Tax Policy #2

Continuing the discussion of how to radically overhaul the federal tax system:

STEP #2:  Treat all income the same for tax purposes

Currently, "earned income" (essentially, income derived from employment) is treated very differently from "unearned income" (essentially, everything else) for the purpose of taxation.

Most everyone is familiar with earned income, in the form of wages, tips, bonuses, etc. from your job.  That's how most people make their money, and most people pay their taxes based on that.  The more money you make, the higher the marginal rate (the percentage of your income over a certain amount that must be paid in taxes).

Not as many people are fortunate enough to have unearned income, such as interest, dividends, rents, capital gains, etc.  This unearned income may be treated differently from your earned income, depending on a number of factors.  Capital Gains for example (profit from the value appreciation of property you sell, such as stocks or other investments) may be taxed at a much lower rate if the capital that was sold had been held for more than a year.

There are a number of reasons for treating unearned income differently from earned income, but none of them have anything remotely to do with fairness.

So, generally speaking, financial gains for individuals should be taxed consistently in the year they are realized, regardless of source.  Rental income, sale of stock, wages, tips, etc. should all be reported together at the end of the year, and tax liability calculated on that basis.  No more separate, lower rates for long term capital gains.  No more estate tax on those who have died, naturally -- but those who realize a financial gain through their inheritance must pay income taxes on that inheritance when they realize the gain (i.e., receive cash or sell the assets that they inherited).

Comments

[David Wright]

Just a clarification on the estate/inheritance tax aspect of what I said above, as this is a radical change with dramatic tax implications:

I propose the complete elimination of the estate tax. Taking the accumulated wealth of a person when they die (particularly just from "rich folks") is inherently unfair.

However, that accumulated wealth is going to be disposed of somehow, as per the wishes of the deceased. And to the beneficiaries, their transfers are direct income, which should be subject to taxation. Not an "inheritance tax" per se, because as I said all forms of income should be lumped together for tax purposes. But it would count as "inheritance income", subject to the normal tax rates that would apply to the beneficiary.

This has a few implications:

Non-cash assets that are inherited would not be considered income at the time of inheritance, and would not be directly subject to taxation. However, when the actual financial gain is realized (when the asset is sold) the profit from the sale would be "capital gains income" (again, subject to normal tax rates like all other income).

The "basis" for the asset, however, would be zero -- cost of acquisition to the owner at that point was nothing, as it was an inheritance. In other words, the full sale price of the asset would be considered capital gains. This too is a radical change from current taxation, since assets transferred are considered to have a new basis to the receiver of market value at the time of the transfer (or, in the past, a "carryover basis" from the original purchase of the asset on the part of the deceased). The net effect is that inherited assets would be taxed at a higher value than currently. However, again the assets would not be taxed until actual financial gain is realized.

It would be possible in this way for family heirlooms to be passed down for generations without being taxed, likewise family business interests or family farms. But at the time the owner converts the asset to cash, they'd pay tax on the full value.