The voices of Tax Policy Center's researchers and staff
Tax bills almost always force Congress to think about how to define income, but President Biden’s campaign promise to never raise taxes for those making $400,000 or less puts the question front-and-center.
If you are not a tax geek, you might be surprised to know there are many definitions of income. Some are used to calculate tax and others to analyze tax policy. They include—from broadest to narrowest-- economic income, expanded cash income, cash income, modified adjusted gross income (MAGI), adjusted gross income (AGI), and taxable income. And that’s just some of them.
When Biden releases his detailed tax plan at the end of this week, we’ll find out what he considers income. And we’ll soon learn what Congress thinks. But the gulf between, say, economic income and AGI can be an ocean wide, especially when it comes to unrealized capital gains of high-income households. And it means taxpayers will need to pay close attention to where lawmakers land.
To help understand the coming income debate, here is a brief description of just some of the many possibilities:
Adjusted Gross Income. This is the one you see on Line 11 of your Form 1040. It includes income from wages, interest, dividends, capital gains, pension payouts, distribution from retirement plans, some alimony, certain business income, and the taxable portion of Social Security benefits. To calculate AGI, you then subtract certain deductible expenses, but we won’t worry about them here.
Taxable income. This is the bottom line for the federal income tax. It is AGI minus either the standard deduction or itemized deductions.
Modified AGI. The IRS uses this one to determine whether you are eligible for certain tax benefits, such as whether you can contribute to a Roth IRA or how much of your Social Security benefits are taxable. The IRS uses different definitions for different purposes, but in general taxpayers must add to their AGI other sources of income, such as foreign income, that otherwise are excluded from AGI.
These first three definitions are used to calculate tax and sometimes to analyze tax policy. The next three are among many tools used to analyze tax policy but don’t affect the taxes people pay today.
Cash income. This includes modified AGI plus employee contributions to tax-preferred retirement accounts, tax-exempt interest, nontaxable Social Security and pension income, cash transfers from the government such as unemployment compensation or from other individuals such as child support, and the employer share of payroll taxes.
The last one requires a bit of explanation. Economists believe workers ultimately pay the employer share of payroll tax through lower wages, thus they consider it cash income. Similarly, because workers and shareholders ultimately pay corporate income taxes, their share of those taxes reduce cash income.
Expanded cash income. This is the one the Tax Policy Center uses in its distribution tables. It includes cash income plus tax-exempt employee and employer contributions to health insurance and other fringe benefits, employer contributions to retirement accounts, income earned within those retirement accounts, and Supplemental Assistance Nutrition Program (SNAP) benefits, often called food stamps.
While none of this income puts greenbacks directly in your pocket as wages do, it does improve your well-being by increasing both current consumption and net wealth. Thus, most economists treat each of these sources as income.
Employment-based contributions to health insurance are a good example of why. If instead of buying you $10,000 worth of health coverage, your employer raises your pay by $10,000 and lets you buy the insurance yourself, that compensation would be included in your AGI and taxed like any other wages. Besides, since your employer does put up the $10,000, you have insurance you otherwise would not have. Thus, TPC includes it in expanded cash income.
Economic income. This includes income from unrealized capital gains, making it hard to measure and very controversial. It fits the classic economic definition of income: These gains increase your net wealth and you can borrow against those assets to boost your current consumption. But because you have not yet sold the assets, unrealized gains are not what many people think of as money in their pocket.
Progressives say unrealized gains are income and should be taxed as such. They also say treating unrealized gains as income would show that very wealthy pay low effective tax rates under current law. And that would buttress their arguments for taxing accrued gains or for a wealth tax.
Critics, on the other hand, often say this calculation is ridiculous. Paper profits, they insist, are not the same as income, thus gains should not be taxed until assets are sold.
It may sound like a technical argument among economists, but the gap between, say, AGI and expanded cash income can run into the tens of thousands of dollars annually. And if you include unrealized capital gains, it can add hundreds of thousands or even millions of dollars to incomes of the very wealthy.
Back to Biden and his $400,000 promise: Different income measures will change the number of people whose taxes Biden would raise. For example, IRS estimates that about 1.7 million tax returns report AGI of $500,000 or more (sadly, it doesn’t break out $400,000 or more). TPC estimates that about 2.6 million have that much expanded cash income and could face higher taxes.
As we all are about to learn, how you measure income can say a lot about how you approach tax policy.
Posts and comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.
Keith Srakocic/AP Photo