As the Bush tax cuts approach their end date at the stroke of midnight on New Year's Eve, much attention is being paid as to what marginal federal income tax rate should be imposed upon those whose incomes are among the nation's highest.
Because "fairness" is in the eye of the beholder, discussions over what the top marginal tax rate (or rates) should be and at what level of taxable income they should kick in are bound to provoke a measure of frustration, especially since there's no clearly correct answer. By changing the question, though, we could enhance the prospect of taking advantage of our current situation to develop an Internal Revenue Code that's more fair.
It's high time that the tax code considered all taxable income equal. Unlike a debate over what the top rates should be, this proposal is immune to criticism as "class warfare"; indeed, it would eliminate existing tax-rate differentials among income classes!
Let's consider for illustrative purposes an individual whose income includes salary, interest, dividends and both long-term and short-term capital gains. If our taxpayer were to segregate her five sources of income into separate but unlabeled stacks of money, there's no way we could identify which funds came from which source; all the dollars would look alike and each would have equal purchasing power.
Why shouldn't income tax law consider them that way, too, rather than imposing artificial distinctions that render the tax code enormously more complicated than need be? Beyond simplifying federal income tax law, this reform also would enhance its fairness.
Of her five income sources, our illustrative taxpayer's salary alone is earned; the other four are unearned. We could debate whether earned income is more worthy of tax leniency. I believe that it is, and back in 1980 federal law apparently agreed. There was a maximum tax on earned income, some 40 percent below the top rate applicable to unearned income at that time.
Under current law, however, unearned income holds far greater promise of provoking less tax. For examples, qualified dividend income is taxed at a maximum of 15 percent, long-term capital gains the same, and interest income can be rendered completely tax exempt through municipal bond investments.
Some argue that lower taxes on investment income are needed in order to encourage capital investment. Oh? Does anyone really believe that stuffing money in a mattress or burying it in a little tin box poses a rational alternative to investing one's accumulated capital? Besides, most money invested in corporate stock does not go into that company's treasury; it goes to other investors who, like most of us in the market, strive to buy low and sell high.
By way of exception, lenient taxation of gains from stock acquired in initial public offerings or the like for startup ventures can be justified. The tax code already provides favored "ordinary loss" treatment to original-equity capital investments that go sour, so it would be fairly easy to grant a lower rate of tax for those which are profitable. That narrow exception is the extent to which special capital gain or loss treatment ought to be available.
Those who consider capital-generated income to be more laudable than income earned by sweat of one's brow, and therefore worthy of more lenient taxation, should acknowledge that greater tax-deferral opportunities exist in respect of unearned income.
The time value of money often imparts a reduced-tax benefit to capital appreciation -- which is not exposed to taxation until the investor "realizes" such gain by sale or disposition of the underlying property. Deferral of taxes on accrued gain is thus fairly easy to achieve. And if a pressing need for funds should arise, the appreciated property can be borrowed against without incurring taxes.
(While somewhat comparable advantages are extended to earned income through tax-sheltered retirement-saving vehicles, the amount or percentage of earned income that can be deferred is limited.)
Even if all types of income were taxed equally, the relative advantage of being readily able to defer income from capital would remain: Eliminating this last vestige of "more-equal" status for gains from capital would involve intolerable administrative complexity and not be worth the candle.
Yet another benefit unique to capital appreciation is that its taxability vanishes when the property's owner dies; in contrast, all other "income in respect of a decedent" remains taxable when collected, despite the earner's death!
A final look at "fairness": During the past few decades, a readily discernible gap has been growing between the haves and the have-nots in this country. Treating all species of income the same under federal income-tax law would not reverse that, but it would render the playing field more level.
It's a steep uphill climb for an income-earning worker to maintain pace with an investor of capital, even if their respective taxable incomes start at identical amounts. After both pay federal income tax, the capital investor will likely have more net income and consequently pull away from the more heavily tax-burdened worker.
Present tax law thereby fosters an ever-increasing gap, year after year, between the two of them. The least we can do, to be fair, is to declare all income dollars equally taxable under the same rate tables.
William J. Brown, emeritus professor of law at the University of Pittsburgh, has taught taxation courses at Pitt, Duquesne University and West Virginia University law schools for more than 40 years and testified on many occasions before the U.S. House Ways & Means Committee regarding tax policy.