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.Continue reading