§ 6. The Practical Working of the Income Tax

In considering the actual operations of the income tax during the Civil War period, attention should be directed to three fundamental points: First, what was the interpretation put upon the provisions of the law by the administrative officials? Second, what was the fiscal significance of the tax as compared with the total revenues? And third, what were the shortcomings of the system?

The interpretation of the law was chiefly the work of the commissioner of internal revenue. His decisions were in most cases final, and but little recourse was taken to the courts. Amid the manifold decisions, attention will here be directed only to a few of special importance. So far as concerns the question of what constitutes income, it was decided at an early period that legacies are not income, but that gifts of personal property made ante mortem should be so considered. In the same way, amounts received on lifeinsurance policies were not deemed income,3 while, on the other hand, the premiums paid on life-insurance policies

1 The decisions began to be published in 1865, in a volume entitled The Internal Revenue Recorder and Customs Journal. With the second volume (July, 1865) the name was changed to the Internal Revenue Record and Customs Journal. The most convenient summary of the decisions up to 1870 will be found in the Internal Revenue Statutes now in force with Notes referring to all Decisions of the Courts and Departmental Rulings, Circulars, and Instructions reported to October 1, 1870. By Orlando F. Bump, New York, 1870, pp. 283-305. A shorter summary will be found in Foster and Abbot, A Treatise on the Federal Income Tax under the Act of 1894. Boston, 1895. For the instructions, forms, regulations, etc., see Charles F. Estee, The Excise Tax Law, appearing July 1, 1862; and all the Amendments, together with the Instructions and Blank Forms, Decisions, and Regulations of the Commissioner, with full Marginal Notes and References. The first edition of this was published in 1863. Cf. also a similar work of A. A. Redfield, A Hand-Book of the United States Tax Law, with all the Amendments, comprising the Decisions of the Commissioner of Internal Revenue together with Copious Notes and Explanation. New York, 1863, and in subsequent years; and Boutwell's work mentioned supra, p. 430, which was issued in various editions.

23 Internal Revenue Record, p. 133. This will hereafter be referred to as I. R. R. 37 I. R. R., p. 59.

were not allowed as deductions. When, however, an individual received an annuity, the payment of the legacy or succession tax on the annuity did not relieve the annuitant from liability to income tax on the annuity. The salaries of state officials were at first declared liable to the income tax,2 but this decision was later on reversed by the courts, and the salary of a judge of a state court was subsequently declared not liable to income tax.3

So far as exemptions were concerned, it was held that husband and wife were to be regarded as members of the same family, although living apart, unless separated by divorce or other operation of the law, so as to break up the family relationship. Minor children and parents were also to be considered members of the same family, whether living together or not.1 In reference to deductions, the most important questions arose under the head of losses, repairs, and depreciation. Although losses incurred in the prosecution of one kind of business might be deducted from the gains in another, assessors were warned to be especially careful not to allow such deductions when in reality they should be regarded as investments or expenditures; 5 and it was held, furthermore, that no deduction should in any case be allowed for depreciation in the value of stocks or other property unless they were actually disposed of, and a loss realized." Repairs, moreover, were sharply distinguished from permanent improvements. The increased value given to a building by permanent improvements was to be charged to capital, not to income account. Repairs were interpreted to include only those improvements which served merely to prevent the property from becoming useless or depreciating in value, and repairs were not to be confused with betterments. Under these and similar rulings, the laws gradually acquired a more precise meaning, and the number of cases submitted for the

7 2 I. R. R., p. 61; 5 I. R. R., p. 130; 7 I. R. R., p. 758.

decision of the commissioner of internal revenue began to decline.

In the second place let us consider the fiscal results of the tax. The income tax law, as in fact the whole code of internal revenue, was very slow in producing results. An entirely new machinery had to be created, and it took some time before this machinery got into working order. One of the strongest arguments for the permanent retention of the internal revenue system by the federal government was precisely this delay in securing any returns. It is entirely probable that had an internal revenue system existed, even in skeleton, at the outbreak of the war, the financial history of that period would have been very different, and we should have been spared the necessity of using legal tenders with their train of disaster and annoyance until the resumption of specie payments. Because of the absence of any such machinery, it was several years before the income tax yielded its normal revenue. The collections in 1863 were, in round numbers, only about two millions; in 1864, about twenty millions; while they increased in 1865 to thirty-two millions, and reached in 1866 the sum of almost seventy-three millions.1 The large figures of 1866, however, were due not only to the increased rates, but to the rise of prices which attended the inflation of the currency. In 1867 the revenue fell to sixty-six millions, due in part to the contraction of the currency, but also in part to the fact that after the war was over the payment of the tax did not appeal so strongly to the patriotic, motives of the citizens. In 1868 the revenue fell to forty-one millions, owing to the decrease of the rates, while after the law of 1870 went into operation the revenue fell to nineteen millions in 1871 and to fourteen millions in 1872.

To the income tax proper, including the tax on dividends. and interest of corporations and the tax on salaries, there ought really to be added the tax on the gross receipts of corporations. This was not considered a part of the income

1 For a full statement of the returns, see appendix at the end of this chapter.

tax because in law gross receipts are distinguishable from income. But in reality the tax on dividends and interest was a tax on the income of the security holder, although stopped at the source, while the tax on gross receipts was supposed to hit the ability of the corporation itself. In most of the foreign income taxes at present the tax, as we know, is imposed upon incomes both of individuals and of corporations, even though in some cases an arrangement is made to avoid double taxation by taxing personal incomes from corporate securities only on the surplus over a certain percentage. These taxes on gross receipts amounted to about three and a half millions in 1864, and reached the maximum of over eleven millions in 1866. Even without the gross receipts tax, however, the income tax was a very important part of the whole system of internal revenue. In 1866 when the income tax, as we have seen, yielded about seventy-three millions, the total internal revenue was about three hundred and eleven millions. The income tax thus produced a little less than one-fourth of the entire revenue. While the proportion was not quite so high in the other years, it did not differ very materially. As a fiscal expedient, therefore, the income tax must be declared to have been in its prime a decided success.

The various states, of course, contributed very unequally to this result. New York, for instance, paid about one-third of the entire tax, its percentage ranging in the successive years from about twenty-nine to thirty-nine per cent. Next came Pennsylvania and Massachusetts, which paid respectively from thirteen to fifteen per cent, and from ten to fourteen per cent. Then followed at a respectful distance Ohio, with four to eight per cent; Illinois, three to six per cent; New Jersey, three to five per cent; and California, three to five per cent.1 In considering these figures it must be remembered that the returns from the southern states were utterly insignificant in the early years because of the war, and in the later years because of the devastations caused by 1 The exact figures will be found in table III at the end of this chapter.

the war. The same caution applies to the number of persons assessed. The figures in reference to this were not published until 1867, and from this period up to 1870 the number of persons assessed varied from 254,000 to 276,000.1 After the great increase of exemptions and the increasing leniency of administration in 1870, the numbers fell to 74,000 and 72,000 in 1871 and 1872.

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When we come to inquire as to how far the income tax was really successful in reaching the incomes that ought to have been assessed, we enter upon a rather difficult field of inquiry. During the years that the war was in progress it is reasonable to assume that the tax was levied with comparative success. We must not forget the very optimistic statement of Morrill quoted above; 2 and even if allowance be made for so rose-colored a view, the tax cannot be considered a failure. After the war was over, however, the situation changed considerably. Senator Sherman, indeed, tells us that the machinery of the law worked more successfully from year to year. But unfortunately his testimony is contradicted, not only by the diminution of the yield in the face of increasing wealth and population, but also by the common repute in which the tax was held. Frauds and evasions multiplied on every hand until in the closing years the honest taxpayer almost became the laughing-stock of his fellow citizens - a situation quite comparable to that which, as we have seen, is found in Italy to-day. Before, however, proceeding to analyze the reasons for this failure, it must be stated, in common fairness, that the federal income tax, notwithstanding all its imperfections, crudities, and ensuing frauds, was nevertheless more successful than the general property tax in the separate states. Let us test this by taking its fortunes in a typical state, utilizing the returns of the state comptroller and the federal officials.

The special income tax of 1865 was levied at the rate of five per cent on all incomes. Its yield in New York state 1 For the detailed figures as to these, see table II at the end of this chapter.