Mark KettlewellTax Policy Seminar PaperPrivate Investment as a Common Pool Resource: Why Productive Assets Should be Exempt from TaxationI. Introductiona. Common pool terminology (BRIEF)Invested funds are fundamentally part of what economists refer to as common pool resources. In this context, common pool resources are those that benefit the community as a whole, rather than benefitting any particular individual.[footnoteRef:1] This article will explore the idea that private investment functions as a public resource until the proceeds from that investment are consumed. As such, fairness requires that individuals be taxed in proportion to their withdrawals from the common pool, rather than on their contributions to it. [1: See Kaldor, supra note 1, at 53.]

b. Definition of Incomec. Expenditure Taxesd. Horizontal EquityII. Basic Income Tax & Simons Definition of Incomea. Definition of IncomeIn his seminal work, Definition of Income, Henry Simons defined income 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.[footnoteRef:2] The first part of this sum is commonly referred to as consumption, and a tax based solely on the first part is known as a consumption tax or expenditure tax. The second part can be phrased more succinctly as the increase in wealth. [2: Henry Simons, Definition of Income 50 (1938).]

Problems in defining consumption occur when it is difficult to discern whether a benefit conferred by an employer is compensation for services or is supplied for the convenience of the employer.[footnoteRef:3] The Court in Benaglia v. Commissioner held that rooms and meals provided to the manager employed by a hotel were for the employers convenience, since the manager was required to live and dine on the premises.[footnoteRef:4] In that case, what would commonly be considered consumption, room and board, was not classified as income by the court. Since income includes all consumption under Simons commonly accepted definition, the managers room and board was not considered consumption by the I.R.S. [footnoteRef:5] [3: Benaglia v. C.I.R., 36 B.T.A. 838, 840 (1937)] [4: Id.] [5: Benaglia v.Commr., 36 B.T.A. 838, 840 (1937).]

While some grey areas exist in the definition of consumption, it is relatively clear when compared to the other element of income, the increase in wealth, or gain. While the primary issue with measuring consumption lies in the definition, the issue with measuring gain prior to realization is valuation. The value of an asset can be difficult to accurately assess prior to a sale. Some assets, such as commonly-traded stocks, are relatively easy to value since the market provides clear prices on stock exchanges. Other assets, such as machinery or homes, are more difficult to accurately value. Generally, the more commonly traded an asset class is, the easier it is value, and the more unique and less liquid an asset is, the more difficult it is to value.[footnoteRef:6] [6: See Simons, supra note 1, at 56.]

b. Income taxes focus on realization events because it is impractical to tax accrual as it occurs Simons discussed the difficulty of consistently defining realization at some length,[footnoteRef:7] acknowledging the impossibility of distinguishing between realized and unrealized gains for the purpose of defining income.[footnoteRef:8] Simons goal was to define income in order to tax it, and yet he dismissed as irrelevant whether or not gains had been realized in this portion of the book, seemingly because he was criticizing competing definitions of income. Later though, he states out right that The realization criterion is not only indispensable to a feasible income-tax system but relatively unobjectionable in principle where it results only in postponement of assessment, or in cancellation of earlier "paper profits" against subsequent paper losses.[footnoteRef:9] [7: See Id., at 59-106.] [8: Id. at 86-87.] [9: Id. at 162.]

Any system that taxes gain upon realization will inevitably produce inequitable outcomes arising from differences in timing. While Simons acknowledged that tax avoidance attempts were inevitable,[footnoteRef:10] he seemed to believe that adequate planning by taxing authorities could prevent material tax avoidance. In spite of this, Simons admits that Realization, broadly conceived, is something achieved only in consumption.[footnoteRef:11] [10: Id. at 153.] [11: Id. at 89; It may be said that private investment is just as much a demand on output as is consumption, and that taxing accumulation will serve to release additional real resources for public use. But investment is not a final use of economic resources; it is an intermediate use by which more is ultimately to be produced for future consumption, private or public, or for further investment. A tax on investment as such means an additional burden on those products and processes that require substantial investment as compared with others that do not. (?) A general revenue tax ought to deal with final products, on an aggregate basis, without discrimination according to means of production. Moreover, changes in the rate of tax on consumption can themselves affect investment in facilities for the production of private consumption goods. William D. Andrews, A Consumption-Type or Cash Flow Personal Income Tax, 87 Harv. L. Rev. 1113, 1166 (1974).]

c. Realization requirement leads to numerous distortions (ideally taxes should not distort economic behavior) (use concrete examples here; legislation, studies, etc.)Warren Buffet, for example, noted that his $350 billion dollar conglomerate, Berkshire Hathaway, has a significant advantage over smaller competitors and investors because of its corporate structure. As a conglomerate, Berkshire Hathaway has the ability to defer realization for tax purposes indefinitely. The tax strategies that Berkshire employs are incredibly complex, but I will summarize a couple of the simpler examples. Comment by Cheryl Block: How exactly does the corporate structure permit the company to do this? And how does this relate to your general consumption vs. income tax theme? In other words, how much of this is unique to the Subchapter C tax treatment of corporations and shareholders, and how much of it relates to the tax base question?A concrete example/hypothetical would help.Berkshire Hathaway has owned insurance businesses since very early in its history. Insurance companies invest something called an insurance float, which is the difference between what it collects in premiums versus what it pays out in claims.[footnoteRef:12] Since Berkshire Hathaway owns insurance companies outright, it is free to invest this float however it chooses, and it chooses to invest with Berkshire Hathaway. Since this money is perpetually invested in a company that doesnt pay dividends, capital gains are the sole returns. Since the stock is never sold by the insurance company, it will never have to pay taxes on those capital gains. Even if the insurance company did sell the Berkshire Hathaway stock, it would have still benefited from decades of tax-free investment growth. Berkshire Hathaway is free to invest the insurance float as it sees fit, so this float acts as a tax-free and interest-free loan for Berkshire Hathaway to invest with. [12: Patrick Morris, Why Warren Buffett's Berkshire Hathaway Won't Pay a Dividend in 2015, The Motley Fool (November 16, 2014), http://www.fool.com/investing/general/2014/11/16/why-warren-buffetts-berkshire-hathaway-wont-pay-a.aspx.]

Another way that Berkshire Hathaway can avoid realization is through like-kind exchanges, which are permitted under 26 C.F.R. 1.103. The company recently conducted an asset swap with Graham Holdings that allowed Berkshire Hathaway to cash out its $1.1 billion dollar investment in Graham Holdings. Berkshire Hathaway essentially traded its interest in Graham holdings for a $364 million TV station, $327.7 million in cash, and $400.3 million worth of Berkshire Hathaway Shares. The basis for that investment was only $11 million, meaning that almost the entire amount would typically be subject to taxation as capital gains. However, through the clever use of a subsidiary created for the purpose, Berkshire Hathaway was able to avoid approximately $400 million worth of tax liability.[footnoteRef:13] [13: Antoine Gara, Berkshire May Avoid $400 Million Tax Bill In Graham Holdings Swap, TheStreet (March 14, 2014), http://www.thestreet.com/story/12529683/1/berkshire-may-avoid-400-million-tax-bill-in-graham-holdings-swap.html.]

Warren Buffet acknowledged the importance of these types of transactions in 2014 when he noted in Berkshire Hathaways annual report that [a]t the shareholder level, taxes and frictional costs weigh heavily on individual investors when they attempt to reallocate capital [but that] [a]t Berkshire, we can without incurring taxes or much in the way of other costs move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise.[footnoteRef:14] Surely any rational person evaluating ability to pay, would not put Berkshire Hathaway at the bottom of the list. However, due to its corporate structure, it enjoys enormous tax advantages over smaller investors. The scale of the enterprise, along with the nature of a sophisticated holding company, allows Berkshire Hathaway to structure transactions in a way that is impossible for smaller or more focused firms.Comment by Cheryl Block: Fn unnecessarily repeats much of the language from text, without explaining much (see above comment).Comment by Cheryl Block: Ditto what about its corporate structure in particular? [14: Warren Buffet, Berkshire Hathaway 2014 Annual Report 30 (2014). Buffet also noted that at the shareholder level, taxes and frictional costs weigh heavily on individual investors when they attempt to reallocate capital among businesses and industries In contrast, a conglomerate such as Berkshire is perfectly positioned to allocate capital rationally and at minimal cost. Id.]

The individual investor lacks the economy of scale necessary to execute the maneuver Berkshire Hathaway did when it cashed out of Graham Holdings. For comparison, let us consider an individual investor who reinvests dividends every year. At tax rate of 15%, someone who receives a qualified annual dividend of 7% for twenty years, and reinvests the dividend every year, will incur 42% more tax cost[footnoteRef:15] than someone who invests in stock and is taxed for capital gains only when the shares are sold.[footnoteRef:16] The only difference between these two investors is the form in which they choose to receive their returns. The frugal retired woman who relies on dividends as a steady stream of income will pay 42% more taxes over 20 years than the younger person who invests in an S&P index fund and receives only the profit on the sale. Comment by Cheryl Block: Again, this goes more to realization than to the choice of income vs. consumption tax as a base, I think. [15: Tax cost refers to the sum of the actual tax paid, and the return that the money paid in taxes would have earned for the remainder of the calculated period. This return represented 3% of the actual tax incurred. ] [16: The figures cited here were calculated using Microsoft Excel. The numbers assume a 15% tax rate for both dividends and capital gains, and a 7% annual rate of return. Calculations assumed that dividends were reinvested each year, and that income was taxed as a qualified dividend at the 15% rate.]

Ironically, the largest corporations reap the greatest tax benefits in this system. In addition to being able to limit their tax liability to one-time capital gains taxes at the point of realization, they have the resources to execute in-kind transfers to further delay a realization event. Warren Buffet has stated explicitly that Berkshire Hathaway does not distribute dividends because of tax implications of annual reinvestment used in the example above. Instead, he recommends that investors sell stock if they are in need of liquidity.[footnoteRef:17] He follows his own advice. In 2010, Buffets taxable income was $39.8 million, and he paid capital gains taxes of only $6.9 million.[footnoteRef:18] During that taxable year, Buffett had a net worth of approximately $47 billion.[footnoteRef:19] If Berkshire followed the average of the S&P 500, it would have paid out about $6 billion in dividends in 2014, and Buffetts share would have been about $1.2 billion.[footnoteRef:20]Comment by Cheryl Block: How so? Explain. [17: Carolyn Bigda, Dividends from Berkshire? Not on Buffett's Watch, Kiplinger (April 17, 2014), http://www.kiplinger.com/article/investing/T052-C008-S003-berkshire-hathaway-won-t-pay-dividends-with-buffet.html.] [18: Morris Propp, Warren Buffetts Nifty Tax Loophole, Barrons (April 11, 2015), http://online.barrons.com/articles/warren-buffetts-nifty-tax-loophole-1428726092.] [19: The Worlds Billionaires, Forbes (March 10, 2010), http://www.forbes.com/lists/2010/10/billionaires-2010_Warren-Buffett_C0R3.html] [20: Propp, supra note 17.]

It is not necessarily a negative that Berkshire Hathaway is allowed to reinvest in this way. Like-kind exchanges under 1031 of the Internal Revenue code allow businesses to trade one productive asset for another.[footnoteRef:21] The most common use of like-kind exchanges involve real estate. The Service articulated two major rationales for section 1031: (i) that nonrecognition treatment should lie where the taxpayer received like kind property because he has not cashed out of his investment; and (ii) that requiring sale or exchange treatment in this context would create administrative burdens with respect to valuing such replacement property.[footnoteRef:22] The second part of this rationale makes sense when considering illiquid assets, such as real property. This rationale would not apply to liquid assets. The first reason, however, applies just as well to stocks and bonds as it does to real estate, and yet stocks and bonds are specifically excluded from this tax treatment.[footnoteRef:23] Because realization is difficult to define at times, and because the length of investments varies greatly depending on a variety of factors, these types of discrepancies in tax treatment are likely inevitable. Cashing out should be the point where taxes are levied, and one way to ensure taxpayers are treated fairly is to tax them all at the same point consumption. The common investor should not be taxed at higher rates than Warren Buffet because he or she lacks the resources to swap entire enterprises and conduct other elaborate tax-avoidance maneuvers. [21: 26 U.S.C.A. 1031 (West).] [22: Stefan F. Tucker, Tammara F. Langlieb, Understanding Like Kind Exchanges (with Checklist) the Idea Behind Like Kind Exchanges May Be Simple, but Making Them Work Isn't, Prac. Tax Law., Summer 2012, at 21, 29.] [23: 26 U.S.C.A. 1031 (West).]

Simons definition of income is valid as a philosophical definition of what constitutes income, and it is logical to calculate income as the consumption plus increases or decreases in wealth. As Simons himself admitted, though, it is completely impractical to implement an income tax based on his theoretical definition of income, and so we are left with gains bastard son realization, which under current law is defined so erratically that no sane person could describe it as fair. Simons had it right when he concluded that broad realization would exclude all income save consumption from an income tax. [footnoteRef:24] What he got wrong was that excluding income as it accrued (prior to consumption) would be unjust, unworkable, or that it would disadvantage those least able to pay. [24: Realization, broadly conceived, is something achieved only in consumption, for only there does one find a stopping place among the sequence of economic relations. Consumption is essentially a destruction, a using-up, an end. Simons, supra note 1, at 89.]

III. Expenditure TaxesIV. The Common Poola. Common Pool ResourcesThe idea of common pool resources originated in economics, and refers generally to resources owned and used by more than one person.[footnoteRef:25] The most famous use of the idea is probably Garret Hardins 1968 article, Tragedy of the Commons.[footnoteRef:26] While the concept itself had been around for centuries, the packaging of the idea as the Tragedy of the Commons is what brought the idea into common modern discourse. Hardin uses the example of a public pasture to explain the concept. If many herdsman have access to the pasture, the incentive for each herdsman is to have as many animals as possible graze in the pasture, since the herdsman reaps the full reward, and the additional cost, in the form of the consumption of the grass, is shared by the entire group. If each herdsman had a private plot, there would be an incentive to manage the pasture to ensure its future productivity. Very little such incentive exists when the grazing area is commonly owned.[footnoteRef:27] [25: See Susan Block-Lieb, Congress' Temptation to Defect: A Political and Economic Theory of Legislative Resolutions to Financial Common Pool Problems, 39 Ariz. L. Rev. 801, 810 (1997).] [26: Garret Hardin, The Tragedy of the Commons 162 Science, New Series 1243 (Dec. 13, 1968).] [27: See Hardin, supra note 6, at 1244.]

Another example is the common fishery. For example, each fishermans incentive is to harvest as many fish as possible from the ocean. As in the pasture example, any single fisherman cannot manage the common pool fishery alone. There is no way for an individual to prevent others from depleting the resource in question, thus making conservation of the fish population impossible. The rational alternative is for each fisherman to catch as many fish as possible, even if the result is a far less productive resource overall.[footnoteRef:28] [28: H. Scott Gordon, The Economic Theory of a Common-Property Resource: The Fishery 62 Journal of Political Economy 124 (April, 1954).]

b. Game TheoryCommon-pool resource problems have been analyzed using the classic prisoners from game theory. which is an economic theory that describes how people can be expected to act using incomplete information to assess the likely actions of others.[footnoteRef:29] One respected attorney summarized the Prisoners Dilemma as follows:Comment by Cheryl Block: Perhaps move this definition or elaboration to fn. Also, I suggest finding a more authoritative source for the definition of game theory, and in particular one that does a good job of explaining the prisoners dilemma. Comment by Cheryl Block: You should add some brief lead in/transition to quote. [29: 5A Ohio Jur. 3d Alternative Dispute Resolution 29.]

Prisoner's Dilemma is a type of non-zero-sum game in which two players may each cooperate with or betray the other player. From the participants' perspective, it has been shown there is no predictable outcome -- the outcome from each player's decision depends on the decision adopted by the other player. However, no matter what the other player does, one player will usually get a greater benefit by betraying or defecting Yet, the best outcome for everyone requires that no one defect. That is the dilemma.[footnoteRef:30] [30: Daniel Donovan & John Rhodes, The Prisoner's Dilemma Becomes the Lawyer's Dilemma to Be A Zealous Advocate or A Judas Goat?, Mont. Law., December 2009/January 2010, at 8, 10. See also Lester B. Lave, An Empirical Approach to the Prisoners Dilemma Game, 76 The Quarterly Journal of Economics, Aug. 1962, at 424.]

Game theory provides a framework with which to analyze common-pool resource problems. As with the prisoners dilemma, those using a common-pool resource have an individual incentive to act to the detriment of the group. Yet, if they act collectively to conserve the resource, all will be better off. This holds whether the resource in question is a pasture, a fishery, or a forest.c. Privately-Invested Capital as a Common-Pool ResourceAlthough privately owned, invested capital may also be viewed as a type of common-pool resource.[footnoteRef:31] Like a common forest or fishery, conservation of capital (investment) helps to ensure that the resource remains productive. Limiting the fish withdrawn from the ocean results in greater numbers of fish and easier fishing. Limiting the amount of capital withdrawn from the common pool results in higher productivity, and the higher standard of living that accompanies such increased productivity. Such capital is invested in factories, infrastructure such as power plants, construction equipment, and innumerable other productive uses. [31: ]

Capital investment multiplies the productivity of every worker in America, and raises the collective standard of living far beyond what it would be absent capital investment. While it is not a linear relationship, it is well settled that the greater the invested capital in a society, the higher the productivity of the workers.[footnoteRef:32] Increasing the standard of living is only possible when, in the aggregate, we consume less than we produce. This is because invested capital is only created, both at the individual and aggregate level, when production exceeds consumption.[footnoteRef:33] Absent such a surplus, no investment can be made, since the lack of a surplus by definition means that total production was completely consumed in a given period. [32: See Kevin J. Stiroh, What Drives Productivity Growth?, FRBNY Economic Policy Review, Mar. 2001, at 37.] [33: [I]n the short run raising per capita output and raising per capita consumption may be antithetical, for the rate of capital accumulation will depend on the extent to which increases in output are not followed by equal increases in consumption. Thus, while the raising of per capita consumption levels may be, and perhaps must be, an ultimate goal of development, if we concentrate on consumption as an immediate goal, it may be impossible of achievement as an ultimate goal. It is therefore per capita output that must be looked upon as an appropriate index of economic development. Walter Galenson and Harvey Leibenstein, Investment Criteria, Productivity, and Economic Development 69 The Quarterly Journal of Economics 343 (August, 1955).]

No one denies that capital is fundamentally necessary to maintain and advance civilization. Even the earliest farmers required seed corn, and the Stone Age hunters used stone axes and arrowheads to feed themselves. A spear tip is a form of invested capital. The time involved in manufacturing an arrowhead constituted the investment, and the increase in hunting efficiency constituted the return on that investment. Every tool, every building, every machine, and every other productive asset represent invested capital, and that invested capital exists because someone chose to consume less than they produced.[footnoteRef:34] [34: See John Stuart Mill, Principles of Political Economy, at 68 (1885).]

The surplus that results from delayed consumption may be thought of as savings or investment, depending on ones perspective. These are two sides of the same coin, since for all practical purposes all savings is investment. John Maynard Keynes noted that this equality was not in dispute among economists, and that the great majority of economists agreed that savings and investment were equal.[footnoteRef:35] [35: Provided it is agreed that income is equal to the value of current output, that current investment is equal to the value of that part of current output which is not consumed, and that saving is equal to the excess of income over consumptionall of which is conformable both to common sense and to the traditional usage of the great majority of economiststhe equality of saving and investment necessarily follows. John Maynard Keynes, The General Theory of Employment, Interest, and Money, at 63 (1936).]

Thomas Hobbes, in his book Leviathan, was one of the earliest and most influential philosophers to write about privately-owned capital in terms of the common pool. The passage in question was so relevant to Nicholas Kaldor that he began An Expenditure Tax by quoting Hobbes:[T]he equality of imposition consisteth rather in the equality of that which is consumed, than of the riches of the persons that consume the same. For what reason is there that he which laboureth much and, sparing the fruits of his labour, consumeth little should be more charged than he that, living idly, getteth little and spendeth all he gets; seeing the one hath no more protection from the Commonwealth than the other? But when the impositions are laid upon those things which men consume, every man payeth equally for what he useth; nor is the Commonwealth defrauded by the luxurious waste of private men.[footnoteRef:36] [36: Thomas Hobbes, Leviathan, at 212-213 (1651). [shouldnt cite be to Kaldor, with a parenthetical (quoting Hobbes . . .?]]

The essence of this quote is that Hobbes believes that government should be funded in proportion to consumption, and that saving should be excluded from taxation. Hobbes was analyzing taxes within a benefit tax framework, which is apparent when he reasons that savers receive no more protection from government than spenders, and that savers should not have to shoulder more of the tax burden as long as they delayed the consumption of his earnings. The underlying assumption in Hobbes writing here is that saving, and by extension capital accumulation, is a virtue in and of itself. This is logical when we think in terms of the whole population, and think of invested capital as a common resource prior to consumption. Who could deny that the savings and investment of all of the people who have come before us do not still benefit us? All of the factories built, the tools and machines invented, the books written, and the research facilities built represent deferred consumption. Wipe away the accumulated capital of humanity and we would all be miserably poor, and the great majority would surely starve.As an illustration, one history professor attempted to estimate the cost of a shirt prior to the mechanization of textile production. She estimated the labor required to produce thread, weave cloth, and sew the fabric into a shirt. The total hours required prior to industrialization came to 479., and the list only included those three labor items. At todays hourly minimum wage of $7.25, the shirt would cost $3,472.75. .[footnoteRef:37] A minimum wage worker today can earn enough to purchase a shirt with less than an hours wages. That same worker can feed himself for a month on two or three days wages. This increase in prosperity is due entirely to the productivity multiplier effect of capital investment. Even though that capital investment is controlled by private parties, the owners choices to defer consumption make civilization possible. That is what makes privately invested capital a common pool resource that should be off-limits to taxes. That collection of wealth is what supports everything else, including our government and its associated social programs. To whittle away at it is to eat our collective seed corn. [37: Eve Fisher, The $3500 Shirt - A History Lesson in Economics, Sleuthsayers (June 6, 2013), http://www.sleuthsayers.org/2013/06/the-3500-shirt-history-lesson-in.html]

While those who control the investment maintain the right to liquidate it at any time, as long as they defer consumption, their capital is used to increase the collective productivity of the nation. In that way, privately invested capital acts as a public resource. When that capital is withdrawn from the common pool and consumed, either by the original investor or by his or her heirs, then the consumption could be taxed. Some large firms basically operate this way now. Amazon is one example of a company that as of this moment, exists as a kind of public service. The company has invested tens of billions of dollars in warehouses, shipping facilities, massive computing complexes, and technological innovation. Amazon is one of the most successful retailers in the world. I also develops products, provides logistics services to thousands of companies, and offers some of the most advanced cloud services in the world. In spite of all this, the company has yet to produce any meaningful profit. All of this effort, and all of this money has served only to provide goods and services to consumers ever more efficiently. Amazon has never paid a dividend. Every dime of profit the company has ever made has been reinvested into the business to the benefit of consumers.[footnoteRef:38] [38: Benedict Evans, Why Amazon Has no Profit, and Why It Works, Quartz (September 10, 2014), http://qz.com/262701/why-amazon-has-no-profit-and-why-it-works/]

V. Horizontal Equitya. Ability to payThe progressive income tax is based on the idea that government should be funded by those with the greatest ability to pay,[footnoteRef:39] and that income is the best measure of that ability. This assertion is questionable, since an income tax ignores wealth altogether, and instead considers only consumption and changes in wealth.[footnoteRef:40] More importantly, the current income tax taxes increases in wealth in an indisputably inconsistent manner. Distortions and inefficiencies arise from taxation upon realization, rather than upon accrual. While it is more practical to impose tax when assets are converted to cash, it is certainly not equitable. [39: The idea that taxes should be levied based on the ability to pay seems to be rooted in Communist thought. Karl Marx created the famous Communist Slogan From each according to his ability, to each according to his need! in 1875. It was first mentioned in a letter entitled, Critique of the Gotha Programme. Karl Marx, Critique of the Gotha Programme, in 3 (Collected works / Karl Marx, Frederick Engels 13-30, (New York : International Publishers) (1975). Nicholas Kaldor also discussed the ability to pay in An Expenditure Tax. He notes that it is impossible to design a just system of taxation independent of morality, and that the almost universally accepted principle behind tax equity is the ability to pay. Nicholas Kaldor, An Expenditure Tax 26-27. Henry Simons also considered tensions between the benefit principle and ability to pay, and argued (?) that the ability to pay principle was as morally correct, without further discussion. Henry Simons, Definition of Income 3-7.] [40: See Kaldor, supra note 1, at 46-47 (noting that income is notoriously difficult to define, results in numerous capricious inequities, and poorly defines spending power, especially since it makes no effort to tax dis-saving).]

For both businesses and individuals, the income tax is a failure with regard to fairness. Huge corporations with massive amounts of revenue avoid taxation altogether, while many smaller enterprises pay much higher effective rates. Wage income is taxed at rates that can be more than double the capital gains rate, with the perverse effect that Warren Buffets secretary is taxed at a higher effective rate than Buffet himself.[footnoteRef:41] [41: Chris Isidore, Buffett says he's still paying lower tax rate than his secretary, CNN Money (March 4, 2013), available at http://money.cnn.com/2013/03/04/news/economy/buffett-secretary-taxes/.]

The progressive income tax was implemented with the idea that those with the most available resources should be those who contribute the most to public expenses, and the income tax is structured to shift consumption from the private spending. The principal purpose of the tax, in terms of real goods and services, is to curtail private consumption so that resources will be released for public use.[footnoteRef:42] As I have discussed at length here, the ability to pay is notoriously difficult to measure in an equitable way, given problems inherent in trying to consistently apply the realization principle. [42: Andrews, supra note 29, at 1121.]

Problems with inconsistent and arbitrary tax treatment of realization can be avoided entirely if one uses consumption as a proxy for the standard of living. In terms of fairness, the income tax attempts to approximate this, but often approximates it poorly. Nevertheless, the income tax is the fairest option tried so far because those with the tax burdens and the standard of living of those being taxed are generally proportionate.[footnoteRef:43] A consumption tax would always align with the standard of living, since the level of consumption is how the standard of living is defined. Also, no income, whether earned as wages or capital gains, would escape taxation, but rather that tax on income would be deferred until consumption.[footnoteRef:44] [43: Id. at 1122.] [44: Id. at ]

b. Standard of LivingAn alternative to taxing based on ability to pay would be to tax based on the standard of living enjoyed by those being taxed. Since productive assets are the foundation of a modern economy, personal consumption would be a more appropriate tax base. c. Realization PrincipleInconsistent and uneven definitions of realization, and the accompanying disparate treatment of investors with regards to timing, leads to the distortions discussed earlier. Under current tax law, Berkshire Hathaway and Amazon realize almost no taxable income, but under any plausible definition of income they certainly have gain. In spite of this, they manage to avoid paying any meaningful income tax. The revenue in excess of costs is there, but because they reinvest cash as fast as it comes in, the tax is delayed in seeming perpetuity.The retired woman I mentioned in the introduction receives no such leniency. Her dividends are taxed even if reinvested immediately with the same firm. How can this be fair or equitable in anyones eyes? The ordinary citizen is treated as realizing income with each transaction. A business such as Amazon is taxed only when it ceases to reinvest its profits. If equitable treatment is a requirement of a fair and just system of taxation, and if the ability to pay is the relevant criteria, then every citizen should have the right to invest with the same tax treatment accorded to business owners and corporations.The fundamental issue here revolves around the realization principle. The realization principle holds that it is impractical to tax capital appreciation prior to the sale of the asset, since the funds required to pay the taxes are unlikely to be available prior to the sale of that asset. In Henry Simons influential work, Definition of Income, he noted that [r]ealization, broadly conceived, is something achieved only in consumption, for only there does one find a stopping place among the sequence of economic relations. Consumption is essentially a destruction, a using-up, an end.[footnoteRef:45] When Simons wrote this, he was arguing against a broad application of the realization principle, but in trying to effectively tax income, he attempted to narrow the application of the principle, since full application of it would result in a consumption tax. [45: See Simons, supra note 1, at 89.]

Defining realization as end consumption is the most consistent and logical way to define income. Individual investments should receive the same tax treatment as business investments, because in practice, they amount to the same thing: expenses in the present exchanged for higher future consumption. A business owner may take a lower salary for years, carefully reinvesting what would have been taxable profits back into his business in the form of capital investment. The individual investor has no such right of deferred taxation on reinvested assets, and this is the fundamental problem inherent in a system that attempts to tax increases in wealth prior to consumption. The disparate impact grows with the size and complexity of the firm involved, since the greater the resources of the firm, the more options it will have to creatively reinvest. Berkshire Hathaway and Amazon both avoid almost all taxes through investment in a variety of enterprises. Much of their ability to avoid tax arises from sophisticated tax strategies that exploit inconsistent treatment and definitions of realization. New investments lose money for a time, and are funded by more mature segments of the business.[footnoteRef:46] The realization principle is what makes this possible. The Internal Revenue Service allows new investment within existing corporations to be counted as an expense against revenue, even if the revenue comes from a business unit that is functionally isolated from the source of the expense. The tax code also allows one business to be traded for another, a maneuver that is unavailable to the vast majority of taxpayers for practical rather than legal reasons. [46: See Benedict Evans, Amazons Profits, Benedict Evans (August 8, 2013), http://ben-evans.com/benedictevans/2013/8/8/amazons-profits; See Also Tim Worstall, The Internal Economics of Amazons No Profits Growth Model (September 7, 2014), http://www.forbes.com/sites/timworstall/2014/09/07/the-internal-economics-of-amazons-no-profits-growth-model/.]

By taxing consumption, rather than income, we can level the playing field.[footnoteRef:47] Large conglomerates, small businesses, and individual investors would be free to invest as they see fit, and would pay taxes when they actually realized income: when it was no longer saved or invested, but rather was consumed. The current system manages to tax the capital gains of only the unsophisticated investor. Taxable income or cash income figures do not reflect the standard of living at the top. Economist Eugene Steuerle found that the wealthiest taxpayers annual income as reported on their income tax returns was 1.88% of the wealth reported on their estate tax returns, at a time when corporate bonds were paying 7%-8% interest rates.[footnoteRef:48] The very wealthy already escape much of the capital gains tax, and at least under a consumption tax those who withdrew funds from productivity-enhancing investment would pay their fair share. [47: See generally Calvin H. Johnson, Was It Lost?: Personal Deductions Under Tax Reform, 59 SMU L. Rev. 689, 702 (2006).] [48: Id., at 110.]

d. Taxing based on standard of living is more fair than taxing based on actual ability to payJohn Rawls recognized the importance of common pool private investment when he wrote about the morality of equality and redistribution. While he was in favor of government policies designed to minimize inequality, including substantial transfer payments, he was opposed to the income tax because he viewed it as unjust. He noted that a consumption tax was preferable to an income tax (of any kind) at the level of common sense precepts of justice, since it imposes a levy according to how much a person takes out of the common store of goods and not according to how much he contributes.[footnoteRef:49] [49: John Rawls, A Theory of Justice, at 246 (1971).]

This language more eloquently states what I noted above, that taxing contributions to the common pool is a fundamentally flawed policy. The saying that a rising tide lifts all boats has become something of a joke amongst those who view supply-side economics as fallacious, but in the long term it is undeniable.[footnoteRef:50] Only by ignoring technological advance and efficiencies could anyone claim people become worse off when aggregate wealth is increased. Even if that wealth is managed by a relatively small proportion of the population, it still works for the benefit of all of us. [50: ]

In areas of the world with much greater wealth inequality than the United States, capital investment can make a huge difference, even when that investment funds so-called sweatshops. Workers in Cambodia and Vietnam experience huge improvements in their quality of life when working in factories instead of farming rice or harvesting hardwood. There is a difference on a macroeconomic scale as well over time. Taiwan and South Korea, which welcomed foreign investment decades ago, have much higher standards of living now than countries that resisted foreign investment, such as India, where millions of children die every year before the age of 5, primarily from easily treatable diseases such as diarrhea.[footnoteRef:51] Over time, capital investment lifts entire nations out of poverty, even though the capitalists making the investment may be motivated only by lower wages in an area. Kaldor found it odd that those who increased the common pool of wealth for society should be tasked with also funding social benefits, and illustrated the absurdity with a hypothetical: [51: Nicholas D. Kristof and Sherl WuDunn, Two Cheers for Sweatshops, New York Times (September 24, 2000), http://www.nytimes.com/2000/09/24/magazine/two-cheers-for-sweatshops.html.]

An Expenditure base would tax people according to the amount which they take out of the common pool, and not according to what they put into it. An inhabitant from Mars, admiring the highly intricate arrangements whereby men in society satisfy their needs in common through mutual cooperation, would surely be puzzled to discover that each individual's contribution to the finance of socially provided benefits depends not on the sum of benefits he receives from the community but on his personal contribution to the wealth of the others. It is only by spending, not by earning or saving, that an individual imposes a burden on the rest of the community in attaining his own ends. In all his other activities his own interests and the interests of the community run not counter to one another but parallel.[footnoteRef:52] [52: Kaldor, Sura Note 1, at 53.]

Capital gains taxes are the primary manifestation of the funding mechanism Kaldor was referring to in his hypothetical. The practice of taxing capital gains at lower rates than income tax is motivated primarily by a need to reduce transaction costs, but the transaction costs still have a significant impact on capital allocation and contribute to market friction, reducing efficiency. Taxing capital gains has also been largely ineffective at capturing tax revenue from those with the greatest ability to pay, and the greatest standard of living. By focusing on the resources consumed and withdrawn from the aggregate invested capital of society, rather than using millions of words attempting to define an equitable intermediate realization principle, the government could create a consistent tax standard that would be far more equitable than the incredibly complex tax code that we have today.Ac consumption tax could be computed on a cash-flow basis, which would level the playing field for less sophisticated investors with fewer resources. Harvard Law Professor William Andrews, wrote that in practice such a tax would be based on a simple cash flow computation of net yield from business and investment activities, with no more effort to keep direct track of particular consumption expenditures than under the existing income tax.[footnoteRef:53] While there would still be the problem of the grey areas of business expenses, at least the problem would be limited to defining what expenses were consumption, rather than at what arbitrary point income should be realized for tax purposes, rather than merely reinvested as a capital expense. [53: Andrews, supra note 29, at 1119.]

Defining realization as end consumption is the most consistent and logical way to define income. Individual investments should receive the same tax treatment as business investments, because in practice, they amount to the same thing: expenses in the present exchanged for higher future consumption. A business owner may take a lower salary for years, carefully reinvesting what would have been taxable profits back into his business in the form of capital investment. The individual investor has no such right of deferred taxation on reinvested assets, and this is the fundamental problem inherent in a system that attempts to tax increases in wealth prior to consumption.Many have criticized a possible consumption tax on grounds that it would exacerbate existing concentrations of wealth and associated inequality. They argue that because capital gains would no longer be taxed, those who earn their living by investing would fail to contribute in proportion to their means. The existing income tax seems to do almost nothing to eliminate huge concentrations of wealth. There are more billionaires than ever before, and smaller proportions of the population control ever larger shares of the aggregate wealth under the current progressive rate system. Wealth concentration has remained relatively stable for decades, with the top 1% controlling roughly one third of wealth in the United States whether the top marginal income tax rate was 90% or 39%.[footnoteRef:54] [54: G. William Domhoff, Wealth, Income, and Power, Who Rules America? (February, 2013) http://www2.ucsc.edu/whorulesamerica/power/wealth.html]

There is no evidence that a consumption tax would exacerbate this situation, and it would at least tax the conspicuous consumption that many find so objectionable. Given the study mentioned earlier showing that the ultra-rich are currently paying taxes on less than a 2% return on assets, on average, it seems unlikely that a consumption tax could do much worse, and it would at least tax those who were depleting the aggregate wealth of society, rather than increasing it.VI. ConclusionMany prominent philosophers and economists have written about the inherently unfair nature of the income tax, and its negative economic effects compared to a consumption tax. Many of these effect arise from the inherently difficult line-drawing associated with realization. As difficult as it is to create a comprehensive definition of income, it is an order of magnitude more difficult to define realization in such a way as to create an equitable system for taxing it. A consumption tax based on assets withdrawn from the common pool eliminates the realization problem, because consumption and realization become one and the same. Such a tax also would not only considerably simplify the tax code, but also would limit market distortions created by the current complexity. While certain definitional issues would remain under a consumption tax, such as identifying certain expenses as either business or personal, such definitional problems would be no greater than those under an income tax.

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