Discover more from Contemplations on the Tree of Woe
The Absurdity of Income Tax
And the Marriage Deduction You Never Knew Existed
Ask libertarians what they think of income taxes, and they’ll likely say “taxation is theft” and demand that government be funded by trade duties or voluntary contribution. Shortly thereafter, they’ll start to talk about Galt’s Gulch and going off grid.
Ask neoreactionaries what they think of income taxes, and they’ll talk to you about government as a business designed to maximize its own long-term profits through sustainable taxation. This will lapse into a discussion of the merits of stationary versus roaming bandits.
Ask conservatives what they think of income taxes, and they’ll produce a Laffer Curve diagram “proving” that the government would earn more if it’ll lower the tax rate. They’ll then say that government should be smaller, which would suggest it should earn less; perhaps this is why taxes stay high under Republicans.
In any case, the one thing nobody says is what I’m about to say, which is that income tax is absurd based on the government’s own preferred theories of economics. It’s so absurd as to be a parody of a rational taxation system and it sustains itself only through willful blindness to how absurd it really is.
Please fasten your tongue firmly into your cheek and read on.
Contemplations on the Tree of Woe is a taxation blog devoted to the careful study of the US Tax Code from a microeconomic perspective. To receive new posts and support my purchase of a new Warhammer Space Marine army, consider becoming a free or paid subscriber.
The Prodigal Professor and the Labor-Leisure Tradeoff
My corporate law professor was an exceptionally well-regarded scholar who we will call Professor Cost. I was a student in his first year of teaching; prior to Harvard, Professor Cost was a partner at Wachtell, Lipton. I later went to work at Wachtell, Lipton myself. If you don’t work in M&A you might never have heard of Wachtell, Lipton. The greatest trick the Devil ever performed… Wachtell, Lipton is the firm that executives turn to when victory is all that mattered and money is no object. It’s the firm that defended Philip Morris and that invented the poison pill that saved entrenched management from corporate takeovers. It’s based in the dreaded Black Rock building on 52nd and 6th in Manhattan, a grim spike of black concrete that intimidates lesser buildings with its contempt for pleasing architecture and beauty. It’s the firm parodied in the movie Devil’s Advocate. Most importantly, it is (or was at that time) the highest-paying and highest-earning law firm in the world, with average profit per partner in excess of $2 million. That’s like $8.4 million annually per partner in 2023, if you want to buy eggs.
When Professor Cost left his job at Wachtell, Lipton, he took what I estimate to be an 85% pay cut. What would motivate a man to do such a thing? From a government accountant’s point of view, Professor Cost has made a terrible mistake. Whereas before he had earned, say, $2,000,000 in income annually, now he was earning only $300,000 annually. Such irrationality! In a socially just world he would be punished for costing the government $700,000 in tax revenues per year.
What would motivate a man to accept an 85% pay cut? Among other things, leisure time. In most law firms, the associates are “leveraged” (i.e. worked to the bone) to bill 2,500 to perhaps 3,000 hours per year so that the partners can live comfortable lives that involve about 2,000 hours per year. At Wachtell, Lipton, the partner that I worked for regularly billed 3,000 hours a year. She, personally, billed that. Her associates billed more. Presumably then-Partner Cost did, too. As a tenured Harvard Law professor, on the other hand, Professor Cost has to teach two courses per semester, which is about 40% of the workload of a college student. The rest of his time he can pursue research, writing, and other matters of personal interest.
In neoclassical microeconomics, Professor Cost’s decision would be considered an instance of the labor-leisure tradeoff.
The "labor-leisure" tradeoff is the tradeoff faced by wage-earning human beings between the amount of time spent engaged in wage-paying work (assumed to be unpleasant) and satisfaction-generating unpaid time, which allows participation in "leisure" activities and the use of time to do necessary self-maintenance, such as sleep. The key to the tradeoff is a comparison between the wage received from each hour of working and the amount of satisfaction generated by the use of unpaid time.
The labor-leisure tradeoff is an instance of a larger neoclassical concept known as consumer choice theory. According to consumer choice theory, consumers make rational decisions about how to allocate their limited resources in order to maximize their satisfaction or utility.
The consumers face a budget constraint, which is the limit on the amount of goods and services they can purchase given their income and the prices of goods and services. The consumer's goal is to choose a combination of goods and services that gives them the highest level of satisfaction or utility, subject to the budget constraint.
Neoclassical microeconomists assume that consumers have a set of preferences over different goods and services, which are typically represented by a utility function. This function assigns a level of utility or satisfaction to different combinations of goods and services. Consumers choose the combination of goods and services that maximizes their utility, subject to the budget constraint. This is known as the consumer's optimal choice or bundle of goods.
Now, as evidenced by the labor-leisure tradeoff, neoclassical microeconomics considers both income and leisure time to be goods which are subject to the utility function. As the saying goes: Time is money. Professor Cost had a choice of two bundles of goods. He could work 3000 hours per year and have 0 leisure time in exchange for $2 million. Or he could work 1000 hours per year and have ample leisure time in exchange for $300,000. Professor Costs’ utility function led him to make the latter choice.
Yet the income tax system does not take this into account. Professor Cost pays far more taxes if his income is $2 million then if his income is $300,000, even though — from Cost’s perspective — he is personally better off making $300,000. The tax code incentives you to be lazy.
Now, the usual neoclassical counterargument to this is that the taxes are “priced in” to the utility function. According to this view, Professor Cost did not make a tradeoff between $2 million and $300,000, but rather between, say, $1.2 million and $200,000, representing e.g. 40% and 33% taxes paid due to progressive rates.
But this is simply not valid at the theoretical level, for three reasons: (1) variability of tax rates, (2) path dependencies, and (3) employment contracts.
Imagine that when Professor Cost left Wachtell, Lipton the marginal tax rate on income at his level was 39%. However, after he has left the firm to work, a Republican Congress reduces tax rates for the wealthy down to 33%. According to consumer choice theory, Professor Cost would now have to re-evaluate his life choices.
“Dammit,” says Professor Cost. “My utility function would have kept me at Wachtell, Lipton if the only the tax rate had been 33%. I must return to the Black Rock building and take up my billable hours crusade again.”
Variability of tax rates is made more problematic by path dependencies: Some life choices are essentially irrevocable. Can Cost return to Wachtell, Lipton? Probably not — he’s cashed out of the practice and handed off his clients. Or consider the case of a hypothetical young man who devotes all of his time and energy from 1910 to 1916 in order to finally get a job as a high-earning investment banker. Then the government raises the income tax rate from 15% to 67% (as actually happened), and his utility function is demolished.
Employment contracts, which are common for high earners, also demonstrate the theoretical inadequacy of the neoclassical response. Imagine that instead of going to Harvard, Professor Cost had joined the NFL on a 5-year $25 million contract. “Although I will work longer hours and take severe physical punishment that may lead to brain damage,” thinks Cost, “It’s worth it to me to earn an additional $3 million per year.” Here, Cost has made the reverse choice, taking more money in exchange for more labor. Now imagine that tax rates increase on high income — again, his utility function is demolished and there’s nothing he can do about it. (We won’t even get into the fact that risk of brain damage isn’t taken into account in income.)
All of these unhappy hypotheticals arise because the notion of income tax is fundamentally absurd. When I work hard to earn money, I’m not getting something for nothing. I’m getting something for my time and my time has value.1
The Criminal Cleaner and the Lawbreaking Lawnmower
We’ve spent enough time abusing poor Professor Cost (who is a real person, btw). Let’s abuse some purely hypothetical people, who we will call Chrissy Cleaner and Larry Lawncare.
Chrissy and Larry are neighbors, and each runs their own small business. Chrissy offers house cleaning services, while Larry offers lawn mowing. One day, Chrissy and Larry meet for coffee and Chrissy hires Larry to take care of her lawn for $250 per month. Thereafter Larry spends two afternoons a month on her lawn and collects $250 for his time. Both Larry and Chrissy are better off, both have gained utility, but only Larry has to pay income tax.
Larry then decides to hire Chrissy to clean his home for $250 per month. Thereafter Chrissy spends two afternoons a month cleaning Larry’s house and collects $250 for her time. Again, both Larry and Chrissy are better off, both having gained utility, but now Chrissy is paying income tax.
Being clever and ruthless small businesspeople, Larry and Chrissy decide to stop billing each other for their services. Instead, Larry agrees to mow Chrissy’s lawn in exchange for Chrissy cleaning his house. Neither of them reports this as income.
Both are arrested for tax fraud. According to the Internal Revenue Service, any income received from bartering is taxable in the same way as income received from other sources. Since no actual income occurs, the IRS instead imputes the fair market value of goods received in the barter transaction as income and demands that it be reported on the recipient's tax return. If you’re not doing that every time you do service for someone in exchange for them doing something for you, guess what — you’re a felon!2
While languishing in prison, Larry is visited by an IRS tax inquisitor demanding his confession. “Confess!” the inquistor screams.
Larry tries to reason with him. “I gave up my afternoon to mow Chrissy’s lawn. My time is money! I didn’t earn any income.” The inquisitor is unmoved. “Don’t try to reason your way out of this,” he sneers.
Larry asks, "Well, would she and I still be in jail if we didn’t run businesses that offer this service? Like, what if we were just neighbors doing favors for each other?” The IRS inquisitor leers at him. “Irrelevant! Barter income is taxable income.”
Larry then says, “OK, so what would have happened if I had given up my afternoon to clean my own house, and Chrissy had given up her afternoon to mow her own lawn?”
The tax inquisitor smiles and relaxes. “Oh, in that case, neither of you would be in Federal prison awaiting trial, because no taxable event would have occurred.”
Larry is dumbfounded. “But there’s no difference between these two scenarios, economically speaking. In both cases time was spent in order to perform a service. The exact same time and the exact same outcome. Why isn’t the tax rate the same?”
The inquisitor’s eyes go large. “By God, you’re right! We should be taxing services performed for your own benefit.” He agrees to waive charges against Larry if Larry is willing to turn state’s evidence against everyone he knows who does their own home repair and lawn care.
Larry denounces everyone in the neighborhood, but especially Bob, who has the nicest house on the block and an irritating habit of doing loud carpentry projects at 7AM.
The Professional Prostitute and the Wage-Earning Wife
Let’s leave Larry to languish with his guilt and Chrissy to clean the prison. We now turn to Amanda and Roger, a beautiful young woman and a wealthy Wachtell, Lipton attorney who meet at a bar and instantly begin having nightly sex with each other. Soon enough, Amanda moves into Roger’s high-end penthouse and begins using his Netflix account, which quickly begins to recommend that Roger watch movies about Victorian courtesans who love horses.3
Amanda and Roger reside in Nevada, where prostitution is legal, and when she’s not getting frisky with Roger, Amanda is getting frisky with her clients at the brothel, whom she charges $250 per hour of ecstasy, $250 per hour being the going rate for sex in the city.
All seems well until, one day, as she’s leaving work, Amanda is arrested. Not for prostitution, which is legal in Vice City, but for tax fraud. Barter income is taxable income, and the IRS asserts that Amanda has been bartering sex for rent and Netflix.
“WHAT?” she screams. “He’s my BOYFRIEND. I have sex with him because I ENJOY it.” The IRS inquisitor, fresh from the show trial against Bob, nods sagely.
“I see,” he says. “How often would you say you and your boyfriend engage in acts of consortium?” “Um, about an hour a day every day for the past six months,” she admits.
The Inquisitor nods, makes a quick phone call, and an hour later Roger is brought into the interrogation room handcuffed and very, very confused. “Roger,” the inquisitor says, “you are being charged with tax fraud for failing to pay gift tax.”
“What? What are you talking about?” says Roger. “I’m an ethical egoist! Ayn Rand is my goddess! I don’t give gifts to anyone ever.”
“Oh, but you do,” says the inquisitor. “You’ve given the gift of 180 hours of sexual services to Amanda, which has a fair market value of $45,000. According to 26 U.S. Code 2503(b), gifts of over $16,000 per recipient are taxable to the gift-giver.”
“Oh my God,” says Roger. “That’s insane! Are you saying if I’d had sex with four different women rather than just Amanda, I’d be a free man, but because I’m monogamous I’m going to go to jail?”
“Sadly, yes,” says the Inquisitor.
“I told you we should have an open relationship!” says Amanda.
“But…” says Roger. “I wasn’t giving a gift to Amanda. You’ve got it all wrong. Actually she was trading sex to me in exchange for living at my apartment and using my Netflix account!”
“Bastard!” screams Amanda! “I’m no whore! Well, I mean, I am, but not for you!”
The couple turn to arguing, and the IRS inquisitor begins to file charges against both of them. Either this is a barter transaction where both parties have unreported taxable income, or its a gift exchange where both parties have unreported gift tax. In either case, the IRS will take its share.
Just then Roger’s friend Leroy, a tax defense attorney, arrives. He throws down a Polaroid photograph on the table that shows a very drunk Amanda and Roger standing with an Elvis impersonator. “Amanda and Roger don’t remember, but they got married they night they met! They’ve been a married couple this whole time,” he says.
“So?” sneers the inquisitor.
“According to 26 US Code 2523(a), where a donor transfers during the calendar year by gift an interest in property to a donee who at the time of the gift is the donor’s spouse, there shall be allowed as a deduction in computing taxable gifts for the calendar year an amount with respect to such interest equal to its value!” shouts Leroy. “If you’re married, you can have as much sex as you want without paying gift tax!”
Amanda is visibly upset. “You mean that the tax code is implicitly incentivizing the patriarchal norms of monogamous marriage? Five minutes ago it was incentivizing polygamous sex!”
Leroy shakes his head. “Don’t get too stressed,” he says. “This entire situation is absurd. It’s only happening because of the weird circumstances where you are a professional sex worker. It’s a one-off. Don’t let it make you think there’s something inherently ridiculous about our tax laws.”
Just then, Nancy and Dave are brought into the interrogation room. The unmarried couple are well-known to both Amanda and Roger, of course, as they are famous influencers. Nancy is a renowned massage therapist and Dave is a Michelin-starred chef.
“What are you guys here for?” asks Dave.
“Tax fraud,” interrupts the inquisitor. “Nancy here has been bartering massage services to Dave in exchange for 5-star meals.”
“You should have gotten married,” says Amanda.
Contemplate this on the tree of wtf.
As an aside, note the gross asymmetry with which human beings are treated compared to consumers when it comes to income. A corporation can deduct, as expenses, all of its costs of doing business. A human being cannot deduct any of the costs of doing labor, such as the cost of food or the cost of giving up time with his kids.
In 2012, the IRS shut down a company called “The Trade Alliance" that facilitated barter transactions among members and required them to report the fair market value of the goods or services they received on their tax returns. However, the IRS discovered that many members were not reporting their barter income. It shut down the company and prosecuted the offenders, some of whom received prison sentences in excess of 10 years.
This anecdote is based on a true story.