27 Jan 2012

Income and Consumption: It’s OK to Be Different

All Posts, Financial Economics 51 Comments

You kids know me, when Steve Landsburg has a new post up with which I find myself in 99% agreement, I have to focus on what I don’t like. (It’s not a grudge or anything. I’m actually testing the Coase Theorem’s prediction that Steve will efficiently offer me $10,000 to leave him alone.)

Anyway, both Landsburg and Scott Sumner (with whom I agree only about 15% of the time, but that’s because he spends 85% of his posts talking about one topic) have lately been hitting their familiar theme of the evils of income taxation. (1, 2, 3) Of course, I totally agree that the government shouldn’t be taxing people’s income, and I also agree that the income tax screws up the intertemporal allocation of present vs. future consumption, and thus inefficiently penalizes saving.

Nonetheless, the way Landsburg and Sumner go about making their case, disturbs me. To give a 30,000 foot view, they often come across as saying: Investment income is really just deferred consumption out of prior wages, and so it’s not fair to tax people more heavily just because they are quirky and happen to enjoy a lifetime consumption stream that’s biased to the right. I don’t have the time to go hunting and make an airtight prosecution. My only pieces of evidence are: [UPDATE: Upon re-reading, I understand what the commenter was saying and why Steve agreed.] (A) a commenter at Landsburg’s site says something that is arguably wrong, depending on how it is interpreted (as my example below demonstrates), and Steve merely says, “Point extremely well taken.” (B) Sumner actually wrote a post saying the very concept of income was “meaningless, misleading, and pernicious.”

Before jumping into my example, here’s my basic message: As the title of my post indicates, consumption and income are different terms, and that’s OK. They are both important. Just because consumption is a more useful concept than income for certain questions, doesn’t mean we should therefore jettison the latter. (So Sumner is wrong.) Furthermore–and this point is less obvious–the standard way that a lot of free-market guys critique the income tax, obscures exactly what the concept of income does for civilization. In short, accountants aren’t fools; there’s a reason they construct Income Statements. (Have you ever heard of a Consumption Statement?)

Without further ado, here’s another Excel chart. (Don’t worry, there are no apples in this example.)

So here’s what’s going on in the table above:

There are two brothers, Paul and Freddy. They each work at a job and earn a single paycheck of $100,000, in the beginning of period 1. Paul blows the whole paycheck on consumption that period. Freddy, in contrast, only consumes half of that paycheck. He saves the rest in a bank account, where it earns 5% 10% interest every period.

The middle column tracks Freddy’s consumption through five periods. The accounting in this example is discrete (not continuous), so I have Freddy earn his interest income at the beginning of period 2 from the $50,000 in wealth that he held at the “end of period” (eop) 1. (Just to reiterate, Paul and Freddy only get labor income of $100,000 at the start. Then neither of them labors another second.) You can see the vagaries of Freddy’s wealth, as he changes his consumption from period to period. During period 5, Freddy consumes his remaining wealth, and so ends with nothing, just as Paul had done by the end of period 1.

Now here is what Steve Landsburg and Scott Sumner want us to take away from this demonstration: Both Paul and Freddy put in the same labor effort in period 1. They each earned $100,000 in salary or wages. Paul is prodigal, and consumed it all immediately. Freddy, in contrast, deferred his enjoyments, and spread the consumption out over 5 periods. However, if you calculate the present discounted value of Freddy’s consumption from the perspective of period 1 then you find over his lifetime, Freddy will consume exactly $100,000 worth of goods and services, just like Paul.

So Landsburg and Sumner argue that because of this phenomenon, clearly it would be unjust to have an income tax, or at least to have a tax on capital income (as opposed to labor income). In the table above, if there had been an x% income tax every period (that didn’t distinguish between labor and capital income), then Freddy would clearly pay more in taxes during his life. In period 1, he would pay the same in taxes as Paul, but then in periods 2 – 5 he would get dinged on his interest income too. Even in present value terms calculated in period 1, Freddy would pay more in taxes during his lifetime, and not because he was “richer” than Paul–so Landsburg and Sumner would argue–but merely because he decided to spread out his consumption.

Another way of seeing this important point is to imagine that there are extensive derivative markets to deliver future goods. (The casual reader probably wants me to call these “futures markets,” but that’s actually not right. Really what we’re talking about here is Freddy using all of his income in period 1 to buy call options with a strike price of $0, on the consumption items dated periods 2 – 5 that he desires.) So in period 1, Paul buys a steak dinner for $100, but Freddy buys an airtight claim to a steak-dinner-delivered-in-period-3 for $90.70 $82.64. (This assumes the spot price of a steak dinner will still be $100 in period 3.)

If this is how Freddy arranged his affairs in period 1, in order to set up his desired lifetime consumption stream using that paycheck from period 1, then gosh it really does look like Paul and Freddy are both spending all of their paychecks in period 1–it’s just that they have different tastes. Paul likes burgers-with-pickles, while Freddy likes burgers-with-onions. Fine; the government shouldn’t be taxing the latter but not the former, because that wouldn’t be fair. Yet by the same token, if Paul likes to eat “steak-in-period-1″ while Freddy likes to eat “steak-in-period-3″ then why the heck should Freddy suffer a higher tax burden?

Now we can finally see why Scott Sumner hates the very concept of income. As the table above shows, even though Paul and Freddy have the same lifetime consumption (measured in market value in period 1), Freddy nonetheless has a higher lifetime income–even if we measure everything in PDV terms in period 1. (This has to be true, since Paul and Freddy both have $100,000 in labor income in period 1. So the further interest income that Freddy earns during periods 2 – 5, no matter how highly discounted, will still in period 1 push Freddy over the top in terms of lifetime income.)

For the purists, another way of seeing the injustice that so irks Landsburg and Sumner is that even doing the derivatives trick would still ding Freddy, so long as the IRS properly measured people’s accounting income. Specifically, if Freddy buys that claim ticket to a steak in period 3 that we discussed, it had a market value of $90.70 $82.64 in period 1. As time passes, that asset appreciates in market value. Maybe the government won’t ding him on the capital gain until it is realized, but when he exercises the claim in period 3, presumably the IRS will say, “Ah! You just exercised that option, which currently has a market value of $100. So you owe us tax on that capital gain from the asset you purchased at a lower price in period 1.” My point is, Freddy can’t help but earn income, even if he avoids banks and the stock market, if we do the accounting right. Because of the positive interest rate, in period 1 he can lock in consumption goods in the future, for a lower price than what their spot values will ultimately be at the time of consumption. That’s the source of the growth in Freddy’s wealth over time (offset by his consumption) and his income.

We now come to my main point: Thus far I’ve just been saying how smart Landsburg and Sumner are. So what the heck is my deal? Well, you might get the idea from those two guys that income is, I don’t know, a meaningless or useless concept. But that can’t possibly be right; of course we need income.

Specifically, Freddy can use the notion of income to guide his decisions through time. In any period, Freddy’s income tells him, “This is how much you can consume this period, without reducing your wealth below last period’s level.” Put differently, if interest rates are expected to remain constant, then your (net) income in a period tells you how much you could consume, if you wanted to maintain that level of consumption forever.

To see how that works, look again at Freddy’s numbers. In period 2, he consumed exactly his income of $5,000. That’s why his wealth at the end of period 2 was the same as it was at the end of period 1. If Freddy continued to consume $5,000 per period, his wealth would remain constant at $50,000 and he could tread water like that perpetually.

But Freddy got impatient. In period 3 he consumed twice his income. So he consumed $5,000 of his wealth or capital; he dissaved $5,000. That’s why he ended up with only $45,000 in wealth at the end of period 3.

So what? Who cares if wealth goes down? Well, that means (with constant interest rates) that in period 4, his income is now only $4,500. That means, just to tread water, Freddy now has to settle for only $4,500 in consumption. Put differently, his one-time splurge of living above his means in period 3, would forever condemn Freddy to $500 less consumption per period, if he just wanted to maintain his wealth at its new, lower level.

Then, just to round out the discussion, I have Freddy consuming all of his wealth in period 5.

In simple little thought experiments like this, Freddy might not care about such questions as, “Did I live beyond my means last period?” or “How much can I consume this period without reducing my opportunities in the future?” But in the real world–especially when things change all the time, from period to period, and we learn new information–we have to continually update our plans. In such a world, the concept of income is crucial.

Sumner is mad at the concept of income because it makes Freddy seem richer than Paul, and hence gets hit with a bigger tax burden. But that’s because Sumner is using a hammer to tighten a screw. The relevant concept is wealth, and yes, given our assumptions in this scenario, Paul and Freddy both have the same wealth in the beginning of period 1, as a result of that paycheck.

Now Sumner might complain, “OK, but in period 2 Paul has no wealth, and Freddy still has a bunch. So this is misleading.” No, it’s not. Who the heck said we should forever be condemned to calculating things from the perspective of period 1? In period 2, looking at Paul and Freddy, it really is the case that Freddy is richer in material terms, and can enjoy a higher standard of living.

We can go ahead and acknowledge these obvious facts without thereby endorsing an income tax (let alone a wealth tax). Look, I can use Sumner’s own logic against him: Take two identical twins, Lazy Larry and Workaholic Will. Larry cuts lawns once a week, and spends all $100 on consumption. Will cuts lawns every day, and spends all $700 on consumption. Under Sumner’s call for a progressive consumption tax, Will not only pays more in absolute terms, he actually pays a higher percentage of his potential consumption to the taxman. And why? Simply because Will has quirky tastes and prefers to exchange more of his leisure for other goods and services. How arbitrary is that, Sumner? What do you have against work? I think we can all see that “consumption” is a meaningless, misleading, and pernicious concept, since it gives ammunition to silly calls for a consumption tax, which is really just a penalty on work.

Last point: As the government debt debate made very clear, an important fact of life is that many people work and invest not to consume, but to pass on an estate to their heirs. That’s yet another reason that people in the real world ask their accountants to keep track of their assets and income.

51 Responses to “Income and Consumption: It’s OK to Be Different”

  1. Max says:

    Because of tax shelters (IRA, etc) the U.S. doesn’t have the pure income tax system which is being critiqued. It’s effectively a hybrid of income tax and consumption tax systems.

  2. Christopher says:

    Just for my understanding:
    If Freddy invested his 50,000 saving in a penny stock which brought him another 900,000 dollars in period 2, he would have earned 1,000,000 in period 1+2 as compared to the 100,000 of Paul. But that would result in the same consumption because you have to adjust for PDV?
    Is that correct?

    • Bob Murphy says:

      Christopher, good question. Probably not. The only way that would work, is if it were common knowledge in period 1 that anybody could earn that kind of return by investing in that particular penny stock, and yet not everybody (like Paul) rushed into it, because the prospect of gaining so much more consumption by waiting one period didn’t appeal to him. But that’s probably not what you have in mind with your numbers. What you are thinking is that people didn’t know beforehand that Freddy would hit such a home run. Maybe Freddy had a good idea, because he was better at evaluating companies than Paul, but I’m assuming you are thinking of a scenario where people are shocked at how well Freddy does in period 2.

      What I’m saying is that in the real world, people can earn higher rates of return on investments than just the “going rate of interest.” So in your example, the 900,000 earned in period 2 would really be income (a capital gain) both in a pure accounting sense and even in a tax sense if he sold the stock and realized the gain. But from the perspective of period 1, you would still be discounting everything in the future by 10 percent, so Freddy would have a way higher lifetime consumption made possible by that big capital gain.

      • Christopher says:

        It would be interesting to hear Landsburg’s opinion on this. I guess you can argue that the present value of the investment in the penny stock has to be discounted to equal 50,000 dollars in period 1 – although that would make much sense to me – but as far as I understand it they are actually discounting the consumption (e.g. the steak in your example).

        Another way to put this is: Add a third guy (Peter) who also saves 50,000 in period 1 but his investment yields 2% more than Freddy’s. So Freddy can consume 55,000 dollars whereas Peter can consume 56,000 dollars in period 2. The only way to make that equal consumption in period 1 is if you discount at different rates, but why would you do that?

        • Bob Murphy says:

          Christopher, sorry, I must have confused you with my first response. Nobody would say the guy who earned $900,000 on the penny stock has the same consumption as Paul–he clearly could have a lot more. That will happen if he earns more than the going rate of interest (10% in my example), and then ultimately consumes all of his income. So his potential for consumption grows more than 10%, but anytime he consumes it just gets discounted back to period 1 at 10% per period.

          I was giving Steve and Scott time to see this on their own, since I was pestering Steve during the debt stuff over email. (I.e. I don’t want to be “that guy” who emails every time I have a new post up.) But if you emailed Steve…. *whistles innocently*

          • Tel says:

            Hmmm, how about risk on the penny stock? Sometimes it will return nothing.

            In Australia at least, you get a tax credit against future capital gains if you buy a stock and blow it on Enron or Chrysler something like that.

            • Bob Murphy says:

              Tel, right, if your assets go up in value, that is a capital gain (income), and if they go down in value, it is a capital loss (negative income).

              E.g. if my stock portfolio goes down $100,000 during the same year when my salary from my job is $100,000, my actual income broadly defined is $0. That’s because I can consume $0 and leave my wealth/capital the same as it was at the start of the period.

      • Christopher says:

        *although that would not make much sense to me

    • T.Geiger says:

      Isn’t there a difference between speculative returns and origninary interest returns? In Bob’s example, Freddy is being taxed on the discount between a present good and future good. In the penny stock example, the gain is not contractually guaranteed in the future.

      There is risk in Freddy’s option contract, but since he intends to excercise the option, the risk is that the price of a steak dinner in period 3 will be less than what he paid for the option in period 1.

      The injustice is that the discount between present and future goods. originary interest, is being taxed. If this concept is just, then there should also be a tax on the difference in price between, for example, a new car and a used car, or a fresh loaf of bread, and a loaf from the “day old” shelf.

      • T.Geiger says:

        (gosh, I hope I didn’t give my governor of “The Free State” any ideas… :)

      • Bob Murphy says:

        T. Geiger, I think what you are saying is basically right, but just to reiterate: “What” is being taxed, throughout, is income. If you earn income from a “sure” thing by investing in very safe bonds, then the interest income from that is taxed. If you earn income in the form of a capital gain from a speculative investment, then that is taxed.

        You’re right, Landsburg and Sumner are focusing on the “sure thing” aspect of it, and saying it’s not really fair to penalize somebody just because he deferred consumption when the intertemporal price made future goods cheaper than present goods. OK, fine, I just want people to realize that income is still a useful concept. It’s not that the guy who invests in super-safe bonds isn’t “really” earning income from them later on, which is the take-away message that Sumner explicitly gives and I think Landsburg might implicitly give.

  3. Mattheus von Guttenberg says:

    Rothbard made it very clear in Power and Market that there IS no fair tax at all. Do you remember the passage? He cites Calhoun I believe.

    • Bob Murphy says:

      Mattheus Rothbard has stuff like that all over, even in MES proper (I think). I don’t remember where off the top of my head though.

  4. marris says:

    Somewhat tangential question:

    In the ERE, Freddy must consume all his interest over a period.

    I’ve often seen you and other economists discuss growing wealth from investments without any sort of “periodicity” imposed on the investors. Like they could grow their money earnings in perpetuity. They take their interest, buy investment goods, and harvest more interest next year.

    If we assume a fixed money stock in the economy, can everyone do this? Does the velocity of circulation speed up or something so that my aggregate in-flows for the period rises?

    Or are you guys thinking in terms of an increasing money stock that somehow enters the system? Maybe the money grows like monster ooze? Or (more realistically), fractional reserves are used to lever up? Or some money factory (central bank) is dropping money into accounts? Maybe in exchange for assets (monetization)?

    I think all of these are internally consistent. Just not sure how you guys think of it…

    • T.Geiger says:

      The ERE is only a model, not ever a real condition.

      http://mises.org/journals/rae/pdf/R3_8.pdf

      In the ERE, there is no growth, because there is no uncertainty. Future demand for consumption is known, and there are no profits for entreprenuers or speculators in the ERE. Land & Labor earn their rents from Capitalists who earns his(her) income by transforming Land, Labor and capital from present factors of production into future consumer goods within the various stages of the struction of production. The capitalist only earns the discounted value (originary interest) of future goods to present goods (the real rate of interest) as his(her) income.

      So with this in mind, there is no need to be concerned with the medium of exchange which facilitates indirect exchange in the ERE, unless one is examining the effects of changes to the supply of that medium would have on the ERE.

      • Joseph Fetz says:

        The whole point of the ERE is to examine changes to particular areas of the economy to determine how they effect the rest of the economy.

        • T.Geiger says:

          Right. The imaginary construction of an ERE is used to determine the effects of a singular specific change imposed upon the imaginary construction. In Marris’ post, unless I misread, there are two changes; economic growth, and money stock growth. Unless I’m mistaken, these two changes should be analyzed separately within the construct of an ERE.

          • Joseph Fetz says:

            Personally, I don’t think that economic growth can be measured in any objective terms. GDP merely measures the unit-value of exchanges (spending, investment, trade), which doesn’t say a whole lot about the actual state of an economy. For instance, if money supply were held constant, I think you could see a “growing economy”, but that GDP (as it is currently measured) could be falling.

            I don’t know that you can only examine one change at a time in the ERE model, I’ve had limited success introducing multiple interventions and/or changes. Granted, I am not an economist and am limited by my own mental capacity, but I often think long and hard within the construct of the ERE, which unfortunately usually takes place when I am trying to sleep.

      • Beefcake the Mighty says:

        J. Patrick Gunning is both a hack and a crank.

      • marris says:

        Thanks for the link. I enjoyed this paper.

        I think the distinction between mathematical and logical analysis are a bit overblown, and the “change prediction” section is a bit confusing (may be feeding off some confusion in the C-F paper here), but very good overall.

        I really like the lens analogy. I think good theory often flows from good counterfactuals.

    • Bob Murphy says:

      marris, we usually have in mind “real” purchasing power. So that could happen different ways. E.g. if “velocity” of money stays the same, then prices in general fall (and producers can afford to stay in business and pay the same wages etc., because of increased physical productivity). Or gold miners could increase stock of money, etc.

  5. Tel says:

    Now Sumner might complain, “OK, but in period 2 Paul has no wealth, and Freddy still has a bunch. So this is misleading.” No, it’s not. Who the heck said we should forever be condemned to calculating things from the perspective of period 1? In period 2, looking at Paul and Freddy, it really is the case that Freddy is richer in material terms, and can enjoy a higher standard of living.

    First point: Willie Sutton’s Law — when period 2 rolls past, there is absolutely no point trying to tax Paul.

    Yet by the same token, if Paul likes to eat “steak-in-period-1″ while Freddy likes to eat “steak-in-period-3″ then why the heck should Freddy suffer a higher tax burden?

    Second point: if Freddy actually *prefers* to eat steak in period 3 then Freddy should not be getting 10% interest because (in principle at least) the 10% interest is a reward to compensate for the deferred consumption, on the belief that everyone would normally prefer consumption now.

    However, of course the guy paying the 10% interest is in a position where he needs to pay the same percentage to all investors. Thus, if most people demand 10% interest on their savings, so also Freddy will get the 10% interest, even though he would have been willing to save for much less. There’s always a boon to be had for market outliers.

    It’s not a special feature of the money market, but a general feature of all markets. Suppose Freddy likes eating liver for dinner and since liver is cheap this only costs $30 for every time Paul is spending $100. Since both brothers are equally happy with their consumption, in effect Freddy is making a “gain” of $70 every time… so maybe that should be taxed? This only reveals the stupidity of how tax works and why it is a dumb idea to go around taxing productive activity.

  6. HP says:

    Bob, Sorry to chop into your post here with a question unrelated to your post …

    How do you answer this question [and I hasten to add I don't come at this with a moral or political view] – I am interested from a purely economic perspective]:

    If regulated minimum wage regulation stands in the path of maximal free market then what about property rights?

    • Bob Murphy says:

      HP not sure what you are driving at. If one defends property rights, then we can see why minimum wage laws make no sense. They infringe on the ability of an employer to exchange money for an employee’s labor.

      • HP says:

        Title to property is legal construct, not a market construct.

        Minimum wages are equally a legal construct, not a market construct.

        In a totally free market labor would bid for capitol, not capitol for labor, wouldn’t they?

        • Bob Murphy says:

          HP I’m not trying to be difficult but I don’t know what you are talking about. We agree I own my labor, right? And we agree Mr. Big owns the money in his wallet, right? So if he wants to give me $3 to work one hour, and I want to sell him my hour of labor for his $3, and the government comes in with guns and says it will punish Mr. Big for doing that…it’s a violation of our property rights, and not a free market, the way I use those terms.

          • Beefcake the Mighty says:

            Hey Bob, just so you know, some other Austro-libertarian blogs aren’t too keen on me posting links to urbandictionary.com. So, it’s not just you.

            • Joseph Fetz says:

              You don’t say…
              ;)

          • HP says:

            No problems Bob I like your stuff – I am a free thinker too able to be convinced and not emotionally committed to a view.

            You possess your labor.

            Mr Big possesses his labor.

            Mr Big also possesses the food making machine.

            Were it not for the two sets of laws, backed by the government with guns, of property rights and tax [which is the same as minimum wages to the extent the wage floor is above a market price for the particular worker] you and Mr Big would physically contest for possession.

            The pure market is the meeting of agents with eyes for the particular resources for particular applications – not being interfered with by the invisible hand of some inefficiently remote general view.

            Isn’t it?

            • MamMoTh says:

              Sure, property rights are enforced through the coercive power of SWAT teams.

        • Joseph Fetz says:

          HP, you say that property rights are a legal construct, not a market construct. So, I must ask, how can a market exist at all without property rights?

          • Watoosh says:

            The way I see it there’s informal property and formal property. The former means that when I’m on the sandbox playing with my Tonka truck, people generally let me do my thing. When some jerk doesn’t respect that and kicks my truck away, people disapprove of that and try to make sure such antisocial behavior doesn’t happen again – using as little force as possible. You could say that this kind of property is a market construct.

            Formal property, by contrast, is when governments decide that the riffraff can’t be trusted to settle disputes on their own. Therefore the rainforest that the natives have inhabited for centuries must be handed over to MegaCorp who need it to extract oil or minerals – and of course, the corporation needs the military and the police to enforce this transaction between MegaCorp and the government. Thus property rights become a tool of the elite/establishment/capitalists/Illuminati/Man/whoever is in charge, instead of being a natural product of the spontaneous order that libertarians want.

            I’m not sure if this is what HP was trying to say, though.

    • Beefcake the Mighty says:

      @HP

      Butt-plug say what?

  7. HP says:

    The Steak Shop can charge customers different prices for a steak on the very same day, or from day to day.

    A banker could pay different rates of interest to customers [as you say Tel capturing the preference for a steak in year 3].

    But there are costs in such a level of specificity in contractual terms.

    These things become best fit based on known imperfections.

    And that is where all such policies like taxation become a world of “best fit”.

    If you want to go full bore economic rationalism then you could say that there should be no compulsive redistribution.

    But then you get into fuzzy areas like that psycho-physiological entities that humans are create behaviors that themselves can all be regarded as compulsion subconsciously or consciously.

    • Joseph Fetz says:

      I am not trying to be a jerk, but I have no idea what point you’re trying to make.

      • Beefcake the Mighty says:

        I’m quite happy to be a jerk. HP is high on something.

        • Major_Freedom says:

          Printer ink?

          • Joseph Fetz says:

            So, I am not the only one, then? I thought that it was just me for a minute. I have been a little out of it today (lack of sleep), but I read HP’s comment a few times and I still got nothing.

            • HP says:

              Sorry this is my first use of the blog posts so was getting used to the sequence and so on.

              A general thrust of the conversation was that there are specific obvious inequities within the tax system.

              I was making the point that “Yes there are – but tax is an imperfect giant because of the costs associated with removing those inequities.”

              My tax professor, as we all lugged around the volumes and volumes of tax law to lectures, used to always say:

              “Folks the problem with tax is they just can’t help themselves – they have to constantly fiddle with it!”

  8. Silas Barta says:

    Your example about the early, discounted sale of period 3 steaks raises an interesting point: through correct accounting, you have to record the appreciation of the steak coupons as income (at least when redeemed), does the IRS actually treat it that way?

    I ask in part because about a year ago I had this idea for avoiding taxes on interest income: a large retailer (say, Wal-mart) could sell interest-bearing gift cards. But rather than say e.g. “This card now stores an additional $X of store credit because Y time has passed”, it could phrase the interest accrual as a discount on Wal-mart’s goods. That is, as time goes by the dollars of store credit are spent as usual, but entitle you to a bigger discount as time goes by.

    It seems the IRS would need some convoluted theory of interest income to explain what they’re taxing you on, but I’m not sure.

    • Bob Murphy says:

      Silas, for sure I can say that the IRS typically taxes you only when you “realize” the capital gain/loss on an asset. E.g. you buy a bunch of stock for $1000 in 2000, and then they go up $100 per year for 8 years in a row, you don’t pay any tax on that if you hang on to them. But then if you sell them (right before the crash) at $1800 in 2008, you pay the tax on the $800 capital gain. That’s why in the late 1970s people were complaining about capital gains not being indexed to inflation, since people were getting hit with big tax bills for selling assets that had actually lost ground, relative to CPI. (And people are still complaining about that.)

      Your question is really interesting. I don’t know for sure, but I strongly suspect that the IRS treats a call option according to its market value when exercised. E.g. suppose you buy 1,000 call options on shares of XYZ stock with a strike price of $10, and at the time you buy, the options themselves have a unit price of $1. So the market value of your asset (the call options) is $1000 at the time of purchase.

      Then a year later, when the expiration date approaches, the calls are way in the money–XYZ stock is trading for $20. At the moment of exercise, your options are worth $10 x 1000 = $10,000 total. So I think the IRS would say you made a capital gain of $9,000 on the whole deal, and tax you accordingly. (In this example it wouldn’t even be a long-term gain, so I think you’d get dinged at the full tax bracket rate.)

      So if we revised the scenario where you bought call options with a strike price of $0, I think it would be the same principle. I.e. the IRS wouldn’t say, “Oh, there’s nothing financial going on here, you’re not paying any money for those things, it’s just a claim ticket.”

      I imagine in principle it would be the same with your WalMart idea. However, I don’t know in practice how they handle gift cards, because nobody declares gift cards on his tax return. I used to vaguely know how WalMart treated such things on its books, but now I can’t remember the details. (It’s like a sale, but not really, and it’s like a loan, but not really, and after a while you get to assume a card that’s never been redeemed is lost and a windfall.)

      • Silas Barta says:

        I’m sure if the benefits were big enough, the IRS would eventually try to tax this benefit, but I don’t know what theory they would do it under. This isn’t much different from other rewards programs where, to a certain class of people, the store gives a discount. And WalMart store credit isn’t money, even though most people, for some amount, can treat it as interchangeable therewith.

        If the IRS claimed to be able to tax this, could they also tax the discounts you get for using a store’s rewards program? Say, I buy $1000 worth of goods from a store, and in return they give me a dollar off my next purchase [2]. That’s definitely not taxable. WalMart could do a little wizardry, then, and say that they’re selling a bottle of atmospheric air and $50 of store credit for $50, and, oh by the way, we have a rewards program for the atmospheric air purchasers that gives you an increasing discount over time. “The more you wait, the more you save!”

        Also, is there any kind of commonly-used exotic call option [1] you can buy in the financial markets that has a strike price that decreases over time, and can be exercised any time? Perhaps some kind of convertible bond?

        [1] I know, contradiction in terms…
        [2] Anonymous, if you were wondering how low an effective interest rate it takes to get people to use a store rewards program, there ya go.

  9. Anonymous says:

    “I ask in part because about a year ago I had this idea for avoiding taxes on interest income: a large retailer (say, Wal-mart) could sell interest-bearing gift cards. But rather than say e.g. “This card now stores an additional $X of store credit because Y time has passed”, it could phrase the interest accrual as a discount on Wal-mart’s goods. That is, as time goes by the dollars of store credit are spent as usual, but entitle you to a bigger discount as time goes by.”

    As far as I can tell this isn’t interest income. This is the absence of incurring a particular cost of consumption.

    The absence of incurring a cost of consumption isn’t a positive income. The card holders wouldn’t be making money income on such a thing. They would “invest” $50 today, and they would get goods worth $55 (say) “return” later on. Only if they got $55 in cash later on would they be making an income.

    In order for this to be in Wal-Mart’s best interests, they would have to be able to invest that $50 for real, and earn a return higher then $5. So they sell a card for $50, invest the $50 and earn a $56 total return, then give goods worth $55 to the gift card holder. Net gain is $1.

    Of course there might be some intangible benefits to incurring a loss on the gift cards, like tracking customer purchases and whatnot, that could result in a monetary gain, but the point is that the gift card holder still wouldn’t be making a money income (again as far as I can tell).

    • Silas Barta says:

      Walmart’s cost of borrowing is a lot higher than the 0% that savings accounts earn. Plus, they could offer a pretty low rate of interest to get people excited about “OMG it’s free money!” In-store rewards programs offer significantly less and still get people to join.

      • Anonymous says:

        What interest are card holders getting? As far as I can tell, they are spending $50, and getting goods in return. I don’t see any interest income.

    • Silas Barta says:

      Also, the point here was that, by proper reckoning, the early, price-discounted purchase of a good delivered later, does in fact return income over time, even if the IRS doesn’t see it this way, and that this gives a means to avoid taxes on investment returns because of IRS inconsistency.

      • Anonymous says:

        I don’t see the money income being earned in your example.

        What money income would card holders be earning? All I see is people spending $50 on the gift card, and getting goods priced at $55 to non-card holders, in return.

  10. Scott Sumner says:

    I agree that in theory income could measure what one could consume, leaving wealth unchanged. But:

    1. In the blogosphere discussions of equality they use a completely unrelated definition of income, which is roughly money you take in during a given year.

    2. The government uses a completely unrelated definition of income for tax purposes, which is roughly money you take in every year.

    3. I’m not sure why it would be interesting to know how much you could spend without affecting wealth, as that generally is not going to equal how much a person would actually want to spend.

    It’s true that a progressive wage tax also has problems (labor/leisure decision) but at least you can sort of measure wage income available for saving, so the unfairness is easy to eradicate. It’s hard to tell the difference between those who earn more because of hard work and those who earn more because of innate ability.

    • Bob Murphy says:

      Scott Sumner wrote:

      3. I’m not sure why it would be interesting to know how much you could spend without affecting wealth, as that generally is not going to equal how much a person would actually want to spend.

      Scott, I guess I’m OK with your other three responses, but this one baffles me. Suppose I say, “Fuel gauges in cars are meaningless and misleading.” You say, “Huh?! Look, my fuel gauge is pretty advanced. It tells me how many miles I can go before I run out of gas.” I say, “Well, I suppose that might be useful in theory, but when in the world are you ever on a road trip, and want to drive exactly how far you can go before running out of gas? Have you ever done that in your life?”

      • Silas Barta says:

        I agree: if that’s your standard for whether or not you find a metric useful, all kinds of them go out the window.

        In my day job, we calculate a margin of safety. That’s how much the load would have to increase (percentagewise) to cause a failure.

        Obviously, that’s a useful number to know.

        Obviously, you don’t throw it out because “come on, it’s not like we’re ever actually going to increase the load enough to cause a failure!”

        (And then there’s the issue of how we often come up with negative margins, and use it as a signal that the aircraft won’t perform as intended and needs to be redesigned, either in its structure, or its permitted flight envelope.)

  11. Joseph says:

    Your post seems to ignore the preferences of Paul and Freddy. It would be simple to assume that they each have a personal discount rate. If Freddy has a discount rate of 0.1%, then by deferring his consumption to get 10% in one year is preferable to consuming everything at once. He has a “higher” income in the sense that you calculate PDV’s and then rank the options according to which one is higher. Paul might have a discount rate of 15% and therefore prefers consuming everything at once. You could make a more sophisticated model with different discount rates for different slices of wealth, but the principle is the same.

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