Washington Appeals Court Finds a Constitutional Limit on Taxable Income

Bruce Bartlett examines a district appeals court decision in the Washington Times:

In the case, a woman named Marrita Murphy was awarded a legal settlement that included compensation for physical injury and emotional distress. The former has always been tax-exempt, just as insurance settlements are. Obviously, it makes no sense to tax as income the payment for a loss that only makes one whole again. One is not made better off, so there is no income. But under current law, compensation for nonphysical injuries are taxed.

Ms. Murphy argued that just as compensation for physical injuries only makes one whole after a loss, the same is true of awards for emotional distress. In short, it is not income within the meaning of the 16th Amendment to the Constitution. The appeals court agreed and ruled her award for emotional distress is not income and therefore not taxable.

Bartlett shows that the ruling overturns the accepted definition of "income" posited by Robert Haig and Henry Simons - consumption plus change in net wealth over a period of time - on its ear. He (rightly, I believe) focuses on the possible implications this ruling could have on the interest income that is permissably taxed per the Constitution.

Given the logic of the Murphy decision, it is quite possible the risk-free, inflation-adjusted rate of interest could also be excluded from taxation on constitutional grounds.

Bartlett uses John Stuart Mill's idea that interest is the payment for forgoing immediate consumption. Certainly, it can be shown that we suffer a real loss by forgoing immediate consumption. Therefore, interest just makes the receiver whole - under the appeals court ruling, it doesn't meet the definition of taxable income. Bartlett stops short, however, of showing the effect of this ruling on individuals and businesses beyond simple interest.

Perhaps the greatest import to this ruling is to tax treatment of individual wages. An individual's time can be used in a variety of ways. If he chooses to use that time working for someone else, he suffers a loss, if no more than the opportunity cost of doing the next best thing. At least a portion of his wages is remuneration - making him whole again. The portion of his wages that is not income (and therefore not taxable) can most permissibly be determined by the treatment of his wages with respect to his employer. The taxable income of his employer is reduced by the whole of his wages; in other words, the whole cost of his labor is not only a necessary cost, but also just compensation for the work performed. To be consistent, therefore, all wages must be treated as non-taxable.

The next greatest import of this ruling concerns net income of businesses. Businesses are taxed on their revenues less allowable expenses (basically all inputs to production and sales). This net
profit or loss is the result of investing in capital, materials, and labor to produce their good or service. Continuing Bartlett's logic, only net income in excess of the risk-free, inflation-adjusted
rate of interest could constitutionally be taxed. Any other treatment of net income while excusing that rate would drive investment dollars to treasuries, ultimately tanking yields and scaring away international investment.

This ruling and its implications will certainly be one to watch.