About Those Income Taxes...

What is income?

Why is this question important? This is more than a simple academic matter. It dramatically impacts your life in many ways. One of those ways is how much you pay in income taxes.

Let’s take a look at the 16th Amendment to the Constitution.

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Tax protesters have long held that the government has no authority to levy income taxes, but this amendment that was ratified in 1913 should make it clear that this argument is false. Disclosure: I once worked for the IRS and have had a fair amount of exposure to many different facets of income taxation, including protest arguments. Of course, some laws and regulations have changed since I left the agency.

OK, so the government can tax any kind of income. But economist Bruce Bartlett points out in this National Review article that income has never been defined in federal tax law. That means that the definition of income has largely been left to the IRS. Unsurprisingly, the agency tends to maximize the definition of income, thereby, maximizing the amount of tax you pay. Since the legislators have left the definition of income to the bureaucrats, there is no legal limit to what can be included in income.

That may be changing. Bartlett cites a recent federal appeals court ruling that says that there is a constitutional limit to what can be included in income. The court ruled that legal settlements for emotional distress are not income, but only compensate the recipient for real, less tangible losses. In effect, such a settlement merely returns the recipient to her/his previous position, much as does an insurance payout for a more tangible loss.

Bartlett asserts that this ruling logically leads to other elements currently included in income that also simply return the recipient to his/her previous position. Interestingly, he mentions interest. (OK, bad pun.) Interest (or at least part of it) is merely compensation for the loss of immediate use of your money. It also helps defray the diminution of the value of your principle due to inflation during the investment period. Bartlett argues that interest is really about the same as an insurance reimbursement.

“Think of it this way. Would you be satisfied receiving your paycheck a year from now instead of on payday? Of course not. You would be suffering a real loss if you had to wait a year to get paid for your work. But if you were offered, say, 10 percent more in a year, you might be okay with this. Collectively, our willingness to put off consumption today for greater consumption in the future is what determines the pure rate of interest.”

This is an interesting thought exercise for economists, but it must be realized that this cuts both ways. My employer has become very pro-active in showing employees the value of non-monetary compensation (i.e. benefits) that it pays on behalf of the employee. Many of these items are currently excluded from income that could probably be considered taxable under a strict interpretation of the term. Of course, it should also be realized that making interest tax free would encourage saving, which is in short supply in our society.

Rather than leave this up to the courts to determine, it would be better for income to be legally defined via the normal legislative process where citizens can have input. Unless the issue becomes a crisis, however, I have little hope that anyone in Congress will become sufficiently exercised about the issue to actually formulate a proposal to fix it. Both chambers of the body are too busy mucking around with stuff that really should have nothing to do with the federal government to worry about such mundane things. A mailer stating, "I sponsored bill XXX that defined the term income," probably won't garner many votes.