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Deferral Until Consumption

30 July, 2015 - 16:51

An “income tax” is a tax on income. A “consumption tax” is a tax on consumption. We have largely regarded the Code as one creating an income tax. In fact the Code creates a hybrid whereby income that a taxpayer spends on certain specific items of consumption is not subject to income tax – if at all – until taxpayer in fact spends it on those forms of consumption. Consider two examples:

Individual Retirement Accounts: Sections 219/62(a)(7) permit taxpayer to deduct above-the-line up to $5000, § 219(b)(5)(A), indexed for inflation, § 219(b)(5)(D), for payments to an individual retirement account. Income on the account is not currently subject to income tax. § 408(e)(1). The payee or distributee must include in his/her gross income payments from the account in the manner provided under § 72 (annuities). § 408(d)(1). Section 72(t)(1) generally imposes a 10% penalty tax – in addition to the income tax due – on an early distribution from an IRA. A distribution is not early if it occurs on or after taxpayer attains the age of 59½, §§ 72(t)(2)(A)(i), 72(t)(5); distributions must begin no later than April 1 of the calendar year after taxpayer turns 70½, § 408(a)(6) (incorporating rules of § 401(a)(9)(C)(i)). Thus, deducted amounts that a taxpayer saves in a “traditional” 1 individual retirement account plus returns on the investment are subject to tax – but at a time when taxpayer will be spending it on consumption in retirement.

Health Savings Accounts: Sections 223/62(a)(19) permit taxpayer to deduct above-the-line amounts contributed to a “health savings account.” A condition of this deduction is that taxpayer must purchase a “high-deductible health plan, § 223(c)(1)(A), a phrase that the Code defines, § 223(c)(2). Taxpayer may deduct contributions to such accounts – subject to limitations, § 223(c)(b)(2). Taxpayer may use funds in the account exclusively to pay “qualified medical expenses,” 2 § 223(d)(1). The account is exempt from income tax, so long as it remains a “health savings account.” §§ 223(e)(1), 223(f)(1). A “health savings account” acquired by a surviving spouse continues to be a “health savings account.” The health savings account provisions of the Code permit taxpayers not to pay any income tax on expenditures for consumption of certain medical services on the condition that taxpayers purchase high-deductible health plans.

Congress may use the tool of providing special income tax treatment – whether deferral or exemption – of the income that taxpayer saves for certain forms of consumption to encourage taxpayers to save current income for such future consumption.