Income Tax and Lifetime Earnings

Forget about March. Beware the Ides of April! Dennis considers an alternative to income-based taxation.

Wilmington NC – [Click the Listen button to hear Dennis' commentary.]

March 30, 2004. With the approaching income tax deadline, my thoughts turn to the question, is there a better way? One proposal that recently caught my attention comes from a Canadian politician, Tony Clement.

An underlying principle of income tax is, ability to pay. That is, a principle justification for taxing income is, the amount of tax one pays is related to income; income is assumed to be a measure of one?s ability to pay. Thus, persons with a greater ability to pay, pay more.

Most income tax systems are also designed to be progressive. This means that, as taxable income increases, the tax rate also increases. In short, persons with higher incomes also pay a higher share of that income as tax. This presumes that higher income people not only have the ability to pay more, but have a responsibility to pay a higher share.

In the US, we no longer have much debate over the merits of an income tax ? it is pretty well accepted. What is debated, of course, is the effective tax rate. That is, what share of our income should be taxed, what percentage should be paid as tax, and how progressive should it be?

This has been nowhere more evident than in the current presidential campaign. One party argues for permanent cuts in the tax rate, with both lower rates and larger exclusions from taxable income for those with higher income. Another argues for higher taxes at upper income levels. Thus, the debate here seems to be about how much one should pay, more so than who has the greatest ability, or obligation, to pay.

Mr. Clement?s novel Canadian proposal, on the other hand, would create a more direct tie between income taxes and ability to pay. It recognizes that people with the same income may differ in their ability to pay at different stages in life. Logic suggests, for example, that an older person with accumulated savings of, say, 120 thousand dollars and earning 40 thousand dollars a year would find a 15 percent income tax less burdensome than a young person who is also earning 40 thousand but is struggling to save enough for a down payment on a house.

Under Mr. Clement?s proposal, taxes would be based on lifetime earnings rather than annual income. In his proposal, a person would pay no taxes on the first 250 thousand dollars of lifetime income. This would allow young earners to more rapidly set aside savings for things such as starting a family and buying that first house. When accumulated earnings top 250 thousand, a 14 percent tax would be paid. The tax rate would increase as lifetime earnings reach higher thresholds, up to a maximum of 27 percent once total earnings pass the million dollar mark.

The proposal would help people when they are young at the expense of when they are older. To mitigate effects on the current generation of older taxpayers, it would be phased in on a new generation as they enter the work force. It could have desirable effects in terms of helping young people more rapidly establish themselves both financially and socially, thereby contributing to the nation?s long-term economic development. By treating all income as part of lifetime earnings, it eliminates on-going debate over what type or share of annual earnings are exempt from taxes, or treated preferentially.

Many of the consequences of a plan such as Mr. Clement?s are unknown. Would it, for example, encourage people to drop out of the work force at a younger age? Might it encourage older people to emigrate? Questions such as these need answers. What is refreshing, however, is instead of political rhetoric, in this case we are getting an innovative proposal that deserves serious debate.