Although, so far as I can determine, there is no United States Supreme Court decision on the question, some courts, in collateral statements and dicta, have indicated that the renewal or exchange of outstanding Government bonds or obligations would not be "new issues", taxable as "future issues", within the meaning of the contemplated constitutional amendment or amendment to the revenue act. It is indicated that so long as the outstanding obligations were callable within the provisions of the contract, their retirement, with voluntary acceptance by the holder of a new issue in exchange, would permit taxation on the new obligation as a "future issue," If the exchange were mandatory, however, this would amount to repudiation of the previous obligation and substitution of a new contract subject to the tax, and would be the same in effect as applying the tax provisions retroactively to the income of all outstanding securities. It will be necessary, therefore, to legally provide for the collection of a tax on income for the present securities which may be called in for renewal or exchange. WAYS AND MEANS COMMITTEE ACTION As this statement is being prepared, I am informed that a subcommittee of the Committee on Ways and Means of the House of Representatives, Seventy-third Congress, second session, has completed a thorough study of revenue legislation, including a study of tax-exempt securities, and has made the following recommendation: "Your subcommittee deliberated at length in regard to the question of making all tax-exempt income taxable, but came to the conclusion that the only proper way to handle the subject in its broad aspect was through an amendment to the Constitution." RECOMMENDATION OF MR. L. H. PARKER With reference to the above recommendations of the subcommittee, Mr. L. H. Parker, Chief of Staff of the Joint Committee on Internal Revenue Taxation, today submitted to me the following statement outlining his personal views regarding the proper form of taxation if such recommendation is followed: "If the general conclusion of the subcommittee is concurred in that this form of income should be made taxable through a constitutional amendment, then the important elements of such a plan may be properly considered. "First, it seems obvious that all such interest should be equally subject to tax, whether the source be Federal, State, county, municipal, or township bonds. Otherwise, certain bonds will be preferred over others, and the interest rates, resulting from such a condition, unequal and unfair. "Second, if all such interest is made subject to both normal and surtax in the hands of the individual and to the corporate income tax, the following questions need careful consideration: "1. Will the taxes imposed substantially increase the interest paid on all future obligations? "2. Will the rate on the bonds of small local communities be increased more than the rate on Federal, State, and city bonds? "3. Will Federal, State, and local bonds find a sufficiently ready market in times of emergency? "4. Will the bond market collapse when the passage of such a constitutional amendment becomes assured? "Many will undoubtedly answer the first, second, and fourth questions above in the affirmative, and third in the negative. If such answers are correct, the whole proposition seems of doubtful merit. However, in the writer's opinion, the danger arising from these four propositions can be undoubtedly avoided by providing that all interest from Federal, State, and local bonds be subject to surtax but not to normal tax or corporate tax. "It appears, since about 67 percent of these bonds are held by corporations and only 33 percent by individuals, that the following advantages might be claimed for such a plan: "1. There will be a negligible increase in interest rates, since banks and other corporations, being the largest buyers, will set such rates. "2. Corporate stockholders will not be affected differently than at present, since under existing law tax-exempt interest loses its exempt character in passing through the hands of the corporation; that is, the dividends from a corporation, all of whose income is from tax-exempt interest, are taxable to the stockholders at surtax rates. "3. Small communities will be able to find purchasers for their bonds, since the banks generally take these issues, and such banks under the suggested plan would not be taxed except indirectly on the dividends declared to the stockholders. "4. A sufficiently ready market would still exist, since individuals with small incomes and corporations would still be free from tax on this form of income. "5. No enormous volume of securities would flood the market in anticipation of the constitutional amendment, making financing of public projects impossible during such a period. "6. Nevertheless, the proposal would result in imposing the full surtax rate on the incomes of our wealthier citizens who choose this form of investment and have ability to pay substantial taxes. "While the gross revenue from this proposal, to apply the surtax only, would be less than from applying normal, surtax, and corporate tax, it is believed that the net result would not be greatly different, on account of the increased interest rate which would probably result in the latter case. "The above comments have been prepared rather hastily, but it is hoped that they may be of some value in your consideration of this subject." L. H. PARKER, Chief of Staff. COMMITTEE MEMORANDUM In addition to the above statement, Mr. Parker also inserted in the hearings of the Ways and Means subcommittee the following memorandum on wholly and partially tax-exempt interests, which I regard as extremely important in connection with the technical and legal phases of the question: MEMORANDUM ON WHOLLY AND PARTIALLY TAX-EXEMPT INTEREST "Much attention recently has been given to the question of whether the interest on Federal, State, and local bonds should be subject to taxation by the Federal and State Governments. A consideration of the facts in connection with the subject does not lead to an obvious conclusion. However, such facts as seem most important will be pointed out, and certain suggestions made in connection with the matter as appear to warrant consideration. "The total interest-bearing indebtedness of the Federal, State, and local Governments is estimated to be approximately $40,500,000,000 at this time. The annual interest charge on this amount is estimated to be approximately $1,805,000,000. The larger part of this latter sum is entirely free from Federal and State income taxes, although it is true that some of the Federal bonds are subject to surtaxes. Also, practically all of the bonds are subject to estate and inheritance taxes, and to the income tax insofar as a profit is realized upon the sale thereof. "Naturally we have accurate figures as to the total amount of Federal securities. On August 31, 1933, the total interest-bearing debt of the United States outstanding amounted to $22,722,597,530, of which amount $12,860,055,350 was subject to surtax and $9,862,542,180 was wholly tax exempt as to both income and surtax. It appears that the average annual interest charge on this Federal debt will be approximately $825,000,000, indicating an average interest rate of approximately 3% percent. "From incomplete data available this office estimates the present State and local indebtedness to be about $17,800,000,000. The annual interest charge on this sum is probably not less than $980,000,000, indicating an average interest rate of 52 percent. "Our revenue acts provide that taxpayers, both individual and corporate, shall report the interest received from these wholly or partially tax-exempt bonds. There is no penalty for not so reporting the wholly tax-exempt interest, and there might be some question as to the legality of such a penalty. In any event, it seems certain that a very considerable amount of the wholly tax-exempt interest is not reported on the returns. This, of course, makes no difference in our present revenue, but is disturbing when we make a statistical study of this question. "It has already been pointed out that our present annual interest charge on the total Federal, State, and local debt will amount to approximately $1,805,000,000. In 1930 this interest charge amounted to considerably less-probably to about $1,370,000,000. Nineteen hundred and thirty is the latest year on which we have complete income-tax statistics, and in this year we can account for the following amounts of wholly or partially tax-exempt interest on the income-tax returns: (1) Individuals with net income of $5,000 and over: Interest on State and local bonds.. Interest on wholly exempt United States bonds_- Subtotal $172, 841, 118 51, 308, 177 (in 38, 133, 605 262, 282, 900 (2) Corporations-all: Interest on Federal, State, and municipal bonds. (3) Individuals with $5,000 gross but no net income: Interest on partially exempt Government bonds.. Grand total__ $536, 260, 563 5, 738, 139 804, 281, 602 "It is apparent, therefore, that the actual figures on the 1930 income-tax returns account for only $804,281,602 out of a total of probably $1,370,000,000 of wholly or partially tax-exempt interest paid out in that year. While we can account for some of this difference of $566,000,000 as going to the individuals with net incomes of less than $5,000, to tax-exempt corporations, and to foreign individuals and corporations, it must be admitted that the larger portion of the difference probably is the result of the tax-exempt interest not being reported on the returns. However, our figures seem sufficiently complete to form a basis for estimates. "Before speculating, however, as to how much revenue may be derived from the taxation of this interest, it will be necessary and interesting to observe the distribution of this kind of interest among our smaller taxpayers, our middle class, and our wealthy class. This distribution need be made only for individuals, since the corporate rate of tax is constant while the individual rates of tax are graduated. Furthermore, it can be computed from the figures already given that the corporations appear to hold about 67 percent of the total of Federal, State, and local obligations. "The wholly and partially tax-exempt interest reported by individuals with net incomes of over $5,000 has been computed for the years 1924, 1927, 1929, and 1930. This interest has been broken up into two groups: (1) United States securities and Federal farm-loan bonds; and (2) State and local obligations. The interest derived from each of these groups has been further classified so as to show the amount received in each case by individuals with net incomes of over $5,000 and not over $25,000, by individuals with net incomes of over $25,000 but not over $100,000, and by individuals with net incomes of over $100,000. These facts are shown in the following four tables covering, respectively, the 4 years already named: Wholly and partially tax-exempt interest reported by individuals with net incomes of over $5,000 by net income classes "The following facts may readily be noted from the above tables: "First. The interest received, and hence the amount of Federal securities held, by all our individual taxpayers with net incomes of over $5,000 has steadily declined. In 1924 the interest received amounted to about one hundred and twenty million; in 1927, to about one hundred and fifteen million; in 1929, to about one hundred million; and in 1930, to about eighty-nine million, a decline of 30 percent from 1924 to 1930. "Second. The interest received, and hence the amount of State and loca obligations held, by all our individual taxpayers with net incomes of over $5,000 has somewhat increased. In 1924 the interest received amounted to about one hundred and nineteen million; in 1927, to about one hundred and fifty-two million; in 1929, to about one hundred and seventy million; and in 1930, to about one hundred and seventy-three million, an increase of 45 percent from 1924 to 1930. "Third. The class of taxpayers with net incomes of from $5,000 to $25,000 do not find the Federal bonds unattractive. In 1924, 65 percent of their interest was received from such bonds and 35 percent from State and local bonds, while in 1930 the Federal interest received amounted to 46 percent and the State and local interest to 54 percent. "Fourth. In the case of the middle class of taxpayers with net incomes between $25,000 and $100,000 the proportion of Federal to State and local interest received is much less than in the smaller class and the shift to State and local investment greater. For instance, in 1924, of the total interest received by this class, 48 percent. came from Federal securities and 52 percent from State and local obligations, while in 1930, 33 percent came from the former source and 67 percent from the latter. "Fifth. In the case of the wealthy taxpayers, with net incomes of over $100,000, the unattractiveness of the Federal issues becomes even more pronounced and the shift to State and local issues still greater. In 1924 this class received 42 percent of their total interest from Federal securities and 58 percent from State and local obligations. In 1930, however, 26 percent came from Federal sources and 74 percent from State and local sources. "It is our conclusion from the above facts that the small taxpayer finds Federal bonds quite as attractive as State and local bonds, because the greater security offered by the former offsets the higher interest rate of the latter. In the case of the larger taxpayers, however, we are forced to the conclusion that State and local issues are preferred over Federal issues, not because this class of taxpayers desire less security, but because the State and local issues are entirely free from surtax, while the majority of the Federal bonds are subject to such tax. "What additional revenue could be secured by subjecting all this interest on the public debt to tax? Based on the data available and the existing tax rates, we believe the maximum revenue which the Federal Government could obtain would not exceed $160,000,000 annually. Of this amount, about $90,000,000 would come from individuals and about $70,000,000 from corporations. "A study of the market quotations on Government bonds indicates that the wholly tax-exempt securities are slightly preferred over the partially exempt securities. This is true in spite of the fact that both classes of securities are wholly tax exempt when in the hands of corporations. Thus, a broad tax-free market is now open to corporations for the bonds which are only partially tax exempt in the hands of individuals. If this were not the case, authorities seem to agree that future bond issues by our governmental units would necessarily bear a higher interest rate. "An increase in interest rate of one fourth of 1 percent on $40,000,000,000 would cost our Government $100,000,000 annually; an increase of one half of 1 percent would cost $200,000,000 annually. Of course, the increase in interest costs would not take effect immediately if Congress taxed bonds already issued in tax-exempt form without retirement and reissue. However, to do so would raise a serious question of breach of faith and might be construed to violate the Constitution. "At the present time, substantial revenue could be secured by taxing the interest on all Federal, State, and local bonds if the income tax were applied to old as well as new issues. The question of whether such a procedure is right or wrong from a moral standpoint is one which is beyond the scope of this memorandum. "It is the opinion of this office that if the income tax were applied in full to all future issues of these bonds the increased interest cost would nearly offset the additional revenue secured. "SUGGESTIONS “If it is desired to subject all Federal, State, and local bonds to the income tax of both Federal and State Governments, it appears that the fairest way, and the only one free from legal uncertainties, would be to present the issue to the people through an amendment to the Constitution. "It is suggested that for present purposes it might be well for the Congress to consider the advisability of making all future issues of Federal interest-bearing obligations subject to the surtax. This would restrict the opportunity now existing for the avoidance of this tax. In fact, much might be said, even in the case of a constitutional amendment, in favor of making the interest on Federal, State, and local bonds subject to surtaxes but not to normal taxes. It would have the effect of preventing tax avoidance without materially increasing the interest rate. "There is some possibility, in view of certain decisions of the Supreme Court of the United States, that even under existing law interest on governmental bonds can be reached by an excise tax in the case of individuals or corporations carrying on business. This question is discussed in the appended memorandum prepared by Mr. Stam, counsel to this committee. "As already stated, no obvious conclusion is apparent in connection with this matter. It is a subject of importance, and needs further investigation and study. (Italics supplied.) "Respectfully, "L. H. PARKER, Chief of Staff." POWER OF CONGRESS TO TAX TAX-EXEMPT SECURITIES EXCISE TAX Many proposals have been submitted suggesting the taxation by the Federal Government of the income received from State and municipal securities. It is settled doctrine that without a constitutional amendment Congress has no power directly to tax the income received from State and municipal securities (Metcalf and Eddy v. Mitchell, Admx., 269 U. S. 514, 521; Pollock v. Farmers' Loan & Trust Co., 157 U. S. 429; National Life Insurance Co. v. U. S., 48 Sup. Ct. 593). However, there is a possibility that such income might be reached through an excise tax measured by the net income from all sources. In the case of corporations, it seems clear that this can be done. The corporation excise tax of 1909 taxed the privilege of carrying on or doing business by corporations. The tax was measured by the net income of the corporation from all sources. Since the subject of the tax was an exercise of a franchise or privilege, the Supreme Court held that Congress had the power to include in the measure of the tax the income from tax-exempt securities, although such income could not be directly taxed (Stone Tracy Co. v. Flint, 220 U. S. 107). Moreover, some of the States through corporation excise taxes are now taxing the income from Federal securities by measuring the excise by the net income of the corporation from all sources. at least two of the States, namely, California and New York, their power to do this has been upheld by the Supreme Court (Pacific Co. v. Johnson, 285 U. S. 480; Educational Films Co. v. Ward, 282 U. S. 379). In the California case the Supreme Court made the following statement as to this point: In "The owner may enjoy his exempt property free of tax, but if he asks and receives from the State the benefit of the taxable privilege as the implement of that enjoyment, he must bear the burden of the tax which the State exacts as its price. "So far as individuals are concerned, there is a possibility that the income received by them from tax-exempt securities may also be reached through an excise. To do this we must first find a taxable privilege upon which to base the excise. It seems clear that all trades, avocations, and employments by which individuals acquire a livelihood may be made the subject of an excise or privilege tax. (See the Stone Tracy and Pollock cases, cited above.) Accordingly, if Congress levied an excise on individuals engaged in any business, occupation, trade, avocation, or employment, it seems entirely possible that such tax could be measured by the net income of the individual from all sources, including the income from tax-exempt securities. As stated by the Supreme Court in the Stone Tracy Co. case, there is no rule which permits a court to say that the measure of a tax for the privilege of doing business, where income from property is the basis, must be limited to that derived from property used in the business.' It is up to Congress to determine the measure of the excise, and it seems entirely possible that the measure of such excise could be the net income of the individual from all sources, including tax-exempt securities. "Under this proposed scheme there would be three taxes levied by the Congress; (1) An excise tax upon the carrying on or doing business by corporations measured by the net income from all sources; (2) an excise tax upon individuals engaged in any trade, occupation, avocation, or employment, measured by the net income from all sources; and (3) a net-income tax imposed upon all individuals and corporations not subject to the excise tax. |