RALEIGH – Before you can conclude that a given class of taxpayers is benefitting from special treatment, you must first show clearly what it would mean to treat all taxpayers the same. To argue that something is unfair, in other words, requires a prior definition of “fair.”
In a recent cover story on the taxation of life insurance, reporters and editors at the Wall Street Journal gave their readers a confusing and misleading account of the issue because they failed to offer clear, concise definitions.
The tax treatment of insurance is, admittedly, a complex topic. But that’s all the more reason to define the terms clearly, and to sketch out what it would mean for the tax system to be “fair” to all households regardless of their size, income, or financial assets.
The Journal reported that because an increasing share of life-insurance customers are affluent, the industry’s traditional base of political support might be ebbing – creating opportunities for federal policymakers who think life insurance isn’t subject to adequate taxation. During past tax fights, insurers used their image as a safety net for widows and orphans to defend their tax preferences. Now their image is changing.
Interesting stuff, I suppose, but for fair-minded analysts of public policy, it is entirely beside the point. Interest groups always use their most-popular arguments to advance their political position. The popular arguments aren’t necessarily the valid ones. In this case, the two tax provisions that make life insurance attractive – that death benefits aren’t taxed and that whole-life insurance accounts grow tax-free – aren’t properly justified because widows or orphans might benefit from them. They are justified because they are the only fair way to apply tax to such insurance products.
Taxes exist to pay for government services. They shouldn’t to be used to interfere with private commercial or familiar arrangements, or to steal income from those who originally earned it in order to transfer the income to others that politicians deem more worthy to receive it.
Thus, true tax fairness treats like taxpayers in like manner – period. Taxpayers ought to be able to understand their tax system, predict their future tax liability with reasonable confidence, and make personal decisions without having the tax collector reward or punish them accordingly.
With consumption activities, applying these principles isn’t particularly challenging on paper, though in practice a combination of special-interest pleading and paternalism means that some goods or services incur higher total tax burdens than others, after accounting for income, sales, excise, and other taxes.
Taxing investments is a bit trickier. What trips most people up is the relationship between the principal and the return. Tax fairness requires that the government tax either the amount invested or the return on that investment – but not both.
Say you are going to invest $1,000 and receive a 10 percent return, increasing your account to $1,100. If the government imposes a 10 percent tax on the $1,000, it is simultaneously taxing the return by the same amount – $900 grows to $990, rather than $1,000 growing to $1,100. If the government imposes a separate tax on the $90 return, the true tax rate on the investment is higher than 10 percent.
Such tax policies make investment artificially expensive and, thus, consumption artificially cheap. This is not only unfair but economically foolish.
There are two solutions to the problem: 1) exclude the principal of an investment from taxation and then tax the return, or 2) tax the principal and then exempt the return.
Traditional IRAs and 401ks are examples of the first solution. Roth IRAs and life insurance are examples of the second solution.
When households pay premiums for life insurance, they pay out of taxable dollars. Thus their death benefits shouldn’t be taxed. On the other hand, if an employer pays the premium for an employee, and excludes the premium from taxation, it makes sense to apply an income tax on any death benefit.
As for whole- and universal-life policies, if their investment components are funded with after-tax dollars, they ought to grow tax-free. This isn’t a special preference deserving of political patronage. It’s just basic fairness.
Hood is president of the John Locke Foundation.