CHAPTER XIII

INCOME TAXES

147. The Use of Income Taxes Represents a Developed
Fiscal System. The development of criteria of justice in
taxation, with the general acceptance of faculty or ability
to pay as the most satisfactory, has been discussed. In
the light of this development various kinds of direct and
indirect taxes have been considered with reference to their
justice, and it has been seen that the incidence of such
indirect taxes as customs duties and excise taxes cannot
be traced with sufficient accuracy to determine the real
burden. Taxes upon consumption, moreover, are regres-
sive, in that they fall more heavily upon the poorer classes,
and for this reason they are no longer advocated as the
essential part of a tax system.

The development of direct taxes to conform to the abil-
ity to pay has followed the changes and growth in eco-
nomic institutions. The place of the individual as the
base of the first direct taxes has already been pointed out.
Poll taxes, however, conformed to the requirements of
justice in only the primitive stages of society. Here prop-
erty held a sphere of minor importance, there were no
such distinctions as rich and poor, and here also the char-
acter of the work of individuals, as well as its reward, was
very much the same. The injustice of the exclusive use
of poll taxes became apparent as property began to occupy
a more important place among economic institutions.
The development of the use of property as a base for taxes
has also been discussed, as well as the outstanding defects
of this system as economic institutions developed into
their more diverse and complex forms,



INCOME TAXES 279

As long as society was primarily agricultural, and prop-
erty consisted almost entirely of land and its appurte-
nances, a tax based upon property could be made to con-
form fairly well to the principles of justice. We have
seen, however, that as property began to take on diverse
forms, and began to assume varying degrees of produc-
tivity, a general property tax did not meet the require-
ments of justice. The difference in ability hi the vari-
ous forms of property to bear tax burdens, the develop-
ment of the ability to bear these burdens without the
ownership of property, the inequality of assessments, and
the failure to assess many classes of property, have em-
phasized the failure of this tax to meet the requirements
of justice.

Most countries outside of the United States, it was
indicated, have long since given up property taxes in their
search for some method which would more nearly conform
to faculty under the modern complex industrial organiza-
tions. Some form of an income tax has been widely
adopted where the property tax has been given up. In
recent years, also, income taxes have begun to play a
much more important role in the fiscal systems of our
Federal and state governments. In the future, no doubt,
income taxes will occupy a place of much greater promi-
nence in the fiscal systems of the states, at least, than
they have held heretofore.

148. Difficulties Arise in Defining Income. Some def-
inite understanding as to what the term income includes
becomes necessary, since income taxes are assuming such
an important place in fiscal systems. Webster defines an
income as "that gain or recurrent benefit, usually meas-
ured in money, which proceeds from labor, business, or
property; commercial revenue receipts of any kind, in-
cluding wages or salaries, the proceeds of agriculture and
commerce, the rent of houses, or the return on invest-
ments."

This definition suggests some of the current ideas which



280 OUTLINES OF PUBLIC FINANCE

are held as to the meaning of income, but it does not in-
dicate all the problems which arise when one seeks to
determine the income which should be made the proper
base for taxes. The popular conception of income is that
of net income, yet the expression is used frequently to
designate the larger category of gross income. A tax is
sometimes levied upon net incomes, and sometimes upon
gross incomes, and in the case of the levy of such a tax
upon a corporation it is customary to refer to it as a
gross or net income tax, because there is no uniformity
as to which is used in the different states, or against
various corporations.

Gross and Net Income. The popular conception of in-
come is that of the net return, and that this differs widely
from gross income is at once apparent. In the case of
salaries and wages, the total amount received is usually
considered as the income, but this does not hold for pro-
ductive enterprises. The income is usually considered as
that which is left after expenses are deducted. In the
case of manufacturers, merchants, or farmers, the total
receipts might be large, while a deduction of expenses
might leave comparatively little or nothing. Even a
greater difference than this should be made, perhaps, in
some cases. In manufacturing plants, for example, the
expenditures for a particular year may not indicate all
that should be deducted from the gross returns. Depre-
ciation is in progress, and provision should be made to
take care of both depreciated building and worn-out or
obsolete machinery. From this conception an income
might be considered as any amount over and above that
sufficient to keep the capital investment intact. To de-
termine this accurately, however, would be impossible in
many cases.

Capital and Income. Many attempts have been made
to make a clear distinction between capital and income,
yet for practical purposes most of the distinctions cannot
be carried too far. Some point out that capital is a stock



INCOME TAXES 281

of wealth, while an income is a flow of wealth. The re-
ceipt of an inheritance, however, is scarcely to be classed
as a part of an income. Some would go farther in modify-
ing the income concept, and limit it to a somewhat regular
flow of wealth, yet many of the returns from dealing on
boards of trade and stock exchanges should be classed as
income, although the flow is by no means regular.

Many attempts have been made by judicial minds to
define income, capital, and property, but there has been
no more uniformity in their concepts than in those which
others have tried to formulate. Fiscal authorities, how-
ever, are more concerned about the concept of income,
and the methods of levying upon it, which will most nearly
conform to principles of justice in taxation.

149. The Concept of Income Is Sometimes Modified to
Conform to Justice in Taxation. In their attempt to reach
ability to pay taxes fiscal authorities often make differen-
tiations in incomes which would not otherwise be made.
A discussion of the uniformity of taxation clause, which is
to be found in many state institutions, will be found in
another place, but the courts have generally held that the
provision does not prohibit the classification of property
provided greater equality of assessment could be secured
thereby. In other words, the contention has been that the
constitutions were concerned about the equality of bur-
den rather than equality of assessment. This principle
has been carried to income assessments, and differentia-
tions have been made.

Funded and Unfunded Income. The distinction be-
tween a funded and an unfunded income, or between an
unearned and earned income, was one of the first to be
made. In the case of a funded income the income is
separated from any personal efforts of the recipient, while
in the case of an unfunded income it is dependent upon
the exertions of the individual. It is the difference be-
tween $3,000 in interest or dividends or in rents from
lands, and $3,000 paid as a salary for personal services.



282 OUTLINES OF PUBLIC FINANCE

It is evident that it is a greater burden to give up a part
of the latter $3,000 than it would be to give the same
proportion of the first $3,000. In the one case savings
need not be considered, because the income is certain,
whether the recipient works or not; in the other provision
must be made for the future, when the income will cease
because of the incapacity of the worker. While the jus-
tice of such a differentiation is at once apparent, it is
evident that such distinctions cannot always be made
with absolute precision. Incomes which appear to be
derived exclusively from property may, upon investiga-
tion, be found to depend to a greater or less extent upon
personal activities. A part of the rent which a landlord
receives from a farm may arise because of his management
of the methods of production, the choice of fertilizers,
or the selection of seed. Dividends from stocks may exist
because the recipient has exercised the utmost discretion
in their purchase. Many incomes from capital invest-
ments, moreover, depend to a greater or less extent upon
the efficiency of the management of the owner. It is quite
evident, then, that many incomes are combinations of
funded and unfunded parts, the separation of which would
involve insurmountable difficulties.

Considerations of Justice. Incomes of the same nature
may vary in their ability to meet fiscal burdens. Some
may have a large number of necessary and fixed charges
against them, while others may have practically none.
The amount of fixed charges, of course, makes a great
difference in the amount which may be disposed of in
any manner which may be decided upon. One man, with
no dependents, may have an income of $5,000, against
which there is no fixed charge, and he can use it for his
enjoyment as he chooses. Another man with the same
income, with a home to support, children to feed, clothe,
and educate, and feeling the necessity of establishing a fund
of savings to meet possible emergencies, may have very
little left after these necessary charges are provided for.



INCOME TAXES 283

Should the privilege be granted of deducting all neces-
sary charges which arise against net incomes before taxes
could be levied, the plan would doubtless be abused to
such an extent that there would rarely be a net income
left against which to impose taxes. The principle of de-
ductions, however, is generally recognized by the fiscal
authorities of most countries which use the income tax.
A fixed amount is usually exempt from taxes, and stipu-
lated deductions are allowed for each dependent. The
attempts of various countries to use this principle will
be noted in the discussion of their method of taxing
incomes.

It is true in a number of cases, furthermore, that an
individual receives an income from his property without
its having taken the form of money. A farmer raises his
own fruits and vegetables, dresses and cures his own
meat, and frequently exchanges wheat which he has
grown for flour at a near-by mill. He has received just as
much enjoyment from these goods as the man who has
received a money return, and has used it to secure the
same utilities. A man who lives in his own house is get-
ting a return from it just as much as the man who rents
his house for a money income.

The impossibility of an accurate measurement of these
incomes, which do not resolve themselves into a monetary
form, is obvious. The principles of justice require that
some account should be taken of such incomes in formu-
lating a scheme of income taxes. The difficulty is at once
encountered, however, of attempting to place a tangible
value upon an intangible income.

150. Variations Occur in Methods of Levying Income
Taxes. Many authorities have recognized the theoretical
justice of the income tax, yet have been skeptical of its
use because of practical difficulties which arise. John
Stuart Mill considered it, in principle, the most just of all
forms of taxation, yet in effect it was more unjust than
many which appeared to be more objectionable. He con-



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sidered that one of the greatest objections was that it fell
most heavily upon the conscientious, and should be used
only in great emergencies.

Exemptions. Many attempts have been made to
eliminate the practical difficulties through the method of
levying the tax. The general use of an exemption is for
securing a more nearly equal sacrifice. The size of the
exemption varies greatly in different countries, with no
particular reason for the amount which has been chosen.
Objection has been made to the granting of any exemption
on the ground that every citizen possesses some ability to
pay to the state. This objection might apply to large
exemptions, but loses its force when the exemption is not
more than the minimum of subsistence. To allow at least
the minimum of subsistence to be free from tax burdens,
on the other hand, seems more logical. To encroach upon
this will mean either a retrenchment of the individual's
expenditure, to his detriment, or that the state must fur-
nish aid in some form of charity. Neither of these con-
ditions is a desirable result from a fiscal system. When
the cost of assessment and collection is considered, more-
over, the amount received from small incomes is an ex-
pensive form of revenue.

Graduation. Some form of graduation is generally used
in levying income taxes, yet in this also there is no uni-
formity in the various countries. The arguments for
progressive rates for income taxes are the same as those
advanced for progressive taxes under the discussion of
that subject. 1 The application of progressive rates to
the taxation of incomes conforms to the faculty basis for
measuring taxes. While the intangible utility of incomes
cannot be measured with any degree of accuracy, yet
there is no doubt that the law of diminishing utility ap-
plies to the acquisition of income. As successive units
are added, the importance of each unit becomes less
than the preceding one. In order to impose the same
degree of burden upon incomes of various amounts,
more than a proportionate sum must be taken as the size
increases.

To formulate a scale of progression which would exactly
secure equality of sacrifice for all individuals would, of
course, be impossible. Human natures and desires are
too diverse for this, yet greater justice would be secured
by an attempt at the ideal than if strictly proportionate
rates were used. In most cases, at least, proportionate
taxes place a lighter burden upon the richer classes than
upon the poorer, and are less felt by those who have a
wide margin above the minimum of subsistence than by
those who have only a small surplus. One of the greatest
justifications, then, for progressive rates in the use of
income taxes is to equalize the burden upon different
classes f incomes.

The advocate of proportional taxation, moreover, should
have no objection to progressive income tax rates, but
rather should encourage them. Many taxes, it has been
indicated, fall more heavily upon the poorer classes than
upon the richer. This is true of many of the indirect
taxes upon commodities of consumption, and also of the
general property tax. To tax the larger incomes at a
higher rate than the smaller simply tends to counter-
balance the regressivity of other taxes and to secure for
the system as a whole a proportionate burden.

In order to avoid the objection of ultimate confiscation
through the use of progressive rates, some form of degres-
sion is used. There is no uniformity of method, however,
in the various countries. In England a progressive rate
is used up to a certain amount, after which the rate is
proportionate. In the Prussian system the amount taken
from each grade of income is a lump sum rather than a
percentage. The amount increases with each grade, but
the tax becomes regressive within the grade. Sometimes,
as in the United States, a normal proportionate tax is
levied, while a progressive surtax is added. The degres-



286 OUTLINES OF PUBLIC FINANCE

sivity of the tax is also affected by the amount of exemp-
tion which is allowed by the different countries.

151. Fiscal Authorities Meet Difficulties in Ascertain-
ing and Classifying Incomes. Incomes have much to
recommend them as sources of taxation. If any single
tax were practicable, one upon incomes would doubtless
most nearly meet the requirements of justice. Incomes
represent a flow of wealth, a part of which can be given up
in taxes more easily than can a part of property against
which taxes may be levied. In cases of property taxes
it is assumed that the tax is to be paid from income from
the property, and that no impairment of capital will be
necessary. The source of the tax upon property is sought
in a separate field from that which measures ability, while
the income tax is taken directly from that which is used
as the basis for measuring the ability. That the latter
will more nearly conform to the requirements of justice in
every case is reasonably sure.

Many individuals with large incomes, and consequently
able to meet tax burdens, may have comparatively little
property. Large property holdings, on the other hand,
do not always indicate that burdens can be shouldered
with ease because of the unproductive state in which the
property may be found.

The difficulties which have been encountered, however,
in finding incomes, and in securing a proper classification
according to taxpaying ability, have restricted the use of
income taxes. It may be said, with some degree of accu-
racy, that three different methods have been used in at-
tempting to secure the amount of income which shall be
subject to taxation.

Estimates of Officials. One plan for assessing incomes
has been to give fiscal authorities the power of estimating
the amount of incomes that shall be subject to taxes. The
difficulties presented are at once apparent. Chances for
variations occur according to the abilities or inclinations
of the various officials, Some may be diligent and others



INCOME TAXES 287

negligent; some may be exacting, and others may be
content with much less than a full assessment. The op-
portunity for favoritism immediately presents itself, along
with the unpleasant inquiries into the business affairs of
individuals. In fact, many of the undesirable features
which accompany the valuation of property by local asses-
sors are found in this method of ascertaining incomes.

Personal Declaration. A second method, which has been
extensively used in ascertaining incomes, is to have the
recipient of the income make a personal declaration of
the amount. The advantage of the plan of self -assess-
ment lies in the minimizing of the duties of fiscal authori-
ties and the absence of any inquisitorial processes. The
ease of evasion, however, constitutes a serious difficulty
with the use of this method. Inequalities arise when the
honest recipients of incomes make full returns, while the
less scrupulous either make no returns or falsify those
which are made. Where a complex system exists, it is
difficult, at times, for the uninitiated to make proper
returns. To secure a semblance of uniformity, then, close
official supervision becomes necessary, which involves
many of the difficulties which have been indicated in the
preceding paragraph.

Stoppage at Source. In order to overcome the problems
indicated above, some attempts have been made to reach
incomes before they have been placed in the hands of the
recipient. This is done either through assessment at
source or collection at source. In the first case the
amount of the income is ascertained before it reaches the
recipient, but the tax must be paid by him; in the latter
plan the tax is deducted before the payment of the income
is made.

Obviously the principle of assessing or collecting at
source cannot be applied to all incomes. It is compara-
tively easy to apply in the case of government salaries, of
interest and dividend payments, and of other incomes of
this nature, but cannot be used satisfactorily where ari



288 OUTLINES OF PUBLIC FINANCE

income consists of returns from the sale of merchandise,
or farm products, or such items as physician's or attor-
ney's fees. Where the source basis is used, then, it must
be supplemented by some other plan to reach those in-
comes which cannot come under its application.

A serious objection to taxing incomes at their source
arises in the difficulty of applying progressive rates. The
income of a particular individual, for example, might be
composed of items from a number of sources. The rate
which would apply to each of these items when a pro-
gressive scale is in force would likely be less than would
apply if the entire income were taken as the base.

If the tax, on the other hand, be levied upon the total
of a dividend or interest payment, the rate would be
higher than what would apply to the amount which
reaches the individual recipients. With the use of collec-
tion at source, then, some readjustments must be made
with the individuals in order that the progressive rates
may have uniformity of application. Serious administra-
tive problems often arise in attempting to make these
adjustments. The burden imposed upon the agency that
withholds the tax, moreover, may not be inconsiderable.
This was one of the difficulties that was encountered in
the attempt of the United States to use this device.

Information at Source. Some attempts have been made
to accomplish the same ends as collection at source, and
yet avoid the difficulties, by substituting what is known as
information at source. Under this plan the one paying
the income does not withhold the tax, but informs the
fiscal officials of how much income has been paid. The
income tax of the United States can be used to illustrate
these principles. Collection at source was provided to
some extent by the first income tax law. By the law of 1916
anyone who paid to another an amount which was sub-
ject to the normal tax was required to deduct the tax
and turn it over to the government. This was soon given
up, and in the law of 1918 a plan of information at source
was substituted. Anyone who makes a payment to an-
other of an amount of or exceeding $1,000 in any year is
required to make a statement of such payment to the fiscal
authorities.