Letter on the Tax Bill.

Dear Mr. Chairman:

The revenue bill as it passed the House and the Revenue Bill just adopted by the Senate differ in many particulars. While differences in detail can, I am confident, be ironed out in conference committee without sacrifice of fundamental principles, in two major respects important principles of fairness in taxation are in issue. I wish to bring these two matters briefly to your attention at this time.

1. Capital Gains.— For many years the country has accepted without question the principle of taxation in accordance with ability to pay. This principle applies to all forms of additional wealth accruing to individuals. There is no fairness in taxing the salaried man and the merchant upon their incomes and taxing at far lower rates the profits on the capital of the speculator. Nor is it fair to subject the salaried man and the merchant to progressive surtaxes upon their earnings and at the same time to tax capital gains, large or small, at the same fiat rate, to the particular advantage of the taxpayer who otherwise would pay much higher surtax rates. In other words, as a matter of principle, if additional wealth in the form of earnings from business, such as dividends, interest, or wages, is taxed at progressive rates then capital gains should also be taxed at progressive rates.

The present law treats capital gains very favorably—more favorably than dividends, interest, or salaries earned over similar periods of time. The advantage given to capital gains under the present law, as compared to ordinary income, in many cases runs as high as 50 per cent. Under the Senate Bill this preferential advantage is further increased by reducing the tax to a fiat rate, no matter how large are the taxpayer's capital gains or how large his other income. For example, a man who makes a capital gain in a given year amounting to $5000 would have to pay a tax of not more than 15 per cent; while at the same time the man who makes capital gains of $500,000 in a given year will also pay a tax of not more than 15 per cent. Desirable as it is to foster business recovery, we should not do so by creating injustices in the tax system, particularly injustices at the expense of the man who earns his income—injustices to the advantage of the man who does not.

2. Corporation Taxes.— For many years the Congress has sought to devise a fair system for taxing incomes from business, whether received by individual proprietors, by partnerships, or by corporations. Legally the corporation is a separate entity from the individuals who own it. Hence, while individual proprietors and partners are taxable at the usual normal tax and surtax rates upon the entire incomes of their businesses, whether taken out of the business or left in it, the corporate charter sets up a Chinese wall which prevents the earnings from being taxed to the shareholders who really own them, unless those earnings are actually distributed to the shareholders in the form of dividends. Thus a wide and basically unfair disparity between the taxation of individual proprietors and partnerships on the one hand, and of corporations on the other is created, unless some provision for taxing undistributed corporation earnings appears in the law.

At present, corporations are taxable on their earnings at a normal rate of from 8 to 15 per cent, whether the earnings are paid out in dividends or not. If dividends are declared, the individual stockholders who get the earnings pay an additional normal personal income tax. If their incomes are large enough, they Pay progressive surtaxes also. Consequently, the Treasury stands to lose where the corporation does not distribute earnings, whereas if earnings were distributed, the Treasury would collect additional taxes on the personal income tax returns of the stockholders. Moreover, with no undistributed profits tax, the partnership or individual proprietor is discriminated against as compared to the corporation. Finally, with no undistributed profits tax, the avoidance of surtaxes through the use of the corporation becomes a readily available device, for those persons in the higher surtax brackets, who seek legally to keep their net personal incomes down for taxpaying purposes, and to hide their actual profits by leaving them in the corporations they own.

For these reasons and others, I recommended the undistributed profits tax in 1936, and the Congress adopted it. Modifications shown by experience to be desirable, in particular the exemption of small corporations, should be made, but the principle of the tax is sound, and it should be retained in our tax system. Otherwise we grant a definite incentive to the avoidance of personal income tax payments through methods which are legal, but which are contrary to the spirit of the principle that every citizen should pay taxes in accordance with his means. It would be particularly undesirable to eliminate the undistributed profits tax at this time, in favor of a fiat rate of tax, representing an increase in the tax burden on many small corporations, and on all corporations which follow established American practices of dividend distribution; and a decrease in the tax burden of many large corporations, which have hoarded their earnings in the past, and would be encouraged to resume the practice in the future.

The Bill as passed by the House gives a flat exemption from the undistributed profits tax to those smaller corporations which make net earnings up to $25,000 per year. Out of the total of 200,000 taxpaying corporations, approximately 176,000 are exempted from the undistributed profits tax under this provision. This means that any young and growing corporation earning up to $25,000 per year can in the discretion of its directors set aside all its earnings for growth and expansion. Moreover, under the House Bill, corporations with incomes in excess of $25,000 can also accumulate reserves for legitimate purposes by paying an additional tax of only from 1 to 4 per cent on undistributed earnings.

There are many other provisions in the two bills which will improve the equity of the tax system, and the efficiency of its administration. Some pending amendments grant unjustifiable exemptions from a fair general rule, complicate the law, and should be eliminated. It is most important, however, to hold fast to that which is good in the tax system. Equal taxation of incomes of similar size and equal taxation of corporations and individual taxpayers are axiomatic. The repeal of the undistributed profits tax and the reduction of the tax on capital gains to a fraction of the tax on other forms of income strike at the root of fundamental principles of taxation.

Business will be helped, not hurt, by these suggestions.

Faithfully,

Honorable Robert L. Doughton,

Chairman, Ways and Means Committee,

House of Representatives,

Washington, D.C.