The Government Raises Money: Introduction to Some Basic Concepts of Taxes and Taxing Income

The word is out: the United States Government needs money in order to operate. The vast majority of us do want the government to operate and to continue to provide benefits to us. There are many ways in which the Government may endeavor to raise money, only one of which is to tax its own citizens on their income. A few examples follow:

Tariffs: The Government might impose tariffs (i.e., taxes) on imports or exports. To sell their wares in the United States, foreign merchants at one time had to pay very high tariffs. Tariffs would of course protect domestic producers of competitive wares who did not have to pay such tariffs. However, this hardly helps domestic consumers of products subject to a tariff because they must either pay an artificially inflated price for an import or a higher price for a (lower-quality?) domestic product. Export duties could also have a pernicious effect. They encourage domestic producers to endeavor to sell their goods at home, rather than in foreign markets where they might have made more profits. Article 1, § 9, cl. 5 of the Constitution provides: “No Tax or Duty shall be laid on Articles exported from any State.” Notice: import tariffs are a cost that mostly the buyers and sellers of the products subject to them alone pay. Furthermore, the economic interests of different regions of the country are hardly uniform. The cotton-exporting southern states early on preferred low tariffs while northeastern manufacturing interests preferred the protection that high import tariffs provided. See generally, Douglas A. Irwin, Clashing over Commerce: A History of US Trade Policy (2017) (recounting history of import tariffs in the United States). The burden of paying for Government is not spread very evenly if tariffs are the means of raising revenue to support the Government. Nevertheless, tariffs were the most important source of revenue for our country’s government in its early days. This is not nearly so true any longer.

Government Monopoly: The Government might choose to enter a business and perhaps make competition in that business unlawful. Most states have lotteries that they run with no competition other than what they are willing to tolerate, e.g., low-stakes bingo games that charities operate. One argument favoring this means of financing government is that there is no compulsion to buy lottery tickets, i.e., willing buyers contribute to Government coffers. Many non-purchasers derive benefits from lottery proceeds at the expense of those willing to give up some of their wealth in the forlorn hope of hitting it big. Governments may also engage in other businesses. For example, some states own the liquor stores that operate within its borders. Governments may charge for services that they provide (e.g., access to parks) with a view to making profits that are spent in pursuit of other government objectives. There is always the risk that the Government might not be very good at running a particular business. Government-operated airlines are notorious money-losers. And again, why should consumers of certain products or services be saddled with the burden of paying for a government that (should) benefit(s) all of us?

Taxing Citizens: Instead of trying to raise money only from consumers of particular goods or services, Government may endeavor to spread the burden more evenly by taxing its citizens or residents. It may perhaps try to tax non-citizens or non-residents as well. This raises the question of what it is government should tax – or more formally, what should be the “tax base.” There are various possibilities.

The Head Tax: A head tax is a tax imposed on everyone who is subject to it, e.g., every citizen or resident, every voter. The tax is equal in amount for all who must pay it. A head tax has the advantage that it is only avoidable at a cost unacceptable to most (but not all) of us: leave the country, renounce one’s U.S. citizenship, surrender the right to vote. Its relative inescapability assures that most of those who derive some benefit from the existence of a government help to pay for it. A head tax of course has an obvious drawback. Its burden falls unequally on those subject to it. Some persons might hardly notice a head tax of $1000 per year while others might find such a tax to be an insurmountable hardship. Surely, we as a society have a better sense of fairness than that. With one notable exception, we hear very little of head taxes in the United States.

The notable exception was the poll tax that some southern states in the post-Civil War era imposed as a condition of exercising the right to vote. The very purpose of such a tax was to discourage recently emancipated and almost uniformly poor Black persons from exercising their constitutional right to vote. The unfairness of the relative tax burdens associated with this cost of voting led to adoption of the 24^th Amendment to the Constitution, which made poll taxes unconstitutional.

Consumption Taxes: As the name implies, consumption taxes tax consumption. There are different variants of consumption taxes. Three important consumption taxes are the sales tax, the excise tax, and the value added tax (VAT).

Sales Tax: A sales tax is a tax on sales and is usually a flat percentage of the amount of the purchase. Sellers usually collect sales taxes at the point of sale. Many states and localities rely on a sales tax for a substantial portion of their revenue needs. Sales taxes are relatively easy to collect. By their very nature, sales taxes are not collected on amounts that citizens or residents save. Hence, their effect is more burdensome to persons who must spend more (even all) of their income to purchase items subject to a sales tax. While such taxes are nominally an equal percentage of all purchases, their effect is regressive (infra). Those who must spend all their income on items subject to a sales tax pay a higher percentage of their income in such a tax than those wealthy enough to be able to save some of their income.

Excise Taxes: An excise tax is a sales tax that applies only to certain classes of goods, e.g., luxury items. Excise taxes on luxury items may be politically popular, but those excise taxes do not raise much revenue because they are avoidable. The demand for luxury items is usually highly elastic (see text box, The Ramsey Principle). Excise taxes on high-demand (arguably) non-necessities, e.g., cellular telephones, raise much more revenue. Tourist-destination states find excise taxes on services that out-of-state visitors are more likely to purchase than residents to be attractive, e.g., renting cars, staying in hotels, visiting tourist sites. There is nothing quite so politically attractive as making someone who cannot vote in state elections fill the state’s coffers.

Value Added Tax: This tax is imposed on all sales, not only the sale to the ultimate consumer, i.e., it is imposed at every stage of production of a product. The seller pays the VAT to the government minus whatever tax the seller was assessed upon acquiring the unfinished good. Thus, the tax base is only a purchaser’s actual additions to the value of a product. The final consumer does not resell the product, and so pays a VAT on the full cost of the item. Many European countries favor a VAT, often in combination with an income tax.

A Progressive Consumption Tax: As we shall see infra from our discussion of the Schanz-Haig-Simons concept of income, it is quite possible for Government to collect a tax on consumption once per year instead of incrementally upon each and every purchase. We could simply use the information that we already collect or can easily begin collecting. We now know what an employee-taxpayer’s total wages are; every taxpayer who works for an employer receives a W-2 wage statement. If a taxpayer saves a portion of her earnings, the saving or investment institution could report resulting increases to a taxpayer’s total savings or investment. Similarly, such institutions could report the total amount of a taxpayer’s withdrawals from savings or investments. A taxpayer’s total consumption for the year would be her income minus increases to savings or investment plus withdrawals from savings or investment. Importantly, the tax on such consumption could be made progressive, i.e., the rate of tax increases as the amount of a taxpayer’s consumption increases (infra).

Wealth Taxes: We could tax wealth. There are two common forms of wealth taxes: estate taxes and property taxes. The estate tax is imposed on the estates of decedents and the amount of the tax depends on the size of the estate. Property taxes are imposed on taxpayers because they own property. Municipalities often rely on property taxes to raise the revenues they need. Notice that in the case of property taxes, the taxing authority can tax the same “wealth” again and again, e.g., every year. This is quite unlike an income tax, infra. The burden of wealth taxes falls upon those who hold wealth in the form subject to tax. Both persons subject to the tax and those not subject to the wealth tax may reap its benefits.

Income Tax: And of course we could tax income. We recognize that this is what the United States and several states do. In the pages ahead, we examine the federal income tax. We describe just what we mean by “income,” i.e., the tax base. It might not be what you expect. We also describe the adjustments (i.e., reductions that are called “deductions”) we make to the tax base and the reasons for these adjustments. An income tax is difficult to avoid: a citizen or resident must have no income in order not to be subject to an income tax. Thus the burden of income taxes should be spread more evenly over those who derive benefits from government activities than the burden of other taxes.

Far more persons will be subject to the Code’s rules year after year than will be tort victims or defendants, parties to a contract dispute, or victims of crime – although many persons reading these lines consider those topics much more important to their legal studies and eventually their legal careers. Such persons may be right, but they might be surprised at how much the individual income tax will affect their practices for the simple reason that the individual income tax affects the lives of nearly all Americans. Federal taxation is about money. Those who claim that they will avoid tax issues in their practices will find that they work for and with people who do care about money, and they will find that avoidance of tax issues can make for some less-than-satisfied clients and colleagues.

Notice that in the accompanying box (“The Tax Formula”), there is a line. We frequently refer to this as “the line.” The figure immediately beneath the line is “adjusted gross income” (AGI). In a very rough sense, § 62 deductions are for obligatory expenditures or for deferring income that will be subject to income tax at a later time of consumption. Subtractions may be “above the line” or “below the line.” Taxpayer is entitled to § 62 deductions irrespective of and in addition to itemized deductions or the standard deduction.

When a subtraction is “below the line,” what happens above the line might be very relevant. The Code limits certain itemized deductions to the amount by which an expenditure exceeds a given percentage of a taxpayer’s AGI. For example, a taxpayer’s deduction for medical expenditures is only the amount by which such expenditures exceed 10% of a tax-payer’s AGI. Congress can use such a limitation to do some customization of such deductions. A 10%-of-AGI-floor on deductibility of medical expenses provides some rough assurance that the amount of a medical expense deduction requires a common level of “pain” among high- and low-income taxpayers.

A credit reduces the taxpayer’s tax liability dollar-for-dollar. The credit is usually a percentage of some expenditure that the taxpayer made. Some credits are “non-refundable.” This means that they cannot reduce a taxpayer’s tax liability to less than zero. Other tax credits are “refundable,” i.e., they can reduce a taxpayer’s tax liability to less than zero in which case the Government will pay the taxpayer the excess. You can see that a refundable credit functions as a Government benefit program because the taxpayer’s right to payment does not depend on owing the Government any money.

Assignment: Go to IRS.Gov, then to “1040 and Schedules 1-6.” Print these forms. Then go to “Other 1040 Schedules.” Print Schedule A. Examine these forms and notice they implement the “tax formula” described in the text box.

A regressive tax is one where the percentage that taxpayers pay decreases as their income increases. A flat tax is one where the percentage that taxpayers pay is equal at all income levels. Some flat taxes are regressive in effect, e.g., a flat sales tax imposed on the purchase of necessities, supra.

Effective tax rate: Because we have a progressive rate structure, not every dollar of taxable income is taxed at the same rate. Moreover, income derived from some sources is taxed differently than income derived from other sources. For example, an individual taxpayer’s “net capital gain” (essentially long-term capital gains plus most dividends) is taxed at a lower rate than her ordinary income. It may be useful for policy-makers to know what certain taxpayers’ “effective tax rate” is, i.e., (amount of tax)/(total income).

Marginal Tax Rate: A taxpayer’s marginal tax rate is the rate at which the next (or last) dollar is taxed. Because we have a progressive rate structure, this rate will be greater than the taxpayer’s effective tax rate. Among the reasons that the marginal tax rate is important is that it is the rate that determines the cost or value of whatever taxable-income-affecting decision a taxpayer might make, e.g., to work more, to have a spouse work outside the home, to incur a deductible expense, to accept a benefit that is excluded from her gross income in lieu of salary from an employer.

Deductions from Taxable Income: Congress permits taxpayers who spend their money in certain prescribed ways to subtract the amount of such expenditures from their taxable income. A deduction reduces income otherwise subject to income tax. Hence, the person who gives her time to work for a charity may not deduct the fair market value (fmv) of the time because taxpayer would not otherwise be taxed on the fmv of her time.

Credits against Tax Liability: A taxpayer may be entitled to one or more credits against her tax liability. The Code allows such credits because taxpayer has a certain status (e.g., low-income person with (or without) children who works), because taxpayer has spent money to purchase something that Congress wants to encourage taxpayers to spend money on (e.g., childcare), or both (e.g., low-income saver’s credit). The amount of the credit is some percentage of the amount spent; usually (but not always) that percentage is fixed.

Income Phaseouts and Deduction Caps: When Congress wants to reduce the income tax liability of a lower-income taxpayer for having made a particular expenditure but not the income tax liability of a higher-income taxpayer who made the same expenditure, it may phase the benefit out as a taxpayer’s income increases. Congress may also limit (i.e., “cap”) the amount a taxpayer may deduct. An example of both a phaseout and a cap is § 219, the deduction for interest paid on “qualified education loans.” The maximum deduction for such interest is $2500. § 219(b)(1). Section 219(b)(2) reduces the cap by a percentage that increases as a taxpayer’s “modified adjusted gross income” increases above an amount indexed for inflation. When the percentage reaches 100%, taxpayer may not deduct any amount for paying qualified education loan interest. Consider: what is the profile of a taxpayer who would benefit most from deducibility of student loan interest and what is the profile of a taxpayer that would benefit least?

Congress can apply phaseouts and caps to both credits and deductions. The precise mechanics and income levels of various phaseouts and caps differ. Income phaseouts and caps increase the complexity of the Code and so also increase the cost of compliance and administration. They can make it very difficult for a taxpayer to know what her effective tax rate is – as any change in AGI or deductions effectively changes this rate. Income phaseouts are a tool of congressional compromise. Perhaps Congress is so willing to enact income phaseouts because there are many inexpensive tax preparation programs available to taxpayers that perform all necessary calculations.

The Internal Revenue Code appears at title 26 of the United States Code. It is the law that Congress passed and that the President signed (unless there was a veto over-ride). The first part of your statutory supplement includes some of these provisions. The second part of your statutory supplement includes some of the regulations that the Department of the Treasury has promulgated. These regulations construe the Code. The Code provisions appear in your supplement without any reference to title 26, e.g., “sec. 61.” Regulations are denoted as “Reg.” The regulations that we study begin with a “1,” followed by the Code section that they construe. Each regulation is numbered according to the sequence in which Treasury promulgated it. Reg. § 61-8 is the eighth regulation that Treasury promulgated that construes section 61.

We will be studying only certain portions of the Internal Revenue Code. You should learn the basic outline of Code provisions that establish the basic income tax. This will give you a good hunch of where to find the answer to particular questions. Some prominent research tools are organized according to the sections of the Code. Specifically –

§§ 1 and 11 establish rates;

§§ 21-53 provide credits against tax liability;

§§ 55-59 establish the alternative minimum tax;

§§ 61-65 provide some key definitions concerning “gross income,” “adjusted gross income,” and “taxable income;”

§§ 67-68 provide rules limiting deductions;

§§ 72-91 require inclusion of specific items (or portions of them) in gross income;

§§ 101-139G state rules concerning exclusions from gross income;

§§ 141-149 establish rules governing state and local bonds whose interest is exempt from gross income;

§ 152 defines who is a “dependent;”

§§ 161-199A establish rules governing deductions available both to individuals and corporations;

§§ 211-223 establish rules governing deductions available only to individuals;

§§ 241-250 establish rules governing deductions available only to corporations;

§§ 261-280H deny or limit deductions that might otherwise be available;

§§ 441-483 provide various rules of accounting, including timing of recognition of income and deductions;

§§ 1001-1021 provide rules governing the recognition of gain or loss on the disposition of property;

§§ 1031-1045 provide rules governing non-recognition of gain or loss upon the disposition of property, accompanied by a transfer and adjustment to basis;

§§ 1202-1260 provide rules for defining and calculating capital gains/losses;

§§ 1271-1288 provide rules for original issue discount.

These are (more than) the code sections that will be pertinent to this course. Obviously, there are many more code provisions that govern other transactions.

Take this illustration one step at a time. You may not grasp all its details early in the semester. Its purpose is to show some of the Code’s “moving parts” and their inter-relatedness. We apply the rates that Congress enacted for 2018.

Bill and Mary are husband and wife. They have two children, Thomas who is 14 and Stephen who is 10. Bill works as a manager for a large retailer. Last year, he earned a salary of $80,000. His employer provided the family with health insurance that cost $14,000. Mary is a school administrator who earned a salary of $85,000. Her employer provided her a group term life insurance policy with a death benefit of $50,000; her employer paid $250 to provide her this benefit. Their respective employers deducted employment taxes from every paycheck and paid each of them the balance. In addition to the above items, Bill and Mary own stock in a large American corporation, and that corporation paid them a dividend of $500. Bill and Mary later sold that stock for $10,000; they had paid $8000 for it several years ago. Bill and Mary have a joint bank account that paid interest of $400. Bill and Mary paid $4300 for daycare for Stephen. They also paid $3000 of interest on a student loan that Bill took out when he was in college. What is Bill and Mary’s tax liability? Assume that they will file as married filing jointly.

How much are Bill’s employment taxes? How much are Mary’s employment taxes?

• Answer: Employment taxes are 6.2% for “social security” and 1.45% for “Medicare.” The total is 7.65%. The tax base of employment taxes is wages. So:

• Bill: Bill’s wages were $80,000. 7.65% of $80,000 = $6120.

• Mary: Mary’s wages were $85,000. 7.65% of $85,000 = $6502.50.

• Answer: Since Bill and Mary will file jointly, we pool their relevant income figures. Employment taxes do not reduce Bill and Mary’s gross income. Thus, they must pay income taxes on at least some of the employment taxes that they have already paid.

• Bill and Mary must include the following: Bill’s salary (§ 61(a)(1)) of $80,000; Mary’s salary (§ 61(a)(1)) of $85,000; dividend (§ 61(a)(7)) of $500; capital gain (§ 61(a)(3)) of $2000; interest income (§ 61(a)(4)) from the bank of $400. TOTAL: $167,900.

• Bill and Mary do not include the amount that Bill’s employer paid for the family’s health insurance (§ 106)(a)), $14,000, or the amount that Mary’s employer paid for her group term life insurance (§ 79(a)(1)), $250. Bill and Mary certainly benefitted from the $14,250 that their employers spent on their behalf, but §§ 106 and 79 provide that they do not have to count these amounts in their “gross income.”

How much is Bill and Mary’s adjusted gross income (AGI)? See §§ 221 and 62(a)(17).

• Section 221 entitles Bill and Mary to deduct interest on the repayment of a student loan. While the couple paid $3000 in student loan interest, § 221(b)(1) limits the deduction to $2500.

• Section 221(b)(2) requires the computation of a phasedown. Section 221(b)(2)(A) provides that the deductible amount must be reduced by an amount determined as per the rules of § 221(b)(2)(B). Section 221(a)(2)(B) establishes a ratio. Section 221(f) requires that the IRS keep the ratio up-to-date by indexing. Every year, the IRS announces in a revenue procedure the values to be used when a relevant Code provision requires indexing. For tax year 2019, the § 221(b)(2)(B) amount for taxpayers married filing jointly is $140,000. Rev. Proc. 2018-57, 2018-49 I.R.B. 827, at § 3.30.

• Since Bill and Mary are married filing a joint return, § 221(a)(2)(B)(i) establishes a numerator of: $167,900 – $140,000 = $27,900.

• Section 221(b)(2)(B)(ii) establishes a denominator of $30,000.

• The ratio that § 221(b)(2)(B) prescribes is $27,900/$30,000, i.e., 0.93.

• Section 221(b)(2)(B) requires that we multiply this ratio by the amount of the deduction otherwise allowable, i.e., $2500 and then reduce $2500 by the resulting amount. $2500 x 0.93 = $2325. $2500 – $2325 = $175.

• Section 62(a)(17) provides that this amount is not included in taxpayers’ AGI.

• Thus: Bill and Mary’s AGI = $167,900 – $175 = $167,725.

How much is Bill and Mary’s “taxable income”? See § 63.

• We are told of no deductions that would be “itemized,” so Bill and Mary will elect to take the standard deduction. This is another figure indexed for inflation. For tax year 2019, it is $24,400. Rev. Proc. 2018-57, 2018-49 I.R.B. 827, at § 3.16.

• The standard deduction for taxpayers who are married and filing jointly is $24,400.

• Do the math: $167,725 MINUS $24,400 equals $143,325 of “taxable income.”

How much is Bill and Mary’s income tax liability? See §§ 1(a, h, and j), 1222(3 and 11).

• Answer: Remember, not all income is taxed alike. Long-term capital gain and many dividends are taxed at a maximum rate of 20%. § 1(h)(1)(D) and § 1(h)(11). Bill and Mary received $2000 in long-term capital gain and $500 in dividends. Bill and Mary’s taxable income will be greater than $78,750 and will not be greater than $488,500, so this portion of their taxable income will be taxed at the rate of 15%, i.e., $375. See Rev. Proc. 2018-57, 2018-49 I.R.B. 827, at § 3.03.

• Do you see the progressiveness in the brackets?

• Total tax liability = $375 + $22,698.50 = $23,073.50.

Are Bill and Mary entitled to any credits? If so, what is the effect on their income tax liability? See §§ 21 and 24.

• Answer: Section 21 provides a credit on a portion of up to $3000 for the “dependent care” expenses for a “qualifying individual.” Stephen is a “qualifying individual,” § 21(b)(1)(A). Thomas is not a “qualifying individual,” but Bill and Mary did not spend any money for Thomas’s “dependent care.” The credit is 35% of the amount that Bill and Mary spent on such care that is subject to a phasedown of 1 percentage point for each $2000 of AGI by which Bill and Mary’s AGI exceeds $15,000, down to a minimum credit of 20%. § 21(a)(2). Bill and Mary may claim a tax credit for dependent care expenses of 20% of $3000, i.e., $600.

• Bill and Mary may also claim a “child tax credit” for each of their children. § 24(a). Both Thomas and Stephen are “qualifying” children. § 24(c)(1). Section 24(h)(2) provides a $2000 credit for each of the children. There will be no phasedown of the credit because Bill and Mary’s “modified adjusted gross income” does not exceed $400,000. § 24(h)(3). Total credit: $4000.

• Total tax credits = $600 + $4000 = $4600.

• The effect of a tax credit is to reduce taxpayers’ tax liability – not their AGI or “taxable income.” $23,073.50 minus $4600 equals $18,473.50.

What is Bill and Mary’s effective income tax rate?

• Answer: Bill and Mary’s federal income tax liability is $19,023.50. Their effective tax rate computed with respect to their “adjusted gross income” is $18,473.50/$167,725, i.e., 11.01%.

• Notice that we could use a different income figure to determine their effective tax rate, e.g., “gross income,” “gross income plus exclusions,” “taxable income.” We have included employment taxes in this determination.

What is Bill and Mary’s marginal tax bracket?

• Answer: 22%. You should recognize this as the multiplier that we obtained from the tax table.

• Question: If Bill and Mary made a deductible contribution of $1, how much would this save them in federal income tax liability (if they itemized their deductions)?

• 22% of the amount they contributed, i.e., $0.78.

• Question: If the neighbors paid Bill $1000 to paint their house, how much additional federal income tax liability would Bill and Mary incur?

• 22% of the additional income that Bill and Mary received, i.e., $220.

Think of statements of tax law and their authoritative weight as a pyramid. As we move down the pyramid, the binding power of these statements diminishes. Moreover, every statement noted on the pyramid must be consistent with every statement above it. Inconsistency with a higher statement is a ground to challenge enforcement.

A private letter ruling is legal advice that the IRS gives to a private citizen upon request (and the fulfillment of other conditions). These rulings are binding on the IRS only with respect to the person or entity for whom the IRS has issued the letter ruling. Publication of these rulings is in a form where the party is not identifiable. While not binding on the IRS with respect to other parties, the IRS would hardly want to establish a pattern of inconsistency.

Other statements of the IRS’s position can take various forms, e.g., technical advice memoranda, notices. These statements are advisory only, but remember: the source of such advice is the only entity who can act or not act on it with respect to a taxpayer.

The United States has adopted an income tax code, and the discussion now zeroes in on the statute that Congress has adopted and some policy issues it raises. The policies give rise to certain principles (see accompanying text box).

Fairness and Equity: Issues of fairness as between those who must pay an income tax arise. If two taxpayers have equal incomes, a reduction in one taxpayer’s taxable income reduces that taxpayer’s income tax liability. If the government is to raise a certain amount of money through an income tax, a reduction in one taxpayer’s tax liability necessarily means that someone else’s tax liability must increase. Thus, reduction of some taxpayers’ tax liability is a matter of concern for everyone else. The government may choose to discriminate in its assessment of tax liability. The policy considerations that justify reducing one taxpayer’s tax liability but not another’s are the essence of tax policy.

Three Guiding Principles: This leads us to observe that there are three norms against which we measure income tax rules:

1. Horizontal equity: Taxpayers with equal accessions to wealth should pay the same amount of income tax. Like taxpayers should be taxed alike. Of course, we can argue about which taxpayers are truly alike.

2. Vertical equity: Taxpayers with different accessions to wealth should not pay the same amount of income tax. Unlike taxpayers should not be taxed alike. Those with more income should pay more and pay a higher percentage of their income in taxes. Income tax rates should be progressive.

3. Administrative feasibility: The tax system only applies to persons who have incomes. The rules should be easy to understand and to apply – for both the taxpayer and the collection agency, the Internal Revenue Service.

We may think of “income” as the amount of money we receive for working at a job or for investing money that we have saved. However, if we wish to tax alike all taxpayers whose situations are alike, our notion of income must expand. Surely two workers whose wages are the same should not be regarded as like taxpayers if one of them wins $1M in the state’s lottery. The difference between these two taxpayers is that one has a much greater capacity to consume (i.e., to spend) and/or to save than the other. This suggests that pursuing the policies of horizontal and vertical equity requires that we not limit the concept of “income” to the fruits of labor or investment. Rather we should treat the concept of “income” as a function of both spending and saving. The economist Henry Simons propounded this very important definition:

Derivation of the same formula is also attributed to Georg von Schanz and to Robert Murray Haig. We may refer to this formula as the Schanz-Haig-Simons formula, the Haig-Simons formula, or the SHS formula. The SHS formula reflects that a taxpayer who receives income can either save (invest) or spend it.

If Algebra or Economics Scare You –

The algebra inherent in the SHS formula is not as daunting as might appear. The phrase “rights exercised in consumption” merely reflects what a taxpayer spent (or would have spent if she received something for which she did not have to pay) to purchase something. The phrase “additions to the storehouse of property rights” merely reflects a taxpayer’s saving money, perhaps by depositing some of her income in a savings account or in a more sophisticated investment.

The SHS definition is an (enormously convenient) “algebraic sum.” If it is true that:

(Income) = (Consumption) + (Additions to the store of property rights)

then it is equally true that

(Income) – (Additions to the store of property right) = (Consumption).

This point is quite useful to those who (believe that they) want the government to tax consumption rather than income, perhaps because they believe that those who save rather than spend will pay less in taxes than they do under the current system or that saving is more worthy than spending. The algebraic quality of this definition assures that no matter what our tax base is, we would never have to bear the expense or endure the inconvenience of keeping track of what we individually spend on consumption. Anyone who has received a W-2 from an employer or a 1099-INT from a bank knows that we can expect an employer or a bank to provide the pertinent information about wages or savings with an acceptable degree of accuracy. From this information, a taxpayer can determine what she spent on consumption by manipulating the SHS formula as above. When a(n odd) question arises outside the ambit of W-2s or 1099s, e.g., whether a taxpayer should include in her taxable income the value of a meal that she does not have to purchase for herself, we simply adjust an element of the formula, and that adjustment will require an adjustment of at least one other element of the formula. Income, consumption, and savings are functions of each other.

Some Obvious or Not-so-Obvious Implications of the SHS Definition of “Income”

If we choose to tax what we spend and what we save during a particular time period, then in some manner we are taxing only increments to a taxpayer’s overall well-being. Our tax code demands an annual accounting and assessment even though this can be inconvenient – and even inaccurate – for some taxpayers. What happens during the year is treated as an increment to what happened before, e.g., we added to a savings account that we already had, we consumed (only) a small portion of an asset we already own. We are not taxing accumulated wealth – property taxes and estate taxes do that. A concept integral to our income tax is “basis,” and its function is to measure what happened before and to assure that our income tax does not tax accumulated wealth but only increments to it.

A. Taxing Income Is Taxing Consumption Plus Increments to the Power to Consume

Focus for now only on additions to “the store of property rights” that a taxpayer may accumulate during a relevant period and not on the consumption element of the SHS definition. Taxing a taxpayer’s increments to savings and investment is equivalent to taxing additions to taxpayer’s unexercised power to consume. Taxation of income is therefore the taxation of consumption and additional increments to the power to consume.

People save money only if they value future consumption more than current consumption and believe that they can spend their savings on future consumption. Congress may encourage taxpayers to save for later consumption by not taxing the income that taxpayers willingly – and provably – save for certain items of consumption, e.g., saving for retirement through individual retirement accounts (IRAs) or “401(k)s.”

B. Income, Consumption, and Value

In fact, buyers try to purchase items at prices less than they value them. The excess is “buyer surplus.” Sellers try to sell items at prices higher than those at which they are willing to sell them. The excess is “seller surplus.” “Buyer surplus” plus “seller surplus” equals “cooperative surplus.” The cooperative surplus that buyer and seller create may or may not be shared equally – in fact there is no way to determine with certainty how they share the surplus. Those buyers or sellers with more market power than their counterparts – perhaps they have a monopoly or a monopsony – may capture all or almost all the cooperative surplus. Nevertheless, every voluntary transaction should increase the overall wealth of the nation, i.e., the sum of the values we all place on what we have.

We assume that taxpayers who voluntarily enter transactions know best what will increase surplus value to themselves, and that the choices each taxpayer makes concerning what to buy and what to sell are no concern of any other taxpayer. The Internal Revenue Code, insofar as it taxes income, assumes that all taxpayers make purchasing choices with income that has already been subject to tax. Indeed, § 262(a) reflects this by denying deductions to taxpayers for purchases of items for personal consumption, including expenditures for basic living expenses. The statement that an expenditure is “personal” implies a legal conclusion concerning deductibility. If the money used to purchase items for personal consumption is subject to income tax, as a matter of policy the choices of any taxpayer with respect to such purchases should be unfettered. This observation supports not taxing the money taxpayer spends to make purchases that she has no option not to purchase.

If the choices of buyers and sellers concerning what to buy and what to sell are matters of self-determination, then their choices should theoretically generate as much after-tax value as possible. A “neutral” tax code will tax all income alike, irrespective of how it is earned or spent. In theory, such “tax neutrality” distorts the free market the least and causes the economy to create the most value possible. We recognize (or will soon recognize) that the tax code that the nation’s policy-makers, i.e. Congress, have created is not neutral. Rather, we reward certain choices regarding purchase and sale by not taxing the income necessary for their purchase or by taxing less the income resulting from certain sales. Such deviations from neutrality cost the U.S. Treasury because they represent congressional choices to forego revenue and/or to increase the tax burden of other taxpayers who do not make the same purchase and sale choices. Such deviations of course take us into the realm of tax policy.

Deviations from neutrality can ripple through the economy. They cause over-production of some things that do not increase the nation’s wealth as much as the production of other things would. We tolerate such sacrifices in overall value because we believe that there are other benefits that override such foregone value. When deviations are limited to transactions between two parties who can negotiate the purchase and sale of an item or benefit only from each other, e.g., employer and employee, one party may be able to capture more of the cooperative surplus for itself than it otherwise might. An employer might provide a benefit (e.g., group health insurance) to its employees, reduce employee wages by what would be the before-income-tax cost of the benefit, and pocket all the tax savings. Such capture might be contrary to what Congress intended or anticipated.

Basis – Or Keeping Score with the Government

We tax only increments to consumption and saving during a particular period – not what came before. The tool by which we assure that “what came before” is not taxed is “basis.” While the Code specifically defines “basis” and “adjusted basis,” the concept of “basis,” as frequently used in this text, is that it is a means of keeping score with the government. A taxpayer’s score is the amount of after-tax income a taxpayer has invested – or is credited with having invested – in an asset that will not again be subject to income tax.

Section 61(a)(3) informs us that a taxpayer’s “gross income” includes gains derived from dealings in property. Intuitively, we know that a gain derived from a dealing in property is the price at which taxpayer sells property minus the price that she paid for the property. Section 1001(a) instructs us how to determine the measure of gains derived from dealing in property. Subtract “adjusted basis” from the “amount realized,” i.e., the amount of money and the fair market value of any property received in the transaction. The subtraction of “adjusted basis” assures that its amount is not subject to income tax. The purchase of something from a taxpayer’s after-tax “store of property rights,” to the extent that it is not for consumption, represents only a change in the form in which taxpayer holds her wealth. It does not represent an addition to wealth and so does not fall within the SHS definition of “income.” It should never again be subject to income tax lest we violate the first of our guiding principles by taxing twice the income necessary to purchase the item.

SHS Accounting for Spending Savings

Another implication of the SHS conception of income is that we might have to follow taxpayer’s after-tax money into or out of her store of property rights and/or her expenditures on consumption. If a taxpayer takes money from savings and spends it on instant gratification so that she acquires no asset in which she has an adjusted basis, intuitively we know that she does not have any income on which she must pay income tax. The SHS definition of income accounts for this by an off-setting decrease to taxpayer’s store of property rights and increase in rights exercised in consumption.

Borrowing Money

A taxpayer who borrows money may use that money either to exercise a right of consumption or to increase her store of property rights. In either case, SHS might provide that taxpayer has realized income. However, an obligation to repay accompanies any loan. This obligation counts as a decrease in taxpayer’s store of property rights. Hence, the addition to income is precisely offset by this decrease in the value of taxpayer’s store of property rights. Incidentally, the Code nowhere states that loan proceeds are not included in a taxpayer’s gross income.

AND: taxpayer may use loan proceeds to purchase an item for which she is credited with basis, just as if she had paid tax on the income used to make the purchase. Doesn’t this seem to violate the first principle of income taxation noted above? No. Taxpayer will repay the loan from future income that will be subject to tax. Taxpayer pays for her basis with money to be earned and taxed in the future. Repayment of loan principal is never deductible. Sometimes the cost of borrowing, i.e., interest, is deductible.

In the pages ahead, we examine various topics concerning income tax. In all cases, try to fit them into the principles described in this chapter. Hopefully, the text will provide enough reminders to make this a relatively easy task.

1. A major issue in recent presidential campaigns has been whether the income tax on high income earners should be increased or decreased. Can you think of any standard by which to determine the appropriate level of progressivity in the Code?

2. The more progressive the Code, the greater the “upside-downness” of deductions. How might this be a good thing? What would be the advantage of granting tax credits instead of deductions or exclusions?

3. What are phaseouts? Why would Congress enact them? How do they affect a taxpayer’s effective tax rate?

4. Taxpayer received a tax-free benefit, perhaps a gift from a company that wanted to increase its business. Why must taxpayer have a fmv basis in the item?

5. If taxpayer receives a benefit but has no choice regarding its consumption – the manager of a lighthouse must live with his family in the lighthouse – should taxpayer be taxed on the value of the benefit? Why or why not?

6. Taxpayer owned some commercial property. Taxpayer recorded the property on its corporate books at a certain value. Over the course of several years, the value of the property fluctuated up and down. Taxpayer did not pay income tax on the increase in the property’s value. Why should taxpayer not be permitted to deduct decreases in the property’s value?

Can you explain or define –

• tax base, deductions, exclusions, income phaseouts

• tax formula, credit against tax

• progressive tax rates

• marginal tax rates

• upside-down nature of deductions and exclusion

• right-side up nature of tax credits

• employment taxes

• the Tax Code, regulations, revenue rulings, revenue procedures, private letter rulings

• tax disputes and the Tax Court, the Court of Claims, and the Federal District Court

• tax norms of horizontal equity, vertical equity, and administrative feasibility

• Schanz-Haig-Simons definition of income and its elements

• three guiding principles of the income tax

• tax expenditures

• income tax treatment of personal expenditures (§ 262)

• tax neutrality, distortion

• basis

• tax treatment of loans