Allocative Fairness and the Income Tax

Abstract

This article seeks to provide a normative justification for the “allocative tax fairness” principle of “objective ability to pay.” First off is a brief overview of norm categories as they relate to taxation. Here, the category of internal-to-tax fairness (“allocative fairness”), referring to how the tax burden should be apportioned among the population, is identified as being distinct from a conception of a good or just society (social equity). Allocative tax fairness is often referred to as “horizontal equity.” Unfortunately, that notion is purely formal, and the remainder of the article develops its proper substantive content, resulting in an objective ability-to-pay income tax.

The first move is to examine the seminal 1938 work of Henry Simons, whose definition of income (namely, that an individual’s personal income equals the sum of her consumption and net increases in wealth for the taxable year) is widely followed. The Simons definition has not, however, been the template for the current income tax in two major respects. First, changes in wealth, rather than being measured by annual changes in asset values, are instead reckoned, under the “realization principle,” upon disposition of assets for cash or its deemed equivalent. Second, consumption is not, in operational terms, an independent category of income (apart from “net increases in wealth”), but instead is viewed as a non-deductible use of income. It turns out that Simons’ definition was only tentative, and that Simons himself ultimately favored an income tax that is very close to the one advanced herein.

Turning to the merits, it is first shown that political theory and practice, general social norms, and human psychology constrain the concept of income so as to exclude non-market benefits, fix realization as a central principle, and justify allowances off the bottom. It is then argued allocative tax fairness should be taken seriously as a norm category. The objective ability-to-pay principle is constructed “from the top down” from the larger social concern with the (re)distribution of material resources. It can also be constructed “from the bottom up” with reference to the function of tax to raise revenue in the form of cash.

It is next contended that the objective ability-to-pay principle is best embodied in a realization income tax, as opposed to an annual wealth tax or a personal consumption tax. What then follows is an outline of the basic features of an objective ability-to-pay tax, which closely follows the existing income tax, except for accrual accounting, depreciation, cash borrowing, and debt-financed asset purchases.