Is Double Taxation Unfair?
What is double taxation? In regards to tax policy, double taxation refers to taxing income more than once that was not intended by the tax authorities or it is the reason given for why the tax law works as it does. So, for instance, partners are taxed on the income they receive from a partnership, but the partnership itself is not taxed because Congress intended to tax only the partners and not the partnership.
However, the double taxation argument is often presented as if it were unfair. Taxes are generally assessed on either income or transactions. Most people think of double taxation as being more than one tax assessed on the same income. For instance, corporations pay tax on their income. If they distribute some of their earnings to their shareholders, then the dividends are taxed to the shareholders. Another example commonly cited as double taxation is the taxation of estates or inheritance. It is argued that the decedent has already paid taxes on the money; therefore, it should be distributed to the beneficiaries tax-free.
But is double taxation unfair? Consider the following 2 scenarios. The 1st scenario is that you receive $100 and are taxed 40% on that amount. The 2nd scenario is that you are taxed 20% on the $100 now and then 20% of the original amount again at some later time, on the same income. Clearly, most people would describe the 2nd scenario as double taxation, yet virtually everyone would choose the 2nd scenario if they had a choice. The 2nd scenario is better because money has time value, so, therefore, the taxpayer can at least benefit from the extra 20% for a certain time. So it is not double taxation per se that is considered unfair. Rather, it is the tax rate on the amount by which most people would judge whether it was fair or not.
In both of the above scenarios, the income went to you and was taxed to you. However, the double taxation argument often refers to when a taxable entity pays taxes on money received, which is then given to other entities, usually individuals, who also must pay taxes on the money. When a corporation earns income and then distributes it to shareholders, the corporation pays taxes on the money, because it is a separate taxable entity, and the shareholders, as another taxable entity, pay tax on the dividend. When an individual earns money, he pays taxes on it. When he dies, the money is distributed to beneficiaries. Of course, thanks to a tax code that benefits the wealthy, beneficiaries do not have to pay any tax on inheritance, and why they shouldn't, it is often argued, is that it would be double taxation. Although there is an estate tax, which is the tax assessed on the estate rather than on the beneficiaries, each individual has an exemption of more than $11,000,000, so that amount can be passed to beneficiaries without any federal taxes assessed on it at all.
The argument goes that since the money has already been taxed, it should not be taxed again. This is the reason often given for not taxing inheritance. However, when you pay your gardener or your housecleaner, they must pay taxes on that income even though you have already paid taxes on it. A tax code that favors the wealthy most often accomplishes its task by putting most of the tax burden on income earned by most people, while taxing income that accrues mostly to the wealthy at a lower rate or not at all. This explains the lower taxes on investments and inheritance.
It also explains the higher taxes on employment income, which is the most heavily taxed form of income. It is not only subject to a marginal income tax, but also to employment taxes. Additionally, states and localities also tax employment income. So at least 4 separate taxes are assessed on the same income that goes to the same individual. Yet, one never hears the double taxation argument being applied to working income. Real estate taxes are also another example of multiple taxation, because the property owner pays taxes on the same property every single year.
The fact is money is taxed over and over again because the government would quickly go broke if it were not otherwise. Although tax revenue depends on the amount of money taxed, it also critically depends on the velocity of money — how quickly it changes hands. If the government could only tax any given dollar once, it would have a very serious revenue shortfall, which is why it is taxed in virtually every transaction, both when people earn it and when they spend it.
The tax system does not work by taxing money — it works by taxing people. Money does not pay taxes — people do, based on the income they receive. So, certainly, if inheritance were taxed, it would not be double taxation, since the beneficiaries would only pay tax on the money they receive. That the money has been taxed before does not matter, since all money, except for the newly created, has already been taxed many times and will continue to be taxed for as long as it is circulating.
If one wants to argue about the unfairness of taxes, then the burden of the tax to the individual paying it would matter more. Indeed, this is deemed to be one of the basic principles of tax fairness, that the amount of tax each individual must pay should be commensurate with their ability to pay it. Certainly, this is how the marginal tax rate works, by assessing a higher rate on higher incomes. On the other hand, since there is no inheritance tax, the beneficiary pays no tax on it at all, even if she is a billionaire!
It is economic sense to tax income earned from work the least, while taxing other forms of income at higher rates. It is a well-established economic principle that demand decreases with increasing prices and supply decreases with decreasing prices. When the government assesses employment taxes on employment income, it increases the price of labor to employers and decreases the amount received by the suppliers of that labor. Therefore, employment taxes have the overall effect of lowering employment. This is often called the deadweight loss of taxation. But it is work that creates the wealth of any nation. On the other hand, beneficiaries do nothing for the money they receive. Indeed, from an economics point of view, it can be said that the supply of death is completely inelastic, in that no matter what the tax rate is on estates or an inheritance, the death rate will be unaffected. Likewise, the demand for gifts by beneficiaries is completely elastic — they will accept whatever they are given, regardless of the tax rate on the inheritance, because they do not have to do anything for it. Therefore, it makes far greater sense, based on well-established principles of economics, to tax estates and/or inheritances at higher rates than employment.
Hence, the double taxation argument is a specious argument. Nothing is inherently unfair about double taxation, and, indeed, it ignores how the tax system actually works, since tax revenue depends not only on the amount of money taxed but also on how often it is taxed!