by John Brooks
II
“EVERY nation has the government it deserves,” the French writer and diplomat Joseph de Maistre declared in 1811. Since the primary function of government is to make laws, the statement implies that every nation has the laws it deserves, and if the doctrine may be considered at best a half truth in the case of governments that exist by force, it does seem persuasive in the case of governments that exist by popular consent. If the single most important law now on the statute books of the United States is the income-tax law, it would follow that we must have the income-tax law we deserve. Much of the voluminous discussion of the income-tax law in recent years has centered on plain violations of it, among them the deliberate padding of tax-deductible business-expense accounts, the matter of taxable income that is left undeclared on tax returns, fraudulently or otherwise—a sum estimated at as high as twenty-five billion dollars a year—and the matter of corruption within the ranks of the Internal Revenue Service, which some authorities believe to be fairly common, at least in large cities. Such forms of outlawry, of course, reflect timeless and worldwide human frailties. The law itself, however, has certain characteristics that are more closely related to a particular time and place, and if de Maistre was right, these should reflect national characteristics; the income-tax law, that is, should be to some extent a national mirror. How does the reflection look?
TO repeat, then, the basic law under which income taxes are now imposed is the Internal Revenue Code of 1954, as amplified by innumerable regulations issued by the Internal Revenue Service, interpreted by innumerable judicial decisions, and amended by several Acts of Congress, including the Revenue Act of 1964, which embodied the biggest tax cut in our history. The Code, a document longer than “War and Peace,” is phrased—inevitably, perhaps—in the sort of jargon that stuns the mind and disheartens the spirit; a fairly typical sentence, dealing with the definition of the word “employment,” starts near the bottom of page 564, includes more than a thousand words, nineteen semicolons, forty-two simple parentheses, three parentheses within parentheses, and even one unaccountable interstitial period, and comes to a gasping end, with a definitive period, near the top of page 567. Not until one has penetrated to the part of the Code dealing with export-import taxes (which fall within its province, along with estate taxes and various other federal imposts) does one come upon a comprehensible and diverting sentence like “Every person who shall export oleomargarine shall brand upon every tub, firkin, or other package containing such article the word ‘Oleomargarine,’ in plain Roman letters not less than one-half inch square.” Yet a clause on page 2 of the Code, though it is not a sentence at all, is as clear and forthright as one could wish; it sets forth without ado the rates at which the incomes of single individuals are to be taxed: 20 per cent on taxable income of not over $2,000; 22 per cent on taxable income of over $2,000 but not over $4,000; and so on up to a top rate of 91 per cent on taxable income of over $200,000. (As we have seen, the rates were amended downward in 1964 to a top of 70 per cent.) Right at the start, then, the Code makes its declaration of principle, and, to judge by the rate table, it is implacably egalitarian, taxing the poor relatively lightly, the well-to-do moderately, and the very rich at levels that verge on the confiscatory.
But, to repeat a point that has become so well known that it scarcely needs repeating, the Code does not live up to its principles very well. For proof of this, one need look no further than some of the recent score sheets of the income tax—a set of volumes entitled Statistics of Income, which are published annually by the Internal Revenue Service. For 1960, individuals with gross incomes of between $4,000 and $5,000, after taking advantage of all their deductions and personal exemptions, and availing themselves of the provision that allows married couples and the heads of households to be taxed at rates generally lower than those for single persons, ended up paying an average tax bill of about one-tenth of their reportable receipts, while those in the $10,000–$15,000 range paid a bill of about one-seventh, those in the $25,000–$50,000 range paid a bill of not quite a quarter, and those in the $50,000–$100,000 range paid a bill of about a third. Up to this point, clearly, we find a progression according to ability to pay, much as the rate table prescribes. However, the progression stops abruptly when we reach the top income brackets—that is, at just the point where it is supposed to become most marked. For 1960, the $150,000–$200,000, $200,000–$500,000, $500,000$ 1,000,000 and million-plus groups each paid, on the average, less than 50 per cent of their reportable incomes, and when one takes into consideration the fact that the richer a man is, the likelier it is that a huge proportion of his money need not even be reported as gross taxable income—all income from certain bonds, for example, and half of all income from long-term capital gains—it becomes evident that at the very top of the income scale the percentage rate of actual taxation turns downward. The evidence is confirmed by the Statistics of Income for 1961, which breaks down figures on payments according to bracket, and which shows that although 7,487 taxpayers declared gross incomes of $200,000 or more, fewer than five hundred of them had net income that was taxed at the rate of 91 per cent. Throughout its life, the rate of 91 per cent was a public tranquilizer, making everyone in the lower bracket feel fortunate not to be rich, and not hurting the rich very much. And then, to top off the joke, if that is what it is, there are the people with more income than anyone else who pay less tax than anyone else—that is, those with annual incomes of a million dollars or more who manage to find perfectly legal ways of paying no income tax at all. According to Statistics of Income, there were eleven of them in 1960, out of a national total of three hundred and six million-a-year men, and seventeen in 1961, out of a total of three hundred and ninety-eight. In plain fact, the income tax is hardly progressive at all.
The explanation of this disparity between appearance and reality, so huge that it lays the Code open to a broad accusation of hypocrisy, is to be found in the detailed exceptions to the standard rates which lurk in its dim depths—exceptions that are usually called special-interest provisions or, more bluntly, loopholes. (“Loophole,” as all fair-minded users of the word are ready to admit, is a somewhat subjective designation, for one man’s loophole may be another man’s lifeline—or perhaps at some other time, the same man’s lifeline.) Loopholes were noticeably absent from the original 1913 income-tax law. How they came to be law and why they remain law are questions involving politics and possibly metaphysics, but their actual workings are relatively simple, and are illuminating to watch. By far the simplest method of avoiding income taxes—at least for someone who has a large amount of capital at his disposal—is to invest in the bonds of states, municipalities, port authorities, and toll roads; the interest paid on all such bonds is unequivocally tax-exempt. Since the interest on high-grade tax-exempt bonds in recent years has run from three to five per cent, a man who invests ten million dollars in them can collect $300,000 to $500,000 a year tax-free without putting himself or his tax lawyer to the slightest trouble; if he had been foolish enough to sink the money in ordinary investments yielding, say, five per cent, he would have had a taxable income of $500,000, and at the 1964 rate, assuming that he was single, had no other income, and did not avail himself of any dodges, he would have to pay taxes of almost $367,000. The exemption on state and municipal bonds has been part of our income-tax law since its beginnings; it was based originally on Constitutional grounds and is now defended on the ground that the states and towns need the money. Most Secretaries of the Treasury have looked on the exemption with disfavor, but not one has been able to accomplish its repeal.
Probably the most important special-interest provision in the Code is the one that concerns capital gains. The staff of the Joint Economic Committee of Congress wrote in a report issued in 1961, “Capital gains treatment has become one of the most impressive loopholes in the federal revenue structure.” What the provision says, in essence, is that a taxpayer who makes a capital investment (in real estate, a corporation, a bl
ock of stock, or whatever), holds on to it for at least six months, and then sells it at a profit is entitled to be taxed on the profit at a rate much lower than the rate on ordinary income; to be specific, the rate is half of that taxpayer’s ordinary top tax rate or twenty-five per cent whichever is less. What this means to anyone whose income would normally put him in a very high tax bracket is obvious: he must find a way of getting as much as possible of that income in the form of capital gains. Consequently, the game of finding ways of converting ordinary income into capital gains has become very popular in the past decade or two. The game is often won without much of a struggle. On television one evening in the middle 1960s, David Susskind asked six assembled multimillionaires whether any of them considered tax rates a stumbling block on the highroad to wealth in America. There was a long silence, almost as if the notion were new to the multimillionaires, and then one of them, in the tone of some one explaining something to a child, mentioned the capital-gains provision and said that he didn’t consider taxes much of a problem. There was no more discussion of high tax rates that night.
If the capital-gains provision resembles the exemption on certain bonds in that the advantages it affords are of benefit chiefly to the rich, it differs in other ways. It is by far the more accommodating of the two loopholes; indeed, it is a sort of mother loophole capable of spawning other loopholes. For example, one might think that a taxpayer would need to have capital before he could have a capital gain. Yet a way was discovered—and was passed into law in 1950—for him to get the gain before he has the capital. This is the stock-option provision. Under its terms, a corporation may give its executives the right to buy its shares at any time within a stipulated period—say, five years—at or near the open-market price at the time of the granting of the option; later on, if, as has happened so often, the market price of the stock goes sky-high, the executives may exercise their options to buy the stock at the old price, may sell it on the open market some time later at the new price, and may pay only capital-gains rates on the difference, provided that they go through these motions without unseemly haste. The beauty of it all from an executive’s point of view is that once the stock has gone up substantially in value, his option itself becomes a valuable commodity, against which he can borrow the cash he needs in order to exercise it; then, having bought the stock and sold it again, he can pay off his debt and have a capital gain that has arisen from the investment of no capital. The beauty of it all from the corporations’ point of view is that they can compensate their executives partly in money taxable at relatively low rates. Of course, the whole scheme comes to nothing if the company’s stock goes down, which does happen occasionally, or if it simply doesn’t go up, but even then the executive has had a free play on the roulette wheel of the stock market, with a chance of winning a great deal and practically no danger of losing anything—something that the tax law offers no other group.
By favoring capital gains over ordinary income, the Code seems to be putting forward two very dubious notions—that one form of unearned income is more deserving than any form of earned income, and that people with money to invest are more deserving than people without it. Hardly anyone contends that the favored treatment of capital gains can be justified on the ground of fairness; those who consider this aspect of the matter are apt to agree with Hellerstein, who has written, “From a sociological viewpoint, there is a good deal to be said for more severe taxation of profit from appreciation in the value of property than from personal-service income.” The defense, then, is based on other grounds. For one, there is a respectable economic theory that supports a complete exemption of capital gains from income tax, the argument being that whereas wages and dividends or interest from investments are fruits of the capital tree, and are therefore taxable income, capital gains represent the growth of the tree itself, and are therefore not income at all. This distinction is actually embedded in the tax laws of some countries—most notably in the tax law of Britain, which in principle did not tax capital gains until 1964. Another argument—this one purely pragmatic—has it that the capital-gains provision is necessary to encourage people to take risks with their capital. (Similarly, the advocates of stock options say that corporations need them to attract and hold executive talent.) Finally, nearly all tax authorities are agreed that taxing capital gains on exactly the same basis as other income, which is what most reformers say ought to be done, would involve formidable technical difficulties.
Particular subcategories of the rich and the well-paid can avail themselves of various other avenues of escape, including corporate pension plans, which, like stock options, contribute to the solution of the tax problems of executives; tax-free foundations set up ostensibly for charitable and educational purposes, of which over fifteen thousand help to ease the tax burdens of their benefactors, though the charitable and educational activities of some of them are more or less invisible; and personal holding companies, which, subject to rather strict regulations, enable persons with very high incomes from personal services like writing and acting to reduce their taxes by what amounts to incorporating themselves. Of the whole array of loopholes in the Code, however, probably the most widely loathed is the percentage depletion allowance on oil. As the word “depletion” is used in the Code, it refers to the progressive exhaustion of irreplaceable natural resources, but as used on oilmen’s tax returns, it proves to mean a miraculously glorified form of what is ordinarily called depreciation. Whereas a manufacturer may claim depreciation on a piece of machinery as a tax deduction only until he has deducted the original cost of the machine—until, that is, the machine is theoretically worthless from wear—an individual or corporate oil investor, for reasons that defy logical explanation, may go on claiming percentage depletion on a producing well indefinitely, even if this means that the original cost of the well has been recovered many times over. The oil-depletion allowance is 27.5 per cent a year up to a maximum of half of the oil investor’s net income (there are smaller allowances on other natural resources, such as 23 per cent on uranium, 10 per cent on coal, and 5 per cent on oyster and clam shells), and the effect it has on the taxable income of an oil investor, especially when it is combined with the effects of other tax-avoidance devices, is truly astonishing; for instance, over a recent five-year period one oilman had a net income of fourteen and a third million dollars, on which he paid taxes of $80,000, or six-tenths of one per cent. Unsurprisingly, the percentage-depletion allowance is always under attack, but, also unsurprisingly, it is defended with tigerish zeal—so tigerish that even President Kennedy’s 1961 and 1963 proposals for tax revision, which, taken together, are generally considered the broadest program of tax reform ever put forward by a chief executive, did not venture to suggest its repeal. The usual argument is that the percentage-depletion allowance is needed in order to compensate oilmen for the risks involved in speculative drilling, and thus insure an adequate supply of oil for national use, but many people feel that this argument amounts to saying, “The depletion allowance is a necessary and desirable federal subsidy to the oil industry,” and thereby scuttles itself, since granting subsidies to individual industries is hardly the proper task of the income tax.
THE 1964 Revenue Act does practically nothing to plug the loopholes, but it does make them somewhat less useful, in that the drastic reduction of the basic rates on high incomes has probably led some high-bracket taxpayers simply to quit bothering with the less convenient or effective of the dodges. Insofar as the new bill reduces the disparity between the Code’s promises and its performance, that is, it represents a kind of adventitious reform. (One way to cure all income-tax evasion would be to repeal the income tax.) However, quite apart from the sophistry—since 1964 happily somewhat lessened—that the Code embodies, it has certain discernible and disturbing characteristics that have not been changed and may be particularly hard to change in the future. Some of them have to do with its methods of allowing and disallowing deductions for travel and entertainment expenses by
persons who are in business for themselves, or by persons who are employed but are not reimbursed for their business expenses—deductions that were estimated fairly recently at between five and ten billion dollars a year, with a resulting reduction in federal revenue of between one and two billion. The travel-and-entertainment problem—or the T & E problem, as it is customarily called—has been around a long time, and has stubbornly resisted various attempts to solve it. One of the crucial points in T & E history occurred in 1930, when the courts ruled that the actor and songwriter George M. Cohan—and therefore anyone else—was entitled to deduct his business expenses on the basis of a reasonable estimate even if he could not produce any proof of having paid that sum or even produce a detailed accounting. The Cohan rule, as it came to be called, remained in effect for more than three decades, during which it was invoked every spring by thousands of businessmen as ritually as Moslems turn toward Mecca. Over those decades, estimated business deductions grew like kudzu vines as the estimators became bolder, with the result that the Cohan rule and other flexible parts of the T & E regulations were subjected to a series of attacks by would-be reformers. Bills that would have virtually or entirely eliminated the Cohan rule were introduced in Congress in 1951 and again in 1959, only to be defeated—in one case, after an outcry that T & E reform would mean the end of the Kentucky Derby—and in 1961 President Kennedy proposed legislation that not only would have swept aside the Cohan rule but, by reducing to between four and seven dollars a day the amount that a man could deduct for food and beverages, would have all but put an end to the era of deductibility in American life. No such fundamental social change took place. Loud and long wails of anguish instantly arose, from businessmen and also from hotels, restaurants, and night clubs, and many of the Kennedy proposals were soon abandoned. Nevertheless, through a series of amendments to the Code passed by Congress in 1962 and put into effect by a set of regulations issued by the Internal Revenue Service in 1963, they did lead to the abrogation of the Cohan rule, and the stipulation that, generally speaking, all business deductions, no matter how small, would thenceforward have to be substantiated by records, if not by actual receipts.
