Global Incident of U.S. Personal Income Tax Revision
Mirshab, Bahman, Multinational Business Review
To alleviate the burden of the heavy taxation of income in the United States creative solutions have been devised, some of which were introduced by legislation, some of which may be termed" loopholes." For example, the Revenue Act of 1971 introduced a system of tax deferral for a new type of corporation called a Domestic International Sales Corporation (DISC). Under these rules, the DISC's earnings were not taxed, but were taxed to the stockholders when distributed or deemed distributed. The Foreign Sales Corporation Act of 1984 was signed into law on July 18, 1984 as part of the Deficit Reduction Act of 1984. The DISC was considered by major U.S. trading partners as a way to subsidize U.S. companies. This was in violation of the General Agreement on Tariffs and Trade (GATT) which prevents countries from using taxes as a form of subsidy. This law replaced the DISC with the new Foreign Sales Corporation (FSC). Unlike its DISC predecessor, the FSC must satisfy a number of requirements. In the recent past, there was a ruling against the United States because income earned abroad was not fully taxed, thus creating a form of subsidy.
DISTRIBUTION OF TAX BY COUNTRIES
In the United States, the single most important source of tax revenue at the federal level is the personal income tax. A look at Table 1 indicates that almost forty percent of tax revenue is derived from taxes on individual incomes.
Moreover, as seen in table 1, personal income tax as a percentage of total tax in the United States is the highest compared to major industrialized countries. Federal personal income tax has been the subject of various attacks. The origin of most attacks can be traced to the progressive feature of the income tax that makes it complicated, and according to some, unfair. A simple tax system is one that taxes all incomes at the same rate. This paper attempts to demonstrate that attempts to simplify the tax without ignoring the expenditure side of the government budget may lead to a shift of the tax burden to individuals in the middle income category.
THE HISTORY OF INCOME TAXATION IN THE UNITED STATES
The history of income taxation in the United States is relatively short compared to some European countries such as England. The first income tax was introduced by Congress in 1861 for raising revenue to meet high expenditures of the Civil War. The Civil War Act, however, was so poorly drafted that Secretary of the Treasury, Salmon P. Chase, decided not to exercise it. Consequently, the Congress came up with a new act in the following year which, after a series of modifications, served as the first federal income tax until its repeal in 1872.
The first law actually executed, that of July 1, 1862, taxed all income in excess of $600. The tax rate was three percent on incomes from $600 to $10,000, and incomes above $10,000 were taxed at five percent. In 1864, a new law was adopted. Income was divided into three classes. On incomes below $5,000 the rate was five percent on the excess above $600; incomes from $5,000-$10,000 were taxed at seven and a half percent; and incomes above $10,000 paid ten percent. In 1865, Congress omitted one of the classes. Under this law incomes below $5,000 paid five percent on the excess over $600 and incomes above $5,000 were taxed at ten percent. After the Civil War, the tax rates were lowered and became uniform, and the limit of exemption was gradually increased until the tax was abolished in 1872.
As expected, the constitutionality of the tax was challenged in the courts because of its similarity with a direct tax. The United States Federal Constitution requires that direct taxes must be apportioned among the states according to their population. Thus, the opponents of the income tax argued that the tax in question violated the constitutional requirement that direct taxes must be apportioned among the states according to their census. The constitutional controversy over the tax was fought before The Supreme Court in Springer v. United States. The question facing The Supreme Court was whether or not a tax on income was direct. The Court adopted the view that direct taxes included capitation and real estate taxes and that a tax on income would fall in the category of indirect taxes. As a result, the tax was declared constitutional. The income tax law of 1862 provided the government with fairly adequate revenue ($376 million) during its short life.
The second federal personal income tax was enacted in 1894 during the Presidential administration of Grover Cleveland. President Cleveland had been elected in 1894 on a Democratic platform that promised to reduce the importance of custom duties at the federal level and find a revenue substitute for it. As a result, the second federal personal tax was introduced in 1894. Under this tax, capital gains, gifts, and inheritance were considered income. The tax in question had a flat rate of 2 percent, but granted a $4,000 exemption per taxpayer.
The tax in question, although proportional, was progressive in effective tax rates for individuals with incomes above $4,000. As we mentioned earlier, this progressivity was recognized and became one of the arguments against the tax.
The constitutional controversy surrounding the tax was fought before The Supreme Court in 1895 in Pollock v. Farmers' Loan and Trust Co. The Constitution requires that direct taxes when levied by the federal government be apportioned according to the population. Therefore, the question facing the Supreme Court was whether or not a tax on income was direct.
Those who favored the tax had the opinion that only capitation and real estate taxes had been traditionally recognized as direct. They pointed out that in 1880 The Supreme Court had adopted the view that a tax on income was indirect The opponents of the tax, on the other hand, reasoned that the income subject to tax in the Pollock Case originated from property, and taxation of property income may readily be translated into a property tax. Therefore, they argued that the tax in question violated the Constitutional requirement that direct taxes must be apportioned among the several states according to the census.
By a majority ruling of five to four the Court adopted this latter view, and revised its earlier ruling in the Springer Case. Consequently, the Income Tax Act of 1894 was declared unconstitutional since it taxed incomes originating from personal property, real estate, and from state and local government bonds. The tax in question raised $77,000 for the federal government during its short life.
The defeat of the Income Tax Act of 1894 did not, however, stop social reformers from campaigning for a federal income tax. The momentum increased during the presidency of Theodore Roosevelt and led, in 1909, to corporate income tax. The tax had a flat rate of 1 percent and was applied to net corporate income in excess of $5,000. To bypass the issue of unconstitutionality, the tax was defined as an excise on the privilege of doing business as a corporation in the United States. Consequently, the size of net income was interpreted as the "measure" of privilege.
Soon after the corporate income tax was introduced, a more powerful campaign was launched by social reformers to remove the barrier raised in the Pollock Case. This campaign led to the 16th Amendment to the U.S. Constitution which paved the way for the introduction of progressive income taxation at the federal level. The 16th Amendment states: The Congress shall have power to lay and collect taxes on incomes from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.
Soon after the ratification of the 16th Amendment in 1913, the House Ways and Means Committee presented the bill to Congress which became the first permanent individual income tax law in the United States. The bill was approved October 3, 1913, taking effect on March 1, 1914.
The first tax law levied a I percent tax on personal incomes above $3,000 for a single taxpayer and above $4,000 for married persons. In addition, a surtax was graduated from 1 percent to 6 percent on incomes in excess of $50,000.
THEORIES OF TAXATION
Views on the principles of taxation are divided into two distinct groups. One group advocates taxation according to the benefits received from government. Another group favors taxation according to ability to pay. The principal difference between the benefit approach and the ability-to-pay approach stems from different views about the very nature of the public revenue-expenditure process. In the benefit approach, the relation between taxpayers and government is one of exchange. That is, an individual voluntarily pays taxes in return for the acquisition of public goods and services from which he receives satisfaction. In the ability-topay approach, the relation of taxpayer and government is not one of voluntary exchange. Compulsion is required to make people pay taxes, and the revenue-expenditure process is viewed as a planning problem. Neither of the theories can establish a compelling case for or against rate progression.
WHAT IS WRONG WITH THE PERSONAL INCOME TAX?
A good income tax system should be (1) easy, (2) fair, (3) neutral, and (4) facilitate the use of fiscal policy for economic stability. Does the current income tax meet these requirements?
The present income tax system is complicated and its compliance cost is high. To comply, most individuals must be sure that they are appropriately organized and equipped to identify and substantiate their incomes, to compute permissible exclusions and deductions, and to calculate their income taxes. A large fraction of the complexity of the tax system derives from its progressive feature. Progression leads to a highly complex tax system. It causes the taxpayers to waste a great deal of their time to evaluate the tax consequences of their economic transactions. It increases the opportunity of people of skill to manipulate their economic behavior in such a way as to minimize their tax liabilities.
Can the progressive income tax be defended on the ground that it leads to a more equitable tax burden distribution? There is no scientific proof to support progression on this ground. The conclusion that a progressive tax system leads to a more equitable distribution of the tax burden than a flat rate tax is a value judgement.
Stability of yield was once regarded as a desirable feature of a good income tax system. However, this assertion was reversed after the idea of fiscal policy was introduced. It was argued that the income tax should rise in periods of inflation and decline in periods of deflation. It was held that a progressive tax system could do better than a flat rate tax. The built-in flexibility of income tax is no longer looked upon as a desirable feature. With a progressive income tax, a rise in nominal income, real income constant, will shift the individual up the rate brackets leading to an increase in average tax rate and reducing after-tax real income. To prevent this arbitrary transfer of resources from private to public sector, income tax systems have been indexed in many countries.
Any income tax may have adverse effects on incentives to work and to save. In general a progressive income tax is more derogative to work incentive and investment than a proportional tax.
EQUITY COST OF SIMPLICATION
There has been a growing sentiment against the high federal income taxes in the United States. One alternative, that has been gaining popularity in the recent past, is to replace the progressive tax with a flat rate tax. A prominent individual advocate of a flat rate tax is Steve Forbes. In many ways a flat tax may be better than a progressive tax. What would be the equity incidence of such a tax?
The table below is used to explore the incidence of a flat-rate tax. The effective tax rate is defined as the ratio of tax over income. Column 5 is the effective tax rate generated by the progressive income tax in 1996. If a flat tax should replace the progressive tax, it should be revenue-neutral; that is, it should generate the same revenue. Dividing total income tax by total taxable income results in the tax rate of approximately 21%. Multiplying taxable income of each bracket by this tax rate, figures in Column 6 are obtained. Dividing these figures by those in Column 2, we generate effective tax rates under a revenue-neutral, flatrate income tax. These effective rates are shown in Column 7. As the figures indicate, effective tax rates are progressive.
At this point it may be useful to distinguish the two meanings of progression. Progression can refer to either progressive marginal rates or progressive average rates. Marginal tax rate is the change in tax liability over the change in taxable income. Average or effective tax rate is the ratio of tax liability over total income. With a progressive income tax, marginal rates graduate upward and so do the average rates. However, it is possible to obtain progressive average tax rates even under a flat-rate income tax. Such progression arises because the taxpayers progressively find a larger fraction of their incomes subject to tax once they are over the income exemptions.
Referring to the last column of the table below, one can easily find the dilemma with a flat rate income tax proposal. It is natural to expect a change in tax burdens with a flat-rate income tax. However, as reflected in Column 8, it seems that such tax will change the tax burden in favor of only the highest four income brackets. Every bracket above $100,000 will realize a decrease in tax burden at the expense of the other brackets. In addition, the increased tax burden diminishes as income increases.
A FINAL NOTE:
A flat-rate tax may be defended on grounds such as simplicity and possible favorable impact on capital formation and work incentives. However, there will be a shift of burden from the higher income brackets to lower income brackets. Unless issues related to deductions and personal exemptions are addressed, changing only the tax rate will benefit only the higher income brackets.
W. J. Blum and H. Kalven, Jr., The Uneasy Case for Progressive Taxation (Chicago: University of Chicago Press, 1953).
Pollock v. Farmers' Loan and Trust Co., 157 U.S. 429 (1894); rehearing: 158 U.S. 601 (1895).
Internal Revenue Service, Statistics of Income-- 1996, Individual Income Tax Returns, Washington, DC 1998
University of Detroit Mercy…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: Global Incident of U.S. Personal Income Tax Revision. Contributors: Mirshab, Bahman - Author. Journal title: Multinational Business Review. Volume: 8. Issue: 2 Publication date: Fall 2000. Page number: 59+. © St. Louis University, John Cook School of Business, Boeing Institute of International Business Fall 2009. Provided by ProQuest LLC. All Rights Reserved.
This material is protected by copyright and, with the exception of fair use, may not be further copied, distributed or transmitted in any form or by any means.