Comprehensive Income Tax
What tax base is desirable? This question is important in relation to actual tax reform as well as the theoretical literature. There are two plausible arguments about a desirable tax base. One is that comprehensive income is ideal; another is that expenditure or consumption is best.
First, we explain the notion of comprehensive income tax. Many tax experts have focused attention on what has become known as “comprehensive” income in order to define an ideal base for taxation. A number of different definitions have been suggested for this concept. These definitions have eventually coalesced to one similar in spirit to that given by Simons (1938): comprehensive income may be defined as the algebraic sum of the market value of rights exercised in consumption and the change in the value of the store of property rights between the beginning and end of the period in question. This is known as the Haig-Simons definition of comprehensive income. Bradford (1986) refers to this concept of income as “accrual income.”
Let C represent consumption, E represent current earned income plus any transfers received, W represent wealth, and r represent the return on wealth (e.g., the interest rate on a savings account). Under the Haig-Simons definition, comprehensive income is equal to C + AW. However, as a simple matter of accounting, this is also equal to E + rW. Thus, E + rW = C +AW is taken as the tax base under an income tax.
It is useful to think of AW as saving that can be negative if the individual is borrowing. Thus, the base under a comprehensive income tax could also be described as consumption plus saving in accordance with a user’s definition of income.
However, the tax base under a consumption tax would simply be C or E + rW — AW instead. Thus, the consumption base is lower (higher) than the income base for a net saver (borrower). The consumption base in the aggregate is smaller than the income base if society is accumulating capital (AW > 0).
The basic notion behind the definition of comprehensive or accrual income is that it measures an individual’s command over resources. A change in accrual income signals a change in the individual’s command over resources. If, for example, an individual experiences an unexpected capital gain on an investment, her or his power to consume has increased and presumably she or he should pay more in income tax as a result. Note that this is true even if the gain has not actually been realized but has only accrued, as in the case of an increase in the value of one’s home.
Then, the government should calculate comprehensive income, which is the sum of all income in a given year, and apply a progressive tax rate on it. Hence, the same tax rate is applied both to labor income and interest income.
The prevailing view among conventional tax theorists is that individuals should pay tax on the basis of their comprehensive income. Further, the driving force in tax policy should be to define and measure comprehensive income carefully. Unfortunately, measuring comprehensive or accrual income can be difficult, if not impossible, to accomplish for several reasons, as pointed out by Bradford (1986) and Kay and King (1986), among others.