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The principle of allowing a reduced rate of tax on earned income was first included in the Revenue Act of 1924. The total tax reduction effected by section 209, which embodies this principle in the present act, was as follows: Total tax credit allowed on account 25 per cent earned income provision for year 1925_

$24, 570, 183.00 Average earned income credit per individual tarable return 1925_

$9.82 Average net tax per individual taxable return 1925

$293. 68 Average tax reduction (per cent).

3. 23 From the above it can be seen that the tax reduction allowed by the earned income credit does not very seriously affect the Government revenues. In fact, it affects only about one-fourth of the reduction caused by the capital net gain tax. It must not be concluded, however, that the relief given is of no consequence, for, as shown later, the 2,375,995 individuals who have net incomes less than $20,000 receive a 15 per cent reduction in tax through the earned income provision.

There are many general arguments in favor of a lower tax on earned income than on income from capital. The acquisition of earned income is attended with uncertainties, such as loss of health and death, which do not affect the income from capital. Further, the individual expends and ultimately uses up his energy in the production of earned income. The income from capital does not impair the principal, or if it does it is subject generally to deductions for tax purposes. One of the most practical reasons for the earned-income principle from a tax standpoint can be stated as follows:

In the ordinary case an individual with earned income incurs necessary expenses in the acquisition of such income which are not borne of necessity by the individual with unearned income. Many of these expenses are not deductible in the case of an individual as they would be in the case of a corporation. On the basic theory of “ ability to pay” it is reasonable, therefore, to make an allowance in the tax on earned income as distinguished from other forms, because with the same income the expenses of the two classes are different, and hence the net residue is greater in the unearned income class,

The propriety of the earned-income principle is recognized by such countries as Great Britain, France, Italy, Belgium, and Spain, While it might be argued that this does not necessarily prove its need in our law it confirms the justice of the principle.

It is apparent that an earned-income provision of some kind has a proper place in our income tax law, and we therefore pass to a consideration of the general difficulties encountered in the administration of the present provision.

The Treasury Department has secured for the committee the opinions of 41 internal-revenue agents and collectors in connection with the present earned-income credit. These agents and collectors, who are charged with the actual administration of this provision, are practically unanimous in recommending the elimination of section 209, the earned-income provision, from future Revenue Acts.

The first ground given for such recommendation is stated typically in the following:

Section 209 has resulted in more confusion to taxpayers in the computation of their income tax than any other section of the internal revenue law. It has produced an abnormally large percentage of errors in returns, resulting in a greatly increased amount of clerical work in the audit, and therefore a material increase in the cost of collection of internal-revenue taxes.

After a careful study of the above and similar statements, it appears that the above statement is correct as to the confusion in the minds of taxpayers as to the many errors made and as to the administrative difficulties. It is not believed, however, that the above is necessarily an argument for the elimination of the provision under discussion, although it is undoubtedly an argument for its simplification.

Investigation shows that at least 10 per cent of all taxable returns filed by individuals are incorrect as a result of the earned-income provision and that 20 per cent of all taxable returns showing a net income in excess of $5,000 are incorrect from the same cause. Simplification is desirable.

Several of the revenue agents and collectors of internal revenue make statements, of which the following is typical:

It would be much simpler and more economical if in lieu of the earned-income provision a reduction was made in the normal and surtax rates.

While there is no doubt that the elimination of the earned-income provision and a corresponding reduction in the normal and surtax rates would be simpler, exhaustive computations reveal that it is impossible to adopt normal and surtax rates which would give even substantially the same result as the present earned-income credit. These computations indicate a difference of at least 15 per cent above or below the tax computed under the present act in fairly typical cases. In fact, such a method fails to give any weight to the present policy of according a lower rate on earned income than on unearned income.

One of the common objections stated in the reports from the revenue agents and collectors is quoted from one of the reports, as follows:

Section 209 appears to discriminate between an individual with dependents as against a single individual or married individual without dependents.

A typical case of this kind was stated as follows:

A man earning $5,000 with three dependents is allowed $1.13, while a man earning $20,000 a year with no dependents is allowed a credit of $191.25.

NOTE.—The above figure of $191.25 is evidently slightly in error.

There is not much merit to the objection that an individual with dependents is inequitably treated in comparison with a single person. It is true that the amount of the credit would at first glance lead to this conclusion, but when it is remembered that the 25 per cent credit is superimposed on a graduated tax structure, and when a comparison is made of the percentage reduction in tax to each class of individuals, it will be found that no inequity of consequence exists.

Attention is drawn to a typical case quoted from a statement of a revenue agent where inequity is said to exist between the $5,000 man with three dependents and the $20,000 man with no dependents. We do not think this is an inequity, for both individuals get a 25 per cent reduction in the total tax, as shown below:


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Net tax.

3. 37
Net tax----

693. 75 Reduction in

Reduction in tax by earned-income provision, 25

earned-income provision, 25 per cent.

per cent. It is obvious from the above that while it may appear from a casual examination that a tax credit of $1.13 to the first taxpayer and a tax credit of $231.25 to the second is inequitable, nevertheless, when the final net taxes paid after these credits are, respectively, $3.37 and $693.75, and each individual has had a 25 per cent reduction in tax, the supposed inequity vanishes. The $5,000 man in this case pays about one-fifteenth of a cent tax on each dollar of net income, while the $20,000 man pays about 312 cents tax on each dollar of his net income.

Some of the agents and collectors appear to have the opinion which is quoted verbatim from one of the reports: The earned-income credit extended to taxpayers is insignificant.

The above statement that the earned-income credit extended to taxpayers is insignificant is not borne out by the facts, as shown by the following statistics for the income classes noted for the year 1925:

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It is impossible to call the earned-income credit “insignificant when it effects an average tax reduction of over 15 per cent in the taxes of 2,375,995 individual taxpayers out of a grand total of 2,501,166 individual taxpayers.

It seems obvious, therefore, that the suggestions advanced by the revenue agents and collectors, discussed briefly above, have merit in favor of simplification of the earned-income provision but little merit in favor of its elimination.

In view of the above, it has been recommended that the policy of taxing earned income at a lower rate than unearned income be retained in some form in future revenue acts.

It is proper, Dow, to turn from the consideration of the propriety of the earned-income provision to a consideration of methods by which the present provision may be simplified.

After testing sereral proposals, a method, called Method No. 2 to distinguish it from the present method, called Method No. 1, has been derised, which meets the test of simplification and also appears to meet the test of equity. The principle of this method may be stated as follows:

A credit against net income should be allowed in computing net income subject to normal and surtax equal to 10 per cent of the amount of the earned net income. If the tour payer's net income is less than $5.00 his earned net income should not be considered to be less than his pet income, and if his net income is more than $5.000 his earned net income show'd not be considered to be less than $5.m. In no case should the earned net income be allowed in excess of $20,000 or in excess of the tarpayer's net inconk,

For purposes of comparison, the rules for computing the earnedincome credit under the Rerenue Act of 1926 will be summarized as follows: 1. In the case of an individual the tax shall

de ved ited with 25 per cent of the amount of tax achich would be payable if his earned net income constituted his entitre net income. 'But in no case shall the credit alloved under this subdivision exceed 25 per cent of his tax under section 210 plus 25 per cent of the tax achich would be payable under section 211 if his earned net income constituted his entire net income.

“ 2. If the tar payer's net income is not more than $5,000 his entire net income shall be considered to be earned net income, and if his net income is more than $5,000 his earned net income shall not be considered to be less than $5,000. In no case shall the crned net income be considered to be more than $20,000."

For the purpose of securing a practical understanding of these two methods, the tax computations required in the same hypothetical case will be set forth for each of these methods.

Hypothetical case A.-Individual A has a salary of $10,000 and interest from mortgages amounting to $5,000. As he has no ordinary deductions, his net income under the present revenue act is $15,000. A is unmarried and has no dependents.

The computation of tax for this same hypothetical case is shown on the following pages for the purpose of comparison in regard to simplicity.


Tax computation oase A, present method (No. 1) Item 1. Total income. 2. Total deductions..




Net income

15, 000). 00

4. Earned net income (not over $20,000).
5. Less personal exemption and credit for dependents..

10, 000.00
1, 600.00

6. Balance (item 4 minus 5)----
7. Amount taxable at 112 per cent (not over first $4,000 of item 6).
8. Amount taxable at 3 per cent (not over second $1,000 of item 6)
9. Amount taxable at 5 per cent (balance over $8,000 of item 6).

4,000. 00


10. Normal tax (142 per cent of item 7).
11. Normal tax (3 per cent of item 8).
12. Normal tax (5 per cent of item 9).
13. Surtax on item 4.--

$60.00 120.00 25. 00 0.00


Tax on earned net income (total of items 10, 11, 12,

and 13) 15. Credit of 25 per cent of item 14 (not over 25 per cent of items

13, 22, 23, 24)


51. 25

16. Net income (item 3 above) 17. Personal exemption---

15,000.00 1,500.00



18. Balance (item 16 minus 17).
19. Amount taxable at 142 per cent (not over the first $4,000 of

item 18)---
20. Amount taxable at 3 per cent (not over second $4,000 of

item 18)--21. Amount taxable at 5 per cent (balance over $8,000 of item 18) -

4,000.00 5,500.00

22. Normal tax (142 per cent of item 19).
23. Normal tax (3 per cent of item 20)
24. Normal tax (5 per cent of item 21).
25. Surtax on item 3_--.

60.00 120.00 275.00 60.00

515.00 51. 25


Tax on net income (total of items 22, 23, 24, and 25). 27. Less credit of 25 per cent of tax on earned net income (item 15)28. Balance (net tax).

463. 75

Tax computation case A, Method No. 2 Item 1. Total income. 2. Total deductions_



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7. Net income subject to normal tax-
8. Amount taxable at 142 per cent (not over first $4,000 of item 7)-
9. Amount taxable at 3 per cent (not over second $4,000 of item 7)-
10. Amount taxable at 5 per cent (balance over $8,000 of item 7)--

12,500.00 4,000.00 4,000.00 4, 500.00

11. Normal tax (142 per cent' of item 8). 12. Normal tax (3 per cent of item 9). 13. Normal tax (5 per cent of item 10) 14. Surtax on item 5_

60.00 120.00 225. 00 40.00

Net tax-----

445.00 A comparison of the computations required by the two methods above set forth shows the greater simplicity of Method No. 2.

The “present method” required 28 separate items and entries. Therefore 13 items are eliminated from the return and the chance of error correspondingly reduced. A plan which will retain the earned-income principle and be much simpler is not likely to be found.

The following chart has been prepared, entitled “ Comparison of tax computed under present method of earned-income credit and as computed by proposed Method No. 2."

1 Not allowed in excess of $20,000 nor in excess of item No. 3.

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