Theory meets reality: the case of the double tax on material capital.

In recent years there has been increased interest in the adoption of a consumption tax as a replacement for the income tax. Typically it is suggested that this result be achieved by (1) taxing only wage income, (2) providing a deduction for all investments in material capital, (3) providing an exemption for all investment income, or (4) providing an excise tax on consumption purchases. One of the leading theoretical justifications for making such a radical change in our tax laws has been an embrace of John Stuart Mill's observation that whereas income from capital is taxed twice, once as earned and again as the income from capital is taxed, income from labor is taxed only once, as it is earned. In this article the author conducts an examination of the relative taxation of labor (human capital) and material capital under the Internal Revenue Code (Code) to determine which of these two forms of capital is taxed more advantageously. Measured against the Haig-Simons definition of income and the ideal taxation of income from material and human capital that would be dictated by Haig-Simons, the author demonstrates that, under the Code, the income from neither form of capital is advantaged over the other. The article demonstrates why it is important for analysts to measure their theoretical conclusions regarding laws against the actual laws themselves and not against an artificial construct of the theoretician.

I. INTRODUCTION

Over the course of the last several decades the income tax has suffered more than its fair share of severe criticism. Both liberals and conservatives have rightly attacked the income tax for its complexity. (1) A significant amount of the academic and ideological criticism of the tax has been based on what critics perceive as inherent shortcomings in the basic nature of the income tax in its generally accepted format. (2) After criticizing the income tax for failing to meet their given ideal standard, such critics typically call for a different tax system, often some form of a consumption tax, which the authors promise will remedy their perceived inherent shortcomings of the income tax which they believe to be unworthy for continued use. (3)

In this article I address one classic criticism of the income tax, namely, that unless income from investment capital is exempted from tax, a double tax results for income from investment capital while no such double tax is present for income derived by labor. Although this is theoretically true, we inhabit an existing legal construct in which judgments about the relative tax burdens of income from investments and labor should be made. When the taxation of investment income is compared to the taxation of income from labor under the Internal Revenue Code (Code), it is virtually impossible to argue convincingly that the Code confers an advantage on either form of income over the other. Consequently, the theoretical double taxation of investment income hardly justifies the radical shift to a consumption tax. The problem simply does not exist in reality, at least not to the extent commonly claimed.

Having set forth what I hope to prove in this article, I wish also to state what I do not want to do. It is not my intention to defend our income tax as it exists. Nor is it my intention to dismiss suggestions that we need to increase our savings and investment rates in this country. (4) My intention is to cause the discussion to depart from the field of pure theory and become rooted in the realities of the legal world that we inhabit.

Before commencing a formal discussion, a few informal observations may be in order. The old maxim that familiarity breeds contempt may offer some explanation of much of the discontent with the income tax. Just as a new acquaintance may seem more attractive than an old friend or family member, so also may a new tax spun from whole cloth by a scholar, or a different tax that prevails in a foreign country, seem more appealing than our existing income tax when imagined or viewed from afar. However, before embracing any such new dreams as realities, it is worth pondering the fact that the value added tax, a form of consumption tax that is widely used throughout much of the world, (5) generates, in both the United Kingdom and on the continent, approximately two times as many litigated cases as does the income tax. (6) As in life, just as old friends often prove to be good friends when reality with all its uneasiness and ugliness intrudes, so too can old taxes prove to be good taxes (7) when held up to the tests of the real world.

This article is structured in the following fashion: (1) the Haig-Simons definition of income is explained; (2) the double tax on material capital is explained; (3) using the Haig-Simons definition as a standard, the ideal taxation of income from material as well as human capital is examined; (4) the actual tax treatment, under the Code, of material and human capital is examined for the purpose of comparing the relative tax burdens each shoulders so that a comparison of this may be made with the proper theoretical result under Haig-Simons for the purpose of determining if either form of capital is disadvantaged when compared to the other; and (5) there is a discussion of some of the steps that would have to be taken if a consumption tax were to be adopted, predicated on parity of treatment of material and human capital.

II. DEFINING INCOME

Early economists defined income as a flow of satisfactions. As Professor Seligman put it: "We desire things at bottom because of their utility. They can impart this utility only in the shape of a succession of pleasurable sensations. These sensations are our true income." (8) Most individuals probably lead their lives based on an implicit embrace of this definition of income. For example, job decisions often turn on personal factors other than the wages offered by different employers and the prospects for advancement. Issues such as location in an attractive community, environmental considerations, and a host of other factors all become part of the equation. Moreover, things not specific to location such as good supportive relationships with family and friends as well as good mental and physical health all contribute to an individual's "pleasurable sensations." Because allocating tax burdens based on such immeasurable factors would prove to be an impossible task, economists struggled to develop a definition of income that could provide a practical, objectively measurable base that could be used to determine each individual's income tax liability. Professors Robert Haig (9) and Henry Simons (10) each contributed to what is now the generally accepted definition of income on which virtually all income tax theory is predicated. (In honor of their contributions, it is referred to as the Haig-Simons definition of income.) The definition posited by Professor Simons is: "Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question." (11)

For our purposes, it is important to note several things about the definition and its elaboration by Simons. First, it is irrelevant whether accretions are used by an individual to support consumption or merely added to the individual's store of wealth. Second, all increases in an individual's net worth are counted equally, regardless of whether they consist of items of personal use such as antique jewelry or a piece of property held for rental in a business. (12) Third, under the definition, if an asset increases or decreases in value over a period of time, this change in value should be accounted for regardless of whether the owner disposes of the asset during the measuring period. A decrease in value of a personal use item is generally regarded as consumption of the decline in value. (13)

In point of fact, it would be impractical to require individuals to keep track of and report their consumption and reconcile it with the change in their net worth each year as they filed their income tax returns. As a practical way of reaching Haig-Simons income, Congress has chosen to use each individual's annual inflow of wealth as a tax base and to make adjustments to it as necessary to derive, as accurately as is reasonably practical, the individual's Haig-Simons income. For example, an individual reports his salary as income but is allowed to claim a deduction for alimony or charitable contributions based on the fact that the sums so transferred result in a diminution of his net worth and do not represent consumption by the wage earner but by others. (14) Similarly, one can justify the disallowance of a deduction for investments in business assets on the same basis as one can justify the allowance of a depreciation deduction with respect to wasting business assets. For example, an investor who turns her cash into an asset, that she will use in her business, suffers no immediate decline in her net worth. The decline in net worth with respect to the asset occurs as the asset is used and suffers wear. Consistent with the Haig-Simons definition of income, the investor is not allowed a deduction on her purchase of the business asset, but is allowed a depreciation deduction predicated on its presumed decline in value as it suffers wear and tear in its use in the business.

III. TAXING CAPITAL TWICE