Definitions in tax policy are not always as simple as they seem.
Michele Bachmann correctly observed that “the devil is in the details” of Herman Cain’s tax plan. However, this is true of any tax changes, not just Cain’s. Such details include very specific, and often arbitrary, definitions of seemingly simple words like “income,” “profits” and “sales.” While such terms seem straightforward, even minor changes in such definitions can alter who pays how much.
Take “income.” In ordinary conversations, this is a concept most people inherently understand. It is the money a household takes in from various sources.
However, if you are going to tax income, you need to be specific. Yes, income includes wages and salaries received for work done. It includes the profits from businesses of self-employed people. But does it also include interest, dividends or rents generated by assets one owns? What about “capital gains” or increases in the value of such assets?
Should it make any difference whether or not those gains are “realized,” i.e. is the asset actually sold and the amount of cash by which the sale price exceeded its purchase price is actually in hand?
What about transfer payments from government such as Social Security or the value of Medicare benefits? What about student financial aid, farm subsidy payments, food stamps, unemployment benefits and so on?
The classic definition of “income” taught in economics, accounting and law courses is “consumption plus accretion to wealth.” In other words, it is what one spends on goods and services plus the change in one’s net worth. Under this definition, capital gains certainly are income, even if not realized. So are Social Security and all other government transfer programs including unemployment compensation and sundry “welfare.”
This academic definition is clear, but it is not politically feasible for taxes in the real world.
Most Social Security benefits go untaxed, as do all other transfer payments, whether entitlements or discretionary. An exception: those ostensibly received as business income, such as agricultural subsidies.
Taxing “unrealized” capital gains causes problems for people with limited cash income who own assets, such as retirees who own homes, so those generally are excluded right at the start.
Also usually not taxed is income that takes the form of consumption of services that are provided by third parties.
Employer-provided health insurance clearly is compensation for labor, just like a paycheck, and the medical services that such insurance pays for clearly are an important part of household consumption of services. But while the cost of such insurance is an allowable expense for businesses, the benefits to employees are not taxable compensation.
Continue to exclude these and you have made an arbitrary choice that benefits some and hurts others.
Cain’s plan specifically exempts all capital gains from personal income taxes but not other forms of income from assets people may own, such as interest, dividends or rent. The justification for this apparently is the belief that capital gains will motivate savings, entrepreneurship and hence economic growth and employment. But exclusions of interest, dividends and rent also could increase savings and investment.
Moreover, if you exempt one source of income from capital or property, you set up all sorts of incentives for legal finagling to convert higher taxed income to something in an exempt category. The existing provision that lets hedge fund managers treat their earnings as a lower-taxed capital gain is the most notorious example, but there are many others.
Exempt all capital gains from tax and you increase incentives for such tactics. These invariably create economic inefficiencies.
Cain would exempt Social Security benefits, but this is another slippery slope. If even well-to-do retirees could get $2,000 Social Security payments tax-free, why should a blind person have to pay on her $600 SSI check? And if SSI is excluded, why not the value of food stamps received by the same handicapped person?
The object of his plan, as with many other tax reform proposals, is to simplify taxes. Starting with a clean slate, and goring dozens of oxen simultaneously, may be the best approach.
Cain nearly did this, but he blinked when it came to charitable donations. The charitable and nonprofit sector is vital to our society. But let’s recognize that the bulk of such giving goes to the congregations in which families immediately worship or to colleges and universities.
The comfortably middle-class church of which I am a member benefits society. So does Harvard. But it is hard to argue that the government should continue to pick up even nine cents of each dollar given to such institutions while completely eliminating all other credits and deductions, including those for child care, education and high levels of health expenses.
One must define “income,” even for a low and/or flat marginal-rate income tax like Mr. Cain proposes. But that is more complicated than people think.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.