THE 1913 INCOME-TAX AMENDMENT

This 1913 income-tax amendment permits taxation of income from whatever source derived. Despite this broad language the Supreme Court has repeatedly restricted its scope. In the case of Eisner v. Macomber (125 U. S. 189) the Court held that stock dividends were not subject to income taxation, and over a period of 16 years thus lost to the Government $1,060,000,000 in revenue. In other words, if a person has a net income of $5,000, he must pay an income tax on it unless he is a State, county, or municipal employee, or comes under other exemption. However, a corporation with the same $5,000 net income can issue stock dividends and thus avoid payment of any income tax.

The Court has held that Congress cannot tax interest on bonds issued by State, county, or other local subdivisions. This act created a large field of tax-exempt securities, and this decision rendered despite the fact that Chief Justice Hughes as Governor of New York opposed the amendment, but as Chief Justice of the Supreme Court continues to adhere to the decision that Congress has no power to tax such bonds. The amount of securities from which the income is wholly exempt as a result of the Supreme Court action runs into billions. The figures for the 12 years, 1925 to 1936, are as follows:

In 1934 a subcommittee of the Ways and Means Committee was appointed to investigate tax-avoiding schemes. Consideration was given to methods of curtailing the amount of tax evasion due to tax-exempt securities. In the report of the subcommittee there is an opinion by counsel of the committee suggesting a method by which he says "most of the income from tax-exempt securities could be reached." Under this method there would be reached an excise tax upon the carrying on or doing business by corporations, measured by the net income from all sources, including interest from the so-called tax-exempt securities, and a similar excise tax on individuals engaged in any trade, avocation, or employment. As pointed out by one of counsel of the Joint Tax Committee on Taxation, this method of reaching tax-exempt securities is constitutional under the decision of the Supreme Court in the case of Stone-Tracy Co. v. Flint (220 U. S. 107). Furthermore, it appears that some of the States have used this method for taxing income from Federal securities, and this method has been upheld by the Supreme Court (Pacific Co. v. Johnson, 285 U. S. 480; Educational Film Co. v. Ward, 282 U. S. 379). Thus, if such a tax were adopted, for example, a corporation had a net income of $500,000 from its ordinary business transactions and $100,000 from interest on municipal securities, the entire $600,000 could be included in determining the amount of the excise tax upon the corporation. In this matter we could reach and tax the interest on all tax-exempt securities.

At least this is one of the ways by which it could be done. The best way, of course, would be to have a Supreme Court which would interpret the sixteenth amendment to the Constitution as it is written and not as the judges want it to be. It is provided in the sixteenth amendment that Congress shall have the power to tax income from whatever sources derived without any limitations being expressed. Nothing could be clearer than this language, and every effort should be made to unpack the Supreme Court, placing men thereon who could interpret the law as it is written and not as the Wall Streeters desire it should be construed for their own private profit. Therefore we cannot criticize the Supreme Court until the law is written so it will reach the interest on the tax-exempt securities. At the present time the income-tax laws specially provide that the interest from these securities is exempt.

Section 22 (b) of the Revenue Act of 1936 provides:

"(4) Tax-free interest: Interest upon (a) the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia; or (b) obligations of a corporation organized under act of Congress, if such corporation is an instrumentality of the United States; or (c) the obligations of the United States or its possessions. Every person owning any of the obligations enumerated in clause

(a), (b), or (c), shall, in the return required by this title, submit a statement showing the income received therefrom, in such form and with such information as the Commissioner may require. In the case of obligations of the United States issued after September 1, 1917 (other than postal-savings certificates of deposit), and in the case of obligations of a corporation organized under act of Congress, the interest shall be exempt only if and to the extent provided in the respective acts authorizing the issue thereof as amended and supplemented, and shall be excluded from gross income only if and to the extent it is wholly exempt from the taxes imposed by this title."

Now, gentlemen, I could go on indefinitely placing material in the record supporting the argument for levying a tax on income from securities now exempt. Books have been written on the subject, and many excellent articles in law journals and other publications have discussed this subject up one side and down the other. For those who may want to make a more complete study of the subject than is provided by these hearings, I refer to the Library of Congress, where a complete bibliography of material is to be found.

I think that this subcommittee is primarily concerned today with two questions:

First: Is a constitutional amendment justified and necessary?

Second: Is the time opportune for proposing such an amendment; that is, would an effort to impose a tax on income from securities now exempt disturb the market and affect the Federal Government's financing operations?

As to the first question I suggest that the best legal opinion is agreed that the proper way to approach this problem of a tax is by constitutional amendment. It may be possible, as has been pointed out, to provide an excise tax, without an amendment, and it is possible, as contended by some, that if the Supreme Court were again to pass upon the whole question of income tax, they would now reverse themselves and hold the Federal Government can tax the income from instrumentalities of States and subdivisions. But these doubts of constitutionality, and of complete coverage of all individuals deriving such income, are too great, and I believe we should take the safe and intelligent course by amending the Constitution, and that this step is necessary before we can levy a tax on income from Federal issues. Now as to the second question: Is the time opportune?

Well, that is the answer I have been trying to obtain from the Treasury Department. They seem to be in favor of this tax, and have been all along, and they also recommend a constitutional amendment in advance of a tax on Federal issues. But the Treasury takes no position as to when the resolutions proposing a constitutional amendment should be submitted. And I believe this is because there is some doubt about the effect such a proposal would have upon the securities market.

us.

I think the experience of Canada will help answer this question for Canada has frequently been pointed to as being entirely free from tax-exempt securities. The report regarding Canada, however, must be considered with that of England. The general policy of the British Government to limit exemptions only to holders resident outside of Great Britain, on certain types of securities, and to limit the other types of issues, has prevented large holdings of exempts. As pointed out by Representative Charles R. Crisp, in the Congressional Record, 64; 716, December 19, 1922, when an amendment was pending in the House:

Canada does not permit any tax-exempt securities to be issued. Canada is having no trouble selling her bonds, and the Canadian bonds, State and municipal,

That

sell for from 1 to 11⁄2 percent cheaper than the highest industrial bonds. will be true here, in my judgment, if this amendment does not interfere with the sovereignty of either the United States or of the several States. It puts them on an exact equality.

With reference to the question of whether the interest rate on securities would increase to offset the additional tax, I refer you to the material I have already inserted in this record covering my study in 1934. I endeavored to answer, in that study, all of the objections raised at the time. I will insert it at this point.

(The extract from the Congressional Record heretofore referred to, containing statement by Senator Lonergan, introduced by Senator Robinson, is here set forth in full, as follows:)

TAX-EXEMPT SECURITIES-A STUDY BY SENATOR LONERGAN

Mr. ROBINSON of Arkansas. Mr. President, I desire to ask that there be printed in the Record a study of the subject of tax-exempt securities made by the Senator from Connecticut (Mr. Lonergan). I have examined the study sufficiently to know that it is both important and valuable. I, therefore, ask that it be referred to the Committee on Finance and printed in the Record.

There being no objection, the matter was referred to the Committee on Finance and ordered to be printed in the Record, as follows:

STATEMENT BY SENATOR AUGUSTINE LONERGAN (Democrat), of Connecticut, IN SUPPORT OF HIS PROPOSALS TO TAX INCOME OF FUTURE ISSUES OF SECURITIES NOW CLASSED AS EXEMPT

The proposal to impose a tax upon Federal securities and also upon securities of the States and subdivisions thereof, which are now exempt from taxation under the income tax laws of the United States and of the States, is by no means new. For many years, leading tax experts have been studying this problem and at various times have made recommendations that a tax in some form should be levied in order to equitably distribute the tax burden among all classes.

This reform in taxation, however, like many others of vital importance to the Nation, found numerous obstacles to delay progress. Like other reforms which are now being accomplished by the administration, this proposal has had to await the gradual development of a public opinion which welcomed and demanded definite action. I believe that that time has now arrived and that the American people not only favor such reform but actually insist on the same prompt action in accomplishing it as has characterized the Government's activity during the past several months in attacking other important and vital problems.

The present existing feeling among the American people regarding the necessity for a tax on the income from securities now exempt was not born in a day in an attitude of "soaking the rich" but is the result of a gradual development of public consciousness and education on this subject, during the past decade in particular. On September 23, 1921, former Secretary of the Treasury Andrew W. Mellon in a report submitted to the Committee on Ways and Means of the House of Representatives in connection with hearings on House Joint Resolutions 102, 211, 231, and 233 of the Sixty-seventh Congress, first session, went on record in favor of restricting further issues of tax-exempt securities. This report, which states that "the ever-increasing volume of tax-exempt securities (issued for the most part by States and municipalities) represent a grave economic evil not only by reason of the loss of revenue which it entails in the Federal Government, but also of its tendency to encourage the growth of public indebtedness and to divert capital from productive enterprises", is set forth in full, as follows:

DEPARTMENT OF THE TREASURY,
Washington, September 23, 1921.

MY DEAR MR. CHAIRMAN: I received your letter of August 27, 1921, enclosing a copy of House Joint Resolution 102, which proposes an amendment to the Constitution of the United States restricting the issue of tax-exempt securities by the Federal Government and States and municipalities, and have noted your request for my opinion with respect to this resolution and the subject in general.

As you know, in my letter of April 30, 1921, to the chairman of the Committee on Ways and Means, a copy of which I inclose, I recommended to Congress that it consider the advisability of taking action by statute, or constitutional amendment

where necessary, to restrict further issues of tax-exempt securities. The everincreasing volume of tax-exempt securities (issued for the most part by States and municipalities) represents a grave economic evil, not only by reason of the loss of revenue which it entails to the Federal Government, but also because of its tendency to encourage the growth of public indebtedness and to divert capital from productive enterprises. The issue of tax-exempt securities has a direct tendency to make the graduated Federal surtaxes ineffective and nonproductive because it enables taxpayers subject to surtaxes to reduce the amount of their taxable income by investing it in such securities, and at the same time the result is that a very large class of capital investments escape their just share of taxation.

Of course, the voluntary withdrawal of the tax exemptions from securities to be issued by or under the authority of the Federal Government would require no constitutional amendment, but to do this as to Federal securities alone would unjustly discriminate against the National Government and leave a clear field for the State and local governments. In general, moreover, the policy of the Federal Government has been not to issue its own obligations with exemptions from Federal surtaxes and excess-profits taxes, and the great bulk of the Liberty loans and other war debts have no such exemptions. As to State and municipal securities, I assume it is clear, since the decision in Evans v. Gore (253 U. S. 245), that the sixteenth amendment does not permit the Federal Government to tax income derived from State or municipal securities, and that the only effective means of restricting the further issue of tax-exempt securities by State or municipal governments would be by constitutional amendment. Such an amendment would doubtless meet with considerable opposition on the part of the States, and for that reason, as well as from considerations of equality and fairness, it is the better view, I should say, that any restrictions on the further issue of tax-exempt securities should be mutual and should apply as well to securities issued by the Federal Government as to State and municipal securities. It is important, however, not to lose sight of the real basis for the existing constitutional principle under which securities issued by the State and municipal governments are now held free from taxation by the Federal Government, and Federal securities from taxation by State and local authorities, and at the same time to provide proper safeguards against any possible discrimination in taxation by the Federal Government against State and municipal securities or by the State governments against Federal securities. It is also important, in order to avoid any question of bad faith, that the amendment should not apply to outstanding issues which now enjoy tax exemptions. For these reasons I think that some modifications of House Joint Resolution 102 are desirable.

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In the first place, I think that the resolution should be so modified as to make it perfectly clear that the right of the Federal Government to tax the income derived from State and municipal securities and of any State to tax the income derived from Federal securities shall exist only to the same extent that each government taxes the income derived from its own securities. This would prevent any discrimination by either government against the securities issued by the other. the second place, it is noted that while the first part of the resolution subjecting the income from securities issued by State and municipal governments to taxation by the United States applied only to securities issued after the ratification of the amendment, the proviso subjecting the income from securities issued by the United States, its possessions, and Territories to taxation by the States is not similarly limited. Such a limitation is, of course, necessary. Furthermore, the language of the proviso subjecting income from issues of Federal securities to taxation by the several States is not expressly limited to the income derived from securities held by residents of the State and should be modified so as to avoid any possible interpretation which would allow a State to tax the income derived from Federal securities not held within the State.

I might also suggest that the language of the amendment be made broad enough to include all securities issued by or under the authority of the Federal Government or of any State. This would apply, for example, to securities issued by Federal land banks and other so-called "instrumentalities" of the Federal and State Governments, which might not be considered as coming within the terms of the resolution as it now stands.

In this connection I am taking the liberty of enclosing a draft of a proposed amendment to the Constitution along the lines of House Joint Resolution 102, modified as I have suggested.

Very truly yours.

To Hon. LOUIS T. MCFADDEN,

Chairman, Committee on Banking and Currency,

A. W. MELLON, Secretary.

House of Representatives.

MAINTAINS FAVORABLE POSITION

Former Secretary Mellon was also on record in various other parts of this same report on the hearings before the Ways and Means Committee on this same legislation.

In a previous report submitted on April 30, 1921, and reported in the hearings, he suggested for the consideration of Congress that it might also be advisable to take action by statute, or by constitutional amendment, where necessary, to restrict further issues of tax-exempt securities. Quoting from this report, Mr. Mellon said:

"It is now the policy of the Federal Government not to issue its own obligations with exemptions from Federal surtaxes and profits taxes, but States and municipalities are issuing fully tax-exempt securities in great volume. It is estimated that there are outstanding perhaps $10,000,000,000 of fully tax-exempt securities. The existence of this mass of exempt securities constitutes an economic evil of the first magnitude. The continued issue of tax-exempt securities encourages the growth of public indebtedness and tends to divert capital from productive enterprise. Even though the exemptions of outstanding securities cannot be disturbed, it is important that future issues be controlled or prohibited by mutual consent of the State and Federal Governments."

Here is a man of great wealth and for many years the head of the Treasury, who would ordinarily be regarded as among the first to go on record against such a policy of taxation if it were true that vast discriminations would be imposed upon wealthy holders of such exempt securities, coming out in favor of such a plan, if reasonably and logically applied, at a time when it was known quite generally that such legislation had little chance of enactment. This same attitude of Mr. Mellon appears in subsequent reports of the Treasury on the tax-exempt question, which will be referred to later, and which will indicate a fairly consistent view on this subject up to the present time.

COOLIDGE ENDORSES PLAN

On December 6, 1923, the late President Calvin Coolidge, in his annual message to Congress, Sixty-eighth Congress, first session, Congressional Record, volume 65, part I, page 67, said:

'Another reform which is urgent in our fiscal system is the abolition of the right to issue tax-exempt securities. The existing system not only permits a large amount of the wealth of the Nation to escape its just burden but acts as a continual stimulant to municipal extravagance. This should be prohibited by constitutional amendment. All the wealth of the Nation ought to contribute its fair share to the expenses of the Nation."

At about the same time the Treasury Department was again on record on the subject in the following report to Congress:

"One of the most difficult problems the income tax presents is the tax-exempt security question. There are two solutions: First, eliminate the tax-exemption privilege; second, adjust the income-tax rates so that the value of tax exemption as a means of tax avoidance shall be lessened. The first solution requires a constitutional amendment, and its adoption has met with serious political opposition. Also, in the last session of the Congress there was defeated a recommendation of the Secretary of the Treasury that a taxpayer should not be permitted to take as a deduction, in figuring his net income, interest paid by him except to the extent it exceeded the tax-exempt interest received by him and which he did not include in his gross income. While the Treasury renews the recommendation made heretofore that a constitutional amendment to reach tax exemption be proposed by the Congress, it feels that the recognition of the necessity for this action by Congress may be delayed and that an immediate remedy should be adopted.

"Fully tax-exempt securities outstanding in the hands of the public now amount to $13,284,000,000 and are increasing at the rate of about $1,000,000,000 a year. The value of a tax-exempt security to a man of large income lies wholly in the fact that the tax-exemption feature gives him more free income than another equally safe investment, part of the return from which the Government takes. Under the present law, if a man has an income of $100,000 and is asked to invest money in some constructive project, the new project must return to him $1.75 for every $1 he would receive from investing the same money in tax-exempt securities. To express this another way, it takes about an 8-percent return on a taxable investment to be equivalent to a 42-percent return on one that is tax exempt. With higher incomes, the disparity is even greater. If the Treasury's recommendation for a maximum aggregate tax of 31 percent should be adopted, the relative values would be $1.44 to $1, or 62 percent taxable as compared with