Tuesday, February 16, 2010

Implicit messages in our tax code

A discussion on an email list for tax law professors has stimulated lots of thoughts in my head about the emotional loading of the usage of the terms "earned" vs. "unearned" income in tax policy.

In popular parlance, referring to income as "unearned" suggests it accrued to someone who did not actually deserve it. So one might think we would tax unearned income more heavily than earned income.

In actual practice, sometimes we do and sometimes we don't.

We have no coherent policy on the matter.

Unearned income is subject to kiddie tax, does not qualify for EITC, and does not qualify for foreign tax exclusions. When these issues prevail, "unearned income" will be taxed more heavily than "earned income."

But not always.

Earned income, on the other hand, is subject to payroll taxes (FICA and FUTA) as well as ordinary income taxation, which famously means that Warren Buffett's secretary pays a much higher percentage of her income in taxes than he does. That's because Warren Buffett is able to take most of his unearned income in ways that are very lightly taxed (long-term capital gains) compared to the ordinary income tax rates that apply to wages.

I see this every day at our VITA site. Sometimes a taxpayer is better off if the type of income he gets qualifies as "earned" and sometimes a taxpayer is better off if the type of income he gets qualifies as "unearned." And these are all taxpayers with very simple circumstances and modest incomes.

Our tax code sends a lot of confusing mixed messages to taxpayers about the activities in which our government leadership would like them to engage and the extent to which they are expected to contribute to the public treasury out of the command of resources they have gained from engaging in those activities.

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