CHAPTER X

CONSTITUTIONAL DIFFERENCES

CERTAIN important differences in the income tax laws of Great Britain and the United States resulting from the limitations imposed upon the Congress by the United States Constitution have already been touched on. In Great Britain no such constitutional difficulties exist. The limitations imposed by the United States Constitution have, in several cases, an important effect on the scheme of the Federal income tax, and they must here be examined in more detail. They are the cause of some inequalities in the tax and result in the exemption of certain persons and income which would otherwise probably be subject to the tax. It may be that in the course of time the Constitution will be amended to remove these inequalities, but it must be remembered that an amendment to the United States Constitution is not a simple matter or one which can be accomplished speedily.1

We have seen that it is unconstitutional for Congress to subject to the income tax any income that accrued before March 1, 1913, the date on which, under the Sixteenth Amendment, it first became lawful for the United States Government to impose a Federal income tax. The resulting necessity for frequent valuations as of March 1, 1913, has been discussed. This constitutional limitation also compli

The procedure for amending the Constitution is set out in Article V thereof, and is as follows: 'The Congress, whenever two-thirds of both Houses shall deem it necessary, shall propose amendments to this Constitution, or, on the application of two-thirds of the several States, shall call a convention for proposing amendments, which, in either case, shall be valid to all intents and purposes, as part of this Constitution when ratified by three-fourths of the several States, or by conventions in three-fourths thereof, as the one or the other mode of ratification may be proposed by the Congress; 2 See Chapter IX.

"

cates the taxation of corporate dividends. In each case it must be determined whether a dividend consists of earnings or profits accumulated before or after March 1, 1913, or of increases in the value of property accrued before or after that date. This difficulty is unavoidable, and will become less and less serious as the date March 1, 1913, becomes more remote.

The second difficulty arises from the lack of power in the Federal Government to tax the means or instrumentalities employed by the States for carrying into effect their legitimate powers. The United States has no power under the Constitution to tax either the instrumentalities or the property of a State. Accordingly, the Federal Government exempts from the income tax the salaries or remuneration of all officers or employees of the States, or of any political sub-divisions thereof. All municipalities are included in the term "political sub-division of a State." A departmental ruling under the 1924 law limited the former broad exemption granted to State and municipal officers and employees. The exemption was, by this ruling, restricted to compensation received by an officer or employee employed in the strictly governmental functions of the State or municipality. The limitation was based upon the distinction between the Government operations of the political unit and its proprietary or private activities. Employees engaged by a State or municipality in the operation of an ordinary private business were ruled not to be within the exemption. Congress has, apparently, considered this limitation unjustifiable, for in the 1926 law 3 it is provided that any taxes imposed by the 1924 or prior laws upon any individual in respect of amounts received by him as compensation for personal services as an officer or employee of any State or political sub-division thereof shall be refunded. Vexatious administrative questions arise in connection with the determination of who are to be included as State or municipal officers or employees. The compensaSolicitor's Opinion 152, Treasury Bulletin, II-35-1217.

• See Holmes, Federal Taxes, 6th ed., p. 540, for a discussion of, and cases decided on, this point.

3 Revenue Act of 1926, Section 1211.

tion of persons serving on the jury of a State, county or municipal court is exempt. The salaries of teachers employed by a State have been ruled to be exempt. On the other hand, a person employed by a village as a special investigator of violations of the State prohibition law is not exempt. The status of over thirty-one different classes of employees has been ruled on by the Treasury Department.1 All interest on State or municipal bonds, debentures or other obligations is exempt from the Federal income tax. It will readily be seen that this takes a great deal of income from the scope of the tax. The figures showing the total income of State officers and employees are not available, but we have information as to the amount of tax-exempt securities outstanding. On this subject Mr. Mellon, the Secretary of the United States Treasury, has said: "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 the 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 I Holmes, Federal Taxes, 6th ed., p. 541.

2 Annual Report of the Secretary of the Treasury for the Fiscal Year ended June 30, 1924, p. 9.

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 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% return on a taxable investment to be equivalent to a 4% 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 % should be adopted, the relative values would be $1.44 to $1, or 6% taxable as compared with 4% exempt. The difference between an investment in ordinary productive business returning 8 %, the requirement under the present law, and 6%, the requirement under the Treasury rates, to equal a 41% tax exempt, is the difference between a sound investment and a speculative investment. One will be accepted, the other not. If the income tax rates are reduced to a reasonable figure, the lure of tax-exempt securities to the wealthy becomes less appealing and many will put their money into business or new projects and be content with less return because it will give them as much free income as would a tax-exempt security. From such investments the Government gets revenue; from taxexempt securities it gets none. By such investments capital is provided for industry at lower rates and the appalling increase of State and municipal indebtedness, with its inevitable taxation of the people to pay this indebtedness, is not encouraged.

"The adoption of the solution of the tax-exempt evil by taking from it the wholly artificial attraction of high income taxes on other investments is within the immediate power of the Congress. This would prove advantageous to constructive business and to all who use capital, would remove the incentive for the most notorious avoidance by

the wealthy of income taxes, and would assist in accomplishing the purpose of taxation-that is, to raise revenue. A continuation of the high artificial value to this legal means of escape must end, or the graduated income tax will cease to be productive." 1

Considerable doubt exists as to whether the Constitution really does forbid the taxation of these two sources of income. It does not expressly do so, and no direct decision has been given by the courts. The income tax law specifically exempts interest on the obligations of States and municipalities, but does not do so in the case of the compensation of officers or employees of States or political sub-divisions thereof. Nevertheless the Treasury Department has ruled that such income is exempt, and no effort has ever been made to tax it.3 The income tax law of the United States can never rest upon a perfectly fair basis until these exemptions have been done away with. It requires no argument to show the evils they carry with them.

The United States Constitution provides that the salaries of the President of the United States and of Federal judges shall not be decreased during their terms of office.4 As a result, it has been held 5 that it is unconstitutional for Congress to tax as income the salaries of these officers. This decision, however, has been interpreted by the Treasury Department so as to exclude from its effect judges appointed after the enactment of the income tax law under which the tax is sought to be imposed. The Department has ruled that though the salaries of Federal judges are not subject to a new tax or an increased tax, if elected or appointed to office before the passage of the taxing statute, the salaries of all Federal judges appointed since February 24, 1919 (the date of enactment of the 1918 law), were subject

The drastic reduction in rates accomplished by the new 1926 law will considerably lessen the value of tax-exempt securities to wealthy taxpayers.

2 Revenue Act of 1926, Section 213 (a) (4).

3 Regulations 65, Article 88; Opinions Attorney-General, 441.

4 United States Constitution, Art. II, Section 6; Art. III, Sec. 1.

s Evans v. Gore, 253 U.S. 245.

6 Treasury Decision 3049.