VIRGINIA LAW REVIEW
VOLUME
70
OCTOBER
1984
NUMBER
7
FEDERAL INCOME TAXATION AND HUMAN CAPITAL
Paul B. Stephan III*
H
UMAN capital is a controversial topic in debates over the
proper configuration of the federal income tax. Some proponents of structural tax reform argue that the present system's
nontaxation of human capital accumulation is a fatal flaw. They
contend that human and financial capital are economically
equivalent, yet under an income tax they face radically different
tax burdens. Other scholars question the validity of the human
capital concept and therefore excuse the failure to account for it in
the income tax. Critics and defenders of the status quo also disagree over the relevance of human capital in defining an income tax
base and the propriety of the indirect ways that the present system
does adjust, and can adjust further, for gains and losses of human
capital. Despite these wide-ranging but often hypothetical discussions, lawyers, politicians, and economists who deal with the income tax have paid little attention to the potential utility of the
human capital concept as a means of aiding tax agencies and
courts in interpreting the law.
I believe that the concept of human capital can uncover patterns
that explain features of present law that seem inconsistent with
the idea of an income tax, and can provide a test for evaluating
arguments for and against the current system. The first section of
* Associate Professor, University of Virginia School of Law.
I am indebted to Lillian R. BeVier, Michael P. Dooley, Michael J. Graetz, Harry L. Gutman, Edmund W. Kitch, Douglas L. Leslie, Saul X. Levmore, Glen 0. Robinson, Julie A.
Roin, and Robert E. Scott for valuable comments and criticisms. Responsibility for errors
remains my own.
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this article describes what is meant by human capital and considers the moral arguments against using the concept. The remainder
of the article illustrates the explanatory and normative value of the
concept by applying it to several topical issues.
The second section examines the role of human capital in the
consumption tax debate. This section concludes that the human
capital concept does not unlock the secret of what constitutes an
optimal tax system, but that it does undermine some arguments
employed to support major changes in federal taxation.
The third section, by discussing the role of nonbusiness exclusions and deductions as adjustments for human capital losses and
gains, shows how human capital can affect the definition of taxable
income. This inquiry reflects both the concerns of structural tax
reformers-most recently manifested in proposals for a "flat
tax"-with broadening the federal tax base, and the more modest
notion that economic income provides an important, although not
exclusive, criterion for assessing the desirability of less radical
changes. I argue that the human capital concept explains several
features of the Code viewed by many as departures from the use of
economic income as a tax base. The human capital concept thus
bolsters the contention that economic income shapes the present
and potential contours of taxable income.
The fourth section examines two narrow issues-the deductibility of education expenses and the exclusion of damage awards-to
show how the human capital concept can elucidate interpretation
of the Code. I argue that the concept has greatest utility when
used by administrative and judicial adjudicators who must accept
economic income as a given in federal tax law. I also touch briefly
on the relevance of the human capital concept to interpretive questions that do not directly involve the tax base, and argue that
human capital has some role to play in the resolution of controversies about capital asset definition, timing of taxation, and attribution of income.
I. THE HUMAN CAPiTAL CONCEPT
A. Economic Definition of Human Capital
Human capital, in economic terms, is equivalent to the present
value of the flow of future satisfactions that an individual can command in the course of his life. Some portion of this capital consti-
1984]
Taxation and Human Capital
1359
tutes endowment, the biological and social inheritance that accompanies a person into the world. The remainder is acquired through
individual action, such as education, on-the-job training, migration, and health care, or stems from exogenous changes such as
technological or social transformation.' When one talks of human
capital as a variety of income for taxation purposes, the discussion
centers on net changes in the value of human capital over an accounting period rather than the value of capital possessed at any
one time.2
For example, assume that a college graduate can expect to earn a
constant annual income of $20,000 for fifty years. Using a ten percent discount rate (for simplicity more than for realism), these future earnings have a present value of $198,200 (if the salary is paid
at the end of each year). Assume also that if the student goes to
law school for three years instead of immediately entering the work
force, he can earn $40,000 annually for the remaining forty-seven
years of his working life. If the student wishes to maximize his
wealth and if no other considerations apply, he would attend law
school as long as the present value of its costs (forgone earnings
plus direct expenses) were less than the present value of the increase in expected earnings. If the only direct expense were annual
tuition of $10,000, the student would "pay" $30,000 a year (because he cannot collect earnings while in law school) for the right
to increase his subsequent earnings by $20,000 annually. Because
the present value of the return ($148,600) exceeds that of cost
($74,000), he will go to law school unless he has an even more profitable means of investing his time and effort. The increase in
human capital produced by his schooling and measured by future
I For the classical treatment of labor inputs to the production process, see A. Marshall,
Principles of Economics 680-88 (8th ed. 1920); 2 J.S. Mill, Principles of Political Economy
346-81 (5th ed. 1901); 1 A. Smith, The Wealth of Nations 5-18, 104-24 (J.E.T. Rogers ed.
1880). For more recent discussions of human capital, see G. Becker, Human Capital (2d ed.
1975); M. Friedman & S. Kuznets, Income from Independent Professional Practice (1945);
L. Thurow, Investment in Human Capital (1970); Schultz, Investment in Human Capital, 51
Am. Econ. Rev. 1 (1961) [hereinafter cited as Schultz, Investment in Human Capital]; Schultz, Capital Formation by Education, 68 J. Pol. Econ. 571 (1960).
' Economic income is generally held to comprise consumption (measured in dollar terms)
plus net changes in the value of savings (also reduced to dollar values), during the relevant
accounting period (typically one year). See H. Simons, Personal Income Taxation 50 (1938).
Using this equation, consumption can be defined as income (receipts less the cost of producing current receipts) minus savings (or plus disinvestment). See Andrews, A ConsumptionType or Cash Flow Personal Income Tax, 87 Harv. L. Rev. 1113, 1120 (1974).
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earnings constitutes income during the period of acquisition, just
as if the student owns securities that grow by a similar amount
over the same period.
Under a comprehensive tax on economic income, increases in future earning power of the sort experienced by the law student
should produce liability and decreases should produce deductions,
even though the investor will also pay tax on earnings when received. Compare changes in human capital to a bond that increases
in value as market interest rates decline: under current law the
bond's gain will not be taxed unless the holder realizes it by selling
the bond, but in theory realization is an administrative concern
rather than an essential element of income. Similarly, changes in
the value of human capital also constitute economic gain, albeit
unrealized.3
B.
PracticalProblems in Defining Human Capital
Human capital has characteristics that distinguish it from other
kinds of assets. Unlike physical capital, earning capacity is specific
to an individual and cannot be transferred. Therefore, although
the theoretical relationship between human capital and future
earnings seems clear enough, in most cases we lack any objective
means to measure changes in or assign money value to human
capital.
The law student example illustrates the point. Several simplifying assumptions were made in that example, including stipulations
of an appropriate discount rate and future earnings before and after education. In practice these figures would be difficult to estimate. Such calculations are not impossible-tort law, for example,
often relies on similar inquiries to calculate damages-but the
mechanics of implementation in a tax that affects hundred of mil-
3 In Eisner v. Macomber, 252 U.S. 189 (1920), the Supreme Court declared that Congress
lacked the constitutional power under the sixteenth amendment to tax unrealized income.
Since the advent of the New Deal Court in the late 1930's, however, it has seemed reasonably certain that the Court no longer views realization as a constitutional requirement. See
Stone, Back to Fundamentals: Another Version of the Stock Dividend Saga, 79 Colum. L.
Rev. 898, 918-19 (1979); Surrey, The Supreme Court and the Federal Income Tax: Some
Implications of the Recent Decisions, 35 ]M. L. Rev. 779, 781-94 (1941); cf. United States v.
Atlas Life Ins. Co., 381 U.S. 233, 246-47 (1965); Commissioner v. Glenshaw Glass Co., 348
U.S. 426, 430-31 (1955); Helvering v. Horst, 311 U.S. 112, 115-16 (1940); Sakol v. Commissioner, 574 F.2d 694, 699-700 (2d Cir.), cert. denied, 439 U.S. 859 (1978).
1984]
Taxation and Human Capital
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lions of people every year seem daunting. Moreover, tort law often
concerns events, like death and serious injury, where the effect on
future earnings is clearer. A comprehensive tax on human capital
acquisition would consider events with diffuse and uncertain effects, and at the same time strive for a degree of uniformity that
tort law, as a multisovereign and multipolicied corpus, need not
attain.
The absence of a market for human capital and the valuation
problems that follow are not insurmountable barriers to taxation.
First, it is possible for individuals to exchange rights to future
earnings for cash. Some entertainers, athletes, and entrepeneurs,
for example, market their talents through service contracts that
convert future returns to present cash, or, less directly, through
financing arrangements such as equity participation in a new corporation. Where such arrangements exist the equivalence of
human capital and physical capital is evident. The market in baseball player contracts, for example, works as most markets do. As
expectations about the player's future performance go up or down,
his trade value moves accordingly.
Admittedly, arrangements for capitalizing unrealized earnings
are not widespread. The moral hazard implicit in the divorce of
compensation from effort is one obstacle. 5 Moreover, one of the
principal inputs in the production of human capital-time-is perishable and nontransferable, and implies limits on an individual's
ability to create human capital or time human capital investments.
Although it is possible for the same person to go to both law and
For a sampling of tort cases concerning capacity, see Levmore, Self-Assessed Valuation
Systems for Tort and Other Law, 68 Va. L. Rev. 771, 800-04 (1982).
5 The moral hazard problem-the fear that separating compensation from effort will degrade the quality of performance due to the absence of incentives-has been documented in
a controversial study involving long term contracts for athletic services. See Lehn, Property
Rights, Risk Sharing, and Player Disability in Major League Baseball, 25 J.L. & Econ. 343
(1982). This concern may be the underlying reason for the traditional refusal to order specific enforcement of employment contracts. Cf. Fitzpatrick v. Michael, 177 Md. 248, 254-56,
9 A.2d 639, 641-42 (1939) (specific enforcement would cause "enforced association with an
obnoxious employee .... which would be intolerable"). If the traditionally invoked liberty
issues were truly at stake, one wonders why the employer's freedom not to work with an
undesired employee has so little weight when an arbitrator rules in an employee's favor and
orders reinstatement. See, e.g., Matter of Staldinski, 6 N.Y.2d 159, 160 N.E.2d 78, 188
N.Y.S.2d 541 (1959). For a full analysis of the role of human capital in the employer-employee relationship, see Kitch, The Law and Economics of Rights in Valuable Information, 9
J. Legal Stud. 683 (1980).
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medical school, he cannot do both simultaneously, and the expected return from either educational choice will decline the longer
the investment is delayed. Neither difficulty of transfer nor dependence on scarce inputs, however, is unknown among types of physical capital.
Because direct observation of most changes in the value of
human capital are impossible, rules designed to account for the
changes require inferences about what produces them. Economists
believe that education, on-the-job training, health care, and migration increase human capital, and that disease, injury, and skill obsolescence decrease it. The field of human capital research is
young, however, and much remains to be learned. On the other
hand, some of these gaps in our knowledge are not crucial for income tax purposes. For example, we cannot tell with absolute certainty the extent to which schooling provides students with skills
that they can trade for earnings, or instead only identifies persons
already possessing the qualities that will lead to success." Nevertheless, if reliable predictions about future income levels are desired, the exact means by which the increased income comes about
does not matter.
The overlap of investment and consumption also complicates
implementation of a tax on human capital gains. Some activities
through which an individual obtains human capital-in particular,
education, health care, and travel-contain substantial elements of
immediate personal satisfaction. The distinction matters because
the tax base, whether income or consumption, should include costs
of personal consumption while allowing some type of deduction for
investments. Under an income tax taxpayers can recover investment costs over an asset's useful life, and a consumption tax allows
an immediate deduction for investments. Although human capital
may present special problems for distinguishing consumption and
investment, similar difficulties exist for taxation of physical capital. Ag&in, the impediments to taxing human capital accumulation
differ from regularly encountered obstacles more in degree than in
kind.7
o
See G. Becker, supra note 1, at 6 & n.17.
To counter easy characterization of personal consumption as business investment, for
example, the Tax Reform Act of 1984 imposed restrictions on deductions for luxury cars
and "listed" property. These rules reflect a concern that businesses often make physical
1984]
Taxation and Human Capital
1363
Mechanical difficulties in calculating the value of changes in
human capital, however, should not dissuade acknowledgment that
the changes exist. Although similar measurement problems have
prevented comprehensive taxation of unrealized changes in the
value of physical capital, they have not barred the use of rules that
provide some offsets or approximations. The depreciation deduction, the corporate income tax, and a variety of more technical provisions at least partly account for unrealized capital gains and
losses.' With a little imagination we could devise more comprehensive and accurate rules. Similarly, if accounting for changes in
human capital were desirable in an income tax we could develop
indirect methods that move toward this goal.
"investments" to meet the consumption desires of their employees. See Tax Reform Act of
1984, Pub. L. No. 98-369, § 179(a), 98 Stat. 494, 713-17 (adding I.R.C. § 280F); cf. Revenue
Act of 1978, Pub. L. No. 95-600, § 361 (a), 92 Stat. 2763, 2847 (amending I.R.C. § 274 (a) (1)
to limit deductions for entertainment facilities).
8 Other technical provisions of the present Code that tax unrealized gains from property
include I.R.C. §§ 83(a) (taxation of receipt of restricted property in compensation for services) and 1256 (taxation of annual appreciation in value of commodities futures contracts)
[Unless otherwise indicated, all citations to the I.R.C. in this article are to the October 1984
CCH version.]. The Tax Reform Act of 1984 expanded significantly the kinds of transactions that can produce prepayment inclusion of interest income. See Pub. L. No. 98-369, §§
41-44, 98 Stat. 494, 531-62 (adding I.R.C. §§ 1271-1288); id. § 172, 98 Stat. at 699-703 (adding I.R.C. § 7872). For analysis of these and related provisions in the Act, see Halperin,
The Time Value of Money-1984, 23 Tax Notes 751 (1984).
Moreover, the areas where the Code explicitly allows adjustments for changes in the value
of human capital suggest a diminished concern with the rigors of realization. For example,
the right of a sports franchise owner to depreciate player contracts he has purchased seems
uncontroversial. See Selig v. United States, 740 F.2d 572 (7th Cir. 1984) (baseball player
contracts); Laird v. United States, 556 F.2d 1224 (5th Cir. 1977), cert. denied, 434 U.S. 1014
(1978) (football player contracts); First N.W. Indus. of Am., Inc. v. Commissioner, 70 T.C.
817, 844-58 (1978), rev'd on other grounds, 649 F.2d 707 (9th Cir. 1981) (basketball player
contracts); I.R.C. § 1056; Rev. Rul. 137, 1971-1 C.B. 104 (football player contracts); Rev.
Rul. 379, 1967-2 C.B. 127 (baseball player contracts). Goodwill and covenants not to compete, much of the value of which may in particular cases reflect human capital, present
similar opportunities for taxpayers to bargain out the tax consequences of a sale of future
services. By denominating the transaction a transfer of goodwill, the seller qualifies for the
capital gain preference but the buyer may not amortize his cost; by calling essentially the
same relationship a covenant not to compete, the seller recognizes ordinary income but the
buyer has an amortizable expense. See Danielson v. Commissioner, 378 F.2d 771, 775 (3d
Cir.), cert. denied, 389 U.S. 858 (1967); M. Chirelstein, Federal Income Taxation, 293-96 (3d
ed. 1982) (discussing Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945)). Finally, in a recent
transfer tax case, the government succeeded in including an unrealized contingent fee claim
in a deceased lawyer's taxable estate. Estate of Aldrich v. Commissioner, 46 T.C.M. (CCH)
1295 (1983). Sections II and III discuss other, less direct means by which current law allows
adjustments for human capital gains and losses.
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C. Moral Problems In Defining Human Capital
Some scholars have argued that the concept of human capital is
too suspect to permit even indirect accounting. One critical tradition, drawing on both Marx and contemporary leftist thinkers, has
challenged the assumption that education produces net future benefits for the educated." Another familiar critique, associated with
Kantian concepts of individual freedom and dignity, contends that
as a moral matter society should not encroach on personal decisions of whether to work or not, and that a concept that equates a
person with his unrealized earning potential verges on a conversion
of free people into slaves.10 Each of these arguments, although
resting on radically different premises about the relation of individual to society, concludes by forbidding any tax on human capital accumulation.
I do not intend to refute these critiques at length. Without passing judgment on the ultimate validity of Marx's insights into the
political economy of industrial production, one can assert that not
all his observations fit comfortably the experience of the century
that has passed since his death."' Moreover, most of the Marxist
See, e.g., K. Marx, Capital 179-80 (S. Moore & E. Aveling trans. 1936); J. Habermas,
Knowledge and Human Interests (1971) (passim); H. Marcuse, One-Dimensional Man 22-34
(1964). For an application of the leftist tradition to contemporary tax issues, see KeInan,
Personal Deductions Revisited: Why They Fit Poorly in an "Ideal" Income Tax and Why
They Fit Worse in a Far from Ideal World, 31 Stan. L. Rev. 831 (1979).
10 See, e.g., Warren, Would a Consumption Tax Be Fairer Than an Income Tax?, 89 Yale
L.J. 1081, 1114-15 (1980); see also Goode, The Economic Definition of Income, in The
Brookings Institution, Comprehensive Income Taxation 12-13 (J. Pechman ed. 1977) (distinction between physical and human capital "arises from the political and legal system");
Gunn, The Case for an Income Tax, 46 U. Chi. L. Rev. 370, 382 (1979) (tax on earning
capacity would lead to "an unacceptable restriction on freedom").
11 For data supporting the proposition that in some cases individuals can capture a significant portion of the income from investment in their professional skills, see G. Becker, supra
note 1, at 147-230; Liebowitz & Tollison, Earning and Learning in Law Firms, 7 J. Legal
Stud. 65 (1978); see generally M. Friedman & S. Kuznets, supra note 1. Further evidence,
albeit indirect, comes from the Soviet Union, which has purported to organize its economy
along the lines suggested by Marx but in many respects has tolerated or adopted markettype arrangements in certain sectors. A continuing problem for those who command the
Soviet economy is that workers with special skills and a willingness to uproot can force
bidding among different state-owned enterprises for these skills and can change jobs upon
the receipt of more attractive bids. The Soviet regime, either explicitly or implicitly, attributes such behavior to bourgeois outlooks and has tried to regulate it. See, e.g., Edict of the
Presidium of the USSR Supreme Soviet, Bulletin of the Supreme Soviet of the U.S.S.R.,
No. 33, Item 507 (1983); V. Artemenko, The Inclination to Change Jobs, Pravda, Nov. 10,
1983, at 3; see generally Armstrong, Control of Mobility of Labor in the Soviet Union, 3
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Taxation and Human Capital
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arguments against taxing human capital prove too much. If their
conclusions have force, the case against the status quo is too devastating for it to be ameliorated by a mere avoidance of human capital taxation.1 2
As for what I will term the "human dignity" arguments, a persuasive response has been made by Theodore Schultz, whose pioneering work on human capital, among other accomplishments, led
to a Nobel prize in economics. Schultz recognized the association
with slavery that the human capital concept provokes. He argued
in rebuttal that attaching a value to potential earnings capacity
does not subordinate individuals to illegitimate social ends, but
rather adds to the stock of knowledge that expands the frontiers of
human freedom. As he observed, "By investing in themselves, people can enlarge the range of choice available to them."1 8 Denying
that these opportunities exist, or at least refusing to think about
them, seems 4a perverse way to pursue the goal of individual dignity
and liberty.'
N.Y.J. Int'l & Comp. L. 173 (1982).
11 Typical of the confusion that results from applying a radical analysis to middle-range
problems is that underlying the interesting argument advanced by Professor Kelman against
taxation of earning potential. Kelman contends that the present system's nontaxation of
human capital accumulation reflects a desire to "confirm" an individual's resistance to the
"commoditization" of his labor. This desire, in his view, represents "a desirable anticapitalist tendency in a market-obsessed culture." Kelman, supra note 9, at 842, 880. Yet he implicitly accepts taxation of wages, i.e., "commoditized" labor, on the ground that such labor
exchanges are voluntary. Id. at 842-43. This concession leads to paradox. Either he is casting
aside the Marxist perspective on the influence of social structure over individual choice and
is treating as taxable volunteers those members of the underclass who are driven into the
labor market to survive, or he proposes an exclusion available only to persons with relatively
high earning potentials. The former position taxes the migrant worker but excludes the
playboy; the latter carves out a special tax advantage for the self-indulgent wealthy. Either
result is at odds with his apparent objectives of exposing how conventional (bourgeois) tax
scholarship seeks to undermine tax progressivity and of offering a radical alternative. See id.
at 879-83. Moreover, as I demonstrate below, the characterization of the status quo as avoiding taxation of earning potential is not quite accurate. The present tax base can be seen as
accounting for changes in stock of human capital, although through indirect devices that
achieve only a rough measurement of this type of income.
13 Schultz, Investment in Human Capital, supra note 1, at 2; see also L. Thurow, supra
note 1, at 6-8.
, Typical of the "human dignity" arguments is that of Professor Warren, who contends
that taxation of unexercised earning capacity would violate "personhood," which "may be
said to extend to [one's] productive capacity, but not [one's] product." Warren, supra note
10, at 1115. I have considerable difficulty in understanding the concept of "personhood,"
which strikes me more as a rhetorical embellishment of a range of natural rights issues than
as a rigorous and unified analytical construct. But even if one can find content in the con-
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Although these general arguments may not convince everyone, a
suspension of hostility to human capital concept, however temporary, may produce unexpected rewards. If net changes in human
capital constitute gain that an income tax theoretically might include in its base, a host of practical problems immediately arise. In
the absence of an observable market for human capital, how can
the tax collector identify and measure it? If rules of thumb help
circumvent the measurement issue, what are acceptable tradeoffs
between precision and accuracy? What device might be employed
to minimize the social costs of taxing human capital? To what extent can one characterize existing law as a reflection of such devices? The remainder of this article will try to show that the search
for answers, however frustrating, is at least as interesting as the
more abstract controversy over the legitimacy of human capital.
II.
INCOME VERSUS CONSUMPTION TAxATION: THE ROLE OF
HUMAN CAPITAL
Fundamental change in the structure of federal taxation is a
subject of intense current interest. Anxiety about the size of the
federal decifit has fueled the never-dormant controversy over tax
reform. The Treasury's recent study of fundamental tax reform is
only the latest effort to explore the available options. 15 One possibility is consumption taxation, an idea of distinguished intellectual
ancestry.1 6 In Congress as well as academe, moving to a consumpcept, I fail to see how taxation in principle violates personhood any more than the manifold
other ways in which society imposes costs on those who choose not to work. Contract law,
for example, not only awards damages for breaches of personal services contracts, but under
appropriate circumstances will also forbid the breacher from accepting comparable employment. See, e.g., Philadelphia Ball Club, Ltd. v. Lajoie, 202 Pa. 210, 51 A. 973 (1902); Lumley
v. Wagner, 42 Eng. Rep. 687 (Ch. 1852). Alimony is another area where present law taxes
those who choose not to work. Domestic relations courts will not reduce a spouse's continuing obligation simply because he refuses to seek a fair return for his services. See, e.g., Hickland v. Hickland, 39 N.Y.2d 1, 5-6, 346 N.E.2d 243, 246, 382 N.Y.S.2d 475, 477, cert. denied,
429 U.S. 941 (1976); Herndon v. Herndon, 305 N.W.2d 917, 918 (S.D. 1981). Moreover,
many forms of taxation (e.g. property and wealth taxes) fall on unrealized gain, forcing the
taxpayer either to sell his labor or part with some other possession to pay the tax collector.
15 1 U.S. Dep't of Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth
(1984).
1' Proponents of consumption taxation include Thomas Hobbes, Adam Smith, John Stu-
art Mill, and a host of modern political economists. Current literature on the subject includes The Brookings Institution, What Should Be Taxed: Income or Expenditure? (J.
Pechman ed. 1980); N. Kaldor, An Expenditure Tax (1955); U.S. Dep't of Treasury,
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Taxation and Human Capital
1367
tion tax is one of the most widely discussed major federal taxation
reforms. The human capital concept has played a significant, although not fully understood, role in the debate.
In simplified terms, a consumption tax would exclude savings
from income by allowing taxpayers either to deduct investments or
to exclude investment income. 17 The tax base would include all
"disinvestment" without the offset for basis that an income tax requires. Under a consumption tax, investors in human capital would
take an immediate deduction for their costs and would include all
of their returns when realized. Several advocates of a consumption
tax have argued that the impossibility of measuring most investments in human capital means that any system, whether incomeor consumption-based, must employ immediate-deduction treatment of human capital accumulation. 18 The costs of acquiring nonhuman capital, on the other hand, often do not produce deductions
under an income tax until the taxpayer consumes or disposes of
some measurable portion of the asset. Because an income tax thus
discriminates between these two types of capital, and a consumption tax would not, the advocates argue for changing bases from
income to consumption. 19
Blueprints for Basic Tax Reform 113-216 (1977); Andrews, supra note 2; Kelnan, Time
Preference and Tax Equity, 35 Stan. L. Rev. 649 (1983). The 1984 Treasury study gave
serious consideration to a consumption tax, although it ultimately rejected the idea because
of obstacles to implementation previously identified in an article by Michael Graetz. See 1
U.S. Dep't of Treasury, supra note 15, at 191-212; Graetz, Implementing a Progressive Consumption Tax, 92 Harv. L. Rev. 1575 (1979).
17 An immediate deduction for an investment and the exclusion of its return have identical tax consequences where the following rather strong conditions are met:
(1) Tax rates are not progressive; moreover, they do not change over time.
(2) Taxpayers have no accumulated wealth when the system is first introduced.
(3) The system is closed; either the taxpayer exhausts his wealth by death, the system
classifies all remaining capital balances (all bequests) as being consumption in the
taxpayer's final return, or an identical tax is subsequently imposed on bequests in
some other manner.
(4) There exists a perfect capital market with no uncertainty; all taxpayers can borrow and lend unlimited amounts at a risk-free interest rate.
(5) All income can be classified as one of two types: wage income or income to capital
accumulated during and after the initial period.
Graetz, supra note 16, at 1602; see generally E. Brown, Business-Income Taxation and Investment Incentives, in Income, Employment, and Public Policy: Essays in Honor of Alvin
H. Hanson (1948).
18 See, e.g., Boskin, Notes on the Tax Treatment of Human Capital, in Dep't of the Treasury Conference on Tax Research 194 (1975).
" See Andrews, supra note 2, at 1145-46; Inst. for Fiscal Studies, The Structure and Re-
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The paradigm that illustrates the argument posits two individuals, A and B. A saves everything above a subsistence wage and B
earns only a subsistence wage while acquiring human capital
through schooling or on-the-job training. If each faced an income
tax of twenty-five percent, and if A's savings and B's human capital had the same pretax rate of return, B would end up with 133
percent as much after-tax return as A because B's forgone earnings
produced no tax liability. Allowing A a deduction for his savings
would place him in the same position as B.
The point is not simply that accumulation of human capital occurs tax-free. Increases in physical capital also produce no tax consequences until realized. Rather, the problem lies in the tax consequences of acquisition costs. In the paradigm, nonhuman capital (a
savings account, for example) comes from retained earnings, which
an income tax includes in its base. Human capital, by contrast, is
acquired through forgone earnings, which produce no tax liability.
More generally, the argument that an income tax favors human
capital accumulation is true only to the extent that acquisitions of
nonhuman capital are made with taxed (undeducted) dollars, while
investment in human capital is financed with untaxed (deducted)
dollars.
In reality, the tax consequences of acquiring human and nonhuman capital are more complicated. The Internal Revenue Code allows several means of financing the acquisition of nonhuman capital with untaxed dollars. Borrowing, combining the investment
credit with accelerated depreciation, and qualified retirement savings all involve accumulation without taxation. 0 As for human
capital, accumulation has various tax consequences. This article
discusses separately the principal ways that an individual can en-
form of Direct Taxation 39-40 (1978); Klein, Timing In Personal Taxation, 6 J. Legal Stud.
461 (1977); Stephan, The Impact of Taxes on Labor's Productivity: A Human Capital Approach, 3 Pub. Fin. Q. 361 (1975); see also Eaton & Rosen, Taxation, Human Capital, and
Uncertainty, 70 Am. Econ. Rev.: Papers and Proc. 705 (1980); Heckman, A Life-Cycle
Model of Earnings, Learning, and Consumption, 84 J. Pol. Econ. Sl (1976) (arguing, in
part, that high income tax rates encourage human capital investment).
20 Borrowing, however, entails less than complete control over the acquired capital. The
equivalence of investment credit plus depreciation to an immediate deduction depends on
the discount rate. See, e.g., Auerbach & Warren, Transferability of Tax Incentives and the
Fiction of Safe Harbor Leasing, 95 Harv. L. Rev. 1752, 1754-56 (1982). Finally, there are
absolute limits as to how many untaxed dollars a taxpayer can put into tax-favored retirement savings. I.R.C. § 219(b).
19841
Taxation and Human Capital
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hance his future earning power and the income tax incidents of
these approaches. The discussion reveals a complex pattern of offsets and adjustments that undermines any confidence that moving
from income to consumption taxation will reduce discrimination
between human and physical capital.
A.
Education
For many people, some portion of their education involves personal consumption without significant prospects of future return.
Parties, athletic events, and creative writing courses, for example,
may be largely consumption rather than investment. But on the
whole, education remains an important means of increasing future
earnings. The four principal ways of financing its costs are public
or private subsidies, forgoing present earnings, borrowing, and direct payments. 2 '
1.
In-Kind Transfers from the Public Sector
As a rule, in-kind government transfers produce no income tax
liability for their recipients. 22 Free or low-cost services provided by
public schools follow this pattern. Moreover, private philanthropy,
encouraged in part by tax deductions and exemptions, enables pri23
vate schools to price their services below average cost.
Tax-free government support, however, also benefits investors in
nonhuman capital. Highways, police and fire protection, and similar facilities replace investments that owners of physical capital
otherwise might have to undertake. I am unaware of any studies
indicating that excluding in-kind government services from income
taxation benefits one type of capital more than another, and intuition suggests no reason why the advantage should be one-sided. If
the exclusion produces roughly equivalent advantages for both
types of savings, then a blanket exclusion of savings from the tax
21 For a more elaborate theoretical treatment of the costs of education, including discussion of the implications of assuming a segmented supply curve, see G. Becker, supra note 1,
at 102-04; see also R. Goode, The Individual Income Tax 80-92 (2d ed. 1976).
12 See generally Aaron, What Is A Comprehensive Tax Base Anyway?, 22 Nat'l Tax J. 543
(1969) (analyzing the ideal income tax treatment of in-kind government transfers and reasons why the ideal is unattainable).
2 The various preferences are described in Stephan, Bob Jones University v. United
States: Public Policy in Search of Tax Policy, 1983 Sup. Ct. Rev. 33, 50-51.
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base would not achieve any greater neutrality. At least for this way
of financing this form of human capital, a consumption tax does
not seem to offer any greater neutrality than does an income tax.
2. Borrowing
Another way to finance education is to borrow money. Taxpayers can deduct most interest expenses as long as they have enough
itemized deductions to exceed the zero bracket amount. 4 Although
Congress has limited interest deductions when the proceeds are
used to finance investments with either tax-free or tax-deferred returns, education loans face no such constraints.2 5
The discrepancy in the treatment of education loans and borrowing for other kinds of investment, however, is not as great as
might appear. The Internal Revenue Service's rules for tracing
loan proceeds favor borrowers by allowing full deductions for personal consumption indebtedness-most significantly home mortgages-even when the taxpayer uses his available cash to buy taxfavored investments rather than to pay off outstanding loans.2 6
Moreover, business, as opposed to investment, indebtedness is free
from all limits on interest deductibility, and much of this presumably finances the acquisition of nonhuman capital.2 7 As with subsidies, then, the present system seems roughly neutral with respect
to human and non-human debt-financed capital, although there
may be a slight preference for human capital. A consumption tax
probably would not achieve significantly greater neutrality.
14 See
2
I.R.C. § 63(c), (d), (f).
See id. § 163(d) (limiting investment interest to $10,000 plus net investment income);
id. § 189 (amortization of real estate construction period interest); id. § 263(g) (amortization
of interest allocable to "straddles"); id. § 264(a)(2), (3) (denying interest deduction for indebtedness used to finance certain insurance and annuity contracts); id. § 265(2) (denying
deduction for interest when proceeds used to purchase or carry tax-exempt obligations); id.
§ 461(g) (deferring deduction of prepaid interest); see also Halperin, Capital Gains and Ordinary Deductions: Negative Income Tax for the Wealthy, 12 B.C. Indus. & Com. L. Rev.
387 (1971) (theoretical discussion anticipating some of the recent reforms); cf. I.R.C. §
55(b)(1)(B), (e)(1)(D), (e)(3) (limiting deductibility of interest under alternative minimum
tax).
16 See Rev. Proc. 18, 1972-1 C.B. 740 (clarified by Rev. Proc. 8,1974-1 C.B. 419).
17Not only is business-related borrowing free from the interest deduction limitations
listed supra note 25, but taxpayers can deduct business interest even when they lack excess
itemized deductions. I.R.C. § 62(1); cf. id. § 63(b)(1)(A) (excess itemized deduction
requirement).
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3. Forgone Earnings
The income tax rules for forgone earnings seem clearly to favor
human capital acquired through education. A necessary and often
substantial cost of the educational process is the student's time,
which has economic value to the extent that he can trade it for
wages. Because only realized earning power produces tax liability,
an individual pays no tax on the economic value of the time invested in education.
Forgone earnings are analogous to retained earnings, as each involves the use of earning power for savings rather than consumption. Unlike forgone earnings, however, retained earnings are
taxed, unless the taxpayer invests his earnings in a manner that
qualifies for a special deduction (retirement savings or the
purchase of business capital, for example). To the extent that education produces human capital and that the cost of education comprises forgone earnings, the charge that the income tax favors
human capital acquisition seems valid.
On closer scrutihy, however, the exclusion of forgone earnings
from income may not favor taxpayers who invest in education as
much as might first appear. It is man's tragic fate that a finite life
bounds human capital, and our system normally makes allowances
for wasting assets. If the tax system could somehow measure forgone wages and treat them as if earned and retained, symmetry
with the treatment of physical capital would require an offsetting
amortization deduction in later years. If tax rates were identical
throughout an individual's lifetime, the time value of money would
lead to a preference for the present rule-exclusion and no deduction-over the alternative of inclusion with a later deduction. 28 In
a progressive system, however, this relationship does not necessarily hold.
If acquisition of human capital normally takes place in earlier
years when total earning power is low, and its amortization occurs
in later, high earning years, then the tax savings of the exclusion
might be small and the loss of amortization deductions might be
costly. With sufficient progressivity, those taxpayers with a small
28 Under certain conditions, an immediate deduction favors taxpayers because it amounts
to an exclusion for the return from the deducted investment. See supra note 17. The argument that follows in the text examines the consequences of relaxing the first condition for
this equivalence, namely the constancy of marginal tax rates over time.
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time value might prefer inclusion and later deduction.29 Assume
that taxpayer A forgoes $1000 in Year 1, when his marginal tax
rate is 14%. If the tax system included this investment in his income, he would pay $140 in tax. Assume (somewhat unrealistically)
that in Year 2 he consumes all of this human capital and would be
due a deduction of $1000. If his marginal rate in this year were
18% (because of either the increased earnings from his human capital investment or other factors), he would reduce his taxes by
$180. Unless A discounted future income by a factor more than
28%, he would prefer the inclusion and subsequent deduction to a
consumption tax (and present law) result of no inclusion and no
deduction.3
Both economic theory and substantial data suggest that many
individuals do invest in education mainly in early, low earning-potential and low marginal-tax-rate years.3 1 As a result, some human
capital investors pay more taxes under the present system, which
produces consumption tax treatment for their human capital investments, than they would under an ideal income tax that coupled inclusion of human capital accumulation with later amortization deductions. These same investors can defer deductions for
investments in physical capital until years when their marginal
rates will produce greater tax savings. For such taxpayers, a shift
to consumption taxation might correct an asymmetry, but one that
currently favors physical rather than human capital. On the other
hand, the shift might result in an overall increase in the after-tax
rate of return on physical capital, which would exacerbate what
already may be a bias against human capital investment. 2
2' See Sgontz, Does the Income Tax Favor Human Capital?, 35 Nat'l Tax J. 99, 101-02
(1982).
30 The example can be made more elaborate by increasing the deferral of the deduction.
Suppose that the same outlay of $1000 would be amortized over five years on a straight-line
basis under an income tax, that the taxpayer has a 14% marginal rate in Year 1, an 18%
rate in Years 2 and 3, and a 20% rate in Years 4 and 5. He would prefer the immediate
deduction totalling $180 only if his time preference exceeded 12.5%.
31 See G. Becker, supra note 1, at 72-75, 215-23.
3 If most investors were to prefer later deductions, a shift to a consumption tax would
force them to take an immediate deduction for all investments, not just those in human
capital. This change would remove an incentive that, under these assumptions, currently
exists for physical capital investments. On the other hand, eliminating the tax on all investment income, as a consumption tax in effect would do, might increase the after-tax return
from physical capital even after price-induced changes in the supply of investments. If a
consumption tax produced this effect, investments in physical capital would be even more
1984]
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4. Tuition and Other Direct Outlays
Even if the nontaxation of forgone wages favors human capital
acquired by education, the nondeductibility and nonamortizability
of out-of-pocket education expenses cut the other way. Almost all
investors in conventional assets can take a deduction for out-ofpocket costs at some point, through either depreciation or an offset
for basis when the property is sold. Recovery of education expenses
is much more limited. Treasury regulations allow an immediate deduction only for a limited class of expenses, which can be roughly
characterized as continuing-education costs for people already in a
profession. The Service and courts have rejected taxpayer attempts
to amortize those profit-seeking education expenses that cannot be
33
deducted immediately.
The charitable contribution deduction may substitute to some
extent for an education cost deduction. If so, the nondeduction of
direct costs may not offset the putative preference accorded to
human capital by nontaxation of forgone earnings. Most of the tax
savings from deducted contributions go to benefactors of schools,
and many of their contributions may be characterized as deferred
payments by past students.3 4 Even though the obligation to contribute is moral rather than legal, the convergence of social pressures and other inducements (e.g., preference for alumni children
in admission) supports the characterization.
But to the extent that former students give greater contributions
in later years, the deduction seems analogous to amortization of
education costs, not to an immediate deduction. Moreover, the
propriety of a charitable contribution deduction in either an ideal
income or consumption tax is debatable. The income tax should
not be attacked simply because the present Code contains a provision of dubious purpose, especially if that rule is likely to reoccur
in a consumption tax. 5
Another indirect way for a student to deduct out-of-pocket eduattractive relative to human capital than they are now.
33 See infra notes 125-27 and accompanying text.
3 See Drucker, Professional Schools Ought to Reap Some of Their Graduates' Earnings,
Chron. Higher Educ., Nov. 10, 1982, at 64; Feldstein, The Income Tax and Charitable Contributions: Part 11-The Impact on Religious, Educational, and Other Organizations, 28
Nat'l Tax J. 209 (1975)
31 For a fuller discussion of the role of the charitable exemption in the federal income tax,
see Stephan, supra note 23, at 59-71.
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cation costs is by persuading an employer to underwrite the expense. Section 127 of the Code allows an employee to exclude the
payments from income,3 6 and the employer normally can deduct
the outlays as compensation. To qualify for this treatment, the
payments cannot favor high-level employees and cannot be accompanied by an option to take cash instead of the education
benefits.3
Although this provision may represent only a sop to well-organized, politically powerful employers or employees, more neutral
reasons may justify special treatment for employer-underwritten
educational expenses. First, the kinds of skills that employers and
employees most likely will finance jointly are those of mutual economic benefit. Without government-supplied incentives, however,
employers and employees might not produce an optimal amount of
this job-specific human capital because its specialized character
may lead them to anticipate future bilateral monopoly problems. 8
Viewed from this perspective, Section 127 provides a subsidy that
might be desirable under either an income or a consumption tax.
Alternatively, Section 127 may reflect faith iii the kinds of education that employers will underwrite. If the acquired skills benefit
only the employee, presumably employers will reduce direct compensation as the price for the payments. Because Section 127 forbids creation of options to take cash instead of benefits, even those
employees who do not take advantage of the plan will help finance
it through lower wages. To the extent that employees can impose
their collective preferences on the employer, they will not consent
to such plans unless a majority of them derive benefits from them.
This tendency may lead employers to monitor the education acquired and, acting on behalf of employees as a class, to disapprove
courses that seem more self-indulgent than self-improving. Education that meets consumption rather than investment goals will be
less likely to be provided by the employer, taking the expense out
30 See I.R.C. § 127. By its terms the exclusion was scheduled to expire at the end of 1983,
but Congress recently extended it until the end of 1985. Act of Oct. 31, 1984, Pub. L. No.
98-611, § 1(a), 98 Stat. -, _. The exclusion would be repealed under the Treasury's proposal for fundamental tax reform. 2 U.S. Dep't of Treasury, supra note 15, at 37-38. An
employer will usually be able to deduct the payments as compensation under I.R.C. § 162.
37 See I.R.C. § 127(b).
38 The bilateral monopoly creates a kind of Prisoner's Dilemma because the joint asset
has value only to the extent that the employer and employee cooperate on its exploitation.
1984]
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1375
from under the Section 127 exclusion. Moreover, because only employees are eligible for these benefits, full-time students, who have
the largest forgone earnings expenses, and consequently the largest
"deductions" for education, do not qualify for the exclusion.
The problem of distinguishing consumption-oriented from investment-motivated education expenses is not confined to an income tax. None of the critics of the income tax's asserted bias
against nonhuman capital has addressed the appropriate treatment
of direct educational expenses under a consumption tax. If consumption taxation means granting an immediate deduction for
capital investments, and if human capital is such an investment,
then presumably students should get a deduction for tuition and
other outlays. But to prevent erosion of the tax base, taxing authorities must devise a way to sort out those expenses that produce
more personal satisfaction than expectation of future earnings.
Different choices in line drawing could produce a consumption tax
that either favors or disfavors physical over human capital.
A comprehensive look at methods of financing education thus
makes it doubtful that the present system favors human capital
over physical capital in ways that a consumption tax would correct.
Until more is known about the mix of sources through which students finance their education and the tradeoffs faced between projected returns and future marginal rates, it cannot be said categorically that either the current system or some hypothetical "pure"
income tax discriminates in favor of human capital. The mix and
tradeoffs may vary with the nature of the investment and its rate
of return. Primary and secondary schooling, which most studies
show have the highest return on investment, generally involve subsidies plus direct costs; undergraduate education involves a greater
degree of forgone earnings and borrowing, although direct costs
also may rise; and postgraduate schooling may require even more
forgone earnings and borrowing and produce the lowest relative
rate of return." These generalizations are guesses, and in any
event do not point in one direction. The most that can be said with
confidence is that no one to date has proved that bias exists in the
income tax rules affecting education.
S For data on the marginal rate of return from educational investment, see L. Reynolds,
Labor Economics and Labor Relations 47-53 (7th ed. 1978); P. Taubman & T. Wales,
Higher Education and Earnings 125-36 (1974).
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On-the-Job Training
Individuals also acquire skills and enhance their future earnings
through on-the-job training. Gary Becker has developed a classification for this process that I follow here: general training produces
skills that workers can apply to a wide range of employments, and
specific training enhances the ability to perform a particular job
for a particular employer. The former leads to returns that, absent
some means of alienating the investment, only the employee can
realize. The latter creates potential wealth that the employee and
employer generate together and can divide between themselves. 0
1.
Patterns of Financing On-the-Job Training
Each type of training takes place within an employment relationship and thus presents special problems in distinguishing
human capital acquisition. Because the employer both buys services and sells training, and because the employee both sells services and buys training, no obvious means exists to isolate the two
exchanges and to identify the human capital component. Nevertheless, the employment context limits the number of ways to finance the increase in human capital. Direct payments and borrowing by the employee do not seem to play a large role in these
transactions, and the role of government subsidies drops into the
background. Rather than serving as only one source of investment
financing, as they do in education, forgone earnings make up
nearly all acquisition costs of both generalized and specialized
training.4 '
To the extent that on-the-job human capital can be traced to
forgone earnings, the point made above about education remains
true: the "bias" of an income tax will rest on the relative value of
40
G. Becker, supra note 1, at 19-37; Hashimoto, Firm-Specific Human Capital as a
Shared Investment, 71 Am. Econ. Rev. 475 (1981); Kitch, supra note 5, at 684-88. In practice, it seems doubtful that any on-the-job training fits purely into either category. Most
training builds skills that not only fit the particular job, but also have other applications.
Nevertheless, the distinction, no matter how rough, may explain some of reasons for different tax rules with respect to various types of training.
"I An often overlooked source of government subsidization of on-the-job training is public
service employment, especially in the armed forces. See G. Becker, supra note 1, at 24-25.
Lawyers who do a turn in the federal government and then resume private practice also
tend to behave in a manner that conforms to the human capital model.
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1377
early exclusions and later amortization deductions.4 2 Given a sufficiently high increase in marginal tax rates due to progressivity and
a sufficiently low time-preference discount rate, the present tax
treatment of human capital, which parallels consumption tax
norms, would be less favorable to taxpayers who accumulate
human capital than would be a "pure" income tax model of inclusion and subsequent amortization. The present system, which enables investors in physical capital to postpone acquisition-cost deductions until later, high-marginal-rate years, actually may place
human capital at a disadvantage. As I observed with respect to education, a tax that allowed an immediate deduction for all investments might exacerbate this bias, although such a result is far
from certain. Until more is known about the interrelationship between progressivity and time preferences for this form of human
capital, it cannot be said with confidence whether, or to what extent, income or consumption taxation favors or discourages the accumulation of human capital.
2. Special Tax Subsidies for On-the-Job Training
Several credits and deductions, none of which is consistent with
an ideal income tax, provide what amount to subsidies for particular varieties of general and special training. The work incentive,
new jobs, and earned income credits43 seem consciously designed to
promote acquisition of basic employment skills that will enable a
worker to participate in the labor market. Research expenses, including payments to employees who may be acquiring job-specific
human capital in the course of their work, qualify for both a tax
credit and, at the employer's option, for either an immediate deduction or rapid amortization. 4' This last provision runs counter to
the general income tax principle that employers should capitalize
salary costs clearly attributable to particular long-term investments. 45 Because they have a choice, investors in research and de41 See supra notes 28-30 and accompanying text.
41 See I.R.C. §§ 38(b)(2), 51-52 (targeted jobs credit); id. § 43 (earned income credit); id §
40 (work-incentive credit), repealed by Tax Reform Act of 1984, § 474(m)(1), 98 Stat. 494,
833 (1984); I.R.C. §§ 44B, 50A, 50B, 53 (new jobs credit), repealed by Tax Reform Act of
1984, §§ 474(m)(1), (2), (p)(8 ), 98 Stat. 494, 833, 838.
" Id. §§ 30, 174.
45 See, e.g., Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212 (7th Cir. 1982)
(payments to an author for work on The Dictionary of Natural Sciences are capital expendi-
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velopment have more power to maximize tax savings from their
outlays. The preferential treatment of research-related employee
payments, like general training credits, seems to be the product of
a deliberate legislative decision to provide incentives through the
tax system, rather than a manifestation of the inherent limits of
income taxation.
Some of these tax advantages require an employer-employee relationship, and leave out self-employed workers. The decision to
impose this condition, like the calculus underlying Section 127's
exclusion of employee education benefits, could reflect any combination of considerations: self-employed people may have less political influence than do employees; Congress may have assumed that
requiring an employee's participation would weight the incentives
toward specific training, which it might want if it believed that the
potential bilateral monopoly inherent in specific training created
special problems that needed a solution external to the employeremployee relationship; or Congress may have expected employers
to act as monitors to screen out employee efforts to disguise personal consumption as on-the-job training (e.g., the Vermont communard who claims his candle-making constitutes training, when
his efforts more strongly suggest self-indulgence).
Of these three explanations, the first is the least interesting, and
to the extent true reflects a feature of the political process that
also would affect the contours of any consumption tax produced by
the present legislative process.4 6 The second suggests a purpose to
favor one kind of human capital over other investments, rather
than unintended distinctions resulting from the choice of the tax
7
base.1
As with education, the general tax treatment of on-the-job training does not suggest a clear bias in favor of human capital. Moretures under § 263(a)). As a practical matter, capitalization of salaries is unusual.
4" See Graetz, supra note 16, at 1629-34 (arguing that legislative choices to implement
nontax policy through tax system probably would be carried forward into a consumption
tax).
'" The third explanation suggests in part that Congress wishes to adjust the tax base to
reflect the influence of human capital. Employers presumably would tend to withhold job
training investments except when they could expect to capture some return through the
creation of job-specific human capital. See Kitch, supra note 5, at 684-88, 715-16 (speculating that such investment takes place and is protected indirectly through business-enterprise
rather than by contract law). Unlike the second explanation, however, this does not suggest
as clearly a decision to favor human capital over other forms of investment.
1984]
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1379
over, the presence of deliberate subsidies for particular kinds of
skills training indirectly supports the opposite inference. For at
least some kinds of human capital, Congress apparently believes
that the equivalent of an immediate deduction for acquisition costs
does not provide a sufficient incentive, and that additional inducements to invest in these skills are needed. A consumption tax,
which might make investments in nonhuman capital more attractive in relation to human capital, therefore could be less friendly to
training-produced human capital than Congress seems to believe is
necessary.
C. Migration
Because the markets for skills can be regional, an individual
sometimes can increase both present and future returns on his capabilities by moving. The costs of this investment include moving
expenses and job search efforts. Under an ideal income tax, a taxpayer would include in income the indirect costs of migration such
as forgone earnings, and would not take an immediate deduction
for direct costs such as moving and employment agency expenses.
He could, however, amortize these costs over the life of his investment. Under a consumption tax, the indirect costs would not enter
the tax base and the direct costs would produce deductions.
The actual rules fall somewhere in between. The Service permits
a deduction for job-seeking expenses, such as an employment
agency fee, when an individual confines the search to a trade or
business in which he currently is employed. When an individual
tries to cross the line into a new profession, or when he first seeks
employment, no deduction is allowed. Success is not required for
deductibility, 48 although as a practical matter a taxpayer may have
more difficulty proving that an unsuccessful search was limited to
his present profession.
Moving expenses-the costs of movers, real estate agents, and
the like-are deductible even when an employee initially enters
the work force or switches professions. To qualify for the deduction, however, the taxpayer must have a new job at which he must
remain employed for a substantial period.4 9
4"
See Rev. Rul. 120, 1975-1 C.B. 55, clarified by Rev. Rul. 16, 1977-1 C.B. 37.
4' See I.R.C. § 82 (inclusion in income of reimbursement for moving expenses); id.
§
217
(deduction for expenses). The Treasury's proposed tax reform would increase the current
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The combination of job-search and moving-expense deductions
creates the equivalent of consumption tax treatment for many migration costs. The failure of either deduction to reach all these expenses, however, and the absence of a right to amortize nondeductible migration costs means that for a limited class of
expenditures-those related to new career searches and unsuccessful relocations-present law is harsher than either an ideal income
or a consumption tax. The lack of any recovery for these costs may
offset the immediate deduction allowed for other costs. But without knowing which group of migration costs is greater-those deductible or those that a taxpayer never can recover-it is uncertain
whether the current rules are closer to those found in an incomeor a consumption-based tax. Moreover, the problem of timing and
progressivity also exists here. Some evidence shows that work-motivated migration takes place disproportionately in earlier, low-income and low marginal-tax-rate years.5 0
D.
Health Care
Health care, whether preventive or acute, enhances an individual's capacity both to earn and to enjoy. In less developed societies, an increase in basic dietary and sanitary standards historically
has produced measurable increases in national productivity.5 1 The
high correlation between income and health care expenses in the
United States, though susceptible of various interpretations, suggests that possessors of greater amounts of human capital seek to
protect their investment through greater levels of medical attention.5 2 Of course, good health can also be an item of immediate
gratification, analogous to recreation or fine wine. Difficulties in
distinguishing investment-oriented medical expenses from those
devoted to personal consumption make it hard to draft rules that
capture the proper relationship between medical care and human
capital. As noted above, this problem hampers the design of both
consumption and income tax bases. A pure consumption tax would
ceiling on deductible indirect expenses. See 2 U.S. Dep't of Treasury, supra note 15, at 12224.
50 See G. Becker, supra note 1, at 39-40, 73 n.32.
51 See T. Schultz, Investing in People: The Economics of Population Quality 13-14 (1981).
52 Cf. Kelman, supra note 9, at 856-68 (interpreting correlation as a reflection of discretionary consumption by the rich).
1984]
Taxation and Human Capital
1381
allow a deduction only for investment-oriented medical costs. An
income tax would make the same distinction between personal and
investment expenses but would allow amortization, rather than an
immediate deduction, for investment-oriented health care costs. As
with education, on-the-job training, and migration, the existing tax
system achieves neither of these ideals.
1. Direct Outlays
Reimbursements by employer-purchased group health insurance
for those medical expenses defined by Section 213(d) of the Code
does not count as income to the employee, but the employer may
deduct the insurance costs. 5 3 When the same expenses are not re-
imbursed, an individual may deduct only costs in excess of five
percent of his adjusted gross income, and then only if he has excess
itemized deductions. 4 As a result, a reimbursed medical expense of
$5000 produces no income for the patient and provides an indirect
deduction in full for the employer, if an employee group plan applies. The same expense, if unreimbursed, will produce a $4500 deduction for someone with $10,000 adjusted gross income (perhaps a
retiree with tax-free social security and homeowner imputed rent
income) and a $1000 deduction for someone with adjusted gross
income of $80,000, assuming each has excess itemized deductions.
Although other kinds of human capital investments enjoy more
favorable tax treatment if underwritten by an employer, the preference is most pronounced for employer-sponsored health care. I
previously suggested three explanations for this preference: political influence, desire to subsidize job-specific human capital, or reliance on employer screening of investment and consumption. These
explanations also apply here.5 5 Furthermore, the rule that governs
as
I.R.C. § 105(b); id. § 106; Treas. Reg. § 1.162-10 (1958). The Administration has pro-
posed to cap the exclusion from employees' income of medical insurance purchased by the
employer. Under the proposal, employer contributions in excess of $70 a month for individual coverage, or $175 a month for family coverage, would constitute gross income to the
employee. See U.S. Dep't of the Treasury, General Explanations of Administration's Revenue Provisions in 1985 Budget 1-2 (1984); 1 U.S. Dep't of Treasury, supra note 15, at 73.
" I.R.C. § 213(a).
55 See supra note 47 and accompanying text.
I do not mean to suggest that competition in the insurance market or among employers
works so well as to guarantee that employers will consume an optimal amount of group
insurance. The nondiscrimination rules contained in Section 105(h) guard against one form
of market failure-when the same decisionmaker acts as both employer and employee.
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when an employer does not underwrite the expense-a limit on deduction that increases with a taxpayer's income-might reflect a
combination of two other discrete judgments. First, a partial deduction achieves rough equivalence with the discounted present
value of a stream of amortization deductions that a pure income
tax would permit. Second, the percentage of medical expenses that
represents discretionary consumption rather than investment in
future earnings generally rises with income.5 The first judgment is
consistent only with an income tax; the latter fits either income or
consumption taxation.
2. Forgone Earnings
An individual can not only purchase health care through direct
expenditures, but also might improve his health by reducing his
employment, either by working shorter hours or by accepting a less
stressful but less remunerative job. Health human capital bought
through forgone earnings, like all investments financed in this way,
has tax consequences equivalent to those under a consumption tax.
As with out-of-pocket medical expenses, mixed- and ulterior-motives complicate matters. A taxpayer may reduce employment to
protect health or to enjoy time off. In some cases, the consumption
element may dominate to such an extent that no system should
allow any deduction or amortization.
These rules may not do enough to meet this problem and may have no effect on other kinds
of market failures. Without collective bargaining, for example, established employees with
significant job-specific human capital may be unable to act on strong preferences not shared
by the pool of possible new hires. On the other hand, it is this class of employees in which
an employer has the greatest economic interest, and therefore the strongest reason for insuring. To the extent that union decisionmaking skews choices toward the satisfaction of more
senior workers' demands, collective bargaining might actually exaggerate the demand for
insurance.
" For one account of Congress' decision to raise the nondeductible amount from three to
five percent of a taxpayer's adjusted gross income, see Staff of the Joint Comm. on Tax'n,
92d Cong., 2d Sess., General Explanation of the Revenue Provisions of the Tax Equity and
Fiscal Responsibility Act 24 (Comm. Print 1982). Another explanation for the percentage
limitation is its dampening effect on the "upside-down" feature that all deductions in a
progressive system possess. Although the limitation does not produce complete equivalence
between the allowable deduction and a tax credit, it moves in that direction. In 1982, the
size of medical expense deductions (although not tax savings) had a significant inverse correlation with adjusted gross income levels of $40,000 and less, but a positive correlation with
adjusted gross income levels above $40,000. Epstein, Preliminary Income and Tax Statistics
for 1982, in 3 Statistics of Income Bulletin, No. 3, at 11, 19 (1984).
1984]
Taxation and Human Capital
1383
Yet the income tax does not treat leisure as income, and no proponent of a consumption tax proposes to include leisure as taxable
consumption. If the consumption element of leisure dominates, the
problem drops out: the failure to include leisure distorts both bases, but neither biases the choice between human or physical
capital.
On the other hand, leisure during a taxpayer's early years might
have a substantial investment purpose. Leisure at the beginning of
a career may reflect a need to restore health so as to re-enter professional life, whereas later forgone earnings may be a form of early
retirement. At the least, the theoretical arguments suggesting that
individuals should invest in human capital more intensively when
they are young justify a rule of thumb characterizing health-related leisure in early years as relatively more investment-oriented,
and later leisure as predominantly consumption-oriented. To the
extent that this generalization holds true, the point made earlier
about forgone-earnings investments applies here: an immediate deduction during low-marginal rate years is not necessarily more
favorable to the taxpayer than is a deduction deferred to a higher
57
marginal rate year.
In sum, the present system allows only a partial deduction for
direct medical expenses and nontaxation of forgone earnings invested in health care. It is plausible that the expenses most eligible
for deductibility-those for which an employer will buy group insurance in return for some reduction in wages-are more closely
related to investment in human capital than are other, less deductible expenses. Without better evidence about the patterns of employer-purchased health insurance and the nature of nondeductible expenses, however, the statement that all health care-related
human capital investments result in an immediate tax deduction
or its equivalent is unproven. The expensing of health human capital investments that does take place cannot be said to favor this
type of capital over others until more is known about the relationship between the timing of these deductions and the marginal rates
of those taxpayers who take them.
7 Cf. supra notes 29-31 and accompanying text.
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E. Summary
Close analysis of the tax treatment of the four principal means
of human capital investment undermines the hypothesis that either present law or an ideal income tax discriminates in favor of
human capital at the expense of other kinds of savings. Until we
learn more about the methods by which individuals finance human
capital investments and the interaction of tax liability timing and
progressivity, we must approach the issue with skepticism. The
role of forgone earnings may be so great, and the effect of progressivity so slight, as to produce a clear advantage for major categories of human capital accumulation under an income tax. If so, the
adoption of consumption taxation might correct a serious deficiency in the status quo.
It is conceivable, however, that because taxpayers cannot recover
some costs under the present system, and because other outlays
might produce greater tax benefits if allowed to be deferred to
higher marginal-tax-rate years, the present system is less friendly
to human than to physical capital. Conversion to a consumption
tax might increase this bias. That the government provides some
subsidies for human capital accumulation suggests, although it
hardly proves, that the tax system has not created an obviously
excessive level of human capital investment.5 8 Whatever the formal
distinction between human and physical capital embodied in the
present Code, the behavioral consequences in terms of investment
choices have not been clearly undesirable.
Removing this argument from the consumption tax debate may
not accomplish much. More concrete reasons, unrelated to the
human capital concept, may exist for either favoring or criticizing
consumption taxation. All that the human capital concept accomplishes here is negative. It only discounts, without disproving, a
reason that some have advanced for favoring consumption over income taxation.
But even this negative use of the human capital concept has
value. First, whatever fundamental choices government may make
about tax structure should be unencumbered by mistaken claims
about the comparative advantage of one system over the status
58 See L. Thurow, supra note 1, at 113-17 (supporting government incentives for human
capital formation).
1984]
Taxation and Human Capital
1385
quo. Examining the human capital concept accomplishes at least
this much. Second, a survey of tax rules affecting human capital
suggests that a supporter of income taxation either in its present
federal incarnation, or in some more comprehensive system, need
not reject human capital taxation as a legitimate goal, even though
a direct levy on accumulations of this type of wealth is impracticable because of measurement problems. The realization that an income tax can indirectly account for changes in human capital is
crucial to two further inquiries. First, to what extent do otherwise
unjustified features of the present system reflect an attempt to account for different levels of human capital accumulation (or depreciation) among taxpayers? Second, to what extent can the human
capital concept help resolve difficult interpretive questions in existing tax law? The remainder of this article addresses these two
issues.
III.
COMPREHENSIVE INCOME TAXATION, PERSONAL DEDUCTIONS,
AND HUMAN CAPITAL
Among the visions of tax reform that compete with consumption
taxation for the attention of the Treasury and Congress, comprehensive income taxation has been a hardy perennial. 59 Both liberals and conservatives have rallied behind this standard. Liberals
support a comprehensive tax base primarily to put increases in income tax progressivity on the political agenda. Their goal has been
to bring all forms of economic income into the tax base, absent
insurmountable administrative obstacles, and then to "spend" the
increased revenues either directly or by enacting tax cuts that do
not undermine the nominal progressivity of the present rate system. Conservatives emphasize base broadening as a means of lowering tax rates. Most recently, the concept has become associated
with the movement for a flat tax, which proposes expanding the
tax base while reducing rate progressivity. The Treasury's latest
proposal for fundamental tax reform, the product of a year-long
5, For a sampling of the literature on comprehensive income taxation, see B. Bittker, C.
Galvin, R. Musgrave & J. Pechman, A Comprehensive Income Tax Base? (1968); H. Simons,
Personal Income Taxation (1938); S. Surrey, Pathways to Tax Reform: The Concept of Tax
Expenditures (1973); U.S. Dep't of Treasury, supra note 16, at 3-112; Feldstein, On the
Theory of Tax Reform, 6 J. Pub. Econ. 77 (1976); Special Comm. on Simplification, Section
of Tax'n, Am. Bar Ass'n, Evaluation of the Proposed Model Comprehensive Income Tax, 32
Tax Law. 563 (1979).
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study, embraces this approach. It would bring most forms of economic income into the tax base but reduce tax rates by twenty percent and the number of tax brackets to three.6 0
Proposals for fundamental tax reform aside, attempts at less ambitious change regularly surface in Congress, and frequently find
their way into the Internal Revenue Code."' Many Code amendments, of course, are narrowly focused and deal with fleeting
problems, but others attempt to reorganize current law in a way
that rationalizes, but does not significantly reorient, the present
system. The Tax Reform Act of 1984 is the latest example of such
62
middle-level reform.
These enactments normally avoid the big questions-progressivity versus a flat tax, income versus consumption
as the base, family versus individual as the taxpaying unit-and
instead invite evaluation in terms of consistency with the established features of the present system. In assessing the wisdom of
these less-than-radical changes, a critic might appropriately ask
not, "Would this new provision fit into an optimal tax structure?",
but rather, "Will this step strengthen or erode the features of our
present system?" The latter inquiry implies not so much that the
status quo stands above criticism, but that the day-to-day repair
and maintenance of the tax system need not entail a constant reference to first premises.
A leading question in debates over the appropriate criteria for
this middle-range analysis has been the use of economic income in
the definition of the tax base. Some scholars assign primary significance to this criterion, and argue that the basic patterns of existing
law point toward a system of comprehensive income taxation.
60
See 1 U.S. Dep't of Treasury, supra note 15, at 37-44. Earlier flat tax proposals and
their relationship to comprehensive income taxation are analyzed in Graetz, The 1982 Minimum Tax Amendments as a First Step in the Transition to a "Flat-Rate" Tax, 56 S. Cal. L.
Rev. 527 (1983).
81 According to my own rough count, in the five-year period 1979-1983 Congress enacted
57 bills containing 2610 amendments of the Internal Revenue Code.
82 Tax Reform Act of 1984, Pub. L. No. 98-369, 98 Stat. 494. Earlier instances include the
Social Security Act Amendments of 1983, Pub. L. No. 98-21, §§ 121-125, 97 Stat. 65, 80-91;
Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, §§ 201-03, 222-32, 96
Stat. 324, 411-23, 478-501; Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, §§ 50109, 95 Stat. 172, 323-35; Bankruptcy Tax Act of 1980, Pub. L. No. 96-589, 94 Stat. 3389;
Installment Sales Revision Act of 1980, Pub. L. No. 96-471, 94 Stat. 2247; Tax Reform Act
of 1976, Pub. L. No. 94-455, 90 Stat. 1520; Tax Reform Act of 1969, Pub. L. No. 91-172, 83
Stat. 487.
Taxation and Human Capital
19841
1387
Others attack this position as myopic in light of the present system's manifold and inevitable departures from this asserted norm.
Several of the latter scholars point to seemingly esoteric forms of
economic income-such as human capital accumulation-as examples of the unavoidable gaps in income taxation that suggest the
presence of some other pattern.6
If it makes sense to envision either a revamped comprehensive
system, or a marginally more consistent version of the status quo,
as accounting for gains and losses of human capital, then it becomes possible to rehabilitate several Code provisions that many
have characterized as inconsistent with comprehensive income taxation. This insight in turn suggests that those who use the comprehensive income taxation criterion for evaluating structural or middle-range tax changes stand on stronger ground than once
appeared, but that these critics occasionally misapply their
standard.
For example, the medical expense deduction and various exclusions for personal loss compensation have drawn fire because they
diminish the tax base without an apparent net-income-measuring
purpose. The Office of Management and Budget's annual tax expenditure budget, which purports to identify departures from comprehensive taxation, includes in its list of quasi-subsidies these two
provisions as well as exclusions for disability benefits and workmen's compensation, although it does not list the exclusion for
damages recovered in personal injury suits.6 4 Yet all of these rules
may promote the goal of adjusting the tax burden in the face of
human capital losses.
A.
1.
Exclusions for Injury Compensation
Current Law and Early Rationalizations
Several kinds of injury compensation produce no income tax liability for their recipients. Section 104 excludes workmen's compensation, tort damages, and the proceeds from certain insurance policies that compensate for personal injuries or sickness. 5 Section 105
43E.g., Bittker, A "Comprehensive Tax Base" as a Goal of Income Tax Reform, 80 Harv.
L. Rev. 925, 980-84 (1967).
" E.g., Office of Management and Budget, Special Analyses, Budget of the United States
Government, Fiscal Year 1982, at 222-24, 229 (1981).
65I.R.C. § 104(a). The Treasury's recent tax reform proposals would end the exclusion for
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excludes the proceeds from several kinds of employer-provided
(and deducted) health and disability insurance, 6 and Section 106
excludes the value of employer-provided accident and health insurance. 7 Courts have extended these provisions to exclude compensation for nonphysical injuries such as defamation or breach of
promise to marry.6 8
When federal tax authorities first tried to interpret the ancestor
of these provisions, they relied on an unsophisticated concept of
human capital to identify those instances when compensation
would produce tax liability. In the early years of the federal tax the
government had difficulty treating any type of capital recovery as
income, especially in cases where segregating the portion of gain
accrued before adoption of the sixteenth amendment was impracticable. 9 Characterization of the human body as a "kind of capital,"
albeit based more on analogies to physical goods than on any abstract notion of future income flows, thus led to exclusion of proceeds from the conversion of any part of this asset. 70 When the
Revenue Act of 1918 ratified this result by expressly excluding personal injury compensation from taxation, the Solicitor of Internal
Revenue explained that Congress meant to endorse the analogy of
the human body to a tangible capital asset. 71
2.
The Concept of Basis Applied to Human Capital
Today the conceptual framework for taxing capital recoveries
seems clearer. Unless some nonrecognition provision applies, conversion of a capital asset produces income to the extent that the
amount realized exceeds adjusted basis. Adjusted basis, though
sometimes dauntingly complex in its calculation, normally equals
worker's compensation and similar disability payments, although it would not alter the exclusion for tort and insurance compensation. A tax credit for disabled taxpayers would restore some of the advantages of the present exclusion. See 2 U.S. Dep't of Treasury, supra
note 15, at 51-57.
:6 Id. § 105(b), (c).
7 Id. § 106. The Treasury wants to limit, but not repeal, this exclusion. See supra note
53.
68 See, e.g., Hawkins v. Commissioner, 6 B.T.A. 1023 (1927) (libel and slander).
69 See, e.g., the labored discussion of the issue in Doyle v. Mitchell Bros.
Co., 247 U.S. 179
(1918) (applying the Corporate Excise Tax of 1909, a predecessor to the post-1913 income
tax).
70 T.D. 2747, 20 Tres. Dec. Int. Rev. 457 (1918).
71 S. 1384, 2 C.B. 71 (1920).
19841
Taxation and Human Capital
1389
those acquisition costs not already deducted. Significant exceptions exist for inherited property, which under Section 1014 normally has a basis equal to the property's value at the time of the
previous owner's death, and for property acquired before enactment of the first modern federal income tax, which under Section
1053 has a basis equal to the greater of undeducted acquisition
costs or value as of March 1, 1913.72
Society might wish to follow this pattern by treating human capital as investment property and by specifying a basis for it. Two
problems immediately arise. Should human capital basis reflect the
inherited property and pre-1913 property rules of Sections 1014
and 1053? To what extent should partial liquidations constitute
basis recovery? Answering these formal tax structure questions will
suggest a solution to the problem of taxing personal injury
recoveries.
3.
The Basis of Endowment
Human capital can be described as having two components: endowment inherited at birth and changes resulting from lifetime
events. The endowment component is analogous to inherited property, and therefore might have imputed to it a basis equal to its
value at birth. Of course, the rule embodied in Section 1014, generally although not completely accurately described as one of
stepped-up basis, has been the target of tax reformers for many
years. 73 Its critics see the rule as a loophole through which large
amounts of accumulated gain escape income taxation, permitting
the small portion of the population that inherits substantial wealth
to escape its fair share of the tax burden. 4 It may seem perverse to
extend such a principle, under fire in its own domain, to the con-
7' I.R.C. § 1014(a)(1) (inherited property); id. § 1053 (property held prior to March 1,
1913).
73 For a brief interval in the 1970's the rule seemed on the edge of extinction. See Tax
Reform Act of 1976, Pub. L. No. 94-455, § 2005(a)(2), 90 Stat. 1520, 1872 (adopting new
I.R.C. § 1023); Crude Oil Windfall Profit Tax Act of 1980, Pub. L. No. 96-223, § 401(a), 94
Stat. 229, 299 (repealing I.R.C. § 1023).
7 Graetz, Taxation of Unrealized Gains at Death-An Evaluation of the Current Proposals, 59 Va. L. Rev. 830 (1973); Gutman, Reforming Federal Wealth Transfer Taxes After
ERTA, 69 Va. L. Rev. 1183, 1235-39 (1983); Kurtz & Surrey, Reform of Death and Gift
Taxes: The 1969 Treasury Proposals, the Criticisms, and a Rebuttal, 70 Colum. L. Rev.
1365, 1381-84 (1970).
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text of human capital.
An important difference between the two contexts, however, is
that for transactions to which Section 1014 applies there exists an
alternative rule, by which the recipient of inherited property assumes the previous owner's basis. For the endowment or "inherited" portion of human capital, the alternative of carryover basis is
unavailable because no method exists for imputing an individual's
biological and social inheritance to a previous owner. As a result,
the endowment portion of human capital must have a basis equal
either to its value or to zero.
One argument for using a zero basis points to the problem of
calculating depreciation. Human capital has an ascertainable useful life, and the normal pattern of capital cost recovery would permit an annual deduction to amortize the taxpayer's basis. If everyone's human capital had a nonzero basis, then separate
calculations of these values for depreciation purposes would be
necessary. A few ingenious taxpayers have attempted to do just
this, but taxing authorities have shown no sympathy for their
arguments. 5
It is possible, however, to accord a positive basis to the endowment portion of human capital while dispensing with a depreciation deduction. We might decide that some combination of the
technical obstacles to valuing human capital and the moral difficulties engendered by imputing different opportunities to individuals from birth justifies assigning a uniform value to everyone's endowment. If we then used straight-line methods and a standard,
rather than individualized, life expectancy, everyone would have
the same deduction every year, in which case the deduction could
be ignored.7 6 A cruder, but perhaps more satisfying version of this
point is that individual differences among ideal human capital depreciation deductions are too small to warrant their calculation,
75 See Sharon v. Commissioner, 591 F.2d 1273 (9th Cir. 1978), cert. denied, 442 U.S. 941
(1979); Huene v. United States, 247 F. Supp. 564 (S.D.N.Y. 1965); Denman v. Commissioner, 48 T.C. 439 (1967); Bourne v. Commissioner, 23 B.T.A. 1288, 1292 (1931), aff'd, 62
F.2d 648 (4th Cir.), cert. denied, 290 U.S. 650 (1933). For criticism of proposals to allow
depreciation of human capital, see R. Goode, supra note 21, at 92-93.
76 Giving every taxpayer an identical deduction does not mean identical tax savings.
Rather, it is equivalent to increasing the zero-bracket amount, a change in rate structure
that reduces progressivity. A decision to ignore uniform human capital depreciation implies
a choice either to make the system less progressive than it appears, or to compensate by
decreasing the nominal zero-bracket amount.
19841
Taxation and Human Capital
1391
but that large variations caused by abnormal disruptions in life
patterns might command our attention.
If a fair market value rule is appropriate for measuring the basis
attributable to the endowment portion of human capital, then the
issue of developing a rule analogous to that in Section 1053 fades
away. Congress originally developed the principle of assigning basis
measured by a property's 1913 value to avoid taxing gain that had
accrued, albeit in unrealized form, before imposition of the modern
income tax." Extension of this principle to human capital would
mean assigning a positive value to the endowment portion possessed by people born before 1913, even if a zero value were assigned to everyone else's endowment. Once the equivalent of a
standard value-at-birth rule is applied to all endowments, however,
the need to distinguish pre-1913 enhancements diminishes.
4.
The Basis of Accumulated Human Capital
As with the endowment component, the rules governing recovery
of lifetime human capital investments could try to identify major
departures from the normal career path without adjusting for minor variations in taxpayers' gains and losses. The normal pattern
for attributing basis to a capital good is to sum undeducted acquisition costs and other undeducted capital expenditures. The discussion in section II demonstrates that many expenses closely associated with human capital accumulation either produce deductions
or remain excluded from the taxpayer's deemed income, but that
some remain unaccounted for and may be assigned to a hypothetical capital account. The nonamortization of this account might be
considered an offset to the immediate deductibility of the other
expenses, but taxpayers could still recover those outlays when they
suffer a sudden and substantial loss, rather than a gradual erosion,
of human capital.
So far we have established the plausibility of treating human
capital as a kind of investment with a positive but nonamortizable
basis. In conventional business environments, the law usually requires taxpayers to document the basis of intangible assets and
treats all recoveries as gain if no basis is proved.78 For the more
" See 2 B. Bittker, Federal Taxation of Income, Estates and Gifts 41-43 n.19 (1981).
7' See Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110 (1st Cir.), cert. denied, 323
U.S. 779 (1944); Note, Tax Consequences of Transfers of Bodily Parts, 73 Colum. L. Rev.
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universal but more complex phenomenon of human capital, however, the system might appropriately assume the existence of some
basis and hold in abeyance the issue of value. The assumption that
everyone starts with the same endowment, even though it beggars
reality, both simplifies the problem and avoids the need for otherwise useless recordkeeping by the mass of taxpayers who might anticipate accidents. Businesses, by contrast, keep track of costs for
reasons besides taxpaying, and hence can more easily bear a documentation requirement.
5.
Timing of Basis Recovery in PartialLiquidations
Only the problem of basis allocation in partial liquidations remains. Life insurance benefits and wrongful death recoveries aside,
most injury compensation involves partial impairments of human
capital. In the analogous area of incomplete sales of property, a
range of rules exists for allocating proceeds between basis and
profit. When the transferor separates income interests from remainders, the system often allocates no basis to the income interests. 79 In the case of part-gifts, part-sales to charities, and partial
conversions of an asset, it imposes a pro-rata rule that imputes to
the sale proceeds the same fraction of basis recovery as the ratio of
total basis to the property value.80 For many transactions, however,
the rules treat all proceeds as nontaxable capital recoveries until
the basis is exhausted.
The early case of Burnet v. Logan s" typifies this basis-first rule.
The taxpayer sold stock in a iron company for a lump-sum payment and a royalty on ore mined. The Supreme Court reasoned
that because a confident guess about the value of the royalty payments was impossible, all proceeds would constitute recovery of
capital until the sum of the lump sum payment and the royalties
equaled the taxpayer's basis. Similar rules, generated by Congress,
2
the courts, or the Treasury, apply to cancellation of indebtedness,
842, 853-55 (1973).
7 E.g., Hort v. Commissioner, 313 U.S. 28, 31-32 (1941) (lease devised to taxpayer);
Helvering v. Horst, 311 U.S. 112 (1940) (interest coupons detached from bonds and given to
son); Irwin v. Gavit, 268 U.S. 161 (1925) (life estate); I.R.C. § 1001(e); M. Chirelstein, supra
note 8, at 60-65.
80 See Treas. Reg. § 1.61-6(a) (1957); id. § 1.1011-2 (b) (1972).
81 283 U.S. 404 (1931).
82 See I.R.C. § 108 (income from discharge of indebtedness can be excluded by reducing
1984]
Taxation and Human Capital
1393
certain condemnation recoveriesas and non-charitable part-gifts,
part-sales. 4
The variety of allocation rules used by the tax system makes impossible the designation of one rule as a norm and disparagement
of all others as departures from ideal income taxation. At one time
or another Congress has applied variations on all three
rules-income-first, pro-rata allocation, and basis-first-to annuities, an important standardized transaction.85 In view of the enormous valuation problems, the basis-first rule makes as much sense
as any for partial liquidation of human capital.
A marriage of the presumption that all taxpayers have a substantial basis in their human capital to a rule allocating the proceeds from partial liquidations first to capital recovery supports
the exclusion of most, if not all, individual injury compensation
awards. The award, whether a tort or insurance recovery, simply
replaces basis, and so as a matter of income definition should fall
outside the tax base.
6. The Problem of Imputed Profit in Human Capital Recoveries
Saying that some, perhaps even the majority, of awards constitute nontaxable capital recoveries does not explain in comprehensive income taxation terms the failure to identify those awards that
do exceed whatever basis we might impute to human capital. Recall the hypothetical law student introduced in section I. Half of
his human capital upon graduation can be attributed to his law
course, and about four-fifths of this component can be attributed
either to subsidies or to forgone earnings, neither of which usually
produces additions to basis. If a compensable injury suddenly reduced the student's earning potential by two-thirds, a significant
portion of the recovery, in the make-believe world where we meabasis in depreciable property); cf. Diedrich v. Commissioner, 457 U.S. 191, 199-200 (1982)
(donor whose gift is conditioned on the donee's payment of the gift tax has income to the
extent that the gift tax exceeds the donor's basis in the property).
See Inaja Land Co. v. Commissioner, 9 T.C. 727 (1947).
Treas. Reg. § 1.1015-4 (1957) (if the transferee of a part-gift part-sale sells the property, he can offset proceeds up to the amount of his transferor's basis, even if that basis is
below the price paid by the transferee).
8 See Burnet, 283 U.S. at 414 (basis-first); Revenue Act of 1934, ch. 277, § 22(b)(2), 48
Stat. 680, 687 (profit-first to extent of three percent of purchase price per annum); I.R.C. §
72 (pro-rata).
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sure such things, would constitute gain. Yet the present tax system
excludes the recovery from income.
Some of this apparent gain is a cashing in of the value of subsidized education, and its taxation might run contrary to the general
pattern of not taxing in-kind government transfers. On the other
hand, converting an in-kind benefit (education) into cash may
eliminate the obvious administrative obstacle of valuation, and
there may be no other reason for not taxing the conversion of the
subsidy into cash."' Just as the recipient of free cheese who turns
around and sells his handout theoretically should include the proceeds in income, the realized value of subsidized education embodied in injury compensation might be characterized as a taxable
87
gain.
8S Cf. Haverly v. United States, 513 F.2d 224 (7th Cir.), cert. denied, 423 U.S. 912 (1975)
(free sample of books not included in income until "converted" through charitable
contribution).
87 A further complication is that the return on reinvested proceeds from the "realization"
of human capital (such as an annuity purchased with an injury award) might be subjected to
more onerous taxation than would earnings that they replace. The possibility arises because
a large portion of the return from invested proceeds might be reinvested in principal but
taxed as interest income, much as the steady payments from a typical home mortgage consist of a greater proportion of interest in earlier years. The conditions under which such
"overtaxation" might exist are complex and subject to debate. See generally C. Goetz, Law
and Economics Cases and Materials 221-222 (1984); Bell, Bodenhorn, & Taub, Taxes and
Compensation for Lost Earnings, 12 J. Legal Stud. 181 (1983); Bruce, An Efficient Technique for Determining the Compensation of Lost Earnings, 13 J. Legal Stud. 375 (1984);
Burke & Rosen, Taxes and Compensation for Lost Earnings: A Comment, 12 J. Legal Stud.
195 (1983); Crick, Taxes, Lost Future Earnings, and Unexamined Assumptions, 34 Nat'l Tax
J. 271 (1981). Although investments that qualify as annuities under § 72 ameliorate this
problem because they receive straight-line basis exclusions, an implicit tax might still exist
if the rate of return on such annuities decreases in response to more favorable tax treatment. Similarly, the fact that the entire return will be tax-free to the payee if the payor
discharges its obligation through installment payments might still result in an implicit tax,
depending on the allowance and timing of the payor's deduction and bargaining between the
parties to share the tax savings.
To the extent that the return from an earnings-substitute award receives harsher tax
treatment than would the earnings, there is argument for exclusion of injury compensation
that does not depend on the applicability of the human capital concept. An analogy is I.R.C.
§ 1033, which allows those who receive proceeds because of certain kinds of involuntary
conversions of their property to avoid taxation by reinvesting in similar property. On the
other hand, the argument may prove too much, because it also would call for the nontaxation of all compensation for "involuntary" injuries, thus reversing the rule of Raytheon
Prod. Corp. v. Commissioner, 144 F.2d 110 (1st Cir.), cert. denied, 323 U.S. 779 (1944).
Because the injury and subsequent compensation, however unanticipated, allows the taxpayer to choose among tax and investment options, there may be a sufficient justification
for a tentative presumption that the profit component of such proceeds constitutes taxable
1984]
Taxation and Human Capital
1395
The dilemma is that identifying the gain portion of a recovery
for injury is prohibitively costly in most circumstances. The problem is similar to that of mixed-motive business expenses such as
entertainment, business clothing, and commuting, where segregation of personal consumption (nondeductible) and investment (deductible) may be impossible. The choice is between overtaxation
and undertaxation, and one can only guess which rule errs more
frequently or more dramatically. 8 Under the basis-first approach
it is consistent to assume that a substantial portion of most injury
compensation represents a tax-free capital recovery. This presumption of nonincludibility produces fewer "wrong" results-those inconsistent with the model of human capital recovery-than would the opposite rule.
7.
Some Special Cases
Although the difficulty of identifying profit in human capital recoveries makes a nonincludibility presumption very powerful, it
need not be irrebuttable. The next section deals with categories of
injuries where the profit element seems strong enough to suggest
an opposite presumption. Here I will discuss some forms of recovery that might trigger tax liability regardless of the injury that
they compensate.
a. Imputed Interest
Sometimes injury compensation may take the form of several
payments, either a fixed number or regularly for an indefinite period such as the victim's life. Current law permits taxpayers to exclude installment payments of injury compensation if the compensation otherwise is exempt from taxation. 9 Yet such payments
income.
88 Cf. Halperin, Business Deduction for Personal Living Expenses: A Uniform Approach
to an Unsolved Problem, 122 U. Pa. L. Rev. 859, 885-86 (1974) (where an amount at stake is
small, or where effects are spread among many taxpayers, a choice should be based on administrative convenience).
89 I.R.C. § 104(a)(2), as amended by Act of Jan. 14, 1983, Pub. L. No. 97-473, § 101(a), 96
Stat. 2605, 2605; Rev. Rul. 313, 1979-2 C.B. 75; Rev. Rul. 220, 1979-2 C.B. 74; Rev. Rul. 230,
1977-2 C.B. 214; see also I.R.C. § 130 (treatment of fimancial intermediary that provides
annuity contract). Before Congress passed the Tax Reform Act of 1984, the interest problem
was exacerbated by the ability of accrual-basis payors to deduct immediately the entire sum
of future payments, assuming that the outlay otherwise qualified as a deductible expense.
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have an interest component as the payor takes on a banking role
by postponing full realization of the purchase price. When the
number of payments is fixed, an internal interest rate can be used
to identify taxable income. Outside the area of injury compensation, the trend in recent legislation has been toward accounting for
the interest component of installment payments.9 0
The problem becomes trickier when payments continue for a less
definite period, such as for life or until recovery from an injury.
Disability compensation often assumes this form. Although picking
a mean payout period to calculate an interest component, much as
Section 72(c)(3)(A) uses actuarial life expectancy to measure the
income portion of life annuities, is theoretically possible, reliable
figures do not exist in practice. 1 Intuition suggests that people
who suffer serious injuries do not enjoy the same life expectancy as
others of identical age and gender, but there is no evidence to confirm this. Useful data about injury recovery times are also rare.
But these technical problems can be obviated or eliminated with
approximations.
b.
Earnings Replacements
Distinguishing sudden losses of human capital from normal erosion is a more difficult problem. As argued above, a depreciation
deduction for normal human capital loss is too costly to implement
given the relatively small variance it would produce in individual
tax liabilities. Large, lump-sum losses, however, produce greater
variations, and employing the presumptions described above, cost
little to measure. But when disability payments are contingent on
continuing inability to work and extend for roughly the same period in roughly the same amounts as the salary replaced, then the
victim may not have suffered a loss. His situation resembles that of
For the new provisions addressing this practice, see Tax Reform Act of 1984, Pub. L. No.
98-369, § 91(a), 98 Stat. 494, 598-600 (adding I.R.C. § 461(h)).
90 See, e.g., the amendments to Section 483 and the new original issue discount provisions
enacted by the Tax Reform Act of 1984, Pub. L. No. 98-369, §§ 41-44, 98 Stat. 494, 531-562,
as amended by Act of Oct. 31, 1984, Pub. L. No. 94-612, 98 Stat. _; see generally Canellos
& Kleinbard, The Miracle of Compound Interest: Interest Deferral and Discount After 1982,
38 Tax L. Rev. 565 (1983); Halperin, supra note 8.
"I Cf. DePass v. United States, 721 F.2d 203 (7th Cir. 1983) (validity of statistical evidence relating particular injuries to reduced life expectancy).
1984]
Taxation and Human Capital
1397
an uninjured person, whose human capital erodes gradually with
92
age.
Prolonged earnings replacement payments, however, do not always fully compensate human capital losses. Injuries may affect
both the ability to earn and the ability to enjoy. Although market
analogues provide less help for measuring the latter than the former, each has a capital value. The victims of such injuries might
treat some portion of earnings replacements as recovery of lost future enjoyment even though the payments purport to substitute
for earning abilities.9 3
Without a suitable mechanism to assign money value to singleinjury losses of earnings and enjoyment capital, it is impossible to
develop a tax rule that accurately identifies the capital recovery,
and hence the excludible portion of periodic compensation payments. A few rules of thumb might be practicable, however. We
could distinguish injuries that affect only working life expectancy,
but not life expectancy, as an admittedly rough way to distinguish
between earnings and enjoyment capital. Earnings replacement
compensation triggered by an injury in this category would qualify
for full taxation. In addition or alternatively, a certain percentage
of any indefinite periodic compensation might be classified as taxable income."4 These suggestions recapitulate the historical treatment of disability income under Section 105(d). For many years
this provision excluded from income a set amount of earnings replacement payments. Congress recently replaced this rule with a
blanket inclusion.9
, Compensation that takes the form of deferred payouts also might avoid or mitigate the
potential overtaxation that results when the taxpayer receives a lump sum and then pays
taxes on its return. See supra note 87. To the extent that payments match lost earnings,
without power in the payor to levy an implicit tax through providing a lower rate of return,
the risk of taxing principal replacements diminishes.
,3Cf. Atrostic, The Demand for Leisure and Nonpecuniary Job Characteristics, 72 Am.
Econ. Rev.: Papers & Proc. 428, 437 (1982) (non-pecuniary job characteristics, as well as
wages and prices, are an important determinant of labor supply); Graham, An Explanation
for the Correlation of Stocks of Nonhuman Capital with Investment in Human Capital, 71
Am Econ. Rev. 248 (1981) (considering, inter alia, the effects of "leisure time" on the acquisition of human capital).
" Cf. I.R.C. § 72(b) (percentage of annuity payments taxable).
" Id. § 105(d), as amended by Tax Reform Act of 1976, Pub. L. No. 94-455, § 505(a), 90
Stat. 1520, 1566, repealed by Social Security Act Amendments of 1983, Pub. L. No. 98-21, §
122(b), 97 Stat. 65, 87.
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B. Deductions for the Costs of Injuries
Not all injuries result in compensation. Gaps in insurance or tort
coverage will force some individuals to absorb the cost of sudden
losses. If the pattern of taxation for injuries to property carried
over to human capital, a taxpayer would be entitled to deduct
whatever basis he might have in the lost asset. s Without a direct
method of measuring human capital and its basis, however, the tax
system must account for these losses indirectly, if at all. 97 Two
costs that may coincide with human capital losses, and so may act
as proxies for properly allowable deductions, are insurance and
medical expenses. To the extent that deductions for these two
items fulfill this function, they are consistent with, rather than departures from, a broad-based tax on income.
1.
Insurance Costs
One way to look at insurance is as a gambling pool where gross
"winnings" (compensation for injuries) are something less than total "wagers" (insurance premiums). Although gambling and insurance are opposites in how they distribute risk, they are similar
(and formally distinguishable from all other investments) in that
they are designed only to distribute risk, and not to seek other
gains from trade. It is critical to the comparison that, aside from
the service charge levied by the industry, the pool is a zero-sum
game. In other words, insurance, like gambling, invites the tax collector to ignore individual risk preferences and to look only at the
expected value of the investor's return, which, unlike almost all
profit-seeking contexts, is invariably a figure less than the
investment.
If winnings and losses are distributed randomly across income
and marginal-tax-rate levels, a hypothesis that is as plausible as
any, and if premium payments are deductible profit-seeking expenses, an assumption to which I return," then absent transaction
costs the government will be indifferent between a rule that deducts premium payments and includes compensation in income,
and one that does not deduct payments but excludes payments
" See I.R.C. § 165(b).
97See supra note 78 and accompanying text.
91 See supra notes 101-03 and accompanying text.
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Taxation and Human Capital
1399
from income. If the enterprise involves only risk distribution, the
rules will produce equivalent revenues and will have equivalent
distributional effects among income classes, although not among
particular individuals.99 When transaction costs are considered, the
no-deduction, no-income rule seems superior. It dispenses with two
difficult tax issues that otherwise would increase recordkeeping,
uncertainty, and dispute-resolution costs for many taxpayers.10 0
A response to this argument is that the tax system should regard
premiums as a form of personal consumption that, like gambling
losses, produces few or no deductions. But the current rule for
gambling losses, which allows gamblers to offset their losses
against winnings but otherwise forbids a deduction,' 0 ' contains the
seeds of an argument for deductibility of insurance premiums. In
spite of Las Vegas, Atlantic City, parimutuel races, and state lotteries, gambling remains principally an underground economy,
with few formalities to aid monitoring of winnings. Disallowing loss
deductions serves as a rough equalizer for unreported winnings.
That the rule is softened when taxpayers report winnings suggests
that a deduction is proper in principle, and that some exogenous
concern, such as systematic underreporting of winnings, explains
the limitation in current law. 0 2 Moral arguments against gambling
might also support the limitation, but these values usually coincide
with an approbation for insurance. 0 3
If nontaxation of insurance compensation is an indirect way to
permit deduction of insurance premiums, then a problem arises
when the compensation also represents a recovery of human capital basis. The compensation exclusion cannot offset both un-
" See M. Chirelstein, supra note 8,at 38; Kelman, supra note 16, at 662-69. The argument in text rests on the premise that at least in some circumstances, the tax system should
be satisfied with ex ante equivalences and disregard ex post differences between taxpayers.
The premise is controversial, and I would not rest on it except where very high transaction
cost savings result from the ex ante approach. See generally Graetz, supra note 16, at 160001; Warren, supra note 10, at 1098-101.
100 See generally Ehrlich & Posner, An Economic Analysis of Legal Rulemaking, 3 J. Legal Stud. 257 (1974).
101 I.R.C. § 165(d).
102 Cf. Groetzinger v. Commissioner, 82 T.C. 793 (1984); Ditunno v. Commissioner, 80
T.C. 362 (1983) (losses of professional gambler, although limited by Section 165(d), are
trade or business deductions under Section 165(c)(1) and hence not an item of tax preference subject to the minimum tax). Contra Gajewski v. Commissioner, 723 F.2d 1062 (2d Cir.
1983), cert. denied, 105 S.Ct. 88 (1984).
203 E.g., P. Samuelson, Economics 400-02 (11th ed. 1980).
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deducted premiums and recovered capital. As a result, the taxpayer must have another device to account for his lost investment
in personal earning power.
For example, assume that society assigns a human capital endowment value of $100,000 to an arm, and that a taxpayer spends
$100 per year for an insurance policy that will pay this amount if
an arm is lost. Under tax rules for tangible business property the
taxpayer could deduct his premiums as an ordinary and necessary
business expense. 04 If he lost his arm, he also could use his "basis"-the hypothetical endowment value-to offset the amount realized on the policy. 0 5 If the goal is to achieve some equivalence in
the tax treatment of human capital and tangible business property,
then the proper result here would be to deduct the premiums and
exclude that portion of the payout that does not exceed basis.
Because of the difficulty of sorting out gain and capital recovery
in human capital, a tax system that struggles to include only the
former in its base needs a slightly different rule to approximate the
desired result. The law relies on an indirect process to achieve this
sorting: It allows full deduction for personal injury insurance purchased for an employee by his employer, but permits a taxpayer to
deduct insurance bought for himself or his family only to the extent that its cost, when added to his medical expenses, exceeds five
percent of his adjusted gross income. Moreover, only those payments from employer-purchased insurance most likely to represent
capital recovery-reimbursement of medical expenses and fixed
sums for permanent physical impairments-qualify for exclusion.10 6 When an employee pays for insurance himself, he gets no
07
deduction for the premiums and can exclude all of the proceeds.
Confining the insurance deduction to the employer and permitting the employee to exclude the value of the insurance from income may produce the same tax result as a rule that allows the
employer to deduct equivalent salary compensation and lets the
employee deduct the insurance cost, but the limitation may influence what kinds of insurance are purchased. By making the
0 Treas. Reg. § 1.162-1(a) (1958)
205 See Trees. Reg. §§ 1.1231-1(e)(1), (g) (1971) (examples involving tangible business
property).
206 I.R.C. § 105(b) (medical expenses); id. § 105(c) (fixed sums for physical impairment).
107 Id. § 104(a)(3).
1984]
Taxation and Human Capital
1401
broader deduction depend on employer purchases, the law may
limit deductibility to the cost of insurance packages more likely to
protect human capital investments common to most employees,
rather than idiosyncratic preferences. Given a choice between
higher wages and more insurance coverage, a class of employees
presumably would not choose insurance unless a significant portion considered the exchange advantageous. 0 8 Employers might be
willing to pay more in insurance premiums than through wages,
but profit-maximization assumptions suggest that most additional
outlays would be limited to cases where the investment concerned
job-specific human capital from which employers could expect a
return.109 Through tax rules that include in the employee's income
the portion of insurance compensation that replaces salary, but
that exclude fixed recoveries for particular injuries, the system attempts to reduce the risk that the profit portion of insurance compensation goes untaxed. 110
Further refinements might make the tax treatment of tangible
and human capital insurance costs more equivalent and strengthen
the pattern of taxing economic income. Sections 105 and 106,
which contain the employer-purchase requirement, do not fully
grapple with the problem of persons who perform both employer
and employee functions, such as top corporate executives or owners of closely held businesses. Applying something like the nondiscrimination standards governing medical expense reimbursement
plans under Section 105(h) or retirement savings trusts under Section 401(a)(4) to all employee accident and health plans might ensure that top management does not use the deduction-plus-exclusion rules to obtain tax-free compensation. 1 ' An absolute cap on
the deduction, such as that proposed by the Administration in its
1985 budget, might also serve this purpose. 12 Despite these minor
shortcomings, it seems fair to characterize the present rules as a
108
But see Feldstein, The Welfare Loss of Excess Health Insurance, 81 J. Pol. Econ. 251,
255 (1973) (arguing that collective bargaining leads to overconsumption of health insurance
because the wage-benefit tradeoffs are obscured).
101 See supra notes 47, 53-55 and accompanying text.
See I.R.C. § 105(a), (b), (c).
"
See id. §§ 105(h), 401(a)(4); cf. id. § 401(h), as amended by the Tax Reform Act of
1984, Pub. L. No. 98-369, § 528(b), 98 Stat. 494, 877 (adding § 401(h)(6), which requires
separate accounts for retirement medical benefits payable to owner-employees).
"2 See supra note 53.
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reasonable attempt to capture the effects of human capital losses.
This characterization in turn suggests a broader pattern for considering esoteric forms of economic income in the shaping of tax rules.
2. Medical Expenses
Medical expenses can not only be investments in future well-being, but can also replace something lost. The amount of medical
care may measure, albeit imprecisely, the extent of this loss. One
way to look at these expenses is as self-compensation in the absence of insurance or tort remedies. A deduction for outlays puts
the self-compensator on the same footing as the person who excludes injury compensation provided by others.
As discussed above, the actual deductibility of medical expenses
turns on who pays for them. Insurance reimbursements produce no
income for the purchaser, and employer-obtained insurance generates deductible premiums. The patient's out-of-pocket payments,
whether for medical services or for insurance to cover them, do not
qualify for deduction except to the extent that they exceed a sum
that grows in proportion to the taxpayer's income." 3
The rationale for structuring the deduction this way is similar to
that for the tax treatment of insurance costs. Expenses covered by
an employer more often involve serious injuries rather than selfindulgence, and serious injuries more likely entail human capital
losses, especially losses of job-specific capital. If a person is unable
to get his employer to pay his expenses, the tax rules in effect insist that he pay for a large portion out of his own pocket to demonstrate the seriousness of the loss. Furthermore, the amount that he
must pay to signal seriousness grows with his income, because we
believe either that money means less to wealthier people or that
their medical expenses tend to involve a larger element of self1 4
indulgence.
I do not suggest that the present rules completely fulfill the objective of measuring net income. Some looseness in the definition
11sSee supra note 54 and accompanying text. Before 1983, a taxpayer could deduct half
the cost of health insurance he had bought for himself and his family, up to a maximum of
$150, without depending on his employer as purchaser. I.R.C. § 213(a)(2), repealed by Tax
Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, § 202(a), 96 Stat. 324, 421;
cf. I.R.C. § 213(d)(1)(C) (treating premiums for health and accident insurance as "medical
care").
114 See supra note 56 and accompanying text.
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Taxation and Human Capital
1403
of a deductible medical expense allows taxpayers to achieve greater
benefits than a precise concept of income definition might permit.
An obvious example is the deductibility of medically-related physi'
cal structures such as swimming pools and motorized stairways. 15
Despite these departures, current law generally conforms to the
pattern of human capital taxation outlined in this article. Taxpayers can deduct medical expenses when especially good reasons exist
to believe that outlays correspond to a loss of human capital to
which we most easily can assign a positive basis. Viewed from this
perspective, the medical expense deduction looks less like a departure from a norm of comprehensive income taxation, and more like
a refinement of the concept of taxable income to reflect losses of
human capital.
C. Summary
Observing that the present system accounts for some of the effects of large changes in human capital, and that simple adjustments could enhance this feature does not resolve debates over the
importance of comprehensive income taxation. I have outlined
ways that one form of hard-to-tax gain is indirectly measured, but
there remain other types of economic income for which comparable
taxation strategies are less apparent. I do not suggest, for example,
that the methods used to account for changes in human capital can
also measure the value of consumption obtained through forgone
earnings. Moreover, the preceding demonstration of how these
methods work rests on conjectures and characterizations that, although plausible, remain uncertain.
The discovery that human capital is taken into account when
measuring taxable income, however, is not simply a negative insight of the sort that ended our discussion of consumption taxation. First, it alters the terms of debate over comprehensive income
taxation. Those who debunk the importance of a comprehensive
tax base must accept the subtle role it plays with regard to this one
particularly esoteric form of economic income. Although I do not
assert that the goal of comprehensive income taxation provides the
predominant explanation of the current system's architecture, the
unexpected persistence of this objective must be acknowledged.
115
See Treas. Reg. § 1.213-1(e)(1)(iii) (1979).
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Second, those who use comprehensive income taxation arguments to criticize aspects of the present system must clarify their
standard. For example, those who attack personal injury exclusions
or medical expense deductions must either retreat from their criticisms or explain more precisely what they mean by taxable income.
In particular, advocates of a flat tax must consider whether these
or similar provisions should carry over in an otherwise expanded
tax base, and the Office of Management and Budget must rethink
its practice of listing the injury exclusion and the medical deduction in the Tax Expenditure Budget.
Although the broader tax base that a flat tax might employ to
offset its reduction of rate progressivity need not account for major
variations in human capital, most base-broadening proposals have
taken net income as the starting point for base definition. The
Treasury's proposed tax reform is the latest and most influential of
such projects. Using an income criterion might require some version of an injury compensation exclusion and medical expense deduction. Resort to such provisions, however, puts in issue the attainability of the simplicity to which some flat tax proponents
aspire.
As for the Tax Expenditure Budget, the question is what purpose this list of lost-opportunity-to-tax "outlays" is supposed to
serve. If it only offers a sampling of easily achievable changes that
would bring in more revenue, then inclusion of injury-compensation and medical-expense exclusions and deductions is justified.
But if the list is meant to bear some relation to a vision of ideal
net income taxation, then the Budget must either drop these
items, or the vision must be modified.
Third, to the extent that it is possible to see the present system
as successfully accounting for changes in human capital in the definition of an income tax base, the wisdom of seeking sweeping reforms is challenged. Those who assert the superiority of ends other
than comprehensive income taxation as tax structure desiderata
must explain the role of human capital in achievement of their
goals. If wealth redistribution is a goal, do we mean to account for
human capital when considering the desired distribution? If not,
the justification cannot rest simply on the difficulty of measuring
human capital, but rather must stem from moral arguments of the
sort discussed in Section I. If we want to stimulate investment,
how do we decide what mix of physical and human capital to
1984]
Taxation and Human Capital
1405
encourage?
Whatever the tax reformer's goal, he must reckon with the presence of human capital and the availability of strategies to account
for major changes in individual holdings of this good. That the federal income tax now employs some of these strategies and could
easily exploit others suggests that current law satisfies some of the
goals of optimal taxation to an extent not generally recognized. Although this does not disprove the desirability of basic changes in
the federal tax system, it increases the burden on would-be reformers to establish the superiority of their proposals to the status quo.
IV.
CODE INTERPRETATION AND HUMAN CAPITAL
The previous two sections demonstrated the importance of accounting for human capital when grappling with issues of ideal tax
structure. Although the frequency and extent of legislative revision
of the Internal Revenue Code guarantee the currency of tax reform
arguments, tax law hardly poses only theoretical questions. Much
of the Code has remained unchanged for decades, but contains persistent interpretive issues that the administrative and judicial authorities must confront and resolve. This last section explores the
role of the human capital concept in interpreting existing law.
A.
Interpreting the Internal Revenue Code
How administrative agencies and courts should interpret the tax
law is a topic broad enough to demand a separate and extensive
essay. Here I only touch on some criteria. I assume that these interpreters should pay close attention to the language of the statute,
that they should attend to hints in legislative history as to what
Congress thought it enacted, and that they should treat Treasury
Regulations as presumptively valid and give deference to other administrative actions. Creative commentators can obscure whatever
plain meaning pertinent language might otherwise have, but I accept the distinction between obvious and hidden ambiguity and assume that tax agencies and courts would do well not to unearth the
latter. This article ignores the possibility of referring to positive
enactments outside the Internal Revenue Code or to broad moral
policies to infuse meaning into the tax law." 6 Nonetheless, the
"I But
see Stephan, supra note 23.
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above approaches will not resolve all interpretive issues, and interpreters thus must assume some posture toward unresolved
11
questions. 7
The posture I advocate is conventional but hardly unassailable.
It posits that interpreters of federal income tax law, when faced
with ambiguity in the statute, regulations, or judicial precedents,
should bring net economic income within the ambit of taxation unless such a result requires a rule so difficult to apply as to create
excessive social costs. Of course, this insistence that taxation is the
norm, and that deduction or exclusion is appropriate only to the
extent that it measures net economic income, may attribute too
much significance to a particular figure and ground and thus may
rest on a logically indefensible choice of pattern recognition." 8 It
may be justified by nothing stronger than a belief that the political
system can more readily contract taxes that interpreters have expanded than it can achieve the reverse. But this rationale, however
fragile, at least has the virtue of corresponding with the interpretive posture that the Supreme Court on occasion has assumed."' 9
If economic income is an appropriate criterion, then the concept
of human capital has a role in interpreting the Code. Interpreters
may find economic gain or loss beneath the surface by looking for
either accumulation or reduction of human capital in a category of
transactions. The presence of such gain or loss may color the reading given particular language in the Code, regulations, or
precedent.
Counterbalancing the role that a search for economic income
might play is the need for judges (here meaning both administrative and judicial adjudicators) to use simplified ways of taking economic income into account. Too wide-ranging an inquiry might
lead to undesirable results. Systematic distortions may exist in the
1,7 Cf. Easterbrook, Statutes' Domains, 50 U. Chi. L. Rev. 533 (1983). For the claim that a
literal reading of the Code supplies the answers to most interpretive puzzles, see Isenbergh,
Musings on Form and Substance in Taxation (Book Review), 49 U. Chi. L. Rev. 859 (1982).
118 For a forceful statement of the position that deduction provisions as much as inclusions reflect the will of Congress and should receive equally liberal treatment, see Griswold,
An Argument against the Doctrine that Deductions Should be Narrowly Construed as a
Matter of Legislative Grace, 56 Harv. L. Rev. 1142 (1943); see generally 1 B. Bittker, supra
note 77, l4.2.1-4.2.2.
11 See Commissioner v. Tufts, 461 U.S. 300 (1983); Commissioner v. Kowalski, 434 U.S.
77 (1977); Commissioner v. Tellier, 383 U.S. 687, 693-94 (1966); Commissioner v. Glenshaw
Glass Co. 348 U.S. 426, 430 (1955).
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Taxation and Human Capital
1407
impressions that judges form about the environment where the
rules that they create will operate. Furthermore, too many options
may diminish the likelihood that court-made rules will achieve any
kind of coherence.1 20 As a result, judges must fashion strategies
that simultaneously look for economic income in categories of
events represented by discrete cases, and yet force the resultant
characterizations into simple classifications that cannot do justice
to complex underlying realities.
The following examples illustrate how judges can use human
capital as a touchstone. Taypayers have had the right to deduct
some educational expenses and to exclude some personal injury
compensation since Congress enacted the first post-sixteenth
amendment income tax in 1913. Nevertheless, questions about the
availability of these tax advantages remain. Showing how human
capital figures in these issues demonstrates an interpretive method
that can extend to other base-definition problems. Areas of tax law
not directly involving inclusions and deductions-capital asset
characterization, income recognition, and income attribution, for
example-also present a host of unresolved interpretive problems.
Although gains or losses of economic income have a lesser role in
these matters, some of the insights flowing from the human capital
concept can aid the interpreter who must wrestle with these
questions.
B.
The Deduction for EducationalExpenses
Nothing in the Internal Revenue Code refers specifically to a deduction for educational expenses. Since 1913, however, the federal
income tax has permitted taxpayers to deduct "all the ordinary
and necessary expenses paid or incurred during the taxable year in
carrying on any trade or business."'' Since 1958, a Treasury regu120 Cf. Easterbrook, Ways of Criticizing the Court, 95 Harv. L. Rev. 802 (1982) (analyzing
obstacles to coherent judicial resolution of multioptioned problems); Ehrlich & Posner,
supra note 100 (analyzing costliness of uncertain rules); Priest & Klein, The Selection of
Disputes for Litigation, 13 J. Legal Stud. 1 (1984) (suggesting systematic biases in the pool
of disputes that command judicial attention). In formalist rather than utilitarian terms, one
can characterize these concerns as outgrowths of process theory and its objections to the
legitimacy of freewheeling judicial behavior. See generally Stewart & Sunstein, Public Programs and Private Rights, 95 Harv. L. Rev. 1193, 1220-46 (1982) (analyzing and criticizing
traditional legitimacy arguments as applied to judicial lawmaking).
11 I.R.C. § 162(a).
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lation elaborating this broad language has identified educational
expenses as eligible for deduction if the taxpayer meets certain
narrow requirements. In general, the education must either maintain or improve skills required in the taxpayer's current line of
work, or meet conditions for retention of a present job. In no event
may the education enable the taxpayer to attain minimum educational requirements for a job or qualify him for a new trade or
business. 122 A social studies teacher, for example, may deduct the
cost of an education course required by the school board as a condition of continued employment, but cannot recover the expense of
pursuing a law degree even if he can prove that he will never practice law and wants only to enlarge his skills as an educator.1 2
Courts have acknowledged the validity of the regulation, and repeated applications have solidified its meaning.'2 4 Yet unresolved
issues remain. Although courts have supported the government until now on the question of amortizing education expenses, the matter may not be closed. Moreover, no consensus has emerged as to
what constitutes an individual's "employment" when he interrupts
a career to take courses. Nor have courts or administrators defined
the boundaries of "trade or business" to distinguish specialization
within an existing trade from qualification for a new one.
1.
Amortization
A few taxpayers have tried to amortize educational expenses
that do not qualify for an immediate deduction but have a clear
investment purpose. Sharon v. Commissioner2 5 is a typical case.
The taxpayer, in arguing for amortization of the expenses of college, law school, and bar review courses, contended that the right
to practice law constitutes an intangible asset intended for the production of income with a limited and ascertainable useful life. The
Tax Court countered, somewhat implausibly, that the element of
personal consumption so dominated these expenditures as to preclude characterization as a profit-seeking investment. 2 6 The Ninth
122 Treas. Reg. § 1.162-5 (1967).
12
See id. §§ 1.162-5(b)(2)(iii) example 1, -5(b)(3)(ii) examples 1, 2.
124 See Sharon v. Commissioner, 591 F.2d 1273 (9th Cir. 1978), cert. denied, 442 U.S. 941
(1979); Taubman v. Commissioner, 60 T.C. 814 (1973).
125 66 T.C. 515 (1976), aff'd, 591 F.2d 1273 (9th Cir. 1978), cert. denied, 442 U.S. 941
(1979).
128 66 T.C. at 525-26.
1984]
Taxation and Human Capital
1409
Circuit affirmed, but rested its decision more on the idea that
nonamortization had become the settled rule, whatever its
7
rationale.
12
Although an unbroken line of judicial and administrative decisions suggests that this point is settled, only one federal court of
appeals has addressed the amortizability question, and repudiation
of settled Tax Court precedent is not unheard of. Distinguished
scholarly authority exists for the proposition that education expenses with a clear and dominant profit-seeking purpose should
qualify for amortization.' 2 A brief discussion of the problem and
the role of human capital in resolving it is therefore appropriate.
On the one hand, what we know about human capital bolsters
the assertion that education is an investment asset, and the Treasury permits amortization of the basis of "an intangible asset...
of use in
. .
.the production of income" that has a determinable
useful life. 2 ' On the other hand, thinking about human capital
forces us to weigh the contribution of forgone earnings to its value,
and the realization that taxpayers have the equivalent of an immediate deduction for this component of human capital acquisition
costs. One general pattern that emerged from the analysis of
human capital taxation in Section II was a tendency to match expensed forgone-earnings costs with unrecoverable direct costs, absent an employer willing to underwrite the investment.
It may be wrong to characterize this treatment as offsetting a
generous deduction with a harsh nonrecovery rule, because many
students might prefer to amortize both of these costs. Nonetheless,
judges are not competent to delve into the circumstances of particular taxpayers, and must assume that this matching generally
achieves a result comparable to amortization of total costs. Without a signal from Congress that it wishes to treat the forgone earnings "deduction" as an incentive equivalent to the expensing elec7
591 F.2d at 1275.
128 See 1 B. Bittker, supra note 77, i 22.1.1; Halperin, supra note 88, at 899-905; McNulty,
Tax Policy and Tuition Credit Legislation: Federal Income Tax Allowances for Personal
Costs of Higher Education, 61 Calif. L. Rev. 1, 16-36 (1973); Wolfman, The Cost of Education and the Federal Income Tax, 42 F.R.D. 437, 535, 546-49 (1966). Contra Gunn, The
Requirement That a Capital Expenditure Create or Enhance an Asset, 15 B.C. Ind. & Com.
L. Rev. 443, 472-81 (1974) (arguing that education does not constitute an asset). Richard
Goode does not contend that current law permits amortization, but has advanced a proposal
for implementing such a deduction. R. Goode, supra note 21, at 80-92.
"I Treas. Reg. § 1.167(a)-3 (1956).
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[Vol. 70:1357
tion for certain tangible business property under Section 179, an
interpreter would best regard the nonamortizability of direct costs
as necessary to avoid upsetting a balance that might approximate
the treatment of human capital accumulation as income. 130 The interpreter would find that education is not an amortizable asset, not
because the literal meaning of the phrase "asset... of use in...
the production of income" excludes education, but rather because
the general pattern of taxing net economic gain points toward this
result.
2.
The Meaning of Employment
The Treasury regulation limits deductibility to courses that
maintain or improve skills "required by the individual in his employment or other trade or business."' 3' Some taxpayers have tried
to deduct the costs of full-time schooling, and occasionally a taxpayer persuades a court that his employment consists of the job he
132
held before taking classes and returned to after finishing school.
In other cases, courts have interpreted the regulation as requiring
present employment and denied deductions to full-time
students."3
The case becomes stronger for requiring present employment
and denying any deduction to full-time students when one considers human capital. A student will normally have greater forgoneearnings costs if he devotes more time to his studies. If it makes
sense to describe the present rule as balancing expensed indirect
costs (such as forgone earnings) and undeductible direct costs
(such as tuition), then large indirect costs should make it harder to
permit the deduction of direct outlays. Nondeductibility would
13. See I.R.C. § 179; M. Chirelstein, supra note 8, at 113-14.
131
132
Treas. Reg. § 1.162-5(a)(1) (1967).
See, e.g., Furner v. Commissioner, 393 F.2d 292 (7th Cir. 1968) (junior high school
teacher); Sherman v. Commissioner, 36 T.C.M. (CCH) 1191 (1977) (business manager); Ford
v. Commissioner, 56 T.C. 1300 (1971), aff'd, 487 F.2d 1025 (9th Cir. 1973) (high school
teacher); Ruehmann v. Commissioner, 30 T.C.M. (CCH) 675 (1971) (lawyer). Applying a
rule used in the business travel deduction context, the Service distinguishes temporary interruption of a trade or business from its abandonment, and tolerates deductions for fulltime schooling of a year or less. Rev. Rul. 591, 1968-2 C.B. 73 (acquiescing, in part, to
Furner).
,33Reisine v. Commissioner, 29 T.C.M. (CCH) 1429 (1970); cf. Rev. Rul. 32, 1977-1 C.B.
38 (anaesthesiologist who suspended practice but took refresher courses to maintain skills
denied a deduction).
1984]
Taxation and Human Capital
1411
also reflect the greater likelihood that, forgone earnings aside,
amortization, rather than deduction, would be a more appropriate
treatment because of the capital nature of the investment. Allowing no deduction might come closer than would expensing to
the present value of the yearly amounts allowed by an amortization deduction. Some students-those who would derive greater
tax savings from amortization than from an immediate deduction-may not fit this presumption, but limitations on fact-finding
and the uncertainty to which a search for such students might lead
probably favors a conclusive, if arbitrary rule.
3.
What Are the Boundaries of a Trade or Business?
The regulation permits deduction for expenses that improve
skills used in an existing trade, but forbids deductions for the costs
of entering a new field. This standard requires some sense of where
one field leaves off and another one begins. The cases do not reveal
any great conviction about where these boundaries lie. For example, a psychiatrist training to become a psychoanalyst remains in a
single trade, but a general practitioner training to become a psychiatrist does not.134 The tax agencies and the courts have treated
each jurisdiction in which a lawyer obtains admission to practice as
a separate business and consequently have denied a deduction
claimed by an established attorney for the expense of satisfying
bar requirements in a new jurisdiction.1 3 5
If the interpreter wants to avoid allowing a deduction when an
expense has a substantial element of human capital investment, it
will draw tight boundaries around particular fields. An expense
that substantially expands the taxpayer's opportunities to earn future income constitutes such an investment, and the rule posited
above denies any recovery of direct investment costs. Even where
the taxpayer has little or no forgone earnings, and hence no offsetting deduction, a rule denying a deduction for direct costs seems
appropriate. Amortization over the taxpayer's life expectancy may
be the most fair result, but it may also present accounting
problems that exceed whatever benefits the deduction would
Fielding v. Commissioner, 57 T.C. 761, 776 (1972) (medical school graduate's training
as psychiatrist not deductible); Treas. Reg. § 1.162-5(b)(3)(i) (1967) (psychiatrist).
1" Vetrick v. Commissioner, 628 F.2d 885, 887 (5th Cir. 1980); Sharon v. Commissioner,
591 F.2d 1273, 1275 (9th Cir. 1978), cert. denied, 442 U.S. 941 (1979).
134
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achieve. Taxpayers who seek this deduction generally have established careers, and therefore do not anticipate as steep an increase
in future earnings as do students looking ahead to their first jobs.
Thus, we have better grounds for assuming that the discounted
present value of the amortized deductions would come closer to
zero than to a full present deduction. Furthermore, the taxpayers
for whom this rule is most inaccurate usually have the strongest
incentive to arrange with their employers for a reimbursement program qualifying for exclusion under Section 127.131
One objective factor aiding in location of trade boundaries is the
presence of entry barriers, whether imposed by government or a
private cartel. Once an individual has overcome such a barrier, he
has acquired ways to employ his talents that he previously lacked,
and so has increased his human capital. Focusing on such barriers
makes some sense out of the cases. Although it seems to distort the
literal meaning of "trade" to treat the practice of law in California
as a different profession from practice in New York, the entry barriers in each jurisdiction justify treating each bar admission as a
separate income-producing asset. Furthermore, a lawyer's failure
to persuade his employer to pay for his bar review course suggests
that he expects to retain all of the benefits of the asset rather than
to share them with his employer. By contrast, although psychoanalysis is a distinguishable methodology within the psychiatric
trade, formal obstacles generally do not cabin psychoanalysts from
the rest of the profession.
Looking to issues on the horizon, the Service and the courts may
soon need to rethink their current lenity toward professional restrictions within trades. For example, the regulation of lawyer specialization is in flux, and some jurisdictions have developed distinct requirements for areas such as tax practice. The Tax Court
has permitted a taxpayer already practicing law to deduct the costs
of a LL.M. degree in taxation, but has disallowed a deduction
claimed by another individual who pursued the same degree before
starting practice, 137 As tax practice becomes more of a separate
specialty, the LL.M. may come to represent more than the en"' See supra
137
notes 36-38 and accompanying text.
Compare Ruehmann v. Commissioner, 30 T.C.M. (CCH) 675 (1971) (deduction al-
lowed for attorney who had practiced), with Wassenaar v. Commissioner, 72 T.C. 1195
(1979) (deduction disallowed for law school graduate who had not yet begun practice).
19841
Taxation and Human Capital
1413
hancement of lawyering skills. As the degree's importance grows,
the unreimbursed employee's argument for deducting his costs will
diminish, even in cases involving established lawyers pursuing the
degree at night rather than reducing their earnings.
C. Exclusion of Compensation for Personal Injuries
Section 104(a)(2) excludes from income "the amount of any
damages received (whether by suit or agreement and whether as
lump sums or as period payments) on account of personal injuries
or sickness."' 138 Congress enacted the ancestor of this provision in
1918, and administrative interpretation created a similar exclusion
even earlier. Yet the meanings of "personal," "injuries," and "damages" remain unresolved in important respects.
1.
When Is an Injury Personal?
Drawing a line between personal and business injuries creates
difficulties similar to those caused by attempts of the tax law to
separate reward-deferral from hedonistic appetites. Human behavior does not generally fit into such neat categories. The problem is
complicated because tort law, which generates the compensation
eligible for exclusion, is usually indifferent to the distinction. The
modern trend, to the extent one exists, involves consolidation of
contract and tort liability into a single compensation system. 39
Even when the underlying law permits assignment of the injury to
a business or personal pigeonhole, the usual means for measuring
the compensation will be lost income, which in turn rests on impairment of income-producing capacity. As a result, rules implementing the distinction seem artificial to the point of
meaninglessness.
The efforts of some courts to separate personal and business defamation recoveries illuminate the inadequacy of the distinction.
After first establishing that defamation is a personal injury, tax
authorities and some courts began to carve out an exception when
the injury involved the taxpayer's business reputation. 4 0 The par139 I.R.C. § 104(a)(2).
1" See G. Gilmore, The Death of Contract (1974); Goetz & Scott, Enforcing Promises: An
Examination of the Basis of Contract, 89 Yale L.J. 1261 (1980); cf. Speidel, An Essay on the
Reported Death and Continued Vitality of Contract, 27 Stan. L. Rev. 1161 (1975).
40 See Agar v. Commissioner, 19 T.C.M. (CCH) 116, 119 (1960), aff'd on other grounds,
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adox from which these decisionmakers attempted to escape was
that business income ordinarily is taxable, and that compensation
for injury to it seemingly should have the same status. But if one
ignores basis in human capital, this concern about the substitutibility of earnings and compensation leads logically to rejection of
the business/personal distinction and taxation of all recoveries
measured by lost income.
Unwilling to go this far, courts have tended to rely on line-drawing apparently devoid of underlying rationality. In Roemer v. Commissioner,14 1 the Tax Court labeled a recovery for a false credit
report that damaged the taxpayer's insurance business as taxable
business defamation compensation. A year later, however, in
Church v. Commissioner,'4 2 a member of the same court excluded
as personal-injury compensation damages recovered by a state attorney general falsely accused of being a communist. The judge
purported to distinguish Roemer because Church presented evi143
dence of personal anguish as well as professional opprobrium,
but a similar record existed in Roemer. In all significant respects
the cases were identical: in each, the taxpayer's professional activity produced a false charge that reflected on his ability to conduct
his business and that hurt his career.14
Three months later the Ninth Circuit reversed Roemer and announced its disapproval of the Tax Court's method of distinguishing personal and business defamation. Instead, the court sought to
define the tort by looking at its nature under state law. The court
noted that California, the state in question, recognized separate
causes of action for defamation and disparagement (trade libel).
By pleading defamation, the taxpayer characterized his damages as
290 F.2d 283 (2d Cir. 1961).
141
142
143
144
79 T.C. 398 (1982).
80 T.C. 1104 (1983).
Id. at 1108-09.
A distinction between the cases might exist if one could plausibly assume that the
value of Roemer's reputation reflected in large part previously deducted expenses such as
advertising and entertainment expenses, and that Church's reflected some more common
interest attributable to the endowment portion of human capital. It is more likely, however,
that a public servant like Church builds up value in his reputation through forgone earnings, excluded campaign contributions, and similar previously deducted outlays or excluded
receipts. Moreover, the best guess may be that all reputations of sufficient worth to induce
their owners to sue for injuries are atypical and distinguishable from commonly endowed
reputational interests. Cf. Priest & Klein, supra note 120.
1984]
Taxation and Human Capital
1415
personal and thereby qualified his recovery for exclusion. 145
Similar confusion governs the tax consequences of civil rights recoveries. The Service has conceded exclusions for compensation
paid to prisoners of war who suffered violations of the Geneva
Convention and to victims of Nazi persecution, but has insisted
that recoveries under Title VII of the Civil Rights Act of 1964 are
taxable income.1 46 The distinction rests on an assumption that Title VII protects only economic rights in employment, but it is just
as plausible that personal dignity and morality concerns infuse this
statute as much as any policy of economic regulation.
Although the human capital concept does not offer talismanic
solutions to these problems, it suggests a perspective that may lead
to different and perhaps less arbitrary line-drawing. One strategy
rests on the link between certain injuries, such as bodily damage,
and the hypothetical endowment for which each taxpayer can have
a standardized basis. Physical injuries are more likely to damage
this endowment, and less likely to harm interests that are unevenly
distributed and are more often the product of self-investment. To
the extent that compensation systems calculate damages by referring to personalized earning capacities, the distinction collapses.
But if the injury leads to more uniformly measured compensation,
14- 716 F.2d 693, 699 (9th Cir. 1983); see also Wolfson v. Commissioner, 651 F.2d 1228
(6th Cir. 1981), where the Sixth Circuit seemed to endorse the Tax Court's distinction between injuries to personal reputation and injuries to professional reputation.
146 Compare Rev. Rul. 518, 1956-2 C.B. 25 (Nazi compensation), and Rev. Rul. 132, 19551 C.B. 213 (Geneva Convention compensation), with Hodge v. Commissioner, 64 T.C. 616
(1975) (Title VII). In Hodge the Tax Court left open the possibility that some portion of a
Title VII recovery might be excludible if the recovery represented something other than
"back pay." Id. at 619 n.7. In practice, however, almost all recoveries under Title VII will be
called "back pay." See, e.g., Sears v. Atcheson, T. & Sta. F. Ry., 30 Fair Empl. Prac. Cas.
(BNA) 1084, 1090 (D. Kan. 1982); Rev. Rul. 341, 1972-2 C.B. 32; cf. I.R.S. Letter Ruling
8,023,093 (age discrimination claim). But see Sweet v. General Tire & Rubber Co., 28 Fair
Empl. Prac. Cas. (BNA) 804, 814 (N.D. Ohio 1982) (finding prior rulings inapposite, and
holding recovery to be nontaxable damages).
A possible distinguishing feature of the prisoner of war recoveries is that they are calculated by a set, per diem schedule, with no relationship to salary. See War Claims Act of
1948, Pub. L. No. 80-896, § 6, 62 Stat. 1240, 1244 (payment of one dollar per day of violation) (codified at 50 U.S.C. App. § 2005(b)); Act of Apr. 9, 1952, Pub. L. No. 82-303, §
1(d)(3), 66 Stat. 47, 49 (payment of $1.50 per day of "inhumane treatment") (codified at 50
U.S.C. App. § 2005(d)(3)). This distinction does not apply, however, to the compensation, or
"wiedergutmachung," provided by the West German government to victims of the Nazi regime. Wiedergutmachung is provided on an individualized basis that considers the victim's
profession, education, and social standing. See Act of July 6, 1956, Bundesgesetzblatt
[BGB1] I 643-46 (W. Ger.); Act of May 11, 1951, BGBI I 291-96 (W. Ger.).
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or is susceptible to such valuation even when tort law does not explicitly resort to it, the case for characterization as basis recovery
is strongest.
147
One bright line that reflects to the above argument would exclude recoveries only for personal injuries entailing tangible physical damage. 148 This distinction is both over- and under-inclusive. It
excludes from taxable income compensation that, because it is
measured by lost earnings, will replace profit from human capital
investment; yet it brings into the tax base compensation for emotional injuries that are essentially indistinguishable from physical
invasions. As an administrable standard, however, it is superior
both to the present confused search for personal and business interests and to a more particularized effort to sort out basis and
profit in human capital.
Given the antiquity of the exclusion for defamation and comparable intangible injuries, Congress may have exclusive responsibility for implementing this new distinction. On rare occasions, however, the Supreme Court has spurned glosses of similar
venerability in favor of rules that conform more closely to a tax on
net economic income. 149 There remains a real, although slight, possibility that a court may strip away past encrustations and overlay
Section 104(a)(2) with a tangible physical injury rule.
2. What Constitutes an Injury?
Although the Service and courts have interpreted Section
104(a)(2) liberally with the respect to the kinds of injuries that it
covers, they are conservative when asked the more basic question
of what kinds of losses constitute injuries. Interpreters have not
'47 This approach parallels self-assessment strategies inasmuch as it treats society as assigning floor values to interests and then permitting individuals to adjust them upwards.
See Levmore, supra note 4.
14' There is evidence that Congress believed that it enacted such a rule when it passed the
ancestor of Section 104 (a) (2). See S. 1384, 2 C.B. 71 (1920). The early decisions extending
exclusion to intangible torts such as defamation and breach of promise to marry involved
the exercise of common law creativity, rather than interpretation of the statute.
149 E.g., Commissioner v. Kowalski, 434 U.S. 77, 85 (1977) (disapproving 1920 supper
money policy) (dictum); Commissioner v. Tellier, 383 U.S 687, 690-91 (1966) (disapproving
long-standing "public policy" exception to business deductions of legal expenses incurred in
defense against criminal charges); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 43132 (1955) (disregarding old Board of Tax Appeals rule that punitive damages were not
taxable).
1984]
Taxation and Human Capital
1417
granted an exclusion in most cases where a person contracts for
compensation before an invasion takes place. 150 One significant exception to this practice involves compensation for lost marital
rights. These payments usually go untaxed even when they are the
151
product of a predivorce or antenuptial agreement.
The articulated basis for these decisions is questionable, but the
results may rest on sounder foundations. An injury is no less an
invasion because it is anticipated. Private contracts to waive claims
in advance of harm are not much different from insurance arrangements, with only the probability assigned to the future injury distinguishing them. Yet Congress explicitly established the excludibility of insurance compensation.' 2
Many advance waiver cases involve intangible torts such as invasion of privacy,1 53 and the refusal to exclude may reflect an indirect effort to draw a line between physical and other injuries. At
least one case, however, involved a direct physical violation. In
United States v. Garber,5 4 the government sought criminal sanctions against a taxpayer who failed to report as income the proceeds from the sale of a rare antibody found in her blood. A Fifth
Circuit panel upheld the conviction, but the full court held that
the rules governing includibility of the proceeds were too unsettled
to sustain criminal penalties for their violation. The court did not
resolve whether the recovery was excludible under Section
104(a)(2), and, if not, whether the taxpayer had any basis in
150Starrels v. Commissioner, 304 F.2d 574 (9th Cir. 1962) (payment in return for daughter's permission to portray her father, aviator Frank W. Wead); Meyer v. United States, 173
F. Supp. 920, 924-25 (E.D. Tenn. 1959) (payment to William Meyer, manager of the 1951
Pittsburgh Pirates baseball club, in return for any damages caused by the movie, "Angels in
the Outfield," which portrayed a fictional disreputable manager of the same team); Ehrlich
v. Higgins, 52 F. Supp. 805 (S.D.N.Y. 1943) (payment to the widow of Paul Ehrlich in return
for portrayal of Ehrlich in the movie, "Dr. Ehrlich's Magic Bullet."); Roosevelt v. Commissioner, 43 T.C. 77, 89 (1964) (payment to Franklin D. Roosevelt, Jr. in return for portrayal
of him in the play "Sunrise at Campobello"); see also Knickerbocker, The Income Tax
Treatment of Damages: A Study in the Difficulties of the Income Concept, 47 Cornell L.Q.
429, 437-38 (1962) (arguing that proceeds from preinjury waiver should receive same tax
treatment as postinjury compensation).
' United States v. Davis, 370 U.S. 65, 73 n.7 (1962) (divorce); Farid-es-Sultaneh v. Commissioner, 160 F.2d 812 (2d Cir. 1947) (antenuptial); Rev. Rul. 221, 1967-2 C.B. 63 (divorce).
152 I.R.C. § 104(a)(3).
'
See cases cited supra note 150.
"
589 F.2d 843, rev'd on rehearing en banc, 607 F.2d 92 (5th Cir. 1979).
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plasma that could offset the sale proceeds.' 5 5
Garber pushes to the limit the formal accomodations embodied
in assignment of basis to human capital. If one can distinguish
each person's endowment and give it a basis equal to market value,
the sale of blood products serves simply as a measure of this value
in an atypical case. If, however, the system assigns uniform basis to
all endowments, then the sale involves a profit based on the taxpayer's windfall from having a rare antibody. Indeed, given the relatively minor discomforts and risks of the extraction process, one
might characterize the proceeds as exclusively gain.
If it makes sense to distinguish standardized and exceptional
human capital as an indirect way of separating basis and gain, then
most advance waiver cases will produce taxable income. That an
individual can market his rights suggests that they have exceptional value. 1 56 Investments may go into the fabrication of marketable notoriety, but most probably involve either deductible expenses (e.g., advertising, entertainment), or forgone earnings.
Unrecovered expenditures that would require adjustments to basis
must be rare. Although the antibody sold by Garber was more tangible, the economic realities may converge: she could extract monopoly profits because she possessed a rare commodity, the creation of which involved few if any unrecovered expenditures.
From this perspective, the definition of an excludible injury
should rest not on the sequence of harm and payment, but on the
nature of the interest harmed. Common and uniform transactions
such as the sale of normal blood products or body organs might
qualify for exclusion either through a liberal interpretation of "injury" or by analogy to Section 104(a)(2).157 The sale of tort-protected interests that entail greater profit elements, such as reputation or privacy, should engender tax liability.
The sale of marital rights may present a test case. Supreme
Court dicta and Service rulings indicated that a spouse who surrendered marriage-based claims could exclude his compensation,
even though until the 1984 tax amendments, the other spouse had
155 607 F.2d at 95 n.2, 97.
15 See Rosen, The Economics of Superstars, 71 Am. Econ. Rev. 845 (1981).
157 Contra Note, supra note 78, at 849-53 (arguing that current law requires taxation of all
such transactions).
Taxation and Human Capital
1984]
1419
to treat the discharge as income. 158 Whether one regards these
rights as a form of social welfare or a means of compensation for
services rendered, a zero basis seems the most appropriate tax
treatment. Little direct outlay goes into creation of these rights,
which stem more from forgone earnings or a profitable equitable
participation. 159 Exclusion of such income instead should rest, if at
all, on a judgment that reorganizations such 1as
marriages and di60
vorces should not count as realization events.
3.
What are Damages?
Section 104(a)(2) excludes "damages received (whether by suit
or agreement and whether as lump sums or as periodic payments).'
61
Although this broad language may cover all of a plain-
tiff's recovery, some doubt exists about the excludibility of one element that may be included in an award. An interpreter can read
this language as implicitly limited to compensatory damages and
therefore not providing an exclusion for punitive damages. The
Service has intermittently permitted exclusion of both, however.
When it first considered the matter the Service ruled that the
punitive component of a libel recovery was taxable income. It did
not refer to Section 104(a)(2), but assumed that libel damages enjoyed exclusion only because of a common-law restoration-of-capi62
tal theory. Noncompensatory awards could not sustain this label.1
The Service shifted ground in a later ruling involving tangible
physical injury that was based expressly on Section 104(a)(2). The
language of the statute contained no distinction between compensatory and punitive damages, and the Service announced that it
would not import one."6 3 In later litigation the Service conceded
108
See United States v. Davis, 370 U.S. 65, 73 n.7 (1962); Rev. Rul. 221, 1967-2 C.B. 63.
As a result of the Tax Reform Act of 1984, the divorced or separated spouse who transfers
property no longer realizes taxable income because of the discharge of his marital obligations. Pub. L. No. 98-369, § 421, 98 Stat. 494, 793-95 (adding I.R.C. § 1041).
ISOCf. St. Joseph Bank & Trust Co. v. United States, 716 F.2d 1180, 1186-87 (7th Cir.
1983) (Posner, J., concurring).
160 One could draw an analogy between a marriage and a corporation that under some
circumstances can reorganize into separate entities without realizing income on its property.
See I.R.C. §§ 355(a), 368(a)(1)(D). The Tax Reform Act of 1984 adopted this result, although not necessarily this rationalization. See supra note 158.
161I.R.C.
§
104(a)(2).
162Rev. Rul. 418, 1958-2 C.B. 18.
163
Rev. Rul. 45, 1975-1 C.B. 47, revoked by Rev. Rul. 84-108, 1984-29 I.R.B. 5.
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that the second ruling applies to libel awards.1 64 But recently the
Service revised its interpretation. It now maintains that Section
104(a)(2) does not permit exclusion of damages calculated by reference only to the degree of the tortfeasor's fault, and not to the
16 5
extent of the victim's injury.
Some authorities justify punitive damages as an indirect means
of making tort victims whole. Compensatory damages, they argue,
fall short of full compensation, making necessary an admittedly inexact balm. 166 A more common explanation, however, concedes
that punitive damages are a windfall for the plaintiff, and roots
their purpose in deterrence principles.8 7 To the extent that the
latter explanation more accurately describes their function, punitive damages do not even roughly substitute for human capital basis. As pure profit, they would fall outside an interpretation of Section 104(a)(2) shaped by the human capital concept.
D. Capital Asset Definition, Nonrecognition, and Attribution
Interpretive disputes involve a wider range of issues than the
definition of the tax base through identification of includible income and allowable deductions. Eligibility for capital gains and
loss treatment, timing of income, and income attribution present
analytically distinct issues on which large amounts of tax liability
can ride. Economic income, and hence gains or losses of human
capital, has a less direct role in resolving these problems. Other
policies-and in many cases the absence of coherent policy-can
obscure the issues. Nonetheless, the concept of human capital may
be useful even here.
Doctrinally, many capital asset, nonrecognition, and attribution
disputes turn on a common question: should the bundle of rights
at issue be termed "property"? Section 1221 limits capital asset
See Church v. Commissioner, 80 T.C. 1104, 1110 n.7 (1983).
Rul. 84-108, 1984-29 I.R.B. 5. Because this ruling dealt with damages received
under a wrongful death statute that permitted only punitive damages, its application to
situations where the degree of harm is a factor in calculation of punitive damages remains
uncertain. The Service has not yet tested this new position in court.
166 See Rice, Exemplary Damages in Private Consumer Actions, 55 Iowa L. Rev. 307, 30911 & n.13 (1969) (collecting cases).
167 See Smith v. Wade, 461 U.S. 30, 54 (1983); Commissioner v. Glenshaw Glass Co., 348
U.S. 426, 429 (1955); W. Prosser & W. Keeton, The Law of Torts § 2, at 14 (5th ed. 1984).
185 Rev.
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status to property;6 8 sections 351 and 721 allow taxpayers to avoid
recognition of gains realized upon the transfer of "property" to a
corporation or partnership; 6 9 and the common-law assignment-ofincome doctrine turns in part on whether the rights nominally assigned to a third party constitute income from property or from
services. 17 0 If verbal uniformity of the doctrinal inquiry implied
consistent outcomes then all these cases might be reduced to the
issue of whether human capital is sufficiently similar to forms of
tangible investment to merit categorization as property.' 7 ' A survey of cases, however, reveals no such consistency.
1.
Capital Asset Definition
Courts generally have refused to characterize contractual rights
tied to personal services as a species of "property" eligible for capital gain preference.' 7 2 Recently, however, the Tax Court avoided
deciding the question under facts that strongly suggested the presence of human capital. In Foote v. Commissioner,1 73 the taxpayer
resigned a tenured university appointment in return for a cash settlement. The court rejected his attempt to characterize the payment as proceeds from the sale or exchange of a capital asset. The
court first argued that a university appointment was no different
from other long-term service contracts, and that termination payments for such contracts normally are regarded as substitutes for
the ordinary income that salary constitutes. 7 4 It also stated, however, that even if tenure has significant value independent of the
university's explicit salary obligation, the surrender of tenure for
I.R.C. § 1221.
28 Id. §§ 351, 721.
170 E.g., Siegel v. United States, 464 F.2d 891 (9th Cir. 1972), cert. dismissed, 410 U.S. 918
1"
(1973); Heim v. Commissioner, 262 F.2d 887 (2d Cir. 1959); Strauss v. Commissioner, 168
F.2d 441 (2d Cir.), cert. denied, 335 U.S. 858 (1948); Lewis v. Rosenthies, 61 F. Supp. 862
(E.D. Pa. 1944), aff'd per curiam, 150 F.2d 959 (3d Cir. 1945).
171 Cf. Harding, Obtaining Capital Gains Treatment on Transfers of Know-How, 37 Tax
Law. 307, 308-12 (1984) (treating as interchangeable precedents on nonrecognition and capital gain treatment of particular forms of human capital).
172 See generally 2 B. Bittker, supra note 77,
51.10.4; Chirelstein, Capital Gain and the
Sale of a Business Opportunity: The Income Tax Treatment of Contract Termination Payments, 49 Minn. L. Rev. 1, 8-9 (1964); Miller, Capital Gains Taxation of the Fruits of Personal Effort: Before and Under the 1954 Code, 64 Yale L.J. 1 (1954).
173 81 T.C. 930 (1983).
174
Id. at 934-35.
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cash does not constitute a "sale or exchange" sufficient to qualify
the proceeds for capital gain preference. 17
Although the result in Foote is defensible, the court's analysis is
dubious. The sale-or-exchange prong of the Foote holding is manifestly inconsistent with other decisions recognizing that relief from
an obligation (here the discharge of the university's duty to continue employing Foote) is a sufficient return for the cash received
to qualify as an "exchange" for capital gain or loss purposes., 6 Nor
is the analogy to long-term service contracts entirely apt. Employment contracts usually bind both the employer and employee, but
tenure works as a "put" enabling the professor to force the university to buy his services while permitting him to seek other buyers.
The choice component of an option-the power not to
sell-normally will have some value in addition to that flowing
from the fixed terms at which the sale will take place.
Generally, identifying one or more policies that justify the capital asset doctrine is an heroic task. Authorities from the American
Law Institute to eminent tax scholars have failed to reach a consensus as to the goals the doctrine is or should be serving.' 7 Without presuming to cut the Gordian knot, I would suggest that one
function the capital gain preference partially fulfills, and that has
particular relevance for human capital, is to offset the effect of inflation on gains calculated by reference to historical cost.17 81 Prop176 Id. at 936.
176 See, e.g., Laport v. Commissioner, 671 F.2d 1.028 (7th Cir. 1982); Middleton v. Com-
missioner, 77 T.C. 310 (1981), aff'd per curiam, 693 F.2d 124 (11th Cir. 1982); Freeland v.
Commissioner, 74 T.C. 970 (1980). The surrender of "call" rights in connection with termination of an employment contract also constitutes a sale or exchange. See Turzillo v. Commissioner, 346 F.2d 884, 890 (6th Cir. 1965); Dorman v. United States, 296 F.2d 27, 29-30
(9th Cir. 1961).
177 Cf. 2 B. Bittker, supra note 77, at 50-53 ("the statutory details, which have varied
widely from time to time, are the product of compromises among strongly held economic
and political views, rather than the logical outgrowth of basic premises"); see also Am. Law
Inst., Discussion Draft of a Study of Definitional Problems in Capital Gains Taxation 16995 (1960); U.S. Dep't of the Treasury, Federal Income Tax Treatment of Capital Gains and
Losses (1951); Blum, A Handy Summary of the Capital Gains Arguments, 35 Taxes 247
(1957); Popkin, The Deep Structure of Capital Gains, 33 Case W. Res. L. Rev. 153 (1983);
Surrey, Definitional Problems in Capital Gain Taxation, 69 Harv. L. Rev. 985 (1956).
178 Inflation particularly distorts the measurement of gain from sale of property because
the calculation involves a comparison between amount realized, measured in current dollars,
and a basis measured in historical, and therefore relatively more valuable, dollars. This effect is distinct from other inflation-based problems such as "bracket creep." See Graetz,
Can the Income Tax Continue to Be the Major Revenue Source?, in The Brookings Institu-
1984]
Taxation and Human Capital
1423
erty such as an artist's or writer's work product, for example, does
not qualify for the preference, 17 9 in part because much of the producer's cost consists of forgone earnings that receive tax treatment
equivalent to an immediate deduction and therefore need no inflation adjustment. Similarly, a significant portion of the costs of acquiring tenure probably stem from expenses such as forgone earnings. This feature seems as good a reason as any for withholding
capital gain treatment from most sales of human capital.18 0
tion, Options for Tax Reform 45-46 (J. Pechman ed. 1984). In mathematical terms, if n =
nominal rate of return; i = inflation rate; g = n - i, the real rate of return; and t = holding
period for an asset, then the appropriate fraction of nominal gain to include in income,
assuming continuous compounding, is
1 - e-9
1- e
nt
See Brinner, Inflation and the Definition of Taxable Personal Income, in Inflation and the
Income Tax 121, 127 n.7 (H. Aaron ed. 1976). Solving for a four percent real return and
10% inflation, arbitrary but not unrealistic figures, the equation indicates that an investor
must hold on to an asset for roughly seven-and-a-half years before his real gain exceeds 40%
(the amount taxed under the current capital gain preference) of his nominal return.
Although an inflation-offset purpose can rationalize many aspects of capital asset definition in present law, such as the ineligibility of inventory assets under § 1221(1) for which
LIFO accounting provides a satisfactory inflation-proof substitute, it hardly unifies the
field. It is inconsistent with the treatment of capital losses, which our system first understates by reference to historical basis and then undercuts with deductibility limits, and the
treatment of loans, for which borrowers get overstated interest deductions and lenders have
overstated interest income. Although one can devise arguments to defend these exceptions,
the point in text does not require that inflation-offset explain every feature of capital asset
definition. It should suffice that in close cases, the absence of any need for inflation adjustment militates against capital asset treatment. See generally 1 U.S. Dep't of Treasury, supra
note 15, at 98-100.
179 I.R.C. § 1221(3).
18oUnder the rationale offered in the text, cases where interpreters have treated preinjury
payments for the waiver of tort rights as ordinary income seem correct. See Starrels v. Commissioner, 304 F.2d 574 (9th Cir. 1962); Miller v. Commissioner, 299 F.2d 706 (2d Cir.), cert.
denied, 370 U.S. 923 (1962) (payments to widow of Glenn Miller for using the life-story of
her husband in the movie, "The Glenn Miller Story"); Runyon v. United States, 281 F.2d
590 (5th Cir. 1960) (payments to Damon Runyon, Jr. for rights to use the story of his father's life); Rev. Rul. 261, 1965-2 C.B. 281. But cf. M. Chirelstein, supra note 8, at 322.
Whether or not it is appropriate to treat taxpayers as having a basis in such rights, see
supra notes 147-49, 156-60 and accompanying text, it is clear that whatever basis one might
use would not comprise unrecovered historical costs and hence would not need an inflation
adjustment. For similar reasons, the Code's increasingly generous treatment of research and
development expenditures and start-up costs, see I.R.C. §§ 30, 174, 195, undercuts the reasons for permitting the capital gain preference when taxpayers sell know-how rights representing the fruit of such investments. For a survey of the cases where courts have nonetheless allowed the preference, see Harding, supra note 171.
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2. Nonrecognition
In contrast with their stance on capital asset disputes, courts
tend to smile on taxpayers who seek to avoid recognizing gain
when they contribute human capital to a business. Sections 351
and 721 call for nonrecognition of accumulated and untaxed gain
stored in property transferred to a corporation or partnership, respectively, in return for an interest in the business. The taxpayer
can thus delay recognition of gain until disposal of his interest.""1
When a taxpayer agrees to commit his talents to such an enterprise, an interpreter has the option to characterize the return interest in the business as taxable compensation for future services.
Nonetheless, courts tend to treat the exchange as nontaxable contributions of property.
A recent case illustrates how far courts have been willing to go in
this area. In United States v. Stafford,8 2 the taxpayer negotiated
a letter of intent with an insurance company concerning financing
of a construction project. The taxpayer then formed a partnership
to exploit the opportunity, taking a one-twenty-first interest in the
new entity in return for the interests embodied in the letter. The
lower court held, and the Eleventh Circuit agreed, that under state
law the letter did not create any legally enforcable rights. The
Eleventh Circuit reversed the lower court, however, by ruling that
the substantial commitment to make a deal embodied by the letter
constituted "property" for nonrecognition purposes."' The court
left for determination on remand an allocation of the partnership
share's value between the letter and the future services that the
taxpayer agreed to perform as a general partner. Only the former
84
would enjoy nonrecognition.
At first blush it may seem absurd to distinguish between the letter of intent, which had value only to the extent that the taxpayer
rendered further services in reducing it to a binding commitment,
and the unspecified future services that he otherwise would provide to the partnership. The result makes some sense, however, as
181
See LR.C. §§ 358, 722 (taxpayer's basis in the business interest is the basis of the
property transferred to acquire it).
182 727 F.2d 1043 (11th Cir. 1984), rev'g 552 F. Supp. 311 (M.D. Ga. 1982), on remand
from 611 F.2d 990 (5th Cir. 1980), rev'g 435 F. Supp. 1036 (M.D. Ga. 1977).
183 727 F.2d at 1051-54.
184
Id. at 1054-55.
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Taxation and Human Capital
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a rough compromise designed to permit nontaxation for some, but
not all, prepayment for future services. Human capital reflects the
discounted present value of future services, and the commitment
of such services to a business entity will augment the entity's
value. A flat rule treating all future services as Section 351/721
property would open substantial deferral opportunities for taxpayers who might sell their business interests long after they had rendered the covered services. At the same time, full immediate taxation of the anticipated value of these services would accelerate
liability and thereby overtax service income. 185 A result such as
Stafford's reasonably accommodates each concern. Limiting nonrecognition to the portion of the consideration received in exchange for a well-defined obligation promising benefits over an extended period should keep the decision from becoming an excuse
for abusive tax deferral.
3.
Attribution
One of the most complex and least coherent areas of tax law is
the judicially created assignment-of-income doctrine. Courts have
developed rules to thwart taxpayer attempts to deflect income to
other taxpayers, usually family members with lower marginal rates.
At one extreme, a taxpayer cannot achieve deflection by contracting in advance to share income from the sale of his services
with another party, even if the contract is enforcable and not motivated by tax concerns.18 6 At the opposite extreme, a taxpayer may
deflect income from property (dividends and bonds, for example),
as long as he transfers ownership of the underlying corpus with the
income interest. 187 Scores of intermediate cases exist, and their
holdings reflect ad hoc, confused judgments and doctrinaire hairsplitting rather than intelligible policy concerns. 18 Why deflection
185 Overtaxation might occur because the taxpayer must pay taxes not only on the present
value of future earnings, but also on the return from the invested human capital. The problem is the same as that discussed supra note 87, complicated because the taxpayer has tied
up his capital in the business and therefore has fewer options to channel his return into taxpreferred forms of payment.
186 Lucas v. Earl, 281 U.S. 111 (1930).
187 Compare Blair v. Commissioner, 300 U.S. 5 (1937) (donor transferred a portion of his
life estate), with Helvering v. Horst, 311 U.S. 112 (1940) (donor transferred interest coupons
but kept the bond).
I" See generally 3 B. Bittker, supra note 77, 1 75.2.1-3.5.
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is any more (or less) desirable in the one extreme than in the other
remains unanswered. 189
As long as there is no clear purpose undergirding the doctrine, it
is unlikely that reference to economic abstractions such as human
capital can guide a perplexed interpreter. A few case law distinctions are interesting because they conform to patterns suggested
by the human capital concept, 190 but close study of the doctrine
does not suggest that this method of analysis has any general influence. The most that can be said about attribution cases is that
they limit the relevance of the human capital concept to interpretive problems under current law.
V.
CONCLUSION
Some critics believe that the business of taxation entails so stark
a conflict of particularized interests and so many tradeoffs between
organized groups as to bar creation of any consistent or principled
structure. They assert that taxation is necessarily arbitrary, and
that whatever patterns might emerge from the rules and practices
that our system has evolved lack intrinsic meaning. Others maintain that a basic concept of taxable income does inform the federal
income tax, but that the core idea of income must exclude esoteric
notions of nonmarketable gains. There are principles of taxation,
they argue, but too much complexity will both frustrate popular
understanding and create slippery-slope problems that might undo
tax reform. One simplified way to capture the latter perspective is
to argue that accounting concepts of income, and not economic notions, will reveal the deep structure of federal taxation.
By looking at the taxation of human capital both as a theoretical
matter and as a practical guide for unraveling some of our system's
mysteries, I have tried to do two things. First, I have attempted to
189 A basic problem is that the doctrine cuts across so many difficult areas: the choice
between the individual and the family as the appropriate taxable unit; the limit of the twotier policy in corporate taxation; indirect taxation of unrealized income; and the appropriate
structure for the charitable exemption. No consensus exists on any of these questions.
190 For example, an author may deflect income from a literary work by transferring his
rights before marketing, but an assignment made after he has signed a contract with a publisher will not succeed. See, e.g., Lewis v. Rothensies, 61 F. Supp. 862 (E.D. Pa. 1944), aff'd
per curiam, 150 F.2d 959 (3d Cir. 1945). This distinction recognizes that a greater moral
hazard exists before consummation of a contract that binds an author to his editor and that
ownership of the income for tax purposes might follow this hazard.
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Taxation and Human Capital
1427
expose what consistency our system has achieved in its treatment
of human capital. Certain themes reappear. In lieu of amortizing
the costs of human capital, we try to match immediate deductions
for indirect costs with the denial of any recovery for direct costs.
The balance between expensing and no-recovery rules may shift as
the deferred return from a particular type of investment diminishes. Investments underwritten by employers generally receive
friendlier treatment, perhaps because shared job-specific capital
merits special incentives, or because employers will screen out consumption disguised as investment. Although no direct way exists to
distinguish unrecovered costs from profit, the rules for replacement of human capital may serve as rough measures for excluding
basis offsets while taxing profits. To the extent that these themes
prevail, they suggest that some patterns stand out against the
background noise of admittedly complex and occasionally irrational federal tax rules.
Second, I have demonstrated the explanatory power of an analytical construct that relies on certain assumptions about human
behavior: that society, in designing its principal tax system, expects people to act as if the acquisition of particular talents will
lead to different mixes of future rewards, and that the pattern of
talent acquisition resembles in some ways that of accumulation of
more tangible properties. By talking of human capital, one necessarily assumes that people are interested in their future wellbeing,
that the acquisition of skills can meet that concern, and that hedonistic welfare-maximization models that economists conventionally use contribute to our understanding of this activity. To the
extent that the human capital concept helps clarify important debates about the tax system, it demonstrates the value of employing
these behavioral assumptions when discussing hard legal problems.