STATEMENT OF JOHN P. BARNES, ESQ., MacLEISH, SPRAY, PRICE & UNDERWOOD, CHICAGO, ILL.

Mr. BARNES. Mr. Chairman and members of the committee, my name is John P. Barnes. I am a lawyer practicing in Chicago, and most of my professional work is in the field of Federal income taxation.

I am one of those invited by your late chairman to appear and give their views on the basic tax policies that are now under consideration by this committee.

The CHAIRMAN. Mr. Barnes, do you have a copy of your statement for the members of the committee?

Mr. BARNES. I am sorry, Mr. Chairman. I finished it only yesterday, and I thought I would speak more or less extemporaneously. The CHAIRMAN. You are recognized to proceed in your own way. Mr. BARNES. Thank you, sir.

In my letter of invitation, it was suggested that I appear as amicus curiae. It is my intention to play that part to the best of my ability. I represent no particular group. What I shall say will be that which, in my honest conviction, needs to be said in furtherance of the best interests of the taxpayer group as a whole and the national welfare.

INEQUALITIES IN INCOME TAX LAW

A net income tax, in theory, is commensurate with the ability of each taxpayer to pay. For this reason, net income taxation is favored by those having special competence and experience in the field of taxation. And I do not doubt that it is likewise favored by a majority of our citizens.

But we do not have taxation according to ability to pay. Instead, our tax law is full of shocking preferences and inequalities.

In my opinion, this condition is attributable to the fact that our law has been formulated without consistent adherence to any basic concept of net income and any basic standard for determining when deviations from that concept should be made. We started, with our first income tax act, in 1913 on an empirical basis, and have continued since that time on the same basis. This is a statement of fact, not a criticism, because I realize that there were practical reasons for this course of development of the law, and I doubt that any other course would have been possible. But nevertheless, the fact remains, that although our law has undergone numerous revisions, usually for the announced purpose of simplification among others, the exceptions, qualifications and special relief provisions in our statute have multiplied; and, instead of simplification, there has been growing complication of the law and, what is worse, there have been increasing inequalities in its application and effect.

When I speak of inequality I mean a disparity in the impact of the tax upon two or more taxpayers which is not founded upon a corresponding disparity in those circumstances of the taxpayers that should govern the impact under a logical concept of net income taxation consistently followed.

The inequalities in our statute are the subject of my comments today. I intend to discuss some, by no means all, of them for the purpose, first, of establishing that they do exist and involve gross unfairness and, secondly, of pointing out what I conceive to be the net over

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all effect of inequalities upon the distribution of the tax burden among the whole taxpayer group.

EXAMPLES OF INEQUALITIES

Deduction of nonbusiness interest and taxes

I shall begin with an inequality of long standing. From the outset, our law has allowed the deduction of taxes on nonbusiness property and interest on indebtedness incurred to carry such property. This provision of law creates an inequality between homeowners and renters. The taxes and interest paid by the homeowner are personal expenses no less than the rent paid by the person renting living space. Moreover, a homeowner whose taxes and interest equal the rent paid by a renter has no less capacity to pay tax than the renter. There is no difference in their circumstances that should determine the impact of the tax under a logical income taxation concept. But there is a substantial difference in the impact of the tax upon them.

I am not suggesting a change in the law in this particular. There may be, perhaps are, sound social and economic reasons for retaining the preference in favor of the homeowner. Moreover, a change would hardly be politically feasible. My purpose in mentioning it is to show by a very simple example the nature of tax inequality, and to make sure that we do not lose sight of this particular one merely because it has been so long embedded in our law.

Additional personal exemption for persons 65 years of age and older

A few years ago, the law was amended to allow a person 65 years of age, or older, an additional $600 personal exemption. Although some may doubt that there is justification for the manifest preference created by this amendment in favor of the group intended to be benefited, namely, the older retired group with small fixed incomes, something, at least, can be said in its favor. But the additional exemption is also available to wealthy persons in the specified age group; and what can be said in defense of the preference thus accorded them. Why should the impact of the tax on older persons with substantial incomes, often from investments, be less than the impact on younger persons with smaller incomes, in most cases consisting of earnings! The foregoing comment also apply, in my judgment, to the larger medical expense deduction allowable in the case of a taxpayer who is 65 years of age, or older, and to the retirement-income credit. Additional personal exemption for blind persons

The additional personal exemption accorded blind persons creates an inequality between that group and all other taxpayers. I have no difficulty justifying this inequality insofar as it exists only between the blind group and other taxpayers having no physical or mental handicaps, but I can think of no reason whatsoever for the discrimination worked against that group composed of persons having other handicaps than blindness. As a taxpayer, I feel no resentment because the law allows a blind person 2 exemptions and me only 1, but I was conscious of a deep sense of resentment when I read the recent decision of the Tax Court denying the deduction of expenses incurred by a severely crippled taxpayer in getting to and from his work in a specially designed and constructed automobile, which was his only possible means of transportation-resentment not against the decision,

for that seemed to me to be sound under the code provisions, but against the discriminatory provisions that denied the taxpayer as many personal exemptions as a blind person.

Capital gains

For further cases of inequality I turn next to the capital-gains provisions of the code. The basic, underlying reason for special treatment of capital gains is to give relief from the harsh impact of a graduated income tax (especially when steeply graduated to a very high top bracket) upon lumped income, that is, income realized in 1 year but attributable to accretion, appreciation, accumulation, or earnings over a period of more than 1 year.

Fairness to the taxpayer may be stressed as the justification' for the special treatment of capital gains. Or, on the other hand, the supposed beneficial effect upon the national economy and the flow of income-tax revenue, resulting from relief to taxpayers may be stressed as the justification for such special treatment. The latter justification was the one assigned for the special treatment of capital gains when provision for it was first incorporated in the statute in 1921. The Committee on Ways and Means, in its report on the bill which became the Revenue Act of 1921, said:

Many such sales, with their possible taking and consequent increase of the tax revenue have been blocked by this feature of the present lawthat is, the treatment of capital gains as ordinary income.

In 1938, when the revenue statute, including the capital-gain provisions, underwent major changes, a subcommittee of this committee considered, and in its report stated at length its conclusions concerning, the question of the proper treatment of capital gains. The subcommittee expressly recognized fairness to the taxpayer as justification for special tax treatment of capital gains, saying:

It will be noted that during almost the entire decade following the adoption of the 16th amendment in 1913, capital gains were fully subjected with ordinary, recurring income to the normal tax and surtaxes in the year in which the asset was sold. It might properly be objected to such method today, however, that it would be unfair fully to subject a capital gain to the present scale of surtaxes in the year of realization, when in fact the appreciation in the value of the asset occurred over a number of years.

And although the subcommittee also recognized as additional justification for capital gain tax relief the supposed beneficial effect upon the national economy, the subcommittee expressed doubt as to the extent of such beneficial effect. On this the subcommittee said:

Except in certain special cases, the scope and force of tax influence upon the sale of securities and other capital assets may be easily exaggerated. In general, neither the available evidence nor analysis of the underlying factors support the large claims often made in this connection. The underlying business situation and the related speculative temper of the times are primarily responsible for stock market and real-estate booms and collapses.

It thus appears that the reason for special treatment of capital gains is to provide relief from the harsh burden of a graduated income tax on lumped income for the purpose (1) of benefiting the taxpayer in the interest of fairness and (2) of benefiting the national economy by removing a tax obstruction upon the free flow of capital transactions. I am not aware that any other reason or justification has been advanced.

Insofar as the capital-gain provisions of the law are intended to, and do, operate for the benefit of the taxpayer who receives lumped

income in the form of capital gain, it is only a partial solution of a much larger problem. There are many forms of lumped income besides capital gains, and the taxation of other kinds of lumped income at ordinary rates is equally as burdensome and unfair as like taxation of capital gains. The taxpayer who receives in 1 year income earned over the previous 5 years has no capacity or reason for paying more tax than another taxpayer who realizes an equal amount of gain in 1 year from the sale of a capital assets held for the same 5-year period. But the taxpayer having the earned income will pay a substantially larger tax, unless very low tax brackets are applicable. Sections 1301, 1302, and 1903 of the code give a measure of relief in the case of lumped compensation, but they are limited in application and the relief afforded is not nearly so extensive as that afforded by the capital-gain provisions.

No attempt has ever been made in our statute to solve the overall problem created by lumped income. Nor has any attempt been made to solve the closely related problem of widely fluctuating income from year to year. Hence, in providing the special tax treatment of capital gains, our law creates a preference in favor of the taxpayer having that kind of lumped income and a discrimination against all other taxpayers having other kinds of lumped income.

But, in answer to this, it may be said that the special treatment of capital gains is for the purpose of benefiting the national economy, not merely the taxpayer, and that unless such additional reason exists the justification for special treatment of any class of income also does not exist. Although some might question the validity of the alleged benefit to the national economy as a basis for so great a preference, I will pass that. Instead, I should like to discuss briefly several classes of gains that have been made subject to the capital-gain provisions in the light of the reasons for special treatment of capital gains.

The capital-gain treatment of a lump-sum payout from a pension or profit-sharing plan, on account of the employee's death or separation from the service of the employer, is clearly an anomaly. No capital asset is involved, and hence no sale or exchange of a capital asset occurs. Instead, the gain realized from such lump-sum payout is chiefly additional compensation to the employee compensation on which he has paid no tax. Since this is no capital transaction, the purpose of promoting the free flow of capital transactions in the interest of the national welfare by lifting the burden of ordinary tax rates on gains from such transactions does not apply here. The only explanation of the capital-gain treatment in this case is relief to the taxpayer in respect of lumped income. But such relief involves the extension of capital-gain treatment to income that is not capital gain at all but compensation and constitutes a discrimination against other taxpayers having lumped income of a noncapital character.

The code provisions for taxing gain to an inventor from the transfer of his patent as capital gain are not justified by the reasons underlying the special treatment of capital gains. The inventor's gain gets the special treatment notwithstanding that the payments for the patent are payable over the life of the patent or are contingent on the use or productivity of the patent. In other words, even though the payments are received in equal yearly amounts, the gain receives the preferred treatment. But in such case there is no lumped income whatsoever, and lumping of income is the basic reason for special

treatment of capital gains. Even when the payments to the inventor are based on the use or productivity of the patent, there is not likely to be lumping of income, althought there may be fluctuation in income from year to year. Finally, I do not believe that patent transfers are in the class of capital transactions which Congress thought it necessary to stimulate through tax preference in the interest of the national welfare.

But even if one could agree that the reasons for preferential treatment of capital gains are applicable in the case of the inventor's gain, there needs to be answered the question why authors, composers, and artists are denied the same treatment as inventors. This difference in treatment is not casual; for the code not only by special provision includes the inventor's gain but also by express provision excludes the author's, the composer's, and the artist's gain from the reach of the capital-gain provisions. The discrimination against the latter class, thus, is deliberate. And discrimination it appears to be, since there is no difference in circumstances justifying the difference in tax impact. Like the inventor's gain, gains from cutting timber and gains from the disposal of timber or coal held for more than 6 months under a contract retaining an economic interest in the owner receive capitalgain treatment. And, as in the case of the inventor's gain, the special treatment of these types of gain is allowed even though there is no lumped income; hence, it cannot be justified by the reasons that have been assigned for taxing capital gain at lower than ordinary rates. Qualified pension and profit-sharing plans

The next inequality that I shall mention is that existing, by virtue of the special provisions of the code applicable to qualified pension and profit-sharing plans, between the class of persons benefited by those provisions and all other taxpayers, particularly those having earned income. On the one hand, the employer is permitted to deduct currently his or its contributions to the fund. On the other, the employees are permitted to postpone the payment of tax until they actually receive distributions from the fund-notwithstanding that under well-established principles they may and often do realize income at the time when the employer makes the contribution or at whatever later time vesting occurs. Through this tax preference the vast sums of money that go into pension and profit-sharing funds are relieved of any current tax burden whatsoever; and because such funds are so relieved it is possible to accumulate large amounts of capital for the employees covered by such plans which are paid to them at or after retirement. Moreover, since the employee's incomes are usually lower when they receive the payments than their incomes were when the employer made the contributions, the postponement of the tax payment permits them to pay lower rates of tax on this type of income. And, if the employee dies or is separated from the service of the employer, and because of such occurrence a lump-sum payout is made to the employee or his beneficiary, it is subject to capital-gain treatment, as we have already noted.

By way of comparison, consider now the case of the self-employed individual or the worker not covered by a qualified plan. No relief is extended to him to enable him to make provision for himself and his wife after retirement. His income is currently subject to the full impact of the tax, and provision for his old age must be made out of savings after payment of income taxes and living expenses. The tax