What Is Income?

The United States, like nearly all countries, has an income tax. What is an income tax? It’s a tax on income. What is income? That’s actually a very hard question.

The question comes up in a recent report by ProPublica on the taxes that very wealthy Americans pay (I’m not going to link to it, because the data was likely illegally obtained, and almost certainly immorally obtained, but you can easily find it). What’s really interesting is that never define income, but they do have an implicit definition which includes changes in net wealth. More on this later, but it does raise an important question under an income tax: what exactly should count as income?

For most wage and salary workers, income is fairly straightforward. It’s the compensation that your employer pays you in exchange for your labor services. Easy enough. There are some wrinkles. For example, most non-cash compensation is not considering income for tax purposes. And even some cash compensation, such as contributions to retirement plans, are not considered income. Still, pretty straightforward.

But what if you own a business? It gets a little more complicated. We could define your income as all of the money you receive when you sell goods and services to your customers. But that has a few problems. Let’s say you run a restaurant. You sell burgers for $5. Should you pay income tax on every $5 burger you sell? Keep in mind that you probably had $4.50 in expenses to sell that burger. You bought the beef, buns, and condiments. You paid your workers. You paid to “keep the lights on” (that’s how small business owners refer to utilities and other overheard). So our income tax system will only tax you on the $0.50 difference, which we usually call profit (in some years, of course, businesses have costs that exceed their sales revenue, in which case they owe no income tax).

Now for the really hard question: what if most of your income is derived from assets that you own? That’s where things get even more complicated, and both legal and philosophical questions come up.

Let’s keep it simple: assume that a billionaire derives almost all of their income from publicly-traded stocks that they own. There are two basic ways that stocks you own can provide you with income. First, they may pay a dividend, which will be quarterly cash deposited in your account. Or, you could sell some of the stock, in which case you would capital gains tax on the difference between what you paid for the stock and what you sold it for. In both cases, the billionaire is likely to pay a 20% tax on both dividends and capital gains (I’m assuming long-term holdings, and not in a tax-protected account). That’s much lower than the top income tax rate for wage and salary income, which is 37%, and probably lower than the marginal rate than many middle class families pay (22%). But it’s not 0%.

OK, all seems clear at this point. So how does the ProPublica report show billionaires paying way, way below 20% average tax rates? They include another form of income related to stocks (and other assets): the change in the value of those stocks. For example, they report that between 2014 and 2018, Jeff Bezos saw his wealth increase by $99 billion (this is public information, so I don’t mind including it).

But of course, he didn’t pay 20% on that increase in the value of his stock. He paid 0%! But this is not because Bezos is exploiting any sort of loophole here: changes in net wealth are not defined as income in our tax system (nor any other country that I am aware of). A few countries do have wealth taxes, though the number of countries is quite small, and these are taxes on the stock of wealth, not changes in wealth.

Should we tax changes in wealth? The idea has some theoretical support in economics. Many undergraduate public finance textbook start with the concept of Haig-Simons income to think about income and taxes. Haig-Simons defines income as consumption plus changes in net worth. Pretty straightforward, and it captures the idea of income as resources under your control. But most textbooks will also point out many of the problems with Haig-Simons.

Here’s a big one for the current billionaire context: calculating changes in net worth is hard. If the assets are held as publicly-traded stocks, it’s easy. But if assets are in other forms, like privately held businesses, land that is infrequently traded, or small but valuable items like jewelry, valuation becomes very difficult, especially done on annual basis. Tax assessment for real estate is already controversial, and at least these are fairly thick markets!

But let’s leave aside the difficulty question. Assume we could value all assets easily, accurately, and regularly. Why not tax changes in net wealth as form of income? First, you are now taxing the value of assets when they are not sold. I don’t have any cash on hand if my AMC stock goes from $5 to $50 in a few months. I don’t have any income in the normal sense of the word. I would have to sell some stock just to pay the tax. That could certainly be done, but now we have the tax system impacting the capital markets in a bad way.

Second, if you did indeed tax changes in net wealth, you would probably need to remove most other taxes on capital income, such as those on capital gains, dividends, and business profits. The reason is that you are now taxing capital much more heavily than labor and other forms of income. One could make the argument that you should tax capital more lightly than other forms of income, since economic growth has positive spillovers. That’s an interesting debate. But certainly you shouldn’t tax capital more heavily than other forms of income.

And finally, the implementation is hard, and can lead to distortions in investment decisions. Let’s say that 70% of billionaire wealth in publicly traded assets, which are easy to value. But you still have 30% of assets that are hard to value. You could just ignore these, because 70% covers a lot and covers most of the really big billionaires. But now you are violating another core principle of public finance: horizontal equity. If two tax payers have the same amounts of income and assets, you should probably tax them equally. That’s hard under a “change in net wealth” tax for non-traded assets. Perhaps more importantly, it might discourage companies from doing things like issuing public stock, if it means they are now subject to this new tax. In general, we don’t want the tax code to bias investment decisions.

At the end of the day, most people would not like the idea of their increase in net worth to count as taxable income. You would need large exemptions, both for income levels and types of assets. Imagine if your local tax assessor said your home had increased in value by $50,000 this year. Now not only do you owe more property tax, that $50,000 is also taxable income! So we’d have to exempt personal residences, and probably have an income threshold before this tax applies (I believe Ron Wyden proposed setting it as $1 million).

But once you start carving up this tax base, we really have moved away from the principle underlying the Haig-Simons definition. And then the tax looks more and more like a way to just punish the very rich, because they don’t pay much in federal income taxes on an annual basis (though they pay lots of other taxes). And really, a tax like this would stand on its head one of the most important features of the current income tax system for retirement income: for most people, capital gains and dividends are completely excluded from income! This is the principle behind tax-preferred accounts like 401(k)s and IRAs (sorry Bezos, the annual limits prevent you from really benefiting from these accounts).

Is there a better way to tax the wealthy? One possibility is a consumption tax. The main objection to a consumption tax is that it is regressive. But there are plenty of ways to make a consumption tax progressive, and these are much easier to implement than a wealth tax or a “change in wealth” tax. In some sense this is the exact same thing we would have to do to make a change in net wealth tax politically palatable! So we are already in the world of second bests.

Billionaires don’t pay much in federal income taxes. If we want to make them pay more, we need to think about which taxes are best. Taxing increases in wealth are problematic in a number of ways, but perhaps the silver lining is that reports like the one from ProPublica highlight some peculiarities of our current tax system, without giving us much guidance on how to fix it.

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