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The first table gives the first year computations of income under

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The greater income under the historic rate methods results from the fact that, although the amount of depreciation allowed in pesos is increased by converting an annual dollar depreciation of $100,000 (22% of $4,000,000) into pesos at the current rate, the cost of the building does not reflect the decline of the peso due to devaluation, but is actually written up in terms of pesos for balance sheet purposes from 40,000,000 ps. to 53,333,333 ps.(1)

The following table shows the results over the life of the building:

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(1) Written up book value of 53,333,333 pesos at 72 produces the frozen cost of $4,000,000, depreciation at 22% of 1,333,333 pesos, or $100,000, and the year end book value of 52,000,000 pesos, or $3,900,000.

(2) The income of $100,000 (4,000,000 pesos at 224) is entirely offset by the artificially high frozen depreciation of $100,000 for the last 35 years of the life of the building.

HOW PROGRESSIVE IS THE INCOME TAX?

Richard A. Musgrave, professor of political economy, the Johns Hopkins

University

The outward appearance of the Federal income tax, with bracket rates ranging from 20 to 90 percent, is exceedingly progressive. However, there are many features of the tax which counteract this progression. The purpose of this paper is to appraise who benefits from these features and to determine how progressive the tax really is.

That there exists a wide gap between nominal and actual progression is evident from even a cursory observation of the data given in "Statistics of Income." Take, for instance, taxpayers with adjusted gross income of from $50,000 to $100,000. In 1956, taxes paid by this group amounted to 37 percent of their adjusted gross income. Yet by applying the nominal rate structure to the average income in this bracket, one arrives at a liability of about 50 percent. Or, let us compare the taxes paid by taxpayers in the $100,000 to $150,000 bracket, with those paid in the $150,000 to $200,00 bracket. By taking the increase in average tax as a percent of the increase in average income, we can compute what the "bracket" or "marginal" rate has been over this income range. Naive reference to the rate structure suggests that it should have been somewhere from 80 to 90 percent, but the actual rate was only 53 percent.

How can these differences be explained? The key does not lie in unlawful evasion, but results from specific features of the tax law. One explanation, especially important for our first comparison, lies in income splitting. For the case of joint returns, this provision means that bracket rates rise much more slowly, when moving up the income scale, than appears at first sight. Another explanation especially important for our second comparison, is found in the favorable tax treatment of capital gains. Thus, the array of special provisions, loopholes, or erosion of the tax base is important not only because it shrinks the base and reduces yield. It is important also because it punctures the pattern of progression provided for by the level of personal exemptions and bracket rates, and because it does so in an arbitrary and inequitable fashion.

BASIS OF ESTIMATES

Our approach will be to compare, for various brackets of adjusted gross income, actual liabilities incurred in 1956 with such liabilities as would result if various specified changes in the tax law were made or if you wish, if various loopholes were closed. This will permit us to determine which income brackets are the primary beneficiaries of which provisions. By relating present liabilities to a revised concept of income without loopholes, we shall be able to see what the "true" schedule of effective rates is like under present practice.1

1The term "effective rate" is used throughout to denote tax liability as percent of income before exemptions. This is the relevant concept since exemptions should be considered a part of the rate structure.

The present pattern of liabilities, as given by payments for 1956, will be compared with estimated liabilities as they would be under three hypothetical plans of tax reform defined as follows:

Plan 1: Four major changes are made in this plan.

(a) The rate advantage of income splitting is abolished and the rate structure now applicable to the single taxpayer is applied throughout.

(b) Source withholding is applied to interest and dividend income.

(c) Realized capital gains are taxed fully like other income. (d) A flat deduction of 10 percent is substituted for present deductions.

Plan 2: This plan is similar to plan 1, with the only change that— (e) Deductions are disallowed.

Plan 3: This plan is similar to plan 2, with certain further changes: (f) Tax exempt interest and percentage depletion are abolished. (g) Unrealized gains at time of death are made taxable as if realized.

(h) Wage supplements are included in taxable income. In making the adjustments involved in (e), (f), (g), and (h) we first determine the total increase in adjusted gross income which results for each item. These totals are then divided between joint and single returns, and for each category are allocated among brackets of adjusted gross income by what seem appropriate patterns of distribution. In this fashion a computed distribution of adjusted gross income is obtained for each plan. By arriving at the corresponding value of average taxable income for each bracket, the average computed tax is determined and from this the various results shown in the following tables are readily obtained. Since the estimated distributions are not necessarily the true distributions of the various items in question, these results are more or less rough estimates only.

RATIO OF ACTUAL TO COMPUTED TAX

Table 1 shows present tax liabilities as a percent of computed tax liabilities under the three plans, and the same information is repeated for joint returns in chart 1.

TABLE 1.-Actual tax paid as percent of computed tax

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Consider first the comparison of actual, with plan 1 liabilities. We

find that actual payments in the $10,000 to $15,000 bracket exceed 80 percent of the computed liabilities under plan 1, but that this ratio declines sharply as we move up the income scale, falling to about 40 percent in the top bracket. Incomes in the range from $25,000 to, say, $100,000 benefit greatly from income splitting, while the preferential treatment of capital gains is of decisive importance in the higher brackets. Taxpayers at the lower end of the scale also show a lower ratio than does the $5,000 to $10,000 bracket. This reflects the impact of source withholding on capital income which, according to our estimates, carries significant weight in the low-income brackets.

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