The Essential Structure of the Income Tax

AuthorDeborah A. Geier
Pages3-43
Chapter 1: The Essential Structure of the Income Tax
Part A. of this chapter introduces the core structure of an income tax under tax theory and how
that theory is translated into positive law (or, in some cases, how positive law departs from theory).
The idea is to demystify the Code, as many of the provisions that make up the backbone of the
current Federal income tax is what you would expect to find there once you grasp the contours of
that underlying normative theory.
Part B., in contrast, departs from core theory to explore three topics: (1) the mechanisms used
in current law that permit a certain amount of subsistence consumption to escape taxation, (2) how
several provisions categorize groups of deductions in a manner that devalues some of them (or,
stated differently, how certain deductions are favored over others), and (3) the difference between
marginal tax rates and effective tax rates.
A. The theoretical core structure of a tax on
“income” and how it is implemented in positive law
As you will read about more fully in Chapter 3, the modern Federal income tax was enacted in
1913 after ratification of the 16th amendment to the Constitution. What does that term “income”
mean for tax purposes? In the early days of the income tax, before a tax-specific meaning of the
term was explored and developed, the temptation was great to borrow meanings from other
disciplines where the term “income” had been used for some time.
For example, suppose that Father died 200 years ago. In his will he directed that all of his land,
which is rented to tenant farmers, be contributed to a trust. The trust document instructed the trustee
(who managed the trust property) to distribute the “income” from the trust annually to his surviving
wife for the rest of her life (a “life estate” to you property law buffs) with the “remainder”
distributed to his son on his wife’s death. Upon his wife’s demise, the trust would distribute the
land to the son, and the trust would be dissolved.
Under trust law at the time, the rent collected from the tenant farmers would be “income” that
would be distributed to the wife annually. If, however, the trustee decided to sell a plot of land for
$100 that had been purchased by Father before his death for, say, $75, the $25 profit from that sale
would not be considered “income” that would be distributed to the wife. Rather, the cash (even if
not reinvested in a different plot of land) would be considered to be part of the trust “corpus” that
would eventually be distributed to the son under his remainder interest. Does that mean that the
$25 profit should not constitute “income” for tax purposes, as well? Early on, some argued that it
did. (And some continue to argue that such profit should not be taxed. Stay tuned.)
Similarly, financial accountants had long been used to constructing “income” statements for
businesses so that those interested in the economic health of the business (such as potential
investors and lenders) could have relevant information upon which to make informed financial
decisions. Here, the $25 profit earned on the sale of land for $100 that had been purchased for $75
would show up on the “income” statement. But should financial accounting be determinative? Or
might the rules of financial accounting deviate from the underlying values that inform how the
Chapter 1 Essential Structure of the Income Tax Chapter 1
-4-
aggregate tax burden $X ought to be apportioned among the members of the population?
Over time, theorists such as Henry Simons and Robert Haig (in the U.S.), George Schanz (in
Germany), and others began to develop a tax-specific meaning for “income” that sometimes
coincided with the meaning of the term in other disciplines and sometimes did not. They
recognized that different disciplines may have different underlying purposes and values that
inform the contours of the term “income” in a way that is uniquely suited to its particular purposes.
By 1938, for example, Henry Simons, a public finance economist at the University of Chicago,
described income for uniquely tax purposes in the following way.
Personal income may be defined as the algebraic sum of (1) the market value of
rights exercised in consumption and (2) the change in the value of the store of
property rights between the beginning and end of the period in question.1
While “the period in question” could theoretically be one’s entire life, with no tax due until death,
for administrative ease (and regular tax collection) the “period in question” is usually one year.
What does this language mean? Generally, the language after (2), above, implies that we should
tax the net increases in the taxpayer’s wealth between the beginning and end of the year. That is
to say, the taxpayer’s increases in wealth and reductions in wealth should be netted together, and
the net increase (if any) should be taxed. Suppose, however, that the taxpayer’s reduction in wealth
arises from, say, spending $5,000 on a vacation trip. The taxpayer is certainly less wealthy after
the trip than before because of the outlay, but should that wealth reduction be factored into his “net
wealth increase” for the year? The language after (1) implies that a reduction in wealth should not
reduce the tax base if that wealth reduction reflects personal consumption spending because
consumption spending is intended to remain within the tax base. We can tax consumption spending
(the vacation trip) only if we forbid that wealth decrease from entering into our determination
under (2) regarding whether the taxpayer has enjoyed a net wealth increase or suffered a net wealth
decrease for the year. Thus, more simply, the formula above could be restated essentially as:
Annual income equals wealth increases less wealth reductions but only if the
wealth reduction does not represent personal consumption.
In this way, wealth reductions spent on personal consumption (such as the vacation trip mentioned
above) do not reduce the tax base (what is taxed). Because they do not reduce the tax base, they
are taxedalbeit indirectlyby remaining within the tax base.
Because Schanz and Haig came to essentially the same conclusion, you will often hear this
construction called the “Haig-Simons” or “Schanz-Haig-Simons” definition of “income” for
purposes of income taxation. For shorthand, we can refer to it as SHS income.
Let’s use a simple fact pattern to explore how a given item would be treated under the SHS
economic conception of income and then proceed to the outcome under positive law found in the
Internal Revenue Code. As mentioned above, the idea is to demystify the Code: a lot of what is in
the Code—at least with the respect to its normative, core provisions (those that seek to properly
measure “income” as a theoretical matter) as opposed to all the bells and whistles that then clutter
it upis what you would expect to find there, once you understand the underlying normative
concepts that define an income tax. This exercise not only helps to rationalize the core structure of
an income tax for you; the best tax lawyers are those whose knowledge of the underlying core
1 HENRY SIMONS, PERSONAL INCOME TAXATION 50 (1938).
Chapter 1 Essential Structure of the Income Tax Chapter 1
-5-
concepts helps them to advise a client on the likely outcome when positive law is ambiguous.
John and Mary are married and have two minor children, Oliver (age 10) and
Sophie (age 7). Mary is an employee—the CEO of a mid-size corporation
and receives an annual salary of $1 million. John is a dentist and the sole owner
of an LLC that houses his dental practice. As described in the Introduction, a
single-owner LLC is a disregarded entity for Federal income tax purposes,
which means that its Gross Income and any allowable deductions will appear
on John’s and Mary’s joint income tax return.2
John’s gross revenue collected from billing patients is $500,000 each year. This
amount, however, is only his “gross” revenue. Unlike Mary, who is an
employee, John incurs many costs in running his business. For example, he
pays his receptionist and dental assistants a salary, he pays rent and utilities
for his office space, and he purchases a new dental chair and X-ray machine
this year.
John and Mary owned investment land that they rented to tenant farmers,
which they purchased more than two years ago in May for $12,000 (Year 1).
By December 31 of Year 1, the land had increased in value by $1,000 and was
worth $13,000. By the end of Year 2, it had decreased in value to $10,000. In
August of this year (Year 3), they sell it for $14,000 in cash. Before the sale of
the land, they receive $1,000 in monthly rent from their tenant farmers. They
also have a bank savings account, which generates $200 of interest this year.
John’s mother makes a substantial gift of $10,000 in cash to her son this year
toward a down payment on the purchase of a new home for $1.5 million.
John and Mary buy food and clothing, pay rent for a flat (before they buy their
new house), pay utility costs with respect to both their rented flat and new
home (after moving in), and take the kids to Disney World this year.
Turning for a moment to positive law, look at § 1 of the Internal Revenue Code, which reveals
that the tax base—what is ultimately taxed—is called “Taxable Income.” Taxable Income is
multiplied by the tax rates in § 1 to reach the tax due. (The tax rates you see in § 1, as well as the
floors and ceilings for each bracket, do not reflect the changes in law since 1986 or the inflation
adjustments mandated by § 1(f). We shall examine the current rate structure in Part B.) If Taxable
Income incorporates perfectly the SHS concept of income, it should result in a tax base that
consists of wealth increases less wealth reductions but only if the wealth reduction is not spent
on personal consumption. What is Taxable Income under the Code?
For now, Taxable Income is “Gross Income” less allowable “deductions.Gross Income
pertains to wealth increases. In contrast, deductions pertain to certain wealth reductions.
Gross Income (wealth increases)
Less Deductions (certain wealth reductions)
Taxable Income (the tax basewhat is ultimately taxed)
2 If John had created a corporation instead of an LLC, the entity would not be ignored for Federal income tax
purposes. The Federal income taxation of corporations, partnerships, and multi-owner LLCs and their owners are
beyond the scope of this introductory textbook, which focuse s on the income taxation of individuals.

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT