Tax CreditsPast Experience and Current Issue s

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Foreword

Greater use of tax policy to help i nachieving nonrevenue goals or in solvin gsocial and economic problems has oftenbeen proposed in recent years . Thesesuggestions for supplying "tax incen-tives " in the form of tax credits haveprompted considerable discussion . Pro-ponents believe that tax credits can beeffective in more actively involving theprivate sector in desirable economic an dsocial activities . Other observers doub tthe desirability of using tax credits tohelp solve specific problems, such as th eunderemployment and lack of job skill sin urban and rural poverty areas .

Tax credits have been used to a limitedextent by different levels of governmen t

( in this country, to accomplish severalspecific objectives . This study review sthis experience and provides back -ground for an evaluation of the efficacy

of tax credits . Emphasis is primarily o nFederal tax credits designed to influ-ence action in the private sector. Tosome extent, however, the discussion i salso relevant to the use of such creditsby state and local governments, as, fo rexample, the granting of a credit againststate taxes for taxes paid to local govern-ments .

Guenter Schindler, Senior ResearchAnalyst, had primary responsibility fo rdrafting this study .

The Tax Foundation is a private, non -profit organization founded in 1937 toengage in non-partisan research an dpublic educa .̀ion on the fiscal and man-agement aspects of government . It serve sas a national information agency for in-dividuals and organizations concerne dwith government fiscal problems .

TAI► FOUNDATION, INC .

November, 1969

Table of ContentsPAGE

I. INTRODUCTION 5

II. EXPERIENCE WITH TAX CREDITS 7

Tax Credits Designed to Remedy Inequities 7

Tax Credits Designed to Influence Resource Allocation 12

1) By Influencing the Behavior of Governments 12

2) By Influencing the Behavior of Individuals and Businesses 1 6

Tax Credits Used by States 18

III. PROPOSED TAX CREDITS FOR STATE AND LOCAL TAXES 20

Tax Credits as Alternatives to Federal Grants 21

IV. THE MONEY COST OF CREDITS AND OTHE R

"TAX EXPENDITURES" 22

V . PROPOSALS FOR NEW USE OF CREDITS 24

Tax Credits to Achieve Nonrevenue Objectives 25

VI . MERITS AND DEMERITS OF TAX CREDITS 27

Arguments in Support of Tax Credits 27

Arguments Against Tax Credits 28

VII. SUMMARY 3 1

VIII. APPENDIX : TAX CREDIT PROPOSALS IN CONGRESS 33

List of TablesTABLE

PAGE1. Death Tax Credit 132. "Tax Expenditures " and Regular Spending by Function 22

3. Credits against Federal Income Taxes 23

I.Introduction

Recent discussions suggest that in -creasing attention will be given to ta xinducements to help in dealing wit hsocial and economic problems . Underdiscussion, for example, are proposedtax credits to be given to business fo rmore active involvement in direct at -tacks on poverty, both rural and urban .

A tax credit is an allowance agains tthe amount of tax payable . A credit mayserve any of several purposes. Becauseit obviously benefits the taxpayer, a ta xcredit can influence individuals andcompanies to alter their actions . Theymay do more or less of something, o rundertake something quite new. Thus ,the tax credit can be a form of what i soften called a "tax incentive ."' The al-lowance can, of course, be tailored todetailed specifications or framed to ap-ply broadly. The amount may be larg eor small in relation to associated magni -tudes .

A rather different use of tax credit semploys theli: instead of deductions orsome other feature of a tax to adjust th efinal burden . For example, the state in -come tax of California allows no per-sonal exemption deduction in computin gtaxable income but permits a marrie dcouple a credit of $50 against tax, Credit scan also serve to prevent multiple bur -

dens when more than one tax law ap-plies to a single tax base.

Tax Credits to PromoteSocial and Economic Goals

In addition to raising money, taxe sfrom time to time have been designed t ohelp in achieving other objectives . FromAlexander Hamilton's first tariff to pro -tect "infant industries" from foreigncompetition, Federal tax policy has oftenbeen directed in part toward the promo -tion of nonrevenue goals . The Employ-ment Act of 1946, for example, repre-sented a commitment by Congress t outilize fiscal machinery to influenceaggregate demand and thereby help i nattaining high-level employment .

Quite another kind of result is ex-pected from many specific taxing provi-sions . Depletion deductions are given toencourage mineral exploration . Taxrates have been steeply graduated toredistribute after-tax income and wealthfor a variety of reasons, one of whic hcertainly has been to keep heavy taxe sfrom worsening greatly the economicposition of lower-income groups .

Government expenditure and loa nprograms have been the major weapo nfor dealing with welfare problems . But,

1 . Some observers object to the term "tax incentives," holding that every tax is to some extent a disincentive ,and removal of the tax burden merely removes an obstace . Nevertheless, the term has apparently gaine dacceptance in standard usage .

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LiX j)loViNiull~ 1' 01 000110111iC 011d ull►t- 1

Il011rC1'ellue purposes ta pe the form of 'special dCclllctiolls, exclusions, exelllp-tlolls, preferential rates, and perhaps th emost powerful as incentives, tax credits .

To distinguish between credits an ddeductions, the 1954 Internal Revenu eCode adopted a uniform style of refer -ring to items to be subtracted from th etux liability as "tax credits," and item sto be subtracted from r ;ross income as"deductions." Per dollar, credits agains ttax are more attractive to taxpayers tha nexclusion or deduction allowances . Fo rexample, the worth of a deduction dif-fers according to the bracket or bracket sfrom which the amount comes, Fou r$600 personal exemption deductions o fit $10,000 family reduce tax by $516 and

Of

_20,000

-2 . jarc said to "collie of} the to p" as one look sat the calculation of taxable income orestate, whereas tax credits "come off th ebottom," the tax itself .

This report attempts to throw light onthe merits and demerits of tax credits a sit possible means of dealing with socia land economic problems . Whine discuss-ing "tax credits, " this report does no tendeavor to coverall ramifications of th elumrevenue aspects of taxation, nor thevariety of tax concessioIls offered . Fo rthe most part, the scope is limited to ta xcredits at the Federal level, and no at -tempt is made to evaluate the relativemerits of the tax credit device accordingto the level of government by which it i sused .

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II.Experience with Tax Credits

Practical experience with the tax cred-it device in this country has been limited .Most earlier tax credit legislation ha seither lost much of its importance or ha sbeen revoked, leaving only a small nurri -ber of measures in effect today . A reviewof the principal tax credit measures call sfor a distinction with regard to th enature and objective of tax credits .

Some of the earlier tax credit lawswere clearly -aesigned to remedy a rea lor imagined horizontal inequity, i .e ., aviolation of the principle that "equal sshall be treated as equal s"—that those inessentially similar circumstances shal lbear the same share of the expense o fgovernment. According to this principle ,when circumstances of taxpayers differin ways that are significant for sharin gthe costs of government, fairness re-quires that tax loads dill.-r . Tax creditsof this nature include the dividend cred-it, the retirement income credit, and th eforeign tax credit .

Another type of tax credit has bee nquite different in nature and purpose ; i tseeks to encourage certain actions whichpresumably would not occur in the ab-sence of the credit . It aims to influencethe allocation of resources by in effec tcreating a horizontal inequity, i .e., bytaxing "equal s" differently depending oncertain conditions. Within this secondcategory a further distinction can b emade between credits designed to alter

the behavior of government units, andthose which would modif \ , the behaviorof individuals or businesses . Credits giv-en by the Federal government agains ttaxes paid to state governments unde rthe estate tax and unemployment insur-ance tax have thus influenced state ta xpolicies . The investment tax credit is themajor example of a tax credit intendedto influence the behavior of individual sor business enterprises, through encour-aging the modernization and expansio nof productive facilities.

Tax Credits Designed to RemedyInequities

1) THE DIVIDEND CREDIT

Before the enactment of the undis-tributed profits tax on corporate earning sin 1936, dividends were totally exemptfrom the normal personal income tax ,but subject to the surtax portion of th eindividual income tax. The rate of nor-mal tax varied from year to year but wa soften around 4 percent. The undistrib-uted profits tax of 1936 made dividend sfully taxable as ordinary income, an dthis practice of taxing dividends wa scontinued even after the undistribute dprofits tax was repealed.

The Internal Revenue Code of 1954introduced a dividend "exclusion" an da tax credit against dividend income .From 1954 to 1963 individuals could ex-clude the first $50 of dividends from

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gross income and take a credit agains tthe total tax other"vlse Bile a111ollilting t o4 perceIlt of dividends received in exces sof $50 . This measure was the result o flengthy discussions and controversy o ndouble taxation of dividend income . Theargll111e11t about double taxation wen tas follows :

Income derived from corporations isessentially taxed quite differently fro mall other income . The corporation itsel fpays corporate income tax on its profits ,and the stockholder pays personal in -come tax on his dividends. These earn-ings are thereby subject to double taxa-tion, once on the corporate level andagain on the individual income level .This conclusion is, of course, based onthe assumption that the corporation in -come tax is not shifted forward in pricesto consumers . There is, however, no as-surance about how much of the tax o ncorporate earnings is passed on to con-sumers . The assumption that the eco-nomic incidence of the Federal corpo-rate income tax is on shareholders ratherthan customers is often a matter of dis-pute .

The need for relief from double taxa-tion clearly depends on the extent towhich there is in fact double taxation ,and this in turn depends on the inci-dence of the corporation income tax ,Traditional economic theory has hel dthat a corporate income tax rests on th ecorporation and is not shifted either for -ward to consumers or backwards toemployees or suppliers . This position hasbeen questioned on both pragmatic andtheoretical grounds and a rather exten-sive literature has developed on the sub-ject. At present there seems to be fairl ylvidespread uncertaiIlty as to the inci -dence of the corporatioIl income tax,

with continued arguments as to whethe ror not the tax is shifted or borne by th eshareholders .'

,

For purposes of this discussion, it i sboth correct and adequate to aSSUI11 ethat dividends paid to individual stock -holders are doubly taxed, both to th ecorporation and to the individual re-cipient .

The dividend exclusion and the ta xcredit for d : vidend income when firs tenacted in 1954 were intended as a par-tial relief from double taxation, The $5 0exemption vas designed to give full re-lief for shall stockholders . It was alsobelieved that the exemption and th ecredit would aid corporations in raisin gnew equity capital, since this tax offse tmakes investment more attractive .

Between 1954 and 1963 the contro-versy over the dividend credit was not somuch over the justification of relief fro mdouble taxation as over the most equit -.11 ;le solution for the achievement of thi sgoal . Different proposals graIlting taxoffset for double taxation of dividend swere coIlsidered. When the tax creditwas enacted in 1954, it was hoped tha tthe rate could eventually be increase dto give more tax relief . However, thedividend tax credit was soon attacked a s

tax "loophole," and its repeal was votedin the Senate in both 1959 and 1960 . Therepeal did not becoIl7e effective unti l1964 . By that time Congress had vote dto reduce the corporate tax by 4 percen tand had grantee' business a new type oftax credit for new investments in pro-ductive capital expenditures .

The maiI1 objection to the dividen dexclusioIl aIld the dividend tax c -edit, i t\vas argued, was that they constituted aI1inequitable means of relieving the dou -

1 . For more discussion of tux incidence 14ec The Cornnrati,m Income Tr,r : An Examination vJ Its Role in th eFederal Tax Syste»t (Ncw York : Tax Foundation, Inc ., 1968), pp, 33-43 .

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He taxation of dividend lncome . 2 Criticsof the dividend tax credit also argue dthat the tax credit gave no relief wher ethere was no double taxation, e .g ., tostockholders not subject to tax, such a spension funds and non-profit organiza-tions .

The 1964 law discontinued the divi-dend tax credit, but increased the "divi-dend exemption " to $100 ($200 for amarried couple) . The exemption is es-sentially a concession to low-incom edividend receiverC. It was hoped that theincrease in dividend exemption wouldencourage a broader stock ownershipamong individuals with relatively lowincomes .

The 4 percentage point cut (8 per-cent) in corporate income taxes grante dby the Revenue Act of 1964 and the ear-lier adoption of the 7 percent investmen ttax credit placed corporations in a bette rposition to raise new equity capital thanunder the investment incentive gener-ated by the dividend tax credit .

(2) THE RETIREMENT INCOME CREDIT

Payments received under the Socia lSecurity Act by retired persons are ex-empt from tax . Persons not elig : , ie forsocial security benefits were f,iven asimilar exemption in 1954 when a specia ltax credit for "retirement income " -wasenacted . As inodified since, the law no wpermits a taxpayer who is 65 years of ag eor over to apply a credit against his ta xliability equal to the amount of his "re-tirement income" up to $1,524, multi -plied by 15 percent or a maximum credi tof $228.60 — $457,20 on a joint return ,".Retirement income " is defined to in-clude pensions and annuities, rents, in-

terest, and dividends, However, to avoidduplication, the law requires that theamount of an individual 's retirement in -come (on which the credit is to b ecomputed) be reduced by social securit yand other retirement benefits which ar eexcluded from gross income for tax pur-poses . Few people now qualify for thi scredit . The retirement income credit hadprimarily been intended as it stopgap toprovide equity until social security cov-erage would become general .

As it tax concession to elderly persons ,the retirement income credit may be sai dto be preferable to the granting of in -creased personal exemptions or a deduc-tion or ('xclusioll from gross incoIne., inthat the credit provides a uniform rat eof benefit to all taxpayers eligible forits use. Thus, no taxpayer, however hig hhis marginal rate of tax, can benefit b ymore than 15 percent of the amount ,with a top of $228,60 . In contrast, if$1,524 of retirement income were al -lowed as a deduction or exclusion, th etax benefit would vary, depending uponthe taxpayer's top bracket rate . The pres-ent credit does, however, discriminat eagainst elderly persons whose incom estill derives, for the most part, fromemployment activities .

In 1967 the Johnson Administratio nrecommended recasting of the specia lprovisions for taxing the elderly . Theretirement credit would have been re -placed, by a special exemption ; Con-gress, however, did not accept the rec-ommendation .

(3) THE FOREIGN TAX CREDITS

Foreign taxes of all types except gif tand inheritance taxes are deductibl e

2. In the political debates on these measures, different ways of viewing tax relief or "equity" brought fort hnumerous alternative computations of the effect of the credit and of the exclusion, leading to conflictin gconclusions about their equity effects . For a fuller discussion, see Dan Throop Smith, Federal Tax Reform(New York ; McGraw-Hill, 1961 ), pp, 215-218 ,

3. This discussion does not deal with the ,Teets of tax treaties,

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from gross income earned abroad whencomputing taxable income of U . S. cor-porations, citizens, and residents withincome from abroad . Included in credit -able foreign taxes are witholding taxe son dividends, as well as the basic tax oncorporate income. The objective of theforeign tax credit is to relieve interna-tional double taxation of income andthereby to remove any impediment tothe flow of international investments .The law allows foreign income taxe s(and taxes in lieu of income), at theoption of the taxpayer, to be credite ddirectly against the U . S. income taxrather than being deducted from gros sincome. In other words, to the extentthat taxes have been paid on foreign in -come, they may be offset against U . S .income tax liability. They thus reducethe U . S. ta:: on foreign income dolla rfor dollar rather than to the smaller ex -tent resulting from deduction in comput-ing income .

The foreign tax credit also serves th epurpose of preserving tax equality underU . S. taxing concepts ; that is, foreignsource income is taxed by the UnitedStates at the same rate as domestic in -come . To tax foreign source income a ta higher rate, of course, would be todiscriminate against such income an ddiscourage foreign investment by U. S.interests .

The foreign tax credit is said to en -courage countries with considerable cor-porate investments from the Unite dStates to raise their tax rates to the ratelevel of the United States. Whenever thetax rate abroad is lower than the U. S .rate—say 30 percent as against our 48percent—a tax becomes due to th eUnited States on the foreign-source in -come at a rate equal to the excess of theU . S . rate over the foreign rate—18 per -

cent in this illustration. By raisiniZ it stax rate, the foreign government can ge tfunds for its treasury at the expense o fthe United States . When the foreign rateequals or exceeds the U . S. rate, thecredit cancels the U .S . tax liability onforeign source income .

The foreign tax credit provision re-flects a concern for achieving fair ta xresults, by avoiding discriminatingly an ddiscouragingly heavy tax burdens, forincome subject to tax in more than on ecountry. In the absence of such specia lprovisions, U . S. citizens and corpora-tions would be fully taxed on foreignincome by both our government and th egovernments of the foreign countries inwhich the income is earned .

When first enacted in 1918, the credi twas allowed dollar for dollar ; but the1921 Revenue Act provided that thetotal credit might not exceed that pro -portion of the U.S . tax which the incomefrom outside the United States bore tototal income. In 1932, Congress enacte da per-country limitation in addition tothis over-all limitation .

The effect of the over-all limitatio nmeant that if a company already operat-ing abroad started operations in anotherforeign country with the expectation o flosses for the first few years, its losse swould be applied against the incomefrom other foreign countries, reducin gthereby the over-all foreign income andwith it the amount of foreign tax whichcould be credited . If the taxes in thecountries where operations were profit -able were substantially the same as th et 1 .S . taxes on the same income befor ethe loss activity was started, total taxesactually paid would be increased . Thisperverse result of the over-all credit le dto its repeal in 1954 .

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It Nvas urged at that time that eac hcompany should have an option to . 1cc teither the over-all or tile PCr-COLllltrN 'limitation . The per-country limitation ,left in the law after 1954, can he restric-tive if rates in some countries are highe rthan in the United States and lower i nothers, or if allocations of income hav eproduced uncreditable taxes in soniccountries . Also, it was argued, sinc emany companies consider all of thei rforeign operations as it single division,all option should be given that woul dpermit taxpayers to compute the allow-able foreign tax credit either on a per -country or on an over-all basis . The lawwas amended effective in 1961 givingtaxpayeI's a one-time option to selec teither the over-all or the per-countrylimitation .

Prior to the Revenue Act of 1962, theincome of controlled foreign corpora-tions was taxed by the United States onl ywhen distributed . A corporation is con-sidered controlled if more than 50 per-cent of its voting stock is controlled b yU. S . persons or companies . A markeddifference resulted in the tax treatmen tof foreign branches as opposed to for-eign subsidiaries of domestic firms . Th eincome of foreign branches was taxe dcurrently, but the tax on the income offoreign subsidiaries was deferred unti lsuch iIlcome was actually repatriatedto the shareholding corporation . Thismeans of postponiIlg tax aroused criti-cism . Moreover, there was growing con -CeI'I1 Dyer the balance of internationa lpayments and criticism of the effects o ntax equity of the use of foreign "taxhavens . "

Before 1962, the accu►nldatcd inconle ~of foreign corporations could solneti►nc sbe converted front ordinary income t ocapital gains at the time of repatriation

through the sale of the stock of the Cor-poration which had canned the foreig nincome . The 1962 act, however, pro-vided that (rains realized by a share -holder owning 10 percent or more of aforci(rn corporation, regardless of thetransactions prior to the repatriation ,would be viewed as dividends . The actalso provided for taxing the full salesprice of a patent, copyright, secret for-mula, or similar item sold by a parentcorporation to a controlled subsidiary isto be taxed as ordinary income .

When a domestic corporation receive sdividends from a foreign subsidiary (ex-cept for a corporation located in a less -developed country) and elects to takethe foreign tax credit, it must "gross up"its tax base. It does so by including notonly the dividends received, but also th eincome tax paid by the foreign corpora-tion oil the earnings from ,'. ,hlch the divi-dends were paid . For example, a U . S .corporation which received $100,000 o fdividends from a subsidiary in a de-veloped country where the tax rat eon net income is 20 percent include s$125,000 in its U . S. gross income an dclaims a tax credit for foreign taxes pai dof $25,000, Prior to 1962 no "gross up"for foreign income tax was required . Ineffect, the law now treats the tax credi titself as something of value to be in-cluded in the hale on which U . S . tax is tobe computed.

The effect of the gross-up provisio ncan be seen in the following illustration ;A United States corporation has a sub-sidiary doing business i, . a foreign Coun-try . 1'hc tax credit under the gross-u prule is computed as follows ;Income earned by subsidiary

ill foreign country

$100.00Foreign Tax (40 r ; rate)

40.00Slll)sidial-\"S net profit after tax $ 60 .00

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U . S . Corporation

Dividend income(from subsidiary)

$ 60.00

"Gross-up" of tax"deemed paid "

40.00

United States taxable income $100 .00

United States tax (52.8% rate)

52 .80

Foreign tax credit

40.00

Net United States tax due

$ 12.80

Total taxes paid of $52 .80 (40.00 +12.80) or an effective tax rate of 52 .8% ,or normal corporate tax rate .

The effects of provisions governing th einvestment tax credit for foreign invest-ment, and the influence on private in -vestment abroad, have occasioned con-siderable discussion . While there is nodenying that the outflows of capitalfunds tend to weaken our alreadystrained balance-of-payments position inthe year in which such outflows occur,these investments do have a positive ef-fect on the balance-of-payments situa-tion in the long run . The income remitte dfrom the foreign earnings of U . S. directinvestments abroad, in the form of divi-dends, interest and branch profits, hav eexceeded the outflow of capital invest-ments in every year of this decade . At thesame time, U . S. exports of capital equip -ment, parts, and components for use an dproduction abroad, have been encour-aged by the flow of private investmentsabroad.

Nevertheless, a major problem nowconcerns ways of preserving tax incen-tives for private investments in less -developed countries without unduly en -

coui aging the outflow of funds to nation swhose development is already advanced .

Tax Credits Designed to Influenc eResource Allocation.

(1) By INFLUENCING THE BEHAVIOR OF

GOVERNNILNT S

(a) The Estate Tax Credit

When the Federal government in 1916enacted an estate tax on the transfer ofproperty at death, several states ha dbeen taxing inheritances for many years .In response to criticism of Federal "en-croachment ," Congress in 1924 provideda credit of 25 percent for state deathtaxes. The estate tax credit was the firs tFederal tax credit . A person liable forFederal estate tax could in effect settl eat first 25, then 80, percent of this ta xwith the receipts for the payment of stateinheritance or estate tax .

Professor Maxwell points out that thi stax credit had several objectives, noneof them sharply defined and some o fthem in conflict . 4 Congress wanted toreduce tax burdens and the Federa lbudget surplus, But some influentia lmembers wanted to keep the death taxwith its progressive rates . By yielding aslice of death tax revenue to the states ,Congress could reduce Federal revenue s(and tax burdens) but retain the ta xwith its graduated rates .

Moreover, the credit would reduce in -terstate competition for wealthy person sand also secure some measure of ta xcoordination and uniformity out o fwidely diverse and complex state deat htaxes. The credit was intended to aidespecially those states which imposedsimi ficant death taxes . The competitionamong; states for wealthy residents wa sgrowing, as a number of states offered

4. James A . Maxwell, Tax Credits and Intergovernmental Fiscal Relations (Washington, D .C . : Brooking sInstitution, 1962), p . 23 .

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themselves as tax havens for the age dwealthy. The Federal estate tax credit ineffect eliminated much of the tax advan-tage that any state was able to offer .

The increase in the credit to 80 per -cent in 1926 obviously decreased theFederal tax revenue . But it also enabledstates to increase their tax receipts byimposing higher inheritance and estatetax rates than some would have at-tempted otherwise . However, a changeat the saIlle time iIl the Federal estatetax exemption from $50,000 to $100,00 0increased the number of estates whichreceived no credit although paying astate tax .

Federal action in offering the creditwas effective in getting all but one stat e(Nevada) to impose an inheritance o restate tax . 5 The tax in most states wa susually, but not always, high enough toabsorb most (up to 80 percent) of th eFederal death tax credit . The only con-dition Congress attached to the credi twas that a state death tax be levied . Thepotential of pushing toward greater uni-formity was largely overlooked, bein glimited to merely an inducement foreach state to maximize the value of th ecredit for its taxpayers . Federal interes tin revenue remained large enough tojustify efforts for strict administratio nNvllich in fact supplemented state efforts .

In 1932, Congress enacted a supple-mentary estate tax to Increase Federa lrevenues, but without increasing thecredit, which was frozen at the 192 6amounts . Consequently, the credit de-clined from 76 percent of Federal tax

Table 1Death Tax Credi t

Size of

Federal tax

Maximum ta xtaxable estate

before credit

credi t

$

40,000 $

4,800

$

0100,000 20,700

560500,000 145,700

12,4001,000,000 325,700

36,5605,000,000 2,468,200

398,32010,000,000 6,088 . 200

1,076,720100,000,000 75,388,200

15,476,400Source : Harvard Law School, World Tax Series, Tax-

ation in the U .S ., Commerce Clearing House ,1963, p . 229 .

liability in 1931 to 10 percent in 1959 .Table 1 shows the pattern of credit tha thas prevailed since 1942 . A 1954 revisionmodified details without altering theamount of credit . 6

The states, under no pressure to ac-complish uniformity, and under growin gpressure to secure more revenue, im-posed death taxes which varied in type ,definition, rate and exemption, so tha tcomplexity and structural disorder re-sulted . Congress has not responded t oproposals that call for the use of thedeath tax credit to bring about greate rhaI niony amoIlg state death taxes .

In the effort to aid states in meetingtheir increased revenue needs, proposal shave been Illade, asking Congress to giv eup Federal estate taxation, thereby leav-ing the death tax to the exclusive juris-diction of the states . Other proposalshave been aimed at increasing the shar eof death tax revenues allowed to state sthrough a greater use of the credit, as asubstitute for — or addition to — som eexisting or projected Federal grants t ostates .?

5. The absence of a death tax in Nevada did not constitute a competitive threat of significant size to otherstates . Wealthy persons could not save their heirs' death tax by establishing residence in Nevada because ,in effect, the tax which Nevada chose not to collect had to be paid, but to the U . S, I reasury ,

6. For further discussion of the death tax credit and for proposals of alternate solutions see Coordination ofState and Federal Inheritance, Estate, and Gift Taxes, Advisory Commission on Intergovernmental Relations(Washington, D .C . : 1961) .

7. Recent recommendations of the Advisory Commission on Intergovernmental Relations, for ex- mple, cal lfor the liberalization and restructuring of the Federal credit for state death tax payments : the ( :ommissio nproposes an alternative Federal credit for state estate tax payments equivalent to 80 percent of the Federa ltax liability on the first $150,000 of the taxable estate and 20 percent of the tax liability on the balance o fthe taxable estate .

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The present system for dividing deat htax revenues between Federal and stategovernments has the disadvantage ofrequiring at least two administrativ edeterminations for each estate that i ssubject to both taxes and likewise, o fincreasing the work for an estate in com-plying with each. 8 However, state scould effectively avoid such doubling u pby generally adhering to Federal defini-tions of the gross estate and allowabl edeductions and providing that final Fed-eral determinations be followed for stat edeath tax purposes. When first enacted ,the death tax credit granted appreciabl etax revenues to some states . However ,presently the death tax credit no longergives substantial relief from Federal tax-ation for estate taxes paid to states . Inview of the rising needs for state rev-enues and the pressure for Federal rev-enues sharing, an increase in death ta xcredits appears as an alternative wort hlegislative consideration .

(b) The Unemployment InsuranceCredit

The Social Security Act of 1935 cre-ated a system of unemployment insur-ance to be administered jointly by theFederal and state governments . Underthis system state funds are built up ou tof which benefits are paid to insure dworkers when they become unemployed .The immediate purpose is to provide th ejobless worker with some financial sup -port . The payment of unemploymen tbenefits also has the secondary effect o fmaintaining purchasing power and cush-ioning the shock of unemployment t othe community and to the nationaleconomy.

Under provisions of the Social Se-curity Act, the Federal government pays

for administrative expenses, enforce scertain minimum standards of adminis-t ration, and serves as repository for th estate funds. The real development of theunemployment in., urance program is lef tup to the states .

The method chosen by Congress t ogive the initial impetus to states fo rlegislation on Unemployment insuranc ewas through the use of the tax credit.The Federal government imposed aFederal unemployment tax of 3 percen tupon the payrolls of employers wit height or more employees . The employe rwas permitted to offset (claim creditfor) 90 percent of the Federal tax ( 1 .7percent of taxable payrolls) for th eamount paid to an unemployment insur-ance system under the laws of the stat ein which he does business .

In this way one of the slain obstacle sto state unemployment compensatio nlegislation was removed . States hadbeen afraid to establish such program sbecause of the belief that home busines swould suffer a competitive disadvantagethrough the failure of otter states tofollow suit .

Under the Federal law, employers i nstates without such programs wouldhave paid the full 3 percent tax to th eFederal government without receivin gany specific benefit from their tax pay-ments . Employers in states whic hadopted an unemployment compensa-tion plan paid only .3 of one percent o ftaxable payrolls to the Federal govern-ment . The remainder of their taxes wen tinto their own state unemploymen tfund .

The use of this tax credit with its at-tendant conditions was successful i nsecuring the creation of state uneIllploy -

8 . Many estates actually pay some death tax to several states ,

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ment insurance programs throughou tthe nation . At the outset, this system ha dconsiderable state-to-state uniformity I nits major provisions, even though rate sand benefits and other regulations wer erecognized state functions . The impor-tance of state control has been stresse dcontinually by experts in this field .

The basic characteristics of thisFederal-state relationship have remaine dsubstantially unaltered for more than 3 0years. The only major changes in th eFederal aspects of unemployment insur-ance are the Increase in Federal tax fro m3.0 to 3.1 percent, and the extension ofthe Federal tax from firms with eight ormore employees to those with four o rmore .

Since 1935 numerous development shave changed the uniform rate of payrol ltax into a variety of rates among indi-vidual firms . All states continue to levya standard rate of 2 .7 percent in order togive their employers the full tax creditallowed under the Social Security Act .However, actual employer tax rates ma ybe above or below that standard rate ,depending upon the employer's employ-ment or benefit experience . The ap-parent differences in tax rates betweenstates result from experience rating laws .Presently all state laws have in effec tsome system of experience rating bywhich individual employers' contribu-tion rates are varied from the standardFederal tax rate (3 .1 percent) on th ebasis of their experience with unemploy -ment risk. This is made possible by aprovision in the Social Security Ac twhich allows employers credit for con-tributions which they have been ex-cused from paving because of thei r"good" unemployment record .

Different formulas are used 1)y' va 2- iousstates for experience rating . Most of

these plans are aliI:e in that they con-sider the employer as being responsibl efor the unemployment of their workers ,which causes a loss to the unemploymentfund. The different unemployment an dmerit rating plans encourage employersto stabilize employment by adjustin grates to the risk of unemployment . Un-employment tax rates are therefore re-duced for those employers whose contri -butions are greater than the benefit spaid on their behalf .

The adequacy of the present system ofunemployment compensation has bee nseriously challenged in recent years . In1965, a far-reaching proposal for basi camendments to the Federal-state unem-ployment insurance system was sub-mitted to the Congress by Presiden tJohnson . This proposal would in effec thave abolished experience rating, whic his a keystone to the present co-operativeFederal-state plan, by providing nationalstandards for benefit and unemploy-ment eligibility . The bill also called forhigher payments and for conformityin unemployment tax rates by graduall ychanging the tax base from the presen t$3,000 to $6,600 . This bill would have ledto a substantial "federalization " of theunemployment insurance system . Thestates and major corporations stronglyopposed the bill as an infringement onstate authority in the area of unemploy-nient insurance. Congress, consequently ,slid not enact the proposed revisions .

The unemployment insurance ta xcredit has served as an ef fective incen-tive for state legislation of unemploy-ment Insurance . Beyond this, the ta xcredit had no further objective . Pro-posals for changes In the unemploymen tinsurance system do not exclude thefui-ther use of this tax credit .

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()) BY INFLUENCING THE, 13I :II :\\ , Iola of

INDIVIDUALS AND BUSINESSE S

(a) The Investment 'lax Credi t

Whereas the estate tax credit, and th eunemployment insurance tax credit in-fluenced the behavioI' of governments ,the objective of the Federal investmen ttax credit was to alter the behavior ofiIldividuals and businesses ,

The investment tax credit was firs tenacted in 196`? . It was designed to en -courage the modernization and expaIl -sion of American industry throug hgreater capital investment in machineryand equipment . It was hoped that in-cI'eased capital investment would pro -duce greater productivity aIld faste reconomic growth, with positive employ-ment results, Greater capital investmentwould help lower unit production costs ,especially since the new equipmen tWould embody the most advanced tech-nolOgy . 0I1e result would be that Ameri-can industr\' would gaiIl a better coin-petitive position in world markets ,

The, Revenue Act of 1962 provide dfoI' a credit of 7 percent agaiIlst tax lia -bility foI' "(lLialified " investment in ne wdepI'eciable machineI'y and equipmen t(3 percent for public utilities), pro-vided that the useful lives of the asset swere 8 years or Illore. With respect tocapital assets with a shorter useful life ,the credit '\vas proportloIlately loweI' .

Applicable portionUseful life

of tax credi t

8 years or more

Total6 yeaI's oI' moI'e

but less than 8 years

Two thirds4 yeaI's of Fibre

but less than 6 years

One third

The investment tax credit applied t oinvestments in "tangible personal prop-erty„ Used for manufacturing, produc-

tion, or extractoIl, of furnishing electri -city, gas, water, of transportation .Capital assets meeting these conditionsare known as "Section 38 Property, " Noteligible for the investment tax credi twere investments in buildings and thei rstructural components, 9

"Section 38 Property " call be new,used, or even leased . The 7 percen tcredit, in no case, could exceed the tota ltax liability . When that tax liability wasin excess of $25,000 the credit colder no texceed $25,000 plus 25 (lateI' raised t o50) percent of the liability in excess ofthat amount during any one year, "New "property is that portion of Section 3 8Property constructed, reconstructed, o re' r'e'cte'd after 1961 . The persoIl claimingthe credit must be the original owner ,if the total amount of credit exceeds th etax liability for any one year durin gwhich the investIllent was Made, th ecredit slay be carried back 3 year's andthen, if not used lip, caIried for\yard 5Years ,

"used" propeIty call qualify for th ecre(lit but only up to a limit of $50,00 0invested per year . This provision wa sintended especially to aid small business ,which often relies relatively heavily onused property . The credit in such c'as(' s\will, of county, illake for higher deman dand better markets for used machinery .

". Leased" property is subject to specia lprovisions. The lessoI' has a choice . Hecan either use the credit himself or pas sit oil to the lessee in effect tIeating th ele'sse'e as the person acquiring the prop-cI'ty. This optioIl is given \\'itli regardOnly to "new" Section 38 Property ,

The Kcimedy administration alined t oencourage the mode'riliz ition and e'xpan-sioli of productive facilities, but it in -

9 . '1 here do, however, qualify for accelerated depreciation under the 1954 law .

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