14. Tax on earned net income (total of items 10, 11, 12, 205.00 51.25 15, 000. 00 1,500.00 15. Credit of 25 per cent of item 14 (not over 25 per cent of items 13, 22, 23, 24). 19. Amount taxable at 12 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). 22. Normal tax (11⁄2 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__. 26. 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)– 13, 500.00 4,000.00 4,000.00 5, 500.00 60.00 120.00 275.00 60.00 515.00 51.25 463.75 $15, 000. 00 0.00 8. Amount taxable at 11⁄2 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)- 15, 000. 00 1,000.00 14, 000. 00 1,500.00 12,500.00 4,000.00 4,000.00 4,500.00 60.00 120.00 225.00 40.00 445.00 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. This chart has been divided into two tables, both of which show the tax on incomes of $2,000 up to $30,000 under the two methods. for dependents. Table A is for individuals with maximum earned income. Table B is for individuals with earned incomes of not over $5,000. The tables follow: Comparison of tax computed under present method of earned income and as computed by proposed method No. 2 TABLE B.-INDIVIDUALS WITH EARNED INCOME NOT OVER $5,000 10, 000. 00 5,000.00 191.87 180. OC 11,000.00 5,000.00 251.87 235.00 129.37 169.37 12,000.00 5,000.00 311.87 295.00 -16.87 219.37 195.00 -24.37 14,000.00 5,000.00 431.87 415.00 -16.87 339.37 315.00 -24.37 16,000.00 5,000.00 571.87 550.00 -21.87 479.37 450.00 -29.37 423.87 18,000.00 5,000.00 731.87 705.00 -26.87 639.37 605.00 -34.37 583.87 20,000.00 5,000.00 911.87 880.00 -31.87 819.37 780.00 -39.37 763.87 720.00 25,000.00 5,000.00 1, 451. 87 1, 405.00 -46.87 1, 359. 37 1, 305. 00 -54. 371, 303. 87 30,000.00 5,000.00 2,071. 87 2, 020. 00 -51.87 1, 979. 37 1, 920.00 -59. 37 1, 923. 87 1, 860. 00 -1.87 69.37 60.00 -9.37 48.37 42.00 -6.37 99.37 90.00 -9.37 67.87 57.00 -10.87 120.00 -9.37 97.87 The following observations can be made from a study of the foregoing Tables A and B: Table A.-On net incomes of $10,000 and under, Method No. 2 makes a slight increase in tax on the single man (except on a $2,000 income, where there is a decrease); it makes practically no consequential change to the married man (except a deduction of $4.12 to the man with a $4,000 net income), and it gives a small deduction to the married man with three dependents. On net incomes from $11,000 to $20,000, the general effect of Method No. 2 is to make a moderate increase of tax to the single man, a slight increase to the married man, and a slight decrease to the married man with three dependents. On net incomes of $25,000 and over there is a small decrease in tax, as in Method No. 1. Table B.-In this special case Method No. 2 gives a moderate reduction in tax over the present method. On the whole, the reduction does not seem too great and is well distributed over the various classes. A careful study of the Tables A and B and the above observations leads us to the conclusion that Method No. 2 secures results which give in general slightly more reduction in tax than the present method. The changes made by Method No. 2 seem to be in accord with the idea of ability to pay and the earned-income principle. For instance, in the general case shown in Table A we find Method No. 2 increasing the tax of the single man, not substantially changing the tax of the married man, and reducing the tax of the man with dependents. It has been pointed out that the present method sometimes gives an earned income credit which cancels the tax liability. The latter part of the limitation upon the earned income credit which permits the credit to equal 25 per cent of the surtax that would be payable if the earned net income constituted the taxpayer's entire net income is responsible for this peculiar result. Because of it the credit may extinguish entirely the tax liability of an individual with earned net income over $10,000. This is true because it permits the credit to be computed on an amount in excess of the statutory net income, since an individual, due to deductions, may pay no surtax and yet be entitled to a credit which not only equals 25 per cent of the normal tax (his only tax liability), but also that amount plus 25 per cent of the surtax which would be payable on his earned net income if it constituted his entire net income. It follows that if an individual has a small normal tax because of deductions and a large earned net income so that the 25 per cent of the hypothetical surtax on such earned net income is very large, the tax liability is canceled. This is illustrated by the following computation: If Method No. 2 is applied to this same case, a tax of $37.50 is found. It is thought that Method No. 2 sufficiently corrects this situation. It is estimated under present conditions that the proposed Method No. 2 will decrease the revenue about $4,000,000 more than the present method. This would give a total annual reduction in tax of $29,000,000 instead of $25,000,000 on account of the earned income provision. To sum up the foregoing discussion of the present method and Method No. 2, it may be stated that 1. Method No. 2 is simpler. 2. The changes in tax effected by Method No. 2 are slight and im the proper direction with respect to the principle of ability to pay. 3. That the revenue of the Government will not be seriously affected by the change. It is recommended that Method No. 2 be incorporated into the law in lieu of the present method. It is necessary to state one further point on which a recommendation is made. Section 209 (a) (1) is quoted in part as follows: In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, a reasonable allowance for the personal services actually rendered by the taxpayer, not in excess of 20 per cent of his share of the net profits of such trade or business, shall be considered as earned income. Suppose an individual taxpayer has a grocery store in which his average capital employed is $30,000. His net profit is $30,000. His earned net income is limited to $6,000 under the present act. This allows an allocation of $24,000 of the profit to a $30,000 capital and. only $6,000 to personal service. If a fair return on capital is 10 per cent, then $3,000 might be allocated to capital and $27,000 allowed. as earned income. In view of the above, giving due regard to practicability, a change from the 20 per cent limit to a 50 per cent limit is suggested. Even after this change the commissioner should have the power to refuse this maximum limit in the proper cases. The effect can not be great in any case, the earned income feature being limited to a tax reduction of $500. Conclusion. In concluding this report it is desired especially to emphasize the opinion of this committee that the earned-income principle is sound and that it should be retained or given greater effect. If the taxes paid by individuals are compared, it will be found that the man with the $100,000 salary pays a much larger tax than. most of the individuals enjoying a $100,000 income from capital. Few statutory deductions can be taken against the $100,000 salary. On the other hand depreciation and depletion deductions often distinctly benefit the man with the income from capital, especially when based on March 1, 1913, or discovery value. Moreover, income from. capital in the case of capital net gains is taxed at a substantially lower rate than income from a salary. Even the proposed method of computing the earned income deduction fails to equalize this inequity to any appreciable degree. It is recommended that further consideration be given to this difference with the purpose of adjusting the existing inequity. CAPITAL GAINS AND LOSSES (Section 208) Section 208 of the Revenue Act of 1926 provides for the taxation of capital gains at the rate of 122 per cent and a corresponding deduction of 122 per cent of the amount of capital losses in lieu of the inclusion of such gains and losses in net income calculations for the normal and surtax. Three main questions with respect to the taxation of capital gains have been considered. These are: (a) Should capital gains and capital losses be eliminated entirely from the scope of the income tax? (b) Should such gains and losses be included in net income for the calculation of the normal and surtax? (c) Should the present policy of taxing capital gains at a flat rate and the corresponding treatment of capital losses as expressed in section 208 of the Revenue Act of 1926 be continued? It is thought that the first and second questions should be answered in the negative. With respect to the third question, the following recommendation is made: RECOMMENDATION The present method of taxing capital gains and the corresponding treatment of capital losses should be embodied in the next revision of the income tax law. DISCUSSION OF RECOMMENDATION History of the provision.-From 1913 to 1922 all gains from the sale of assets were subject to normal and surtax. The Revenue Act of 1921 provided that, beginning with the year 1922, the net gain arising from the sale of property held for more than two years could, at the option of the taxpayer, be omitted from his ordinary net income and separately reported for the imposition of a tax at the rate of 122 per cent. Under this act no reference was made to net losses from the sale of property held for more than two years. 66 Capital assets" is the name given to property held for more than two years. It included any kind of property, whether or not connected with the trade or business of the taxpayer, except stock in trade or property properly included in inventory. "Capital gain," "capital loss," "capital net gain," "capital net loss," and "capital deductions" have the same specialized meaning in the statute that is, they all refer to or appertain to the designated kind of property held for more than two years. These terms are used in their special sense throughout this report. It should be noted that capital gains do not comprehend all gains from the sale of assets. Any profit on the sale of assets made within two years after purchase is not a "capital gain," but comes under the term "ordinary net income.” Under the Revenue Act of 1924 capital net losses were included in the same category as capital net gains. Such losses could not there |