The U.S. federal income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
code has a problem with timing: sometimes it assesses taxes too early, in a way that creates a measurable bias against saving or investment. On Tuesday, the Supreme Court will hear arguments in Moore v. United States, a case all about timing. The plaintiffs, Charles and Kathleen Moore, argue that a component of the 2017 tax reform taxed their income from an international business venture too early, before it was “realized.”
At first glance, a ruling for the plaintiffs in Moore might seem to solve some of the timing problems with the U.S. tax system. Unfortunately, upon greater inspection, such a ruling might create new timing problems. And the more rigid the ruling, the harder it would be to fix the timing problems it would create.
Why Tax Timing Is Important
In the last two months, Tax Foundation has shown some of the timing problems with the income tax and illustrated the virtues of a system timed to consumption. In a simple two-period model with a 10 percent return on investment and a 20 percent income tax, we show that an income tax effectively taxes deferred consumption at a greater rate than present consumption.
It is better, Tax Foundation generally argues, for the government to bide its time, let taxpayer investments grow, and then take its cut only when investments are liquidated and used for personal consumption. Consider a tax system with the same 20 percent rate, but with the tax timed to coincide with consumption:
This method equalizes the tax rates on consumption in different periods and doesn’t discourage people from investing. This is important because Taxpayer B is likely better for the economy. First, the government typically has a discount rate lower than taxpayers do—in other words, the government more than makes up for not taxing $100 today by taxing $110 tomorrow, even after accounting for borrowing costs. Furthermore, Taxpayer B’s investments are more likely to raise worker productivity by funding new technology or equipment.
The Timing Argument at Stake in Moore
This brings us to the Moores. Their money, they argue, was still locked up abroad in a company they didn’t fully control, and therefore, not realized yet. The Sixteenth Amendment does allow Congress to levy an income tax, but the Moores argue that prior case law shows income must be realized before it’s taxed. One possible standard, articulated by Chief Justice Earl Warren in Commissioner v. Glenshaw Glass is “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” The fate of the Moores’ tax bill, and potentially many other provisions, rests on how strict the standards are for recognizing income.
A ruling for the petitioners may seem to bring us closer to the tax system articulated by Tax Foundation in the second table. Don’t tax the plaintiffs yet, the reasoning might go. Wait until they cash out. Imagine $100 earned in an arguably unrealized investment abroad, and one is deciding whether to tax it now or wait until it is fully realized. The Moores are the helpful Taxpayer B in our examples above. Both the Treasury and society would benefit from letting their investments compound for a while longer.
So, does Moore have the potential to give consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible.
advocates what they want? Unfortunately, no. While requiring a specific “realization principle” might fix some of the timing problems in our tax code, it would also introduce new timing problems. And the more rigid the ruling, the harder it would be to fix the timing problems it would create.
A Realization Principle Is Not a Consumption Tax BaseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.
A realization principle does well at matching a consumption tax base in the simple toy examples we gave above, and those examples do match some typical cases. However, a realization principle doesn’t consistently replicate a consumption tax base in real life. Some arguments to this effect are articulated in an amicus brief to the Court in the Moore case filed on behalf of a group of tax economists that includes Kyle Pomerleau, formerly of Tax Foundation.
Two problems are worth highlighting. First, many taxpayers will still pay too early. A tax on realization doesn’t have the right effect on investments that are realized and then reinvested elsewhere. The taxpayer who reallocates his portfolio still pays tax too early, prior to eventually liquidating the second investment and consuming. Taxpayers who wish to avoid this problem might inefficiently stay in investments that aren’t actually ideal, all to avoid realization and paying tax. This is known as a “lock-in” effect.
And second, particularly clever taxpayers will pay too late. The Court, Congress, or the IRS may choose a particular realization principle, but global and liquid financial markets do not have to play by the same rules. A taxpayer could, for example, borrow from a financial institution, using the appreciated asset as collateral, and use that borrowed money to spend on personal consumption. This functionally achieves the effect of “realizing” the asset by using financial instruments to convert it into cash. But crucially, it doesn’t turn the asset directly into cash in the way a naïve tax code might expect. Granted, sometime in the far future, they may need to sell the asset and pay tax. But they would not be paying tax timed with their consumption, as consumption tax advocates would hope for.
Therefore, there’s a key policy trade-off to be made between offering appropriate tax treatment to the median saver and curbing unusual schemes or minimizing lock-in problems.
That trade-off should be navigated primarily by Congress. Ultimately, consumption tax advocates are unlikely to find their policy preferences implemented effectively through Supreme Court rulings. Maintaining a principled tax code—whether a consumption tax, an income tax, or a hybrid of the two—is difficult, as taxpayers are good at inventing exotic financial instruments and are highly motivated to avoid taxation.
If the Court gets too far into the difficult business of defining income and defines income too rigidly, it may create a cottage industry for tax planners to devise adversarial strategies that take advantage of the technical differences between a realization principle and a consumption tax base. Furthermore, with its relatively low number of tax cases per year, it will be unable to sufficiently follow up on that definition.
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