Virginia Tax Review
discretionary income, nondiscretionary income, gratuitous receipts
The signature tax policy tension of the last two decades (at least) has been whether the federal tax base ought to reach income or only consumption. At the individual level, the current Internal Revenue Code (payroll taxes aside) incorporates an income tax base with numerous consumption tax components - provisions that allow either immediate deduction of a non-consumption capital expenditure (as under a cash-flow consumption tax), such as qualified pension plan and IRA savings, or exclusion of the returns to capital (as under a wage tax), such as the exclusion for home sale gain and Section 103 interest. (A more subtle wage tax feature is the reduced tax rate, at the individual level, of most capital gain and dividend income; a pure wage tax would apply a zero rate.) The hybrid nature of the current Code is often said to be the chief indicator that it is theoretically dysfunctional (as well as inexcusably complex on an administrative level). The confluence of income and consumption tax provisions seems to indicate that we simply can't make up our minds which base is best, and thus we've enacted a hodgepodge of provisions from both worlds, picking and choosing here and there from both menus. But there is, I believe, a persuasive argument that this debate misses the point, after all. I think the key to understanding the theoretical construct underlying our desires for the ideal tax base - as well as the key to improving current law - is that we wish to protect from taxation wealth accessions spent on nondiscretionary consumption or saved for future nondiscretionary consumption. This distinction between discretionary and nondiscretionary income, first explored several decades ago by Canada's Royal Commission on Taxation in connection with a progressive rate structure, has significant explanatory force with respect to several key provisions in our current tax base and offers a promising route to significant reform. After discussing that study, the paper discusses the Nondiscretionary Deduction that is proposed as a replacement for the Standard Deduction, the Personal and Dependent Exemption Deductions, the Child Tax Credit, the Qualified Residence Interest Deduction, the Deduction for State and Local Taxes, and perhaps the Dependent Care Credit and the Hope and Lifetime Learning Credits. The Nondiscretionary Deduction that I propose would be keyed to median nondiscretionary outlays rather than the actual outlays of each taxpayer, although the amount of the deduction would be derived under a check-the-box format that takes into account relevant taxpayer status criteria (such as household size, whether the taxpayer owns or rents a home, perhaps whether the taxpayer or dependent is a full-time student in higher education, etc.). While a nice side effect of this approach would likely be significant simplification, it is based in principle - in a rationalization of the implicit values underlying current law - and not on a desire for simplicity for its own sake. If discretionary income is more fairly taxed than nondiscretionary income, the paper also argues that the reduced tax rate for net capital gain and dividend income, as well as a blanket exclusion for home sale gain, is not defensible (though integration of the individual and corporate taxes would be). Moreover, large gratuitous receipts (above an administratively feasible exemption amount of, say, $25,000 per year), whether received as an inter vivos receipt or at death of the transferor, should be included in the recipient's tax base. All included in-kind receipts could then take a fresh, fair market value basis, as under current section 1014 (section 1015 would be retained only for in-kind receipts excluded under the de minimis rule), and the wealth transfer taxes (the estate, gift, and generation-skipping tax regimes) could be permanently repealed.
Deborah A. Geier, The Taxation of Income Available for Discretionary Use, 25 Virginia Tax Review 765 (Winter 2006)