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