ast week, a federal appeals court in
Washington handed down an important decision relating to the
definition of income for tax purposes. What is important about
the decision is that it is the first one in decades saying that
the Constitution itself limits what the government may tax. If
upheld by the Supreme Court, it could significantly alter tax
policy and possibly open the door to radical reform.
In the case, a woman named
Marrita Murphy was awarded a legal settlement that included
compensation for physical injury and emotional distress. The
former has always been tax-exempt, just as insurance settlements
are. Obviously, it makes no sense to tax as income the payment
for a loss that only makes one whole again. One is not being
made better off, and therefore there is no income. But under
current law, compensation for non-physical injuries are taxed.
Murphy argued that just as compensation for
physical injuries only makes one whole after a loss, the same is
true of awards for emotional distress, as well. In short, it is
not income within the meaning of the 16th Amendment to the
Constitution. The appeals court agreed and ruled that her award
for emotional distress is not income and therefore not taxable.
Tax experts immediately recognized the
far-reaching implications of the Murphy decision for other areas
of tax law. Tax protesters have long argued that the 16th
Amendment did not grant the federal government the power to tax
every single receipt that it deems to be income. Yet in
practice, that is what the Internal Revenue Service does.
The problem is that the very concept of
income itself has never been defined in the tax law. It is
pretty much whatever the IRS says it is. Tax analysts generally
use a definition devised by two economists named Robert Haig and
Henry Simons, which says that income consists of consumption
plus the change in net worth between two points in time.
But the Haig-Simons definition goes far
beyond that in the tax law. Most importantly, it includes
unrealized capital gains. There is also no place in the Haig-Simons
definition for things like 401(k) plans, individual retirement
accounts or other retirement savings, nor for lower tax rates on
realized capital gains.
Under Haig-Simons, owner-occupied homes would
be treated as businesses, with homeowners taxed on the implicit
rent they pay to themselves, less depreciation. And if your
home's value increased over the course of a year, you should pay
tax on that even if you didn't sell your house.
Now, clearly, the IRS is not going to do any
of these things, nor would Congress allow it to do so. But
because tax analysts implicitly accept the Haig-Simons
definition of income, even though it appears nowhere in law,
there has been a long-term tendency for the IRS to push the
limit of what can be considered taxable income. Now, a federal
court has said there is a constitutional limit.
One area where I would like to see the court
go further has to do with the question of whether interest
constitutes income. To economists, some portion of the interest
we receive on our savings is merely compensation for loss --
loss of the immediate enjoyment we would receive if we consumed
our income today instead of saving it.
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 say that was OK.
Collectively, our willingness to put off consumption today for
greater consumption in the future is what determines the pure
rate of interest.
But in the view of many great economists,
such as John Stuart Mill, the future interest one receives is
merely compensation for the loss of immediate satisfaction.
Therefore, it is not income, but more like an insurance
settlement that simply makes us whole. Now, obviously, market
interest rates are more than simply a discount between present
and future, as my example implies. A lot represents a return to
risk and an adjustment for expected inflation. But in principle,
some portion of interest is compensation for loss and therefore
Given the logic of the Murphy decision, it is
quite possible that the risk-free, inflation-adjusted rate of
interest could also be excluded from taxation on constitutional
grounds. Following through that logic consistently would
revolutionize taxation and eventually lead to a pure consumption
tax, which most economists today favor.
I'm not predicting that the Supreme Court
will follow this logic. But it does open an interesting
possibility that tax analysts will follow with interest.