UnitedHealth Group did a service for all econ teachers by demonstrating that income is fungible. Something is fungible when it is “freely interchangeable with something else in satisfying an obligation.”
By paying CEO William McGuire with highly favorable stock options, UnitedHealth illustrated how “ordinary income” can be converted into “capital gains.”
UnitedHealth did not invent the process. The insurer just possibly carried it to new — and possibly illegal — levels. But schemes to convert other types of income into capital gains surface whenever capital gains receive special treatment under federal personal income taxation.
First, a review of some terms. Income from working for someone else usually comes in the form of wages or salaries. Self-employed people and business owners make profits.
If you lease land or a building to someone, you earn rent. Save money in bank accounts or bonds and you earn interest. Owning stock entitles you to periodic shares of profits called dividends.
If you buy an asset like a house or share of stock and later sell it for more than you paid, the increase in value is a “capital gain.”
If investing — reducing current spending to put money into new machines or factories — makes an economy grow, then it should be encouraged, the argument goes. One way to encourage investment is to tax investment income less than income from working.
The evidence on how much such preferential treatment actually increases investment and economic growth is mixed. Tax preferences foster growth but probably not as much as some true believers claim.
One problem is that once one category of income is favored, there are incentives to somehow transform other income into that rubric.
When I was young, if a farmer raised a hog or steer and sold it, the net income was taxed at usual rates. However, money from selling a sow or beef cow “held for breeding purposes” was counted as a capital gain and taxed half as much. Selling breeding livestock for more than cost was like selling a tractor for a higher price than originally paid.
The IRS had to define just what constituted “holding for breeding purposes.” For a time it meant animals 6 months or older that gave birth at least once. That opened a loophole for hog producers.
Sell a female hog directly from birth to market in five months and earn ordinary income taxed at one rate. Raise it, breed it and sell it as soon as its pigs were weaned, and the income would be “capital gains” taxed at half the rate.
Whenever market prices for butcher hogs did not exceed those for young sows, the capital gains treatment made it profitable to breed hogs once and then sell them.
This did not make any sense in terms of production efficiency. It helped wealthier farmers a lot. It helped young, beginning farmers very little. It wasted resources. But the federal tax code encouraged it.
If a corporation pays its CEO a $2 million salary, she will owe income tax at regular rates. If it pays her $1 million in salary and lets her buy company stock for $1 million that she will be able to sell for $2 million, she gets the same income but owes far less in taxes. That is because the $1 million difference between what she pays for the stock and what she sells it for is a capital gain taxed at a lower rate.
After-the-fact finagling of the date — and thus the price — at which the executive gets to buy the stock can constitute tax fraud. That may be what happened at UnitedHealth. The IRS, among others, is investigating.
Whether UnitedHealth broke the law is secondary, however. The important point is that income categories like “earned” or “capital gains” are not as cut-and-dried as they might seem.
People respond to incentives. If one pays less tax on capital gains than on salaries, smart accountants and tax lawyers will find all sorts of creative ways for people to be paid via capital gains rather than a paycheck. And it probably won’t involve checking any sows at 2 in the morning.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.