On Human Capital

AuthorDeborah A. Geier
Chapter 16: On Human Capital
What is “human capital” and how do we distinguish it from other forms of capital, such as
financial capital (e.g., shares of stock in a corporation or a corporate bond) or tangible capital (e.g.,
plants and equipment)? Just as financial capital and physical capital can earn a return, so can
human capital—in the form of labor income, i.e., a return earned on one’s personal effort.
“Human capital” refers literally to the human body and all of the attributes of an individual that
allow him or her to earn services income. Much human capital is inherited through good genes, such
as an able body, physical attractiveness, height (with research showing that the more attractive and
taller earn more than the less att ractive and shorter), and a functioning mind. Other aspects of human
capital are an unknowable mix of genes, environment, and effort, such as IQ, creativity, sociability,
the ability to work diligently, to work cooperatively with others, to lead, and to focus on and
complete tasks efficiently. Human capital is even affected by how well the child has chosen his or
her parents, with research showing that those born into wealthy families tend to earn significantly
higher incomes than those born in poverty. That is to say, it is not surprising to learn that human
capital is affected by social and family connections. Some human capital, however, can be
purchased, with the most important of these examples being education and skills training. All of
these facets contribute to allowing the person to earn personal services income.
How do we distinguish between human capital and other forms of capital? You cannot sell your
human capital and thereby divest yourself of it, as you can with non-human capital, such as
business equipment or corporate stock. I can share my human capital with you—my knowledge of
the income taxbut I do not thereby divest myself of that knowledge. Nevertheless, human capital
can sometimes create a property interest that can be bought and sold in the marketplace, such as
goodwill or a patent owned by the inventor of the patented process (as opposed to a later purchaser
of that same patent, who holds it as conventional capital). The inability to differentiate easily
between the return on human capital and the return on conventional capital in some contexts leads
to difficulties throughout the Internal Revenue Code—particularly in the case of differentiating
capital gain from ordinary income, as discussed in the previous two chapters.
Part A. of this chapter will focus on one aspect of human capital: education costs. To what
extent should tuition scholarships be excluded from Gross Income? When an employer pays for
an employee’s education, to what extent should this compensation be excluded? Are the education
tax expenditures justified? Well crafted? To what extent should tuition costs be deducted as a
business expense?
Part B. will explore the tax consequences of receiving a settlement or jury award on account of
the loss of human capital.
A. Education costs
Education costs implicate both (1) wealth accessions (possible § 61 Gross Income) when the
taxpayer obtains a scholarship from an educational institution or a fringe benefit from an employer
that pays for the taxpayer’s education costs and (2) wealth reductions (possible deductions or
credits) when the taxpayer pays for education costs herself. With respect to the latter, they also
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implicate the line between an income-producing activity (deductions are allowed) and personal
consumption (no deductions in a pure SHS income tax or pure consumption tax).
Human capital acquisition costs are generally relegated to the personal sphere, including
education costs, because the acquisition of human capital is inextricably intertwined with the
taxpayer’s personal life. Even though education augments the taxpayer’s ability to earn income
in exchange for services, it also inevitably brings personal benefits, as well, including the ability
to consume life more fully as one’s mind is opened to art, music, literature, history, political
thought, psychology, etc. Research shows that education even contributes significantly toward
one’s ability to meet a life mate. Thus, many of the tax-reducing provisions attributable to
education costs in the Internal Revenue Code are properly categorized as “tax expenditures,” a
concept that you first learned about in Chapter 3, Part B.
Because tax expenditures are not normative income tax provisions, i.e., they are not necessary
to measure “income” accurately, how do we evaluate the wisdom or folly of a particular tax
expenditure or evaluate its efficacy as a policy matter? The answer: cost-benefit analysis, which is
not an easy task. In a cost-benefit analysis, the policy analyst must define the goal of this particular
government action and ask whether the tax expenditure is the best means (in the sense of economic
efficiency, fairness, and administrative ease) to accomplish that goal. Could the goal be better
accomplished outside the tax system or inside the tax system? Recall that only about 60% of
households earn enough to owe income tax, which means that delivering social spending through
the Internal Revenue Code fails to reach many households. Moreover, some of these provisions
are delivered in the form of an Itemized Deduction, which is worthless to the approximately 70%
of filers that take the Standard Deduction, as described in Chapter 1, Part B. If the tax system is
going to be used, is the goal with respect to a higher education tax expenditure to provide a subsidy
(to those having trouble financing education) or to change behavior (to increase the number of
students attending college)? In either case, how should the provision be structured to deliver the
benefits to the targeted population? Tax expenditures often have complex definitions, income
ceilings, and phase-out rules—all in order to limit the indirect government spending to the targeted
population. In employing cost-benefit analysis, the policy analyst must also be concerned with
windfall losses (rewarding people for engaging in behavior that they would have engaged in
anyway) if the goal of the tax expenditure is to change behavior and upside-down benefits (with
more of the lost revenue absorbed by high-income families than low-income families) if the goal
is to provide a subsidy. Finally, we need to discuss “capture” through the price mechanism, which
is the flip side of the coin of tax “incidence,” also discussed in Chapter 3.
On the face of the statute, the education deductions and credits are aimed at the student or the
student’s family. The exclusion for employer-provided health care in § 106 (discussed in the next
chapter) is aimed at the employee on the face of the statute. The deduction of qualified residence
interest in § 163(h)(3), exclusion of home sale gain under § 121, and deduction of real estate
property taxes under § 164(a)(1) (also discussed in the next chapter) are each aimed at the home
owner. And so on. These tax benefits, however, can often be captured by other actors in the
marketplace through the price mechanism. The more broadly available a tax expenditure, the more
easily it can be captured by raising the price of the purchased asset or service at large. If a tax
benefit is limited to a small, select population, providers find it difficult to raise prices generally.
In the context of the education tax expenditures, capture can mean that universities are able to
raise tuition to higher levels than they would be able to charge absent the tax expenditure. When
the Hope Credit was enacted in 1997, for example, California community colleges charged an
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average annual tuition of less than $1,500, and they immediately raised their tuition to the $1,500
that could be credited each year under § 25A. Even in the case in which tuition is already higher
than the amount currently creditable, the very existence of § 25A can result in tuition inflation, as
universities generally raise tuition to capture all or part of the benefit. Whether that is a good or
bad development may depend on what the university or college does with the extra tuition dollars.
If the institution uses them to replace reductions in state funding (in the case of a public university),
the Federal dollars merely maintain the status quo. If it uses the increased tuition to provide more
scholarship dollars to needy students, perhaps the capture is a good thing. If it uses the increased
tuition to raise professors’ salaries, perhaps not so much….
The primary tax expenditures pertaining to education that are explored through the problems
below are:
The § 117(a) exclusion for certain scholarships
The § 117(d) exclusion for certain tuition waivers for employees of educational institutions
The § 127 exclusion for tuition benefits paid by employers who are not educational
The § 25A(i) American Opportunity Tax Credit (AOTC), which effectively replaced the
less generous Hope Credit in 2015
The § 25A(c) Lifetime Learning Credit
The § 221 deduction for interest on education loans (taken above the line under § 62(a)(17)
Recall that, under a pure SHS income tax, borrowed principal is excluded from Gross Income,
repaid principal is not deducted, and personal consumption interest is not deductible. The § 221
deduction a tax expenditure. Recall also, however, that under a cash-flow consumption tax
borrowed principal would be included, and repaid principal as well as interest would both be
deducted. Finally, recall f rom Chapter 3 that the current Internal Revenue Code generally functions
as a consumption tax for the middle class because the primary savings of most middle-class
taxpayers (retirement savings in qualified pension plans, § 401(k) accounts, and IRAs, built-in
gain in a primary residence, and life insurance) are accorded consumption tax treatment under
current law. The Code functions more as an income tax for wealthier taxpayers, whose savings
exceed the limits that can be protected from taxation under current law.
Professor Larry Zelenak has provocatively suggested that students be permitted to elect to treat
their student loans under cash-flow consumption tax principles.1 Because they would include the
borrowed principal in their low- or no-earning student years, perhaps much of the borrowed funds
could be sheltered from taxation under the Standard Deduction, with the remainder falling in the
lowest tax brackets. In their later, higher-earning years, they would be permitted to deduct not only
the interest (as under current § 221, within limits) but also repaid principal, offsetting Gross
Income that would otherwise be taxed under higher marginal rates than applied in the earlier
borrowing year, thus reducing the aggregate tax paid over time. In short, many students could
benefit by shifting tax base inclusions from higher-bracket years to lower-bracket years by taxing
at the earlier of consumption (with borrowed funds) or income (the repayment of the borrowed
funds), notwithstanding the time value of money. Currently, however, students are deprived of that
1 See Lawrence Zelenak, Debt-Financed Consumption and a Hybrid Income-Consumption Tax, 64 TAX LAW REV. 1

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