The Investor and His 'Direct' Taxes

This department is designed to help readers to a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to specific investments.

O-DAY. when the investor, large or small, thinks of taxes, his first concern is the Revenue Act of 1936. Though surrounded by a multitude of taxes, federal, state, and municipal, he is not always aware of them, since they are frequently concealed in the price he pays for food, clothing, shelter, and recreation — in fact, for practically everything that is necessary for the preservation and enjoyment of life. Rut his federal income tax is something he can recognize as a direct contribution toward defraying the cost of government; and if he lives in a state such as New York or Massachusetts, consideration of his state income tax follows close upon his concern as to his federal tax and its effect upon his investment policy.

The investor may well look with concern upon the Revenue Act of 1936. Rather generally conceded to be inadequate as a means of producing the vast revenue required to meet federal expenditures, it seems merely an omen of things to come.

Why, it may be asked, is so much emphasis placed upon the investor in this discussion? Are not the taxes imposed by the Act equally applicable to earned income and taxable return from investments? They are, except for the exemption from normal tax of 10 per cent of earned income, which exemption in no case may exceed $1400. However, generally speaking, to the extent that taxable earned income and taxable investment income are equal in amount, they are equally subject to the levies imposed by the Act. This was not always so, since, until the enactment of the Revenue Act of 1936, dividends received from domestic corporations were not subject to normal tax. Commencing in 1936, therefore, we have an additional federal tax burden placed upon the investor.

Let us consider a few illustrations of the increasing demand upon the income of individuals in varying circumstances for the maintenance of federal and state governments. A, B, and C are residents of New York State, each married and with two dependents. The income of each is as follows:

A B C Salary. $2,500 $5,000 $12,500 Interest (taxable). 500 1,000 2,500 Dividends. 2,000 4,000 10,000 Total $5,000 $10,000 $25,000

For the purpose of these illustrations, let us ignore the deductions from the above amounts such as interest paid, taxes, and so forth, which would be allowable in computing taxable net income, for, although they might vary considerably, they would not materially affect our final conclusion.

Under these circumstances, A would have paid no 1935 federal income tax, but would have been subject to a New York state tax of $58, which amount represents only 1.16 per cent of his total income. Under the same circumstances for 1936, however, A will pay a federal tax of $56 as well as a state tax of $58, a total of $114, or 2.28 per cent of h is income.

B’s tax burden, with double the income of A, is a great deal heavier. He would have paid a 1935 federal tax of $203 and a state tax of $312, or $515 altogether — 5.15 per cent of his income. For 1936 he will pay a total of 6.75 per cent, or $675, of which $363 will go to the federal government, his state tax remaining the same as for 1935.

The case of C is more serious. His 1935 federal and state income taxes took 13.676 per cent of his income, while for 1936 the levy will be increased to 15.276 per cent. His taxes are as follows: —

1935 1936
Federal $1,933 $2,333
State 1,486 1,486
Together $3,419 $3,819

It has undoubtedly been noted that in each of the above examples it is anticipated that the New York state tax for 1936 will be the same as for 1935. Barring changes in the law subsequent to this writing, it is a fact that the state tax will not be increased. The impression should not be gained, however, that the state income tax rates have not advanced in recent years. Whereas income received in 1934 was subject to a normal tax of 2 per cent on the first $10,000 in excess of exemptions, 4 per cent on the next $40,000, and 6 per cent on the balance, the normal tax rates for 1935 and 1936 start at 2 per cent on the first $ 1000, increase 1 per cent on each succeeding $2000 up to $9000, with a top rate of 7 percent thereafter. Furthermore, for the calendar year 1933 and subsequent years the state has imposed a 1 per cent emergency tax in addition to the normal tax.

In each of our illustrations an increase in federal tax is indicated for 1936. It may be argued that the increases are not tremendous. In fact, they are entirely due to the imposition of the 4 per cent normal tax upon dividends, which should not be an unbearable hardship to individuals in such circumstances.

But let us look once more at our illustrations and note again that whereas in 1936 A, with an income of $5000, will pay a total federal and state tax of 2.28 per cent, C’s taxes will take 15.270 per cent of his $25,000 income. Of course, the increase in proportion of tax to income, which increase continues into the larger incomes, is in accordance with the theory of taxation which would place the burden where it can best be borne; and right here we have the reason why the imposition of a normal tax of 4 per cent on dividends may well be of far greater significance to the investor than the immediate rise in his income tax bill, for it is he who can bear, and so probably will have to bear, the bulk of further additional taxes.

So far as individual taxpayers are concerned, it is to the investor that the government must look for the tremendous increase in revenue which will have to he obtained sooner or later. Earned income will not provide the required base for taxation, since the aggregate amount thereof must be more or less limited by sound, even if liberal, business policy. On the other hand, the provisions in the Revenue Act of 1936 which impose a surtax upon undistributed corporate earnings will unquestionably result in a very substantial increase in dividends.

It is extremely unlikely, however, that this extended base, together with the addition of a normal tax thereon, will produce more than a fraction of the necessary yield. Therefore, although large incomes will undoubtedly be further increased, it seems inevitable that the government will have to cut deeper and deeper into them, so that, as has been stated, the present demand upon the income of the investor may well be merely an indication of what is to be expected in the future.

Undoubtedly, the individual with an income of $25,000 feels that he is already bearing a fair share of the burden when he is required to pay more than 15 per cent of that income directly to his federal and state governments, and he will naturally view with alarm the prospect of a substantial increase in the percentage. But what can he do about it? The current low level of return on tax-exempt governmental obligations renders investment in such securities impractical even if he were disposed to seek such relief.

Perhaps, as an individual, there is nothing he can do but hope for an early recession in the flood of government spending.