In-Depth Essay

Earned vs. Unearned Income

by Peter Barnes

Part Four (Parts 1-3 are available here)

Another tax break for wealthowners is the deductibility of depreciation from taxable income, often at accelerated rates. This amounts to a hefty federal reimbursement for wear- and-tear, general obsolescence and decreasing earning power of wealthowners' assets. There is no comparable compensation for the declining earning power of workers' bodies and minds; there is, in fact, a regressive labor depreciation tax (i.e., social security). Some wealthowners are particularly favored by the depreciation rules. Real estate wheelers-and- dealers, for example, are permitted high depreciation rates during the early years of owning a building; when deductions for depreciation start diminishing on one building, they can sell and start deducting on another. Owners of timber, oil, coal and other mineral properties receive a special allowance called percentage depletion. This enables them to deduct from taxable income not the actual decline in value of their assets, but an arbitrary percentage of gross revenues. What they save on income taxes can be many times what they pay for their properties.

By far the largest loophole for wealthowners is the preferential treatment for capital gains, (i.e., increases in the value of property). First, unrealized capital gains are not taxed at all. This allows wealthowners to accumulate wealth without interruption or diminution; if they don't cash in their holdings before death, their heirs escape taxation on the long-term capital gain. Second, only half of realized capital gains need be counted as taxable income, or, if all is counted, the tax rate is approximately half the tax rate of income from labor, up to a maximum rate of 35 percent.

The epitome of unearned income is that which derives from inherited wealth. Theoretically, self-perpetuating fortunes could be whittled down by estate, gift and inheritance taxes, and there exists a federal estate tax with a nominal maximum rate of 77 percent on taxable estates over $10 million. But the tax has become increasingly porous since the 1940s. Through marital and other deductions, gifts and placement of estates in tax- exempt foundations and trusts, most large fortunes can be passed on virtually intact.

One could go on to discuss tax-exempt state and local government bonds, the tax advantages of stock options and various tax-sheltered investment schemes, but the point is clear. Except for dividends on stock and interest on savings deposits - the two types of unearned income most frequently collected by persons of moderate means - unearned income is treated by the Treasury with far greater respect than earned income. In other words, wealthowners not only reap from the labors of others, they pay lower taxes.

It is worth noting that the tax system was not always so one-sided. The property tax was, in its historical antecedents, a genuine tax on wealth; only in relatively recent times has it become primarily a tax on the average man's residence (i.e., property on which banks make income, but workers pay taxes). The federal income tax was intended to be a levy upon income "from whatever source derived," as the 16th Amendment put it, and not primarily a tax upon the wages of labor. There was once, in fact, a special deduction from federal income taxes for income earned from labor, but it was abolished during World War II for the sake of "simplification of the tax code." Nowadays the maximum tax rate on earned income is 50 percent, as opposed to 70 percent for unearned income, but this is a distinction that benefits salary-earners only at the very top, rather than the bottom, of the wage scale.

Things would be sufficiently out of kilter if government favoritism for wealthowners stopped with the tax code, but the state's generosity goes further. In addition to the relatively small sums that the government dispenses to those who are too old, young or sick to earn income from labor, the government expends billions of dollars annually that add to the unearned wealth and income of the propertied. Sometimes the subsidy to wealthownership is indirect, as when a government-built highway, irrigation project, airport or other public facility augments the value of nearby land (and, to a degree, capital). In such cases, workers benefit in that they may use the new facility, or be employed by it, but they enjoy no gain in net worth, and indeed may have to pay user fees (e.g., tolls), higher rents and property taxes.

This essay is part of a series written by Peter Barnes for The New Republic magazine in 1971-72. We think you'll be pleased -- and perhaps shocked -- to see how timely and insightful the essays are for today. Each essay will be republished, in installments, by The Progress Report.