state ought to contribute toward the support of government as nearly as possible in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state." It would fall upon that portion of the community which is best able to contribute to the expenses of government, for it presupposes an income, and justice demands that it shall be levied only upon income that is not essential to the existence of the payer. Moreover as a direct tax it falls more upon the richer classes than upon the poorer, for this is the general tendency of direct taxes, and this tendency is further increased by an exemption from taxation of incomes below a certain amount. An income tax may then be regarded as a compensatory tax, as a tax which is complementary to a system of indirect taxes; because indirect taxes, falling upon consumption, require a relatively greater sacrifice from the poorer classes, and as the expenditure of people upon taxed commodities bears no regular proportion to their wealth, these indirect taxes touch but slightly the rich. While an indirect tax upon consumption will reach every class in the community, an income tax will, as has already been noted, fall upon that class which is in the enjoyment of an income over and above a certain sum. But the crowning merit of a tax upon income is that, if justly assessed, it would not act upon prices, like a tax upon a commodity; nor would it affect the normal distribution and employment of capital, or interfere with the free action of labor; nor finally, would it favor any particular class or classes of the community at the expense of any other class, or of the great body of the people, the consumers—effects which are apt to be produced by indirect taxation. All this supposes that the tax is equitably levied, and were this condition possible no tax would be more in accordance with correct economic principles. It is moreover an elastic tax, for as the wealth of a people increases, the proceeds of the tax must increase, and at the present time (1882) there is no surer index of England's advance in material prosperity than the slow increase in the returns of the income tax. No objection, based upon general principles, could be raised against the assessment and collection of a moderate tax on incomes above what is necessary to existence, if it could be assessed equitably and without causing injustice to any one, and if it could be collected with facility.
—But such a tax can exist only in theory, and when an attempt is made to put it in practice it becomes one of the most unequal taxes that can be imposed, the difficulties being almost wholly in the assessment. Such a tax can not, under any of the methods that have been suggested, be made an equal tax without raising up such a complex system of assessment and collection as to create insuperable obstacles to its collection. We can only approximate to an equal assessment. The first difficulty lies in the determining of what is the income to be taxed. Either the personal statement of the tax payer of the income he enjoys must be depended on, or there must be a body of trained officials for determining the income of each contributor; or the two methods must be combined. The weakness of depending upon the statement of the tax payer is at once apparent and unless there is an open and honest declaration on the part of the individual, the tax either becomes nugatory, or arbitrary and oppressive. The interest of the tax payer will induce him to evade his share of the burden by concealing a part of or underrating his true income, and the higher the rate of the tax the greater is the inducement offered to evasion. Moreover, while the conscientious tax payer makes a full and honest return of his income, the dishonest one will seek to escape his burden, and in this way the tax will be an unequal tax. For this reason the tax has been called "a tax upon honesty and a bounty on perjury and fraud." This is illustrated by the manner of collecting this tax as now practiced in England. The bank of England when it pays the dividends on the funds deducts the income tax and credits it to the government; the salaries of those employed in the government offices and in the army and navy are definitely known to the officials, and not one of these fund holders and government employés, can escape the payment of his full tax. The income of farmers is roughly estimated to be one-half the rental of the farm, and the tax is levied on that basis. But for the incomes of all engaged in manufacturing or other industrial enterprises, and of those engaged in professions, the statement of the interested parties must be depended upon, and undoubtedly evasion of taxation is practiced to a great extent among these classes. So that there are certain classes of the community taxed either upon their full incomes or upon a portion of them fixed on a well-defined principle, from which there can be no escape, side by side with others who may wholly escape taxation. The result is, that such a system is a discriminating and therefore unjust system, and the difficulty thus raised has never been successfully overcome. So long as the income tax rests mainly upon voluntary assessment it will be an unjust tax, and on that ground stands condemned. Yet there is one very curious instance in which this principle of voluntary assessment was carried to its fullest extent. "At Hamburg every inhabitant is obliged to pay to the state ¼ per cent. of all that he possesses, and as the wealth of the people of Hamburg consists principally in stock, this tax may be considered as a tax upon stock. Every man assesses himself, and, in the presence of the magistrate, puts annually into the public coffer a certain sum of money, which he declares upon oath to be ¼ per cent. of all that he possesses, but without declaring what it amounts to, or being liable to any examination upon that subject. This tax is generally supposed to be paid with great fidelity." And, Adam Smith adds, it is not peculiar to the people of Hamburg. To attempt to put into practice any such tax at the present day would be absurd, and it could never be said of it that it was paid with great fidelity.
—A system of government officials to decide on a person's ability to pay, has become a necessary appendage to an income tax, and unless the rate of taxation is very low there should be some means of establishing the correctness of the individual return, and of making such corrections as may be deemed necessary. But if voluntary assessment causes inequality of taxation, an official assessment only increases this inequality, though at the same time it may serve to remedy some evils incident to such a system. Thus, in their report for 1861-2, the inland revenue commissioners gave some instances where official interference had remedied some glaring abuses of voluntary assessments. "We have already reported to your lordships one remarkable case of recent occurrence, where a trading firm having returned 'nil' as their profits for the year 1861-2, the surveyor induced the district commissioners to assess them at £12,000, and upon appeal obtained a close confirmation of his estimate by proof from their own books that the correct charge was rather more than £12,000 as the average of the three preceding years. To take another example from a different part of the kingdom: A. B. some years ago returned £15,000 as his assessable income, but the amount was raised by the commissioners to £20,000, which he paid. The following year he made no return, and the assessment of the commissioners was again £20,000, but the surveyor charged him on £45,000, the duty on which was paid without appeal. Again, the next year he made no return, and again the charge was raised by the surveyor, who raised him to £60,000, with the same result as in the former instance."
—Yet official assessment is an arbitrary assessment. All income is not derived from the same source, but from many; and some of these are of an intangible nature, and will escape the closest official scrutiny, while others are not easily appreciated. So that such assessment is at best guesswork. Nor is the situation improved by introducing any artificial measure of income, such as the size of the house, the number of horses, or of servants, the rental paid for a farm, etc., etc. Expenditure is no true gauge of income, for a man may be induced to spend more than he can reasonably afford, to maintain appearances. But the greatest objection to official assessments is that they require inquisitorial proceedings which are more suited to a despotic than to a liberal and enlightened government; they require a constant interference with the affairs of individuals, and while they often fail to discover what it is their object to learn, they serve to keep up a feeling of irritation and discontent. The tax is regarded as obnoxious chiefly on the ground that it is inquisitorial.
—An objection that is urged against the English income tax, by which all incomes above a certain limit are taxed at the same rate without regard to the sources from which they are derived, is, that no distinction is made between transient and permanent incomes. It is urged that professional incomes, which are in their nature precarious, depending upon the continuance of the life, health, or other physical or mental quality of the receiver, should be taxed at a lower rate than permanent incomes, such as are derived from land or from investments in the public funds. This objection is a just one, but in order to remedy it such a complex and cumbrous scale of duties and exemptions must be introduced as to create obstacles as great, if not greater, than those now existing. A uniform rate is easily collected, and this question of administration is an important one. The inequality caused by taxing both classes of income alike would be somewhat diminished were the income tax made permanent. Thus, to take the example of Mr. Fawcett, the sum of £10,000 will purchase a life annuity of £600 or an annuity of £300 forever, supposing the rate of interest to be 3 per cent. "But if the income tax were permanently fixed at the uniform rate of 5 per cent., A's £10,000 would have to pay an income tax of £15 a year forever, because he is supposed to invest it in the form of a permanent annuity. B's £10,000, however, would only have to pay £30 a year during his lifetime, because his annuity of £600 will cease at his death. If A and B wished to redeem the income tax on the £10,000 they respectively possess, they would each have to pay exactly the same sum to the government; for the present value of an annuity of £30 to be continued during B's lifetime must be equivalent in value to a permanent annuity of £15, because it has been assumed that the present value of these annuities is equal." And he goes on to show that if the tax was not permanent an injustice would be done to A were temporary incomes taxed at a lower rate than permanent incomes. But these conditions are not fulfilled. The English income tax is not a permanent one, but is renewed from time to time, although it might, for all practical purposes, be regarded as a permanent tax; because while it has ever been considered a temporary tax, to be maintained only so long as it is necessary, yet the state of the British revenues is such as to preclude the possibility of its suppression for some time yet to come.
—The justice of exempting small incomes from the income tax can not be questioned, for, as has been said, this tax is in modern systems of finance intended to supplement indirect taxation, which falls most heavily on small incomes, and this object would be defeated were additional burdens imposed through its agency on the incomes of the lower classes. But at what point to limit the exemption is a difficult and important question to decide, because on the correct solution of this question depend the incidence of the tax and its productiveness. A sum sufficient to obtain the necessaries of life should be exempted, for otherwise the condition of the people would deteriorate, a recourse to a lower standard of living being enforced. But any further exemption must be decided by the amount of taxes to be levied, the state of public opinion respecting taxation, and, above all, the economical condition of the people. Thus, in England the limit of taxable income may be fixed higher than in France; for in the former country the wealth is massed chiefly in a comparatively few hands, and the incomes of a large portion of the people average much higher than in France, where wealth is more evenly distributed among the population and the average income is comparatively small. The exemption of all incomes below £150 is estimated to exempt from taxation one-half of the taxable income in England; under a like exemption three-fourths of the taxable income of France would escape taxation. On the other hand, when the limit is fixed too high the tax becomes a farce. Thus, in the United States in 1868 when incomes below $1,000 were exempt, the number of persons who paid the tax was 259,385; but when the amount of exemption was raised to $2,000, the number of taxable persons was reduced to 116,000, and subsequently fell to 71,000 out of a total population of about 40,000,000. Experience, therefore, demonstrates that an exemption in the United States of $2,000 of income will exempt more than nine-tenths of the entire property of the country, and more than ninety-nine-hundredths of the property owners from the tax. The results proved that the limit was absurdly high.
—In England not only are all incomes below £150 exempt, but a deduction of £120 is made on all incomes between £150 and £400, so that an income of £400 is taxed only on £280. But if some inequalities are abolished by this generous allowance, others as glaring and unjust are created. Thus, an income of £150 will pay the full tax, but an income of a few shillings less will be exempt. Again, an income of £400 is taxed on £280 only, but one of £401 is taxed at its full value. To correct this manifest injustice Mr. Mill proposed to determine the limit of exemption, fixing it at as low an amount as possible, to be determined as nearly as may be by the bare cost of subsistence, and to deduct this sum from all incomes whatever, only taxing the remainder. Thus, if £100 was selected as the limit, then an income of £350 would be taxed on £250; one of £500 on £400, etc., etc. This plan, which was actually in operation in this country, does away with whatever injustice is incident to the system of allowing a deduction from certain incomes as just described.
—An income tax can be levied with profit only in a country where capital is abundant, manufactures and commerce well developed and progressive, and where there is a marked tendency for the national wealth to increase. The distribution of wealth in a country affects the rate of the tax and the limit of exemption, both being lower in countries where wealth is evenly distributed and the average income is small. But the lower a nation stands in material wealth and commercial and industrial activity, the less is it fitted for an income tax. Thus, in India there is an immense population, but very little wealth, and an attempt to introduce an income tax in that country signally failed. In the Chittagong district of Bengal, which may be taken to illustrate the operation of this tax, the population numbered 1,127,402 souls. Yet in the whole district only 876 incomes were assessed in 1870-71, as exceeding £50 per annum. The total amount of these 876 incomes was about £100,000, and the amount of income tax realized was £3,161. In the following year the rate was reduced from an average of 3 1/8; per cent. to 1 1/24 per cent., and the minimum of income liable to assessment was raised to £75 per annum; the amount of the tax then realized for 1871-2 was only £809, which probably did not cover the cost of administration. The impossibility of continuing such a tax was soon recognized, and it was abolished.
—To return again to the maxim of Adam Smith: "The subjects of every state ought to contribute toward the support of the government as nearly as possible in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state." Many economists and financiers have believed that to carry out this maxim it is necessary to tax income in proportion to its amount; to frame a scale of rates increasing with the amount of the income, so that the higher the income the greater in proportion is the tax paid. If, they say, a man with $1,000 income pays a tax of $50, one with $10,000 income should pay, not $500—not at the same rate—but at a higher, say $1,000. But this, apart from the difficulty of framing a scale of rates, would be an extremely vicious method of imposing a tax. For no two persons are circumstanced alike, although both may receive the same income as measured in dollars; for the one may be able to spend all in his personal enjoyments, while the income of the other may be already burdened by necessary charges, which consume a large part of it. To tax these incomes at the same rate would cause hardship and gross injustice; for what is to one a comparatively small contribution, to the other amounts to confiscation. Suppose the amount of tax is tripled every time the income is doubled—a progression that does not appear to be rapid—a point is soon reached where the whole income is absorbed by the tax. Thus:
Such a tax would discourage all saving and end by driving from the country those with large fortunes unless by fraud they could escape the tax. It is moreover a communistic tax, because it seeks to equalize fortunes by discrediting saving, and in so doing aims at a more general distribution of the wealth of a country. In a country with democratic institutions there is danger that the income tax even when levied as in England at the present time, may be used by the poorer classes as a means of oppressing the richer classes on whom the tax falls, and this tendency has been noted in England by Prof. Fawcett, and in this country by Mr. David A Wells. A graduated or progressive income tax is but a logical sequence of the theory that the state may properly interfere with the distribution of wealth, a theory that rests on purely sentimental grounds, and has no basis in fact or reason. In many of the cantons of Switzerland the tax upon income is made a progressive tax, only a certain portion of the income being taxed, or a graduated scale of rates is framed. Thus, in Zurich incomes of 20,000 francs pay on only one-half of this amount, or on 10,000 francs; incomes of 30,000 francs pay on six-tenths; of 50,000 francs on seven-tenths; of 100,000 francs on eight-tenths, and of 200,000 francs on nine-tenths. But the tax is not levied on a like method in other cantons in which a progressive tax is imposed. (See Traité de la Science des Finances, Leroy Beaulieu, vol. i., p. 151.)
—HISTORY. In the United States but one tax upon income has been imposed by the federal government, and it arose from the necessities of the government incident to the rebellion. An act of congress of Aug. 5, 1861, authorized an income tax of 3 per cent. on all incomes over $800 per annum, but this law was in the following year superseded by that of July, 1862. Under this act incomes under $5,000 were taxed 5 per cent., with an exemption of $600 and house rent actually paid. Incomes in excess of $5,000 and not in excess of $10,000 were taxed 2½ per cent. in addition, and incomes over $10,000 5 per cent. additional, without any exemptions whatever. Further taxes of 5 per cent. on incomes accruing to Americans residing abroad, and 1½ per cent. on incomes from interest on securities of the United States were imposed, but these expired after 1865. In estimating the income, all other taxes, national, state and local, were first deducted, as well as the $600 exempted as above. In 1864 a special tax of 5 per cent. was imposed on all incomes above $600, as well from banks, railroads and salaries, as from other sources, and produced to the treasury $28,929,312.02. In the same year the income tax was readjusted, and all incomes between $600 and $5,000 were taxed at the rate of 5 per cent.; and incomes above $5,000 at 10 per cent. The revenue obtained from this source reached its highest point in 1866 under these rates. Mr. Fessenden, at that time secretary of the treasury, in his annual report for 1864, suggested that "the income tax should be collected upon all, without exemption. As the law is, it opens the door to innumerable frauds, and in a young and growing country the vast majority of incomes are small, while all participate alike in the blessings of good government. The adoption of a scale, augmenting the rate of taxation upon incomes as they rise in amount, though unequal in one sense, can not be considered oppressive or unjust, inasmuch as the ability to pay increases in much more than arithmetical proportion as the amount of income exceeds the limit of reasonable necessity." Fortunately for the country, at that time burdened with one of the most oppressive systems of taxation ever imposed, neither of the secretary's recommendations were acted upon, and the nation escaped adding to the already long list of its financial and commercial blunders, those of a universal and a graduated or progressive income tax. Although when incomes below $5,000 were taxed at one rate, 5 per cent., those between $5,000 and $10,000 at a somewhat higher rate, 7½ per cent., and finally incomes above $10,000 at 10 per cent., there was a moderate progression, it was not such as is recommended by Say, or like the tax we have described in a previous paragraph.
—In 1865 the limit of exemption was raised from $600 to $1,000, being rendered necessary by the great rise in prices consequent upon the onerous internal and customs duties on commodities and the great depreciation of the currency, and the differential taxes on incomes in excess of $5,000 were repealed.
—In 1866 the whole number of persons assessed on the annual list was 460,170. In the following year the full effect of the changes in the amount of exemption and in the rate of the tax began to be felt; and as showing these changes and at the same time as giving a rough indication of the distribution of the wealth in this country, the following table will be instructive:
And further as showing the unequal incidence of the tax it may be noted that in 1869 the states of Massachusetts, New York, New Jersey, Pennsylvania, Ohio, Illinois and California, paid three-fourths of the entire income tax collected in that year, although they possessed but 40 per cent. of the assessed property and 40 per cent. of the total population of the country.
—The tax was to expire in 1870, but it was renewed, the rate of tax being reduced to 2½ per cent. and the sum allowed to be deducted from each person's gross income was raised to $2,000. Whatever reasons there were for raising the limit of exemption from $600 to $1,000, they did not exist for still further raising it to $2,000, and as if to make the tax a still greater absurdity all state or local taxes paid in the preceding year, and all losses "actually sustained during the year from fires, floods, shipwreck, or that occurred in trade; the amount of interest paid during the year; the amount paid for rent, or labor to cultivate land; the amount paid for rent of premises actually occupied; and the sums expended for the usual and ordinary repairs of such premises," could be deducted before the tax was assessed. The result of such sweeping exemptions and deductions could easily have been foretold. The number of persons assessed for income fell in 1871 to 74,775, and in 1872 to 72,949; while the proceeds of the tax practically hardly afforded revenue sufficient to pay the cost of collection. The tax expired in 1872, not being renewed. It was but a war measure, and it is doubtful if another such tax will be again imposed in this country unless a like necessity arises. The amounts collected from income, including salaries, for each year from 1863 to 1872 are given in the following table:
Together with the arrears collected since 1872 the total amount raised from income was $346,911,760 48.
—We have purposely omitted to speak of the question of the constitutionality of an income tax as levied under the act of 1864, because the question never came before the supreme court for adjudication, and it would be useless to revive the question now, and the main reasoning on either side will alone be noticed. The supreme court had already decided that according to the constitution direct taxes are only such as fall upon land or upon polls, and the economic definition of a direct tax was thus thrust aside. But it is urged that a tax upon income is in reality a tax upon the property from which the income is derived, and under such a theory a tax upon income derived from land would fall under the constitutional definition of a direct tax as explained by the courts, and should therefore be apportioned among the states according to their population. Moreover internal revenue law seems to recognize the principle that a tax upon income is a tax upon the property from which the income accrues. Thus by section 127 of the act of 1864 a tax was laid on succession to real estate, and such succession was defined to be every such disposition of real estate whereby any person should become entitled to any real estate or the income thereof. Furthermore it is established by statute law in this country that a grant or devise of the income of real estate in perpetuity is a grant or devise of the fee itself. In Dobbins vs. the Commissioners of Erie County (16 Peters, 435), it was held that a tax upon income or profits of real estate is a direct tax, upon the principle that a tax upon the income of a thing is the same as a tax on the thing itself. And many more cases in which the same principle was recognized could be cited. The tax was however levied and collected, and, although a most unpopular tax and regarded as a fit subject of evasion, was endured so long as congress deemed it necessary to continue it. It is a curious fact that the dissatisfaction against the income tax was most loudly expressed while the $2,000 exemption was in force, or, in other words, while it fell upon the rich alone.
—The history of income taxes as practiced by other nations has been often told, and we have space only for a statement of the general principles of these taxes. In England the income tax is rather a collection of different taxes, and, as Mr. Gladstone said in 1853, is more of a code or system of taxation than a single tax. To the bulk of the people, however, it is known in its most obnoxious form as a tax upon ordinary incomes—salaries, professional earnings, profits of trading, etc. Assessments on these are now made under schedule "D," which is the most important of all the five schedules into which this system of taxation is subdivided; for it comprises, in addition to incomes of this private character, the profits of public companies, such as gas and water works, or railways, dividends on foreign and colonial investments, as well as the profits on working mines and quarries, the rents of fishings and shootings, etc. The next in importance is schedule "A," which comprises incomes from the rent of land and houses, proceeds of tithes, royalties, etc. With this may be classed schedule "B," which embraces the tax payable by occupiers of land, except nursery gardens, the profits on which are assessed, like those of trades and professions, under schedule "D." Schedule "C" regulates the assessment on incomes from the public funds, and schedule "E" that on incomes derived from official appointments, whether in the public service, or in the service of corporate bodies. These duties yielded in the year ending March 31, 1881, the sum of £10,776,000. They are the most elastic of the English taxes.
—In Prussia are found two taxes, the classensteuer and the einkommensteuer, the former reaching only incomes of less than 1,000 thalers. The einkommensteuer is assessed in forty classes, and varies from 2½ to 3 per cent. In Austria the tax is divided into four parts, and varies from 1 to 10 per cent. Its product is but small. In Italy a tax is imposed on all incomes other than that derived from land, and is even more complex than that first levied by the United States. Moreover it is a tax of a very burdensome nature, amounting to no less than 13 1/5 per cent on the incomes taxed, although certain allowances and exemptions reduce its burden on incomes of an uncertain nature. Thus, all incomes below 400 lire are exempt, and the tax falls upon only three-eighths of incomes derived from labor alone, and upon one-half of incomes derived from public offices or pensions. The elaborate attempts made to render the incidence of this tax equal have signally failed. Of the 184,000,000 lire collected in 1877, 85,000,000 lire were obtained from incomes derived from state pensions and salaries, interest on the public debt, gains of lotteries, and other forms of income which can not possibly escape the cognizance of the government. The remaining 99,000,000 lire represent what was collected on incomes derived from all sources apart from land, and should represent a very large share of all the private income of the Italian people, and these figures prove to what an extent the tax is evaded. (See L'Impot sur le Revenu Mobilier en Italie, by M. Vessélovsky, St. Petersburg, 1879.)
—BIBLIOGRAPHY. First and Second Reports of the Select Committee on the Income and Property Tax, London, 1852; Leroy Beauheu's Traité de la Science des Finances; M'Culloch, Taxation and the Funding System; Levi, On Taxation; Reports of the Commissioner of Internal Revenue.
WORTHINGTON C. FORD.
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