The Four Different Ways the Tax Code Treats Saving and Investment
May 24, 2016
What’s the proper way to tax personal saving and investment? It’s a great question, and under current tax law, we have lots of different answers! Specifically, we have four of them, which I’ll get to in a moment. But first let’s talk a little about what saving and investment is.
What Is Saving?
Personal saving is putting aside some resources today in order to get benefits later. The way economists think of saving, this is a little bit more expansive a definition than it first appears. I’ll come up with a few different examples.
Some kinds of personal saving are pretty obvious. They’re the thing people do when they build up some kind of account with a financial institution that includes some mix of equity, bonds, and cash. Here are some examples: brokerage accounts, traditional Individual Retirement Accounts (IRAs) and 401ks, Roth IRAs, Health Savings Accounts (HSAs) and so on.
In addition to those, you can consider your defined-benefit pension contributions a kind of saving. You put aside money that you otherwise would have earned immediately. It goes into a big account managed by the pension fund, and it gives you the right to future benefits.
But saving is not necessarily just a financial account. You could also own a real physical object, like a house. (Technically, the stocks and bonds in your IRA also give you claims on real physical objects, but it’s behind a layer of abstraction. For example, if you have a stock, you might own a portion of a company that owns physical objects. Or if you have a bond, you probably have a claim on a physical object that the borrower owns if they don’t manage to pay you your money back.) Taking up an equity stake in a house, becoming an owner of it, gives you future benefits: you can either rent it out to someone else, or live in it yourself.
You can even apply the idea of saving to smaller durable goods, like improvements to homes, or even tables and mattresses and clothing and the like. While these aren’t notably different from houses in the way a single expenditure gets you many uses, we tend to just ignore these kinds of saving as too trivial to account for in economic statistics.
So we can see that “saving” can actually be a pretty expansive concept. And in fact, this expansive definition is the one that economists usually use. It encompasses a diverse array of potential choices a person might make to improve their life in the future.
How Is It Taxed?
The diverse kinds of saving listed above are taxed in an equally-diverse number of ways. The chart below includes all of the examples described above, sorted into four categories.
What does this chart mean? I described the process of saving as putting aside resources today to get benefits later. The columns and rows show the tax treatment of both the resources you set aside today and the benefits you get later from those resources.
The columns show the treatment of principal: the initial resources you invest. If you pay income tax on those resources, that’s a layer of taxation. Some investments have it, other investments don’t. The money you invest in a brokerage account or Roth IRA, or the money you use to purchase a house (whether you rent it out or occupy it) is money that you typically have paid income tax on.
However, sometimes we don’t tax the principal. In many cases, that’s because an explicit deduction is offered for contributing to a favored kind of account. But also, at times, it’s because no money changes hands. If you imagine a do-it-yourself home project, there’s no exchange of money that the IRS can point to and say that new investment was made. But nonetheless, an economist would consider the work you put in a new investment into the housing stock.
The rows of the chart show the treatment of returns: the benefits you accrue later from the resources you invested. Typically, if this benefit comes in the form of money, it’s taxed: this is true of most financial accounts, or even rental income you might earn as a landlord. However, in a few cases, such as Roth IRAs and HSAs, that income is tax-free by rule. But the biggest tax-free benefits people get from investing are usually the sort of benefits that don’t come in the form of visible exchanges of money: for example, ownership of a home.
Each box is filled with multiple examples, showing that every single permutation of tax treatment currently exists under the U.S. income tax.
Why Are There So Many Different Treatments of Investment?
This diversity of tax regimes exists for several reasons.
First, it exists because politically-popular economic activity often finds its way to better tax treatment. Second, it exists because of the limits of tax administration. And third, it exists because there’s legitimate difference of opinion on the right way to tax saving and investment theoretically.
Some of these examples, like retirement accounts and HSAs, are constructed deliberately as exceptions to the general treatment of income under the tax code. This is in part because the ideas of retirement saving and health saving are popular, and thought of as societal priorities that deserve unique special treatment.
This also applies, to some degree, to owner-occupied housing. But the owner-occupied housing also escapes taxation on the returns for another reason: it’s not easily countable. In order to administer a tax on imputed rent, the IRS would have to come up with a value for each owner-occupied home, and claim that the owners owe tax on this. People would be suspicious of this process, and probably reject it.
But finally, even setting aside the difficulties tax administration and tax politics, there’s an actual disagreement of substance on which portion of the chart we should be placing investment into, even in theory. Few economists say the lower-right quadrant (which would lead to no revenue at all) but you can find healthy numbers arguing for each of the other three.
In effect, the different views on appropriate taxation of investment have each seized portions of the income tax code and made it in their preferred image. But the result is that we have a hodgepodge, with four different ways of approaching what’s fundamentally the same concept.
What Treatment Is Most Appropriate?
Those who like the treatment on the upper right—the quadrant that includes traditional IRAs and defined benefit pensions—have the best end of the argument. It’s not necessarily easy to administer for all economic activity, but it has the best economic properties. Unlike the lower-right quadrant, it generates revenue. Unlike the lower-left quadrant, it captures the benefits of lucky or inframarginal investments. And unlike the upper-left quadrant, it does not create a differentiated tax on present and future consumption.
For more depth on how a system based entirely on the upper-right quadrant might work, and why it’s most beneficial, this proposal from Norman Ture, a longtime tax policy advisor to presidents like Kennedy and Reagan, is worth a look.