Last week, a federal appeals court in Washington handed down an important decision relating to the definition of income for tax purposes. What is important about the decision is that it is the first one in decades saying that the Constitution itself limits what the government may tax. If upheld by the Supreme Court, it could significantly alter tax policy and possibly open the door to radical reform.
In the case, a woman named Marrita Murphy was awarded a legal settlement that included compensation for physical injury and emotional distress. The former has always been tax-exempt, just as insurance settlements are. Obviously, it makes no sense to tax as income the payment for a loss that only makes one whole again. One is not being made better off, and therefore there is no income. But under current law, compensation for non-physical injuries are taxed.
Murphy argued that just as compensation for physical injuries only makes one whole after a loss, the same is true of awards for emotional distress, as well. In short, it is not income within the meaning of the 16th Amendment to the Constitution. The appeals court agreed and ruled that her award for emotional distress is not income and therefore not taxable.
Tax experts immediately recognized the far-reaching implications of the Murphy decision for other areas of tax law. Tax protesters have long argued that the 16th Amendment did not grant the federal government the power to tax every single receipt that it deems to be income. Yet in practice, that is what the Internal Revenue Service does.
The problem is that the very concept of income itself has never been defined in the tax law. It is pretty much whatever the IRS says it is. Tax analysts generally use a definition devised by two economists named Robert Haig and Henry Simons, which says that income consists of consumption plus the change in net worth between two points in time.
But the Haig-Simons definition goes far beyond that in the tax law. Most importantly, it includes unrealized capital gains. There is also no place in the Haig-Simons definition for things like 401(k) plans, individual retirement accounts or other retirement savings, nor for lower tax rates on realized capital gains.
Under Haig-Simons, owner-occupied homes would be treated as businesses, with homeowners taxed on the implicit rent they pay to themselves, less depreciation. And if your home's value increased over the course of a year, you should pay tax on that even if you didn't sell your house.
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