The Coming Tax Reform
The present tax statutes, riddled with special advantages, follow a crazy-quilt pattern, and the Kennedy Administration has promised tax reform along with a tax cut in 1963. The background and possible results of this bill are here analyzed. The author, writing under a pseudonym, is a tax lawyer with a New York firm.
As MILLIONS of Americans have heard, taxes may be cut in 1963. As few realize, this does not mean a bonanza. A big chunk of the relief will come in lowered corporation taxes and will not be felt directly by the taxpayer. Even the fairly sizable drop the Administration is projecting — perhaps $6 or $7 billion — will give the average taxpayer only $65 more spending money, and unless Congress does something about the withholding rates, this may mean simply a refund the next year or a series of hardly noticed reductions in the quarterly payments of estimated tax.
This is not because the government is fainthearted. The overall cut is not designed as succor for the oppressed but as a stimulus to business, a recognized Keynesian move to pump a strong dose of consumer demand into a vacillating economy. Each taxpayer may never feel the money come and go, since Administration studies indicate that 94 cents of every dollar cut will be spent instead of saved, adding a nearterm demand factor of over $6 billion.
There are many economists, some of them as close to the White House as John Kenneth Galbraith, who feel that this tack is wrong. The economically orthodox (and they include a surprising number of congressmen) object to the very severe budget deficit which the resulting drop in revenue will inevitably produce. The Galbraithian school would tolerate the deficit all right, but would simply create it in the other direction, by increasing government spending rather than consumer consumption.
The White House is not necessarily for a smaller government-spending role, but the President’s Council of Economic Advisers has persuaded him that the present tax rates are stultifying the economy, especially by tending to pinch off post-recession upsurges before they have ripened into genuine recoveries. The Administration’s almost legendary concern with “getting the country moving” has overcome any lingering doctrinaire hesitation.
Rate slashing is, however, only half of the tax program which President Kennedy will send to the Congress this January. The second part is tax reform. Many political commentators have already dismissed the chances for reform, on the grounds that Congress will accept none. But there can be no question that the Administration attaches the greatest importance to it. The President’s decision against cutting taxes in 1962 was dearly predicated not only on Congress’ coolness to an immediate cut but also on Secretary Dillon’s view that the President should not fritter away a year ahead of time the only conceivable quid pro quo for congressional approval of his distasteful reform ideas.
It has been a persistent policy of this Administration that the existing tax structure is in need of major overhaul and that this overhaul must take into account not only some traditional ideas of tax fairness but some harsh new facts of economic life which the changing world has thrust upon us. The Revenue Act of 1962, though cut down from what the President requested, was a solid first step. And if Mr. Kennedy can get Congress to take successive steps in 1963, or over a period of years, the result could be some dramatic changes in the relative size of certain individuals’ tax bills and an equally dramatic change in the orientation of the tax law toward business.
FROM the Internal Revenue Code’s tables of tax rates, one detects a reasonably clear and consistent pattern based on two simple principles: first, the rule of tax equality, or tax neutrality — that every taxpayer experiencing the same increase in wealth should bear the same tax; second, the rule of progressivity — that as a taxpayer’s income goes up, the percentage of that income taken in tax also goes up, to an almost confiscatory maximum of 91 percent.
The first rule, a basic concept of equality before the law, applies to taxes paid both by individuals and by corporations; but the second affects only the individual’s tax. That is what is known popularly as “soaking the rich.” But its purpose is not to raise a wad of revenue from the upper tax brackets. Only a tiny fraction of the government’s revenue could under any circumstances come from the wealthy — there are simply too few of them. It is the expression of a social policy which seeks to fertilize democracy by redistributing the wealth and narrowing the economic gap between the richest and poorest members of society. While differences of opinion exist on just how steeply the progressive rates should rise and how high they should ultimately climb, these general rules seem widely accepted. What, then, is all the fuss about?
The trouble is that practice falls a sad distance short of theory. For example, the rate tables indicate that a married man with an income of $1 million should pay a tax of $859,000, or almost 86 percent, but he doesn’t. Statistics for the latest available year, 1960, reveal that taxpayers in the $1 million-and-over class paid only some 45 percent of the amount they reported as taxable income. Previous studies show that if receipts not technically required to be included in taxable income were taken into account, the effective rate would be only about 35 percent. Similar differentials could be established for various categories of taxpayers in lower brackets.
This anomaly arises from what tax specialists call “erosion of the tax base.” A wilderness of special provisions written into the Internal Revenue Code insulate particular kinds of income from the regular rates of tax, either by carving them out of the category of ordinary income or by allowing offsetting deductions or credits. To take a famous example, a person who owns an oil well is permitted to deduct a so-called “percentage depletion allowance,” which frequently ensures that he will pay little income tax on his profits from selling the oil. An advertising salesman may find that most of the pleasures in his life — the shows and expensive meals, his clubs, yachts, and vacation resorts — come to him tax-free, courtesy of his expense account. The list could drone on through the dozens of cases in which special exceptions are made.
The reason for these myriad exemptions is easily identified. Whatever our feelings about taxes in general, each of us knows that his own are too high. Given time, each could construct a (to him) perfectly reasonable argument why, in his own case, the tax should be lower. It is just this specialcase thinking which has made the Internal Revenue Code the patchwork of preferential provisions which it is today. When some group, generally expressing itself through a forceful professional lobby, pushes for a special tax break, there is no public-interest lobby pushing the other way. Even though the necessary effect of reducing one group’s taxes is to thrust that much more of the burden of government on all the other taxpayers, the millions who loot the bill seldom notice, or even know about, the change. There is remarkably little political hay in holding out against a tax cut, even a preferential one; and quite understandably, few congressmen have enough concern for abstract tax justice to take the political risks involved in offending the farmers, the steel industry, the old folks, the labor unions, or whoever happens to be knocking on the door.
But there is more to this than sheer political cowardice. Tax men, including the dean of American tax thinkers, the late Randolph Paul, have long maintained that Congress simply does not believe in the high rates which the tax tables set forth. Congress, they contend, would do away with them if it were not an embarrassing move to explain to low-income constituents. So they simply vote the special concessions as a kind of political end run.
Some years ago, H. L. Seltzer put forward a more imaginative theory. He saw in the tax laws the expression of America’s love for a good game. In his view, Congress never wanted to make the Internal Revenue Code a clear and simple dispenser of equity; it was willing to create a kind of fiscal maze through which an astute taxpayer could straight-arm his way for a touchdown, a feat which presumably brought him honor as well as wealth. This may be closer to the psychological truth than we should like to admit. The trouble is that the game has got out of hand. In an interview with Cameron Hawley, one company executive reluctantly admitted that almost every action taken by the directors of his company over a period of several years had been largely motivated by tax considerations, adding: “It’s frightening.”
No one concession in the tax law is earthshaking, and each may seem to follow from the one before. The process is as gradual and relentless as erosion. But the cumulative effect of all these tax deals is tremendous. Where the weary taxpayer antes up sonic 21 percent of the gross national product in federal taxes (over 26 percent counting state and local taxes), inequities in the distribution of the load raise pressing questions of economic justice which a democracy ignores at its peril.
Futhermore, there is a major political and economic issue hidden under the tax-preference system. In general, the special tax provisions are made for men of property, or at least men of business. As a result, the people bearing the highest relative tax loads are those who live by their wits — teachers, engineers, government administrators, social workers, writers, architects, accountants, and others. These intellectual producers have one thing in common: most of them live entirely on straight salaries, with no fringes, no capital gains, no depletion, no exemption — that is, no tax gimmicks. This hard fact has drawn more and more able and educated people out of the government, the schools and colleges, and even the garrets, into the ad agencies and the business world, where tax advantages are available. An issue which we have never faced squarely is whether we need incentives for business growth more than we need tax incentives to produce excellence in other activities necessary to a healthy body politic.
To all of these problems of tax erosion or preference, the classic solution is simple and Spartan: simply remove all preferences and impose the progressive rates stated in the Internal Revenue Code to all kinds of income without distinction. The trouble with this, as with so much of classical theory, is that it does not really work out in practice. It is easy to say that high progressivity must be imposed, but there is also good reason to believe that the confiscatory rates we now have really do stifle work incentives. It is also easy to say that all taxpayers should bear the same tax load, but do we really mean that when we compare a vital young workingman with a retired person trying to eke out a pension shrunken by decades of slow inflation?
IF CATEGORICAL solutions are impossible, one can still point to several areas where the tax reformers by and large feel that changes ought to come. Today, unlike ten years ago, there is a fairly broad consensus that the top rates should fall substantially. Rumor has the top rate scaling down from 91 percent to 65 percent, undoubtedly with some softening on down the line. This will probably be achieved in the process of allocating the tax cuts scheduled for 1963. There is a strong feeling in some circles that at the same time certain preferential provisions should be killed.
One subject of scrutiny is the businessman’s fringe benefits. The 1962 revision has already taken a swing at expense accounts. Up for further consideration will be stock options, lump-sum pension payouts, and a host of problems which arise in closely held corporations, where the plans stated to be for the benefit of all employees sometimes turn out to be primarily for the benefit of the owners.
The second area will be the special tax preferences given to individual investors. Although it is really an enforcement problem, the Administration’s request last year for withholding on dividend and interest payments reflects the fact that large numbers of investors are simply not reporting these items as income — costing the government some $600 million every year in lost revenue. There has been talk for some time of ending the tax exemption on interest received by investors from municipal and state bonds. The Administration has already requested the end of the dividendsreceived credit, a device which reduces taxes in proportion to the amount of dividend income, thus granting the greatest benefit to the wealthiest investor.
Somewhat similar issues are raised by the deduction allowed for charitable contributions of wealthy donors. A man in a 91 percent tax bracket can actually make money by giving to his favorite charity — often one which he controls — securities which have appreciated in value. If he sold the securities, he would pay a capital-gains tax of 25 percent and have 75 percent left. If he gives them to charity, he pays no capital-gains tax, but is allowed to deduct 100 percent of this value, thus saving 91 percent on the deduction from his income. Undoubtedly we need to redefine the limits of charity.
A healthy look will also be given to the tax treatment of oldsters. There are several provisions now in the law (exemption of social security benefits and the retirement-income credit, for example) which are supposed to alleviate the hardships of old age but which in fact benefit the very wealthy as well as the poor. Many tax students would scrap all of these, substituting some form of special exemption or expressly stated preferential rate limited to those in the lowest income group, who probably suffer the most from living on pensions or fixed incomes in an era of inflation.
Just as the list of preferences could continue almost forever, so could the list of proposals for doing away with them. If erosion of the tax base has been a gradual process, so the task of rebuilding the lost base must also take time. Many changes will simply never see the light of day, although this depends in large measure on the extent to which the voting public can be made to see its own interest in tax reform.
FOR many people the only proper function of the tax law is to raise revenue impartially from those who can best afford it; they are not concerned with the impact of the law on economic activity. But the taxing power is one of the government’s most potent tools for guiding the economy. This is the carrot-and-stick theory, by which the government is enjoined to give tax incentives to desired activities and to set up barriers against others. Historically, this interventionist philosophy has been the property of conservative spokesmen identified with business interests. Their plea, notably limited to the carrot side of the theorem, is that government should give tax incentives to the entrepreneur, making exceptions to the rules of tax neutrality and progressivity to stimulate savings and investment. Conversely, the liberal philosophy has generally favored tax neutrality. To the extent that liberals have deigned to answer the interventionists on economic grounds, their parry has simply been that we are doing all right under a regime of heavy business taxation. Alvin Hansen observed in the 1950s that we live in an Alice in Wonderland economy; the more we tax and spend for defense, the more prosperous business grows.
The Kennedy Administration, interventionist by instinct, has abandoned classic dogma to take up the carrot and the stick. The rapid changes which it discerns in the American world economic position have persuaded it that the liberal orthodoxy is too pat, and this in turn has produced a new look in the taxation of business which may spell far-reaching consequences for the economy as a whole.
The motive behind this shift is a deep-felt concern over the deteriorating economic position of the nation. Internally, the economy has slouched back into its fourth successive recession; unemployment hangs at peak levels, unused industrial capacity has built up, and the rate of national growth is one of the lowest in the industrial world. At the same time, U.S. companies have been flocking in droves to invest in booming Europe, lured not only by the fastest-growing market in the world, but also by impressive differentials in wage scale. The President has been faced with the frustrating spectacle of U.S. capital departing a faltering domestic economy to make a major contribution to the economic strength of Europe, and this at the very moment Mr. Kennedy must attempt to negotiate with the European nations the allnecessary free-trade deal, whose terms will depend critically on the relative economic strength of the two continents.
One solution is to apply the stick of greater tax burdens to companies investing overseas, in Europe particularly, while holding out the carrot of tax benefits to those investing at home. But for the domestic investor the carrot is hardly big enough; the overseas investor has a long lead in tax avoidance.
As long as we have had taxed income, U.S. businesses have been able to avoid tax on their foreign operations simply by incorporating a subsidiary company in another country. With some naïveté, our statute has always defined the subsidiary as something separate from its parent; since it is a foreigner and does no business here, no tax is due, at least until the profits are paid over into the parent company’s bank account. And if the profits are accumulated until the foreign company is liquidated or sold, only the low capitalgains tax would apply.
This freedom from U.S. tax has proved quite tempting. In some of the balmier climates the local tax burden is very low. In Bermuda and Nassau there is no income tax at all. Carrying this to the extreme, some companies and investors have been led into the so-called tax-haven operation. In this case, a U.S. company can shovel manipulatable income, such as insurance premiums, patent royalties, or profits on export sales, into companies in Panama, Switzerland, or other low-tax countries. For instance, a sale of American-made goods to a German buyer can escape a large measure of tax by passing in legal concept through a Panamanian corporation, even though the goods were shipped direct and the only thing which happened in Panama was the filing of one bill of lading and the issuance of another while the shipment was still at sea.
The recently enacted Revenue Act of 1962 has already struck at these tax havens by subjecting much of their income to an immediate U.S. tax, a move predicated on the idea that one American should not get rich free of tax while another pays the bills.
The Treasury’s original program, however, went much further, seeking to impose the immediate tax on all foreign subsidiary operations, no matter how legitimate or far-reaching. Treasury officials deny that this was designed to penalize overseas investment; it was merely the logical application of the tax-neutrality rule in the international field. International businesses have tried hard to disprove this notion by claiming that paying U.S. taxes on their overseas operations will put them at a disadvantage compared with their foreign competitors. In many cases, this may be correct. But domestic products also compete with foreign goods, both at home and in the export trade, and taxes hurt as much in Indiana as in Singapore.
If the Treasury is interested in fairness, the Administration is even more concerned with the need to keep native industry competitive in a cutthroat economic world. Therefore, 1962 also produced a proposal surprisingly unorthodox in America — a relaxation of depreciation rules, which will permit many businesses to write off equipment costs against their taxes more quickly, and the legislation of a new device, the investment credit, which would permit a business to recover a portion of the cost of capital equipment when it is purchased without waiting for it to depreciate at all. In both cases, the objective was to make it more profitable for a businessman to invest in better equipment, thus making the American plant more efficient and better able to compete in the world economy. This two-stage program would boost productivity at the same time that the tax cut increases demand.
Walter Heller, the President’s chief economic adviser, has said that this was simply a decision to make investment in capital assets more profitable; it was the most practical way to reach a result that he feels is essential. Nevertheless, the investment-credit idea has changed the impact of the investment stimulus. The orthodox conservative theory, as frequently voiced by Keith Funston of the New York Stock Exchange, is to give the incentive to the individual investor through freedom from capital-gains taxation and the removal of the double tax on corporate dividends. His recommendation would be to increase the available amount of investable funds in the hands of the public, trusting that this in turn would cause greater capital investment.
The Administration’s theory is markedly different. The investment incentive is given not to the individual investor in a business but to the business itself. Heller shrugs this off as a matter of practicality. The business executive is the decision maker, he argues, and it does no good to make new funds available to him if he does not consider it profitable to invest in new equipment. He might merely put his increases in savings into a spiraling real-estate market or overseas investments.
As a result of these seemingly pragmatic decisions, we are witnessing a strange economic phenomenon. The Kennedy tax reforms, if Congress will see them through, will undoubtedly increase the tax cost of getting corporate profits into individual hands. At the same time, the tax law is giving the corporation an incentive to reinvest earnings in assets of its own. It seems inevitable that this will bind into corporate solution a great mass of paper wealth which the individual stockholder will never get his hands on, thus stimulating the already established trend toward greater corporate self-financing, autonomy of management, and independence of the capital marketplace.
This may have been inevitable in any event. Certainly the tax program could not create such an important change if there were not other strong stimuli. However, clearly we have come to the point of final decision among three very basic goals of taxing policy: the redistribution of wealth through progressive tax rates; the fostering of economic growth; and the preservation of a competitive marketplace of capital as the ultimate check on management authority. The Administration’s program seeks the first two goals at the partial sacrifice of the third. The Funston theory would keep the second and third at cost of the first. The orthodox liberal would choose the redistribution of wealth and a free marketplace and ignore economic growth, which could be left to more direct forms of government intervention. This is the choice that lies ahead.
The most searching question about tax reform at the moment is not any specific philosophy or proposal but the critical issue of whether the Congress can be made to stand freer than it has in the past of the pressures put upon it for special tax deals. It is idle to argue the abstracts of philosophy until hard-pressed legislators are given an opportunity to decide tax issues rationally on the basis of a comprehensive scheme. In 1955 Professor Cary predicted that taxation by lobbyist would eventually break down the entire self-assessing tax system. Today that prophecy is all too near fulfillment.