1917 and the higher normal rate25 and the steeper progression made the tax much heavier upon moderate incomes than the previous one.26

The 1918 law is simpler and more equitable than its predecessor. One set of rates and personal exemptions replaces the double set in force in 1917, and many of the limitations and restrictions which, since the beginning, have hedged about the various deductions and caused endless confusion and complication, are removed. Under the 1918 law, for the first time an individual is permitted to deduct all losses, whether incurred in trade or otherwise. Also for the first time he is required to report upon the basis of his annual accounting period, even though that period does not coincide with the calendar year. Affiliated corporations must file consolidated returns.27 Depreciation allowances which may be deducted are made more liberal. Depletion in the cases of mines and gas and oil wells is placed upon a more satisfactory basis. Special provision is made for charging off reasonable amortization on equipment which contributed to the prose'cution of the war. Profits derived from the sale of mining and oil properties by prospectors and "wild-catters" are given a special concession in the basis of calculation. Corporations for the first time are relieved of the arbitrary limitation on deductible interest which had been in force since 1913, and of the discriminating tax on dividends received from other corporations. Income and excess profits taxes paid to other jurisdictions are allowed as credits against the tax. A specific credit of $2,000 is granted corporations. The rule allocating dividends to the year earned, established in the 1917 law, is abandoned.2

28

25In the case of earned incomes, the normal rate of 12 per cent was actually no higher for individuals than in 1917, because of the application in that year of the 8 per cent excess profits tax to professions and occupations in addition to the normal income tax of 4 per cent.

Except in the case of certain stock dividends, see Chapter XXI.

One can discern in the 1918 law some indications of a very laudable disposition to allocate to each taxable period all the gains and all the deductions and losses properly attributable to it. Such a policy is absolutely essential to satisfactory administration when a law carries rates as high as the present act. The disposition is evident not only in the greater deductions mentioned above but also in sections like 214 (a-12-a) which permit an abatement to be claimed in cases where a substantial loss was sustained in 1918 through a shrinkage in inventory.

As in the case of previous laws, partnerships are not taxed as such, the individual members being liable on their distributive shares. The new law introduces an innovation by putting in the same category with partnerships certain corporations "whose income is to be ascribed primarily to the activities of the principal owners or stockholders who are themselves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether invested or borrowed) is not a material income-producing factor" (section 200). At the end of the taxable year the undistributed net income of each of these "personal service corporations" is assigned for taxation to the stockholders in proportion to their holdings. They are relieved of the federal profits taxes, which would otherwise attach because of the corporate form of the enterprise.

Greatly refined though the statute is, opportunity remains for still further improvement. Many anomalies are embedded in it and some of them are difficult of exact and equitable adjustment. Several of them, on the other hand, await mere legislative attention.

Among the questions now pressing for settlement are sharper differentiation between income and capital, establishment of a distinction between earned and unearned income, so that earned income may be more lightly taxed, and elimination of some of the extreme variations in the tax through a system of averaging or some similar method.

Differentiation between capital and income.-The tax is levied on "gains, profits, and income derived from any source whatever" [section 213 (a)], subject to certain specific exemptions and deductions. Definite provision is made for the taxation of appreciation in property values [section 202 (a)] accruing after the date of purchase, or after. March 1, 1913, if purchased before that date. This raises the very interesting question as to exactly what should be considered the dividing line for tax purposes between capital and income-a question upon which there are still wide differences of opinion among economists and great variations of practice in income tax legislation. In the United States this forms a particularly interesting legal problem, because a national tax upon capital or property, as distinguished from income, is unconstitutional unless apportioned according to population.

In the administration of trust estates, a distinction is made between "income" and "capital gains," the former being distributable to the life tenant and the latter added to the corpus or principal of the estate. Similarly, "capital losses" are permitted to diminish the principal of the estate and need not be made good out of current income. The distinction between "income" and "capital gains or losses" in the case of estates may be stated broadly as that between the ordinary income for the realization of which the trust funds are invested and the more or less extraordinary gains or losses resulting from appreciation or shrinkage in the value of the investments of the principal.

A somewhat similar distinction is observed, at least partly, in the income tax laws of some other countries, the income tax being laid only on income proper as distinguished from capital gains, and only limited or no deduction being allowed for capital losses. Such a distinction is made in the English act.29

From an accounting point of view as well as from that of the conservative business man or banker, there cannot be any real income unless the capital which is being used for

"Seligman, The Income Tax, page 202.

the production of the income is maintained intact, or, if depleted, restored from income before stating the net amount of income realized. This principle has been observed from the beginning of income taxation in the United States, although at first in only an incomplete way. The 1918 law provides more adequately than any of the previous laws for the maintenance and replenishment of capital before stating the net income on which the tax shall be imposed. Provision is made for the deduction from gross income of all losses incurred in the business or in the transactions entered into for purposes of profit and for accruing depletions of capital, such as depreciation and obsolescence, which do not necessarily call for a present expenditure of money but are nevertheless gradually exhausting the capital invested for the purpose of producing income. In addition the law permits the deduction of losses suffered through casualty to private capital as well as to business capital.

Differentiation between earned and unearned income.There is a growing sentiment in favor of relatively heavier taxation of unearned income. Such a change was recommended by the Treasury for the 1918 act. Largely because of the administrative difficulties involved, the suggestion was not adopted at that time-and, in view of the present heavy responsibilities of the Treasury, this may have been quite as well. It is highly probable, however, that this feature will be added to the income tax law in the near future. The question is made more important by the establishment of higher rates and lower personal exemptions.

Some maintain that the operation of state and local property taxes makes a sufficient discrimination between earned and unearned incomes. The burden imposed by local taxation upon property, while nominally comprehending personal property, usually falls heavily upon real estate only. Therefore a differentiation between earned and unearned incomes in favor of the former would undoubtedly increase the present heavy

taxation of real estate in some communities. But where the real estate tax is already inordinately high, the remedy should be sought in a reform of the state and local tax system.

Perhaps the greatest difficulty in differentiating between earned and unearned incomes lies in the distinction which will have to be made between income derived by an individual or partnership from the conduct of a business enterprise, and the dividends received by stockholders interested in a corporate enterprise engaged in the same kind of business. This apparent inequality will largely disappear if some means can be devised whereby those closely associated with the management of a corporation, as the officers and directors of a close corporation, will be deemed to be in active business and entitled to the rate of tax applicable to earned incomes.

This distinction between "lazy" and "industrious" incomes, to use Gladstone's famous terminology, has been recognized in Great Britain since 1907 and appeals powerfully to the British people's sense of justice. There the differentiation is applied in the case of smaller incomes only, which materially simplifies the administrative problem. The inland revenue officers consider the distinction a simple one to establish in practice and the people generally believe it to be sound in principle.

Taxation on the basis of averages. In a period like the present, when rates vary violently, the person whose income is irregular from year to year will pay taxes differing widely from those paid by the person who receives a regular income of the same aggregate amount. Adoption of a system of averaging assessments over a period of several years, similar to that employed in Great Britain, would tend to eliminate this inequality. There the tax imposed upon income from trades, professions and employments is based upon a threeyear average. Such a plan would operate in a beneficent fashion, also, in the case of concerns carrying large inventories

30

30 Murray and Carter, Income Tax Practice, page 142 et seq.