The measure of value is what a person is willing to pay for something s/he does not have or the price at which a person is willing to sell something s/he does have. A person cannot value something more than what s/he has to give in exchange. There are no truly “priceless” things. A person should pay no more than the value s/he places on an item s/he wants or sell an item for less than the value s/he places on it. 1
Taxing Only the Creation of Value?
Voluntary exchanges are often essential to the creation of the income that the Internal Revenue Code subjects to income tax. Arguably, the Code should not subject to tax events that everyone understands (probably) reduce a taxpayer’s wealth, but this is not the case. Court-ordered damages that a plaintiff deems inadequate to compensate for the loss of an unpurchased intangible (e.g., emotional tranquility) may nevertheless be subject to income tax. See § 104(a).
In fact, buyers try to purchase items at prices less than they value them. The excess is “buyer surplus.” Sellers try to sell items at prices higher than those at which they are actually willing to sell them. The excess is “seller surplus.” “Buyer surplus” plus “seller surplus” equals “cooperative surplus.” The cooperative surplus that buyer and seller create may or may not be shared equally – in fact there is no way to determine with certainty how they share the surplus. Those buyers or sellers with more market power than their counterparts – perhaps they have a monopoly or a monopsony – may capture all or almost all of the cooperative surplus. Nevertheless, every voluntary transaction should increase the overall wealth of the nation, i.e., the sum of the values we all place on what we have.
We assume that taxpayers who voluntarily enter transactions know best what will increase surplus value to themselves, and that the choices each taxpayer makes concerning what to buy and what to sell are no concern of any other taxpayer. The Internal Revenue Code, insofar as it taxes income, assumes that all taxpayers make purchasing choices with income that has already been subject to tax. Indeed, § 262(a) reflects this by denying deductions to taxpayers for purchases of items for personal consumption, including expenditures for basic living expenses. The statement that an expenditure is “personal” implies a legal conclusion concerning deductibility. If the money used to purchase items for personal consumption is subject to income tax, as a matter of policy the choices of any taxpayer with respect to such purchases should be unfettered. This observation supports not taxing the money taxpayer spends to make purchases over which the taxpayer exercises no choice.
On the seller’s side, we should not have a tax code that favors selling one type of good or service over another. Sellers should be encouraged to utilize their resources in whatever trade or business maximizes their own seller surplus, even illegal ones. 2 This is good for buyers because sellers should choose to produce those things whose sale will create buyer surplus. A seller’s choice of which good or service to offer should not depend on the cost of producing or providing that good or service. A necessary implication of this is that we should tax only the net income of those engaged in a trade or business – not gross proceeds. Section 162 implements this policy by allowing a deduction for ordinary and necessary trade or business expenses. One engaged in a trade or business generates profits by consuming productive inputs, and the cost of those inputs should not be subject to tax. If a taxpayer’s trade or business consumes productive inputs only slowly, i.e., over the course of more than a year, principles of depreciation 3 require the taxpayer to spread those costs over the longer period during which such consumption occurs. See, e.g., §§ 167 and 168. Those who engage in activities that cannot create value but which really amount to a zero-sum game, e.g., gambling, should not be permitted to reduce the income on which they pay income tax to less than zero. See § 165(d). 4
Congress may choose not to make citizens pay income tax on receipt of certain benefits or on purchase of certain items. For example, an employee who receives up to $10,000 from an employer for “qualified adoption expenses” may exclude that amount – as adjusted for inflation and subject to a phaseout – from his/her “gross income.” § 137. A taxpayer who pays such expenses may claim a credit equal to the amount that s/he paid. § 36C. A taxpayer who benefits from either of these two provisions enjoys a reduction in the federal income tax that s/he otherwise would have paid. We can view that reduction as a government expenditure. In fact, we call it a “tax expenditure.” These two tax expenditures were expected to be $0.5B in tax year 2012. Cong. Res. Serv., Tax Expenditures: Compendium of Background Material on Individual Provisions 791 (2012). The tax expenditure for employer contributions for employee health care was expected to be $109.3B. Id. at 5. Total tax expenditures for tax year 2015 were expected to be $1366.3B. Id. at 11. A government expenditure of nearly $1.4 trillion should be a matter of some policy concern.
If the choices of buyers and sellers concerning what to buy and what to sell are matters of self-determination, then their choices should theoretically generate as much after-tax value as possible. A “neutral” tax code will tax all income alike, irrespective of how it is earned or spent. In theory, such “tax neutrality” distorts the free market the least and causes the economy to create the most value possible. We recognize (or will soon recognize) that the tax code that the nation’s policy-makers, i.e. Congress, have created is not neutral. Rather, we reward certain choices regarding purchase and sale by not taxing the income necessary for their purchase or by taxing less the income resulting from certain sales. Such deviations from neutrality cost the U.S. Treasury because they represent congressional choices to forego revenue and/or to increase the tax burden of other taxpayers who do not make the same purchase and sale choices. Such deviations take us into the realm of tax policy.
The Essence of Basis
Adjusted basis represents money that will not again be subject to income tax, usually because it is what remains after taxpayer already paid income tax on a greater sum of money. More pithily: basis is “money that has already been taxed” (and so can’t be taxed again).
If Congress chooses to allow a taxpayer to exclude the value of a benefit from his/her gross income, we must treat the benefit as if taxpayer had purchased it with after-tax cash. By doing so, we assure ourselves that the value of the benefit will not “again” be subject to tax. This means that taxpayer will include in his/her adjusted basis of any property received in such a manner the value of the benefit so excluded. If the amount excluded from gross income is not added to taxpayer’s basis, it will be subject to tax upon sale of the item. See, e.g., § 132(a)(2) (qualified employee discount). That is hardly an “exclusion.”
Deviations from neutrality can ripple through the economy. They cause over-production of some things that do not increase the nation’s wealth as much as the production of other things would. We tolerate such sacrifices in overall value because we believe that there are other benefits that override such foregone value. When deviations are limited to transactions between two particular parties who can negotiate the purchase and sale of an item or benefit only from each other, e.g., employer and employee, one party may be able to capture more of the cooperative surplus for itself than it otherwise might. An employer might provide a benefit (e.g., group health insurance) to its employees, reduce employee wages by what would be the before-income-tax cost of the benefit, and pocket all of the tax savings. Such capture might be contrary to what Congress intended or anticipated.
Losses and Basis
When the Code permits the taxpayer to reduce his/her taxable income because of a loss sustained with respect to his/her property, the loss is limited to taxpayer’s adjusted basis in the property – not some other measure such as the property’s fair market value. Whatever loss the Code permits to reduce taxpayer’s taxable income must also reduce his/her basis in the property. The reduction cannot take taxpayer’s adjusted basis below $0. Do you see that this prevents the Code from becoming a government payment program?
When taxpayer has no adjusted basis in something measurable by dollars, we treat any amount a taxpayer realized in connection with the disposition of that “something” as entirely taxable income, i.e., the result of (amount realized) minus $0. This accounts for the rule that all of the proceeds from the sale of taxpayer’s blood are subject to income tax. It also makes the precise definitions of exclusions for damages received on account of personal physical injury set forth in § 104 particularly important.