(2) Graduation by a super-tax is practicable. If it be desired to levy a much higher rate of tax upon large incomes (say of £5000 and upwards) than has heretofore been charged, a super-tax based on personal declaration would be a practicable method.

(3) Abandonment of the system of collection at the source,' and adoption of the principle of direct personal assessment of the whole of each person's income would be inexpedient.

(4) Differentiation between earned and unearned income is practicable, especially if it be limited to earned incomes not exceeding £3000 a year, and effect be given to it by charging a lower rate of tax upon them.

(5) A compulsory personal declaration from each individual of total net income in respect of which tax is payable is expedient, and would do much to prevent the evasion and avoidance of income tax which at present prevail."

Such were the two celebrated reports on the income tax. It was not long before most of the proposals of the two committees were substantially put into practice; but with characteristic English conservatism it was decided to take only one step at a time. Thus it was that some of the reforms were accomplished in the year 1907, and some more in the year 1910. The law of 1907 dealt primarily with the subjects of differentiation and fraud and with certain administrative features; while the law of 1910 took up the topic of graduation and made further attempts to prevent fraud.

§ 7. The Adoption of Differentiation in 1907

In his budget speech of April 18, 1907, H. H. Asquith, the Chancellor of the Exchequer, took up the matter of dif ferentiation. "The income tax," he tells us, "as it is one of the most productive, so it is one of the most delicate parts of our fiscal machinery. There is nothing like it to be found anywhere else in the world." Starting with the important

1 The Parliamentary Debates, 1907, vol. 172, p. 1198.

statement that "it must now be regarded as an integral and permanent part of our financial system," he discussed the theory of the question. Comparing two individuals, one "who derives, we will say, £1000 a year from a perfectly safe investment in the funds, perhaps accumulated and left to him by his father," and, on the other hand, "a man making the same nominal sum by personal labour in the pursuit of some arduous and perhaps precarious profession, or some form of business," he maintained that "to say that those two people are, from the point of view of the state, to be taxed in the same way is, to my mind, flying in the face of justice and common sense." He referred to the unanimous decision of the committee as to the necessity of making a difference between earned and unearned incomes.

"What is an earned income?" asked the Chancellor. "It is not easy to draw a distinction," he answered, "but we can but do our best." He declared that earned incomes included incomes of all officers and employees paid by salaries, including clergymen; of every class of professional men; and of all traders whose income is derived substantially from their own personal labor. He conceded that to distinguish in this third class between incomes which are either wholly earned or partly earned and partly unearned, "means a degree of logi cal precision where there will be the greatest possible difficulty in hindering overlapping in dubious cases." The most practical way of dealing with the problem, therefore, he held, was to confine the differential treatment to earned incomes which do not exceed £2000-not, as the select committee had recommended, £3000. That is to say, the lower rate on earned incomes was to be limited to persons whose total income from all sources does not exceed £2000. The Chancellor suggested for the coming year the full rate of one shilling in the pound as the normal tax on unearned incomes, and the lower rate of 9d. for earned incomes. The benefit of the lower rate was to be granted by abatement, and the abatement in the case of mixed incomes was always to be made from the earned, and not from the unearned, portion.

Taking up next the question of graduation, the Chancellor declared that he was not yet ready for it. "Quite apart from other reasons, it would not be possible, for administrative reasons, to introduce any change in graduation simultaneously with the already sufficiently complicated alterations of a differentiated tax. The machinery would break down under the strain." He stated, however, that he did not desire to announce at that moment any final opinion on the question of graduation.

The law of 19072 adopted the Chancellor's proposals. The rate of income tax in general for the coming year was put at 18., but it was provided that if any individual claimed and proved that his total income from all sources did not exceed £2000, and that any part of that income was earned income, he should be entitled to such relief from income tax as would reduce the amount payable to 9d. A statutory definition of earned income was given,3 and the usual methods followed in the proving of all claims to exemption, relief, or abatement were to apply to this new form of relief. Two points are here to be noted: First, that earned income includes partners' salaries and interest on capital, while profits of a limited or sleeping partner are deemed to be unearned income. Secondly, as soon as a private business becomes a

1 The Parliamentary Debates, 1907, vol. 172, p. 1206.

2 The Finance Act, 1907, 7 Edw. VII, c. 13, part v, secs. 18-28.

3 Earned income is stated to be: (a) Any income arising in respect of any remuneration from any office or employment of profit held by the individual, or in respect of any pension, superannuation, or other allowance, deferred pay, or compensation for loss of office given in respect of the past services of the individual, or of the husband or parent of the individual, in any office or employment of profit, whether the individual or husband or parent of the individual shall have contributed to such pension, superannuation, allowance, or deferred pay or not;

(b) Any income from any property which is attached to or forms part of the emoluments of any office or employment of profit held by the individual; and

(c) Any income which is charged under Schedules B or D in the Income Tax Act, 1853, or the rules prescribed by Schedule D in the Income Tax Act, 1842, and is immediately derived by the individual from the carrying on or exercise by him of his profession, trade, or vocation either as an individual, or, in the case of a partnership, as a partner, personally acting therein. Sec. 19, par. 7.

Sec. 19, pars. I and 6. The claim must be male by Sept. 30.

corporation, the profits change from earned to unearned income. The test whether a given income is earned or unearned may be described as follows: If it is derived from personal labor or from pensions, or from property forming part of the emoluments of office, or from carrying on a business or profession, and the recipient is actively engaged therein and is not protected by limited liability, then such income is earned, otherwise it is unearned.1

The law, furthermore, provided for the carrying out of some of the recommendations of the departmental committee. In the first place, employers are henceforth required to make a return not only of the names and places of residence of their employees, but also of the salaries paid to them.2 Thus was adopted a scheme which, as we shall see later, had long been in vogue in Italy. In the second place, every person is required to make a return of his income, whether or not he is liable to income tax, the penalty for failure so to do being fixed at £5. This provision also follows some of the continental laws. In the case of corporations, etc., the secretary is to make such returns. In the third place the time for making a surcharge or additional assessment is extended to three years. Fourthly, section 133 of the law of 1842 and section 6 of the act of 1865, which deal with the three-year average system in Schedule D, are repealed, and it is provided that when any one who is charged upon the three-year average system proves that his actual profits fall short of the profits as computed according to that system, he shall be entitled to be charged on the former, instead of the latter, basis. If any business is discontinued during the year, the taxpayer shall be entitled to a repayment of the excess, in case he can prove that the total tax paid during the three previous years exceeds the total amount which would have been paid if he had been assessed in each of these years on the actual profits.5 Finally, specific provision is made for

1 E. E. Spicer and E. C. Pegler, Income Tax in Relation to Accounts. 2d ed., London, 1910, p. 19.

2 Sec. 21.

8 Sec. 22.

4 Sec. 23.

5 Sec. 24.

such allowance as the commissioners may think just and reasonable for wear and tear of machinery or plant; and if the deductions for this purpose happen to be greater than the profits for that year, they may be carried on to subsequent years. In no case, however, will such deductions be allowed if they exceed the actual cost of the machinery or plant, including in cost any capital expenditure by way of renewal, improvement or reinstatement.1

Thus, finally, was introduced in 1907 the principle which, almost from the very introduction of the tax at the close of the eighteenth century, had been demanded by numberless critics and reformers. The great change which, as we remember, had been so persistently and successfully opposed by Gladstone, was now definitively accomplished. But it was after all only the entering wedge. As compared with the more highly developed system in the Italian tax, for instance, the distinction between earned and unearned incomes must be considered simply as a first and halting step in the process of differentiation.

Some of the opponents of the change had based their opposition on the old idea of Gladstone that it would obviously interfere with the revenue. These fears, however, proved to be unfounded. The fiscal results, in part, were unexpectedly favorable. Asquith had estimated in his budget speech that the loss due to the introduction of the principle of differentiation would be about two million pounds - one and one-fourth millions due to the effect of differentiation itself, and three-fourths of a million due to delays in collection, in consequence of the change in the law. It turned out, however, that there was virtually no loss at all. In the budget statement of May 7, 1908, which was delivered by Asquith (who had in the meantime become Prime Minister), in lieu of the new Chancellor of the Exchequer, D. Lloyd

1 Sec. 26. This provision was inserted to overrule a court decision to the contrary, in a case that was won by a lawyer, who now, as Chancellor of the Exchequer, was instrumental in undoing his own work. See Spicer and Pegler, Income Tax in Relation to Accounts. 2d ed., London, 1910, p. 72.