We may think of “income” as the amount of money we receive for working at a job or for investing money that we have saved. However, if we wish to tax alike all taxpayers whose situations are alike, our notion of income must expand. Surely two workers whose wages are the same should not be regarded as like taxpayers if one of them wins $1M in the state’s lottery. The difference between these two taxpayers is that one has a much greater capacity to consume (i.e., to spend) and/or to save than the other. This suggests that pursuing the policies of horizontal and vertical equity requires that we not limit the concept of “income” to the fruits of labor or investment. Rather we should treat the concept of “income” as a function of both spending and saving. Indeed:
Consumption plus or minus increments to savings
We may accept the idea that “income” is not only money we receive as wages or salary plus return on investments (e.g., interest on a savings account) plus consumption acquired in a way not requiring the taxpayer to spend his/her/its own money. But shouldn’t the definition of “income” have something to do with “work,” “labor,” and perhaps “return on investment?” How is it that “income” is determined not by what we make by but what we save and spend?
Consider this simple fact pattern. A taxpayer earns at his/her job $50,000. S/he has no other income. What are the only two things this taxpayer can do with that money? Answer: spend it (consumption) or save it (addition to his/her store of property rights). Consumption and additions to the store of property rights are the two elements of income in the SHS definition of income. What the SHS formula of income can incorporate quite easily are “non-traditional” forms of income such as winning a lottery or winning a sizeable addition to savings, even when one cannot spend (consume) the winnings immediately. SeePulsifer v. Commissioner, 64 T.C. 245 (1975) (minors whose winnings in the 1969 Irish sweepstakes were held in trust for them by an Irish court realize income in 1969, not the year in which they turn 21; economic benefit doctrine applied). Lottery winnings of course are either spent on consumption or saved. Receipt of a U.S. savings bond is an addition to a taxpayer’s store of property rights.
Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question. 1
The economist Henry Simons propounded this definition. Derivation of the same formula is also attributed to Georg von Schanz and to Robert Murray Haig. We may refer to this formula to as the Schanz-Haig-Simons formula, the Haig-Simons formula, or the SHS formula.
If Algebra or Economics Scare You –
The terminology of the SHS formula is not as daunting as might appear. The phrase “rights exercised in consumption” merely reflects what a taxpayer spent (or would have spent if s/he received something for which s/he did not have to pay) to purchase something. The phrase “additions to the storehouse of property rights” merely reflects a taxpayer’s saving money, perhaps by depositing some of his/her income in a savings account or in a more sophisticated investment.
The SHS definition is in fact an (enormously convenient) “algebraic sum.” If it is true that:
(Income) = (Consumption) + (Additions to the store of property rights)
then it is equally true that
(Income) − (Additions to the store of property right) = (Consumption).
This point is quite useful to those who (believe that they) want the government to tax consumption rather than income, perhaps because they believe that those who save rather than spend will pay less in taxes than they do under the current system. Use of the algebraic quality of this definition means that no matter what our tax base is, we would never have to bear the expense or endure the inconvenience of keeping keep track of what we individually spend on consumption. Anyone who has received a W-2 from an employer or a 1099-INT from a bank knows that we can expect an employer or a bank to provide the pertinent information about wages or savings with an acceptable degree of accuracy. We already understand that the disposition of these funds is either going to be consumption or additions to saving. From this information, the amount a taxpayer spent on consumption can easily be determined simply by manipulating the SHS formula as above. When a(n odd) question arises outside the ambit of W-2s or 1099s, e.g., whether a taxpayer should include in his/her taxable income the value of a sumptuous meal that s/he would never have purchased for himself/herself, an affirmative answer requires no more than to add that value to “Consumption” which in turn increases the algebraic sum that is “Income.” Identifying a particular element of consumption, savings, or income will drive the others. Income, consumption, and savings are functions of each other.
Some Obvious or Not-so-Obvious Implications of the SHS Definition of “Income”
If we choose to tax what we spend and what we save, then in some manner we are taxing only increments to a taxpayer’s overall well-being. Our tax code demands an annual accounting and assessment even though this can be inconvenient – and even inaccurate – for some taxpayers. What happens during the year is treated as an increment to what happened before, e.g., we added to a savings account that we already had, we consumed (only) a small portion of an asset we already own. We are not taxing accumulated wealth – property taxes and estate taxes do that. A concept integral to our income tax is “basis,” and its function is to assure that our income tax does not tax accumulated wealth but only increments to it.