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What is income?

Posted by Richard on August 30, 2006

Bruce Bartlett’s pretty excited about a recent D.C. Circuit Court decision regarding how the IRS defines income for tax purposes:

What is important about the decision is that it is the first one in decades saying that the Constitution itself limits what the government may tax. If upheld by the Supreme Court, it could significantly alter tax policy and possibly open the door to radical reform.

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. … But under current law, compensation for non-physical injuries are taxed.

The court agreed with Murphy’s claim that the payment for emotional distress merely made her whole for her loss, so it wasn’t income under the 16th Amendment. According to Bartlett:

Tax experts immediately recognized the far-reaching implications of the Murphy decision for other areas of tax law. Tax protesters have long argued that the 16th Amendment did not grant the federal government the power to tax every single receipt that it deems to be income. Yet in practice, that is what the Internal Revenue Service does.

The problem is that the very concept of income itself has never been defined in the tax law. It is pretty much whatever the IRS says it is. …

But because tax analysts implicitly accept the Haig-Simons definition of income, even though it appears nowhere in law, there has been a long-term tendency for the IRS to push the limit of what can be considered taxable income. Now, a federal court has said there is a constitutional limit.

I suspect Bartlett’s enthusiasm and optimism are more than a little bit premature. The result of the Murphy decision, if upheld, is likely to be some modest pushing back of those limits that the IRS has been pushing. I’d be surprised — but delighted — if it led to profound changes. But Bartlett’s fantasizing about the logical implications of Murphy for the taxation of interest are well worth reading.

Orrin Kerr posted about this decision at Volokh Conspiracy, and he had some yummy details (emphasis added):

Murphy drew a very favorable panel for this sort of claim — Chief Judge Douglas Ginsburg, Judge Judith Rogers, and Judge Janice Rogers Brown — and the panel held, in an opinion by Ginsburg, that the text of the Internal Revenue Code does not exclude such compensation but is unconstitutional for not doing so.

If I had a question of Constitutional rights — especially economic rights — before the D.C. Circuit, I think that’s the panel I’d want to have hear it. Read the excerpt from Ginsburg’s decision that Kerr quoted. Pretty good stuff.

I still greatly regret that Doug Ginsburg didn’t make it to the Supreme Court — and just because he inhaled in college!
 

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