IN THE NEWS: Tax Reform and the Estate Tax – But I Thought We Had an Income Tax?

Posted by Mark Hutson on 12/14/17 10:29 AM

Dr. Mark Hutson is a Manager at Summit with extensive experience in building, designing, and running economic forecasting models in private, public, and academic settings. He has consulted for government agencies, law firms, trade groups, think tanks, and academic researchers.

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With Congress currently drafting a tax bill, there have been all kinds of proposed changes and modifications to the income tax system. Whether it is changing the marginal tax brackets, the corporate tax rate, or eliminating deductions for state and local taxes, all of these are fundamentally changing how the IRS treats income. All, that is, except for one proposal: eliminating the Estate Tax.

What is the Estate Tax? Basically, it is tax that is paid when a person dies, and the value of the tax is based on the person’s net worth on the day they die. In other words, it is structured like a tax on property, rather than income. Despite appearances, it actually is a form of income tax because it is designed to capture a certain type of income (albeit in a fairly complicated way). To explain how a property tax can stand in for an income tax, we need to cover some background first.

Government 101:
How to Raise Money

Transaction Fees are levied whenever a certain type of transaction occurs. Common examples of these are tariffs (a good gets imported), sales or value-added taxes (a good or service changes hands), or user fees (tolls, or fees for services such as customs inspections or getting a driver’s license). The bulk of the US government’s revenue originally came from these.

Property Taxes are levied at regular intervals based on the value of some good or item that a person has. The most common form of these is state or local property taxes on land, though these could theoretically be levied on anything (For example, Virginia has an annual tax on motor vehicles). While states and local governments use these, the federal government generally does not.

Income Taxes are levied whenever somebody is paid for labor or rents. Common forms of labor include salaries, wages, and tips, though these can also include commissions, interest, rents, and profits. More than 90% of federal revenue is raised through income taxes.

What is Income, Anyway?

The primary driver for the development of the estate tax is caught up in how we define certain transactions as income. Or, more specifically, when we define it as income. The broadest and simplest idea for income is called the Haig-Simons definition, where income is any event that results in your net worth going up. For example, your employer deposits your paycheck into your checking account on Monday, so you now are wealthier (or less poor…) than you were a day ago. As far as the tax authority is concerned, you’ve just had an income event. In this case, you’d have recorded income on that day, and you’ll have to pay taxes on that deposit in that tax year. Pretty simple, right?

Well, it can get complicated pretty quickly. What if the money is paid to you on January 1, 2018, but it is for work you performed in December, 2017? Does that income count towards your bill for 2017, when you were slaving away at your desk? Or can it wait until you pay taxes for 2018, when you officially got the money? Suddenly, it isn’t so clear. (In this example, the IRS considers the paycheck 2018 income.) And the issue can get even more complicated when we start talking about other forms of income, such as rent and capital gains.

Capital Gains – Buying Low and Selling High

Capital gains are pretty straightforward in theory, but they can get pretty tricky in practice. For the sake of explanation, let’s use a simple example. Imagine that Grandpa Bob buys $1,000 of stock in EZ Examples, Inc. The value of the stock is somewhat volatile, dropping down to $800 but also soaring at one point to $2,000. Grandpa Bob goes to file taxes, and he checks the value of the stock on the day he files: the holdings are worth $1,500. That is, the stock holding has gained $500 from the day he bought it to today. So, how much does he owe in income taxes?

The answer is actually zero, because he hasn’t realized any income yet! This is because he doesn’t actually make any money until he sells the stock. The price could double, return to $1,000, or even drop to zero if the firm goes bankrupt. The government does not make you pay taxes on your theoretical (unrealized) gains until you actually get the money in your hand from selling the holdings. So, Grandpa Bob only owes taxes on the $500 of income if he sells it at $1,500.

This is a big benefit. Basically, if you have any asset, whether it be stocks, direct ownership in a business, a house, or something else, you can defer taxes while you hold it. The government is letting you accrue income without paying taxes until you sell. This is, in part, why you hear that the “buy and hold” method of investing is tax efficient. For example, Warren Buffett, a Nebraskan who has shown some aptitude at investing, says that his favorite holding period for an investment is “forever.” In so doing, he never has to pay taxes on the gains from that stock.

A BRIEF HISTORY OF THE US INCOME TAX

The United States hasn’t always had an income tax. In fact, it is a relatively new idea. Here are some key events leading to the development of our current system:

  • 1861—The first (federal) income taxes are levied to pay for the civil war.
  • 1862The first tax brackets are employed, with marginal rates increasing with higher levels of income. All income taxes expired in 1872.
  • 1895Pollock v. Farmer’s Loan & Trust decided, whereby the Supreme Court rules taxes from rents cannot be spent in the same manner as other forms of income.
  • 1913The 16th amendment, allowing all forms of income to be taxed and spent as the government deems fit, as thus undoing the Pollock holding from 1895.
  • 1916Estate Tax Established.
  • 1935Authorization of payroll taxes (FICA) passed, funding Social Security.
  • 1913, 1916, 1926, 1939, 1954, 1986Major revisions or replacements of the Internal Revenue Code.

In our next post, we’ll cover how the Estate Tax addresses these problems and what that could mean for the budget.

Topics: tax

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