hold that capital value represents capitalized income, that the value of an investment is equal to the present discounted value of the expected earnings from the property. Capital value increases or decreases with the increase or decrease in expected income. Income discounted at the market rate of interest is capital value. The relation of income and capital is that of cause and effect. An income tax is undoubtedly levied on the cause, but can it be levied also on the effect? If there is an increase in income, the addition, as such, would unquestionably be taxable as income, but may also the consequent increase in capital be counted as income and be subject to an income tax?

The general view just expressed may be illustrated. Suppose A had real estate that had cost him $100,000 and, on that basis, had brought a net rental of $8,000 a year. Assume then that rentals have doubled and promise to continue at $16,000 a year. On this basis the property is worth $200,000, and it has this actual value to the owner whether it is sold or not. There can be no question that the increase in rental from $8,000 to $16,000 a year is additional income and subject to tax, but is the consequent increase in capital value from $100,000 to $200,000 also to be counted as income?

Under the law, such increase in capital value is not taxable until realized through sale or exchange for other property, but does this limitation have any real bearing on the issue? Suppose A sells for $200,000; all he can do is to reinvest, and on ordinary investments will again receive an income of $16,000 a year which would be taxable. It is because of this doubled income that he has a double capital value. The income tax as such would reach the additional income, but would leave intact the resulting increase in capital.

It is true that A has increased his net worth by $100,000, but this is due to the fact that he has increased his income from $8,000 to $16,000 a year. If the additional income is taxed, A pays his full burden from the standpoint of an income tax. If, however, he is taxed also on $100,000 of the value of his investment, he is taxed on capital and not on income. Moreover, if he is taxed on the $100,000 increase in capital the government encroaches on his investment and reduces his future income. After paying the taxes at prevailing rates, he would only have $160,580 to reinvest instead of $200,000 for which he sold the property. His new investment, therefore, at 8% would bring only $12,846 a year instead of the previously established income of $16,000 a year.

The tax on the increase in capital value is a capital tax and not an income tax. Its result is to reduce capital and to diminish the future taxable income. If the increase in income is taxed as income, the corresponding increase in capital value cannot be taxed also as income.

It may be urged that the purpose of the income tax is to tax people on the basis of their ability to pay, and that the increase of $100,000 in A's net worth represents such an increase in ability. It is true that the income tax law is designed to tax according to ability, but ability may be measured in one of two ways: (1) according to income, or (2) according to capital. The sixteenth amendment provides for the taxation of income and not of capital. A's ability to pay was measured in the first instance by $8,000 a year with the capital value of $100,000, and then by $16,000 a year with the capital value of $200,000. The tax should rest, therefore, upon the income and not also upon the resulting capital value.

The issue may be approached also from the standpoint of changes in price level to show that an increase in capital value is not income. Since 1914, prices in general have doubled, so that the present equivalent in money income, or money capital, is twice that of 1914. Suppose, then, that A's property was worth $100,000 in 1914 and brought $8,000 a year; then to maintain the equivalent at the present time it must be worth $200,000 now and bring $16,000 a year in income. If he sells and is taxed for the $100,000

so-called profits, obviously he is left worse off than in 1914, and the government has seized some of his capital and has left him a smaller relative income than he had before.

The change in price levels is, of course, the chief factor affecting increases in investment value since 1913, from which date the so-called profits on the sales of capital assets are computed. During this period, in practically all cases, the sale of investments has resulted in so-called profits, and the tax on the amounts has resulted in diminishing the individual's future income and reducing his actual capital. The matter, however, should be viewed not only from the taxpayer's standpoint, but also from the viewpoint of the government. The purpose, of course, has been to tax the nation's income and not something else, but if we count as income the increase in capital value that has taken place since 1913 because of the shifting in price levels, we are manifestly pulling ourselves up, as a nation, by our bootstraps. By this procedure we count not only the nation's actual income from the operation of its farms, factories and industry, but we count also the general increases in property values that have followed the rise in price. levels. We count as income the effect of price levels upon capital values and thus cut into our actual capital.

The analysis set forth, I believe, is entirely in accord with general accounting practice. In any event, however, it is the primary function of the accountant to determine what are the facts and then record them according to suitable classification. If the increase in capital assets is not income, the accountant will have no difficulty in showing this fact, as he would be able to show the increase as income if it were properly so counted.

The general purpose of accounting may be stated to keep a record of investment and income. My belief is that very few accountants would include in the income statement of a period profits realized from the sale of investments or capital assets. Such profits would almost invariably be credited to surplus and not to income account. The latter would include gains realized through operation of plants and other returns from business assets, but it would not include any adjustment in the value of capital items.

The practice just described of crediting so-called profits realized on the sale of capital assets to surplus and not to income is followed in the various classifications of accounts prescribed by the interstate commerce commission in the case of the railroads and other public utilities under its jurisdiction. It is carried out, also, I believe, by all the classifications of the various state public utility commissions and would be accepted by most competent ac

countants.

In ordinary business, the terms "income" and "profits" are used loosely, and there is, in such use, no guide in the present issues. The ordinary business man understands little of accounting, and there could be no serious purpose to base accounting classifications upon the ordinary business man's views. We have to deal in accounting and economics with technical matters which should be determined from a scientific standpoint and not according to loose every-day usage of terms.

I agree fully with the editorial view that the broadest possible interpretation should be given to the term "income," leaving determination of the forms of income to be considered by congress. But shall we go so far as to change the entire purpose of the sixteenth amendment? Shall we stretch the meaning of income to include capital, and shall we levy a capital tax under the term of "income tax"?

These are far-reaching questions, and I firmly believe that it is much better policy to stick to an income tax until we actually decide upon a capital levy. These matters fortunately can now be squarely placed before the supreme court of the United States in passing upon the Brewster case and similar cases now pending.

The editorial in question was reprinted by the New York Evening Post, and a reply to the editorial from Mr. Bauer was published in that paper. The substance of Mr. Bauer's letter to the Evening Post was practically the same as that of his letter to THE JOURNAL OF ACCOUNTANCY.

Following the publication of Mr. Bauer's letter in the Evening Post a communication from George O. May was printed in that paper, and as it deals with the matter comprehensively we reproduce his comments:

Referring to the editorial article on the case of Brewster against Walsh, which you recently quoted from THE JOURNAL OF ACCOUNTANCY, I believe Judge Thomas felt constrained by decisions of the supreme court to hold that profits on the sale of investments were not income. Inasmuch, however, as your correspondent, Mr. Bauer, suggests that such a decision is also required by sound economic principles, it may be permissible to discuss the question on its merits, ignoring for the moment the effect of any past legal decisions.

Approaching the question in this way, I would like to suggest:

(1) That even economists are by no means all agreed in the support of the position taken by Mr. Bauer.

(2) That the best opinion among those qualified to express opinions, apart from the economists, would not support the position that increases in capital assets are never income. And

(3) That the injustice and other evil consequences that would ensue from such a ruling would be far greater than could flow from the opposite decision.

In considering this question it must always be borne in mind that it is not the wisdom of taxing such profits, but the right to tax them, which is involved. The sixteenth amendment gave congress the right to tax incomes from whatever source arising: the plural itself is suggestive. Certainly the amendment does not seem to contemplate any abstract but rigid economic concept as the limit to be placed on congress, nor does it specify the group of economists whose interpretation shall prevail.

It must also be remembered that there is a converse to the proposition, and that if increments of capital are in no circumstances income, decrements of capital cannot be allowed to enter into the computation of income. If, therefore, a machine is employed for ten years in the production of an article and then sold as scrap, the net income would require to be computed without any allowance for the difference between the cost and the scrap value of the machine.

Furthermore, increments and decrements of capital may arise from different causes, involving materially different considerations; these may conveniently be illustrated by the cases of:

(a) The rise in value of a bond bought at a discount between the date of purchase and maturity, or, conversely, the decline of a bond bought at a premium.

(b) The rise or fall in value of a bond due to a fall or rise in interest rates.

(c) The rise or fall in the value of a plant due to a general change in price levels.

If the question whether profits from appreciation of capital assets should be treated as being sometimes or always income were referred to a conference, in which in addition to economists there would be representatives

of accountants, actuaries, bankers, bond buyers and business men generally, I think there would be practical unanimity among all except the economists in favor of the proposition that increments or decrements in class A, including all those due to conditions inherent in the form of investment, are both in theory and practice in the nature of income, and I believe this proposition would find very considerable support from the economic group; indeed, at the recent meeting of the American Economic Association at Atlantic City I found that there was at least a very respectable body of economic opinion in favor of the view that all increases of capital assets are income.

Turning to class B-appreciations or depreciations representing increase or decrease in exchange value due to external causes—I think a wide range of opinion would be found to exist, with a middle group suggesting that in theory whether appreciation or depreciation should be included in computations of income might depend on the motive of the taxpayer; that is to say, whether he was buying primarily as an investor for the sake of annual income or as a speculator or trader.

In the case of increments or decrements of the third class-changes in money value of an asset due solely to a change in the value of money and not containing any element of increase or decrease in exchange value-I think a majority would probably agree that in theory such increments or decrements did not enter into the determination of income, and that if it were possible to segregate them they should be excluded from the operations of an income tax.

If, then, the body should proceed to make concrete recommendations, I believe it would hold that it was impossible to administer an income tax on a basis which would require the treasury department to determine the motives of taxpayers and analyze the causes of every appreciation or depreciation of a capital asset. It would also, I believe, hold that it was better for the commonwealth that a few taxpayers should be taxed on profits which theoretically might contain an element of increase of capital rather than that it should be put in the power of congress to determine income without any deduction for the exhaustion of capital necessarily involved in the production of income.

Holding these convictions, I shall share the regrets of THE Journal of ACCOUNTANCY if now, after hundreds of thousands of transactions have taken place, and hundreds of millions of taxes have been paid under a law taxing profits on the sale of capital assets, and allowing losses on such sales as a deduction from taxable income, the supreme court shall feel constrained on legal grounds to hold such a law unconstitutional.

If I could be privileged to attend such a conference as I have mentioned, I should be tempted to remind it of the testimony before the British royal commission on income tax of Dr. J. C. Stamp, who combines a grasp of theory, practical experience and broad common sense in an extraordinary degree. In his testimony he suggested that—

"The wanton and bigoted way in which persons obsessed with certain mathematical ideas urge the sacrifice of all practical points to their lust for algebra would be a serious public danger if their influence became great."

I would suggest, more mildly, that it would be unwise to attach undue weight to the insistence of certain economists on the line of fundamental distinction they would seek to establish between capital and income, especially as the fundamental difference most apparent to the lay observer is the difference in views among the economists themselves.

We question Mr. Bauer's view that not a single economist holds that "whatever is spent is ipso facto income," but we would

point out that in our editorial we merely said that those who would approve the decision would include any such economists. Certainly there is a considerable number of economists who hold that whatever is not spent is not income. It would seem to follow, therefore, that whatever is spent is, in their view, income. "Are savings income?" is, we believe, a favorite topic of debate among economists.