Time Value of Money (One More Time)

Abstract

Nearly 40 years ago I wrote Interest in Disguise: Taxing the Time Value of Money. The article showed that if the party’s marginal tax rate is constant, since the present value of the amount included or deducted may not change, deferral (or acceleration) of income or expense does not necessarily affect the tax impact. However, there seems to be surprisingly little recognition of the widespread impact of the insight that the timing of income and deductions may not affect value.

There are several academic proposals suggesting that recognition of present value equivalence can improve understanding of the impact of the tax law and might lead to better ways to measure income that may be more administrable or less controversial. These include such disparate issues as depreciation deductions, achieving uniform taxation of corporate and partnership income, comparison of the impact of gift and estate tax and the determination that income tax exemption for fees received by a non-profit for goods or services can, nevertheless, correctly measure income. However, as far as I am aware, there is little or no research in this area. Further, only in very limited situations has Congress or the IRS relied on present value equivalence to achieve their desired result.

Moreover, the effect of present value equivalence is poorly understood. For example, for Roth IRAs to be truly equivalent to traditional IRAs, as it is often claimed, the minimum distribution requirement must apply equally to both. The essential purpose of requiring distributions is to limit the advantage of continued tax exemption for the plan’s earnings, not to prevent delay in the taxation of the distribution.

Importantly I have only very recently understood that despite deferral of unrealized gains, the return to basis remains fully taxed unless there is a basis step-up at death or a charitable contribution. Only the return to the reinvestment of the untaxed appreciation is benefited by deferral. The tax, which is now due on sale, can instead be collected over time by an annual tax on the return to basis. If we are able to do so, we could eliminate the step-up in basis at death without a tax at death while otherwise retaining the benefit of deferral.

Time Value also showed that the key to whether deferral was advantageous is often the effective tax rate on investment income, which in some situations can be exempt from tax. This Article clarifies the conditions, which are now often ignored, or at least not emphasized, for investment income to be exempt under an income tax as compared to a consumption tax. It also offers a more detailed description of when a surrogate tax on the counterparty is likely to occur.

The goal of this Article is to increase understanding of the potential impact of present value equivalence. My hope is that consolidating what I have learned over the last 40 years in one place will increase understanding of these ideas and thereby stimulate interest in the possible additional use of present value equivalence to better measure taxable income.