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may be stated broadly as that between the ordinary income for the realization of which the trust funds are invested and the more or less extraordinary gains or losses resulting from appreciation or shrinkage in the value of the investments of the principal.

A somewhat similar distinction is observed, at least partly, in the income tax laws of some other countries, the income tax being laid only on income proper as distinguished from capital gains, and only limited or no deduction being allowed for capital losses.

Such a distinction is made in the English act.1 In Italy three classes of income are recognized: unearned income, business income, and pure labor income.2 At best this distinction can never be exact, because the procedure in distinguishing between the income assigned to a life tenant and the capital losses or gains accruing to or borne by the principal fund of an estate or trust is based to a considerable extent on expediency and the practicability of applying the distinction to concrete cases. Decisions of the courts in various states are by no means uniform in this respect.

From an accounting point of view as well as from that of the conservative business man or banker, there cannot be any real income unless the capital which is being used for the production of the income is maintained intact or, if depleted, restored from income before stating the net amount of income realized. This principle has been observed from the beginning of income taxation in the United States, although at first in only an incomplete way. The 1918 law provides more adequately than any of the previous laws for the maintenance and replenishment of capital before stating the net income on which the tax shall be imposed. Provision is made for the deduction from gross income of all losses incurred in the business or in the transactions entered into for purposes

'Seligman, The Income Tax, page 202.

Ibid., page 342.

of profit and for accruing depletions of capital, such as depreciation and obsolescence, which do not necessarily call for a present expenditure of money but are nevertheless gradually exhausting the capital invested for the purpose of producing income. In addition the new law permits the deduction of losses suffered through casualty to private capital as distinguished from business capital.

Differentiation between earned and unearned income.— Decided progress has been made in developing sentiment in favor of relatively heavier taxation of unearned income. This change was even suggested by the Treasury for the 1918 act. Largely because of the administrative difficulties involved, the suggestion was not adopted this year and in view of the present heavy responsibilities of the Treasury this may be just as well. It is confidently predicted, however, that this feature will be added to the income tax law in the near future. Its adoption is made more imperative by the establishment of higher rates and lower personal exemptions.

Some maintain that the operation of state and local property taxes makes a sufficient discrimination between earned and unearned incomes. The burden imposed by local taxation upon property, while nominally comprehending personal property, usually falls heavily upon real estate only. Therefore a differentiation between earned and unearned incomes in favor of the former would undoubtedly increase the present heavy taxation of real estate in some communities. But where the real estate tax is already inordinately high, the remedy should be sought in a reform of the state and local tax systems.

Perhaps the greatest difficulty in differentiating between earned and unearned incomes lies in the distinction which will have to be made between incomes derived by an individual or partnership from the conduct of a business enterprise and the dividends received by stockholders interested in a corporate enterprise engaged in the same kind of business. This apparent inequality will largely disappear if some means can be

devised whereby those closely associated with the management of a corporation, as the officers and directors of a close corporation, will be deemed to be in active business and entitled to the rate of tax applicable to earned incomes.

Taxation on the basis of averages. In a period like the present when rates are varying violently from year to year, the person whose income is irregular from year to year will pay very different taxes from the person who receives a regular income of the same aggregate amount. The adoption of the system of averaging assessments over a period of several years, similar to that of Great Britain, would tend to eliminate this inequality. There the tax imposed upon traders and in some cases upon salaried employees, such as salesmen and clerks, is based upon a three-year average.1 The adoption of such a plan would operate in a beneficent fashion, also, in the case of concerns carrying large inventories which fluctuate in price from year to year. These variations often turn the profits of one year into losses of the next.

Retroactive taxation.-Under a strict definition of the word, any increase in rates applicable to income accrued prior to the enactment of a tax bill would be retroactive. The income tax law of 1913 was effective October 3, 1913, but taxed income accrued after March 1, 1913. The income tax law of 1916 was effective September 8, 1916, but increased the rates as of January 1, 1916. The 1917 law was effective October 3, 1917, but increased the rates as of January 1, 1917. The 1918 law did not become effective until nearly the first of March, 1919, but increased rates as of January 1, 1918. Strictly speaking, all these laws were retroactive in their effect, but none was dangerously so.

The amendment to the federal constitution empowering Congress to pass an income tax law was adopted by the requisite number of states by February, 1913. Therefore, during

'Murray and Carter, Income Tax Practice, page 142 et seq.

practically all of the year 1913 an income tax law was expected. The rates were low and no harm was done. Early in 1916 it was obvious that the necessary "preparedness" expenditures by the United States would call for more revenue. During the entire year, therefore, taxpayers were on notice that higher taxes would have to be levied. The 1916 rates when made effective were not unexpectedly high and taxpayers generally did not complain.

As early as January, 1917, it was evident that the United States would become involved in the war and this carried with it notice to all taxpayers that profits and incomes during 1917 would be taxed at far higher rates than under any previous tax measures since the Civil War. During 1917, therefore, business concerns and individuals were on notice to set aside a very considerable part of their net incomes for the use of the government. There was an almost unanimous acquiescence in this policy. Business men did not deceive themselves as to the cost of the war and no intelligent person expected that the entire cost would be met by bond issues.

It appeared for a time, however, that in 1917 a measure would be adopted which was genuinely and objectionably retroactive. In May, 1917, the House of Representatives passed a measure which levied heavy additional taxes on 1916 incomes. Income tax returns for 1916 had been rendered months before and, relying upon precedent, business men had proceeded to divide and spend much of the balances remaining. Fortunately the measure was defeated in the Senate.

In the case of the 1918 law business men were on notice that the rates would be greatly increased after the address of the President in May, 1918. They were, however, subjected to great inconvenience by the tardy passage of the bill, being unable to make even approximately accurate estimates of their tax liabilities for a considerable period after the end of the calendar year.

Congress has shown an increasing disposition to take ad

vantage of the fact that retroactive income tax laws are legal.1 Taxpayers who are seriously inconvenienced can justly complain that the business interests of the country deserve more attention than has been accorded to them. It is true that retroactive laws can be enforced, but there is some limit to the patience of taxpayers and a repetition of the delay which took place in enacting the 1918 law will not be tolerated.

The Administration of the Law

Organization of the Bureau of Internal Revenue. The administration of the revenue act is placed in the hands of the Commissioner of Internal Revenue, referred to hereafter as the "Commissioner," subject to the general supervision and control of the Secretary of the Treasury. The Bureau of Internal Revenue, referred to hereafter as the "Bureau," as its name implies, is charged with the collection of all federal revenue from inland sources. There are five deputy commissioners and one assistant to the Commissioner, who is authorized to act as a deputy. Income and excess profits taxes are collected through the local collectors of internal revenue, who are also charged with the collection of all other internal revenue taxes. The collectors of internal revenue are the officers who come into the most direct touch with the taxpayers and they are held primarily responsible for the proper collection of the tax in their districts. At present there are some sixtyfour collection districts each with a collector at its head and supplied with a staff of subordinates. In addition there are thirty-one internal revenue divisions with internal revenue agents or supervising internal revenue agents in charge.

"It is the duty of the collector to cause his deputies to proceed through every part of his district, and inquire concerning

"It is clearly perfectly constitutional as well as expedient, in levying a tax upon profits or income, to take as the measure of taxation the profits or income of a preceding year. To tax is legal, and to assume as a standard the transactions immediately prior is certainly not unreasonable, particularly when we find it always adopted in exactly similar cases." (Drexel v. Commonwealth, 46 Pa. St. 31.)

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