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The Concept Of Income For The Purpose Of Income Tax

By Dr. Rup Khadka

It is not easy to define income precisely. While one can find various definitions of income in the literature, many writers have cited definitions given by Haig and Simons. In 1921, R. M. Haig defined income as the "money value of the net accretion to one's economic power between two points in time." In 1938, Henry C. Simons defined income as the "algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period."

The essence of these definitions is that income is the sum of consumption plus increase in net wealth. It is the definition of comprehensive income and is generally referred to as the Haig-Simons definition.

It is, however, difficult to adopt such a broad definition for the purpose of income tax in real life. According to this definition, it would be necessary to include income generated by any means in the tax base. However, income generated through housewives' services, or other services provided within the family (such as medical services provided by a doctor to his/her family members or tuition provided to children by family members), value of the product produced by a person in his kitchen garden for self consumption etc. are practically impossible to include in the tax base. Similarly, it is difficult to tap other types of income earned in kind. Value of owner occupied house or leisure is also equally difficult to tax.

Because of these problems, it is difficult to stick with the Haig-Simons definition strictly for income tax purposes. Attempts are made to limit the definition of income to the wealth created by a person in the course of an earning activity when another person pays it. Activities not paid by others, such as self-employment or imputed rents are kept outside the tax net.

Similarly, there is also a practice to exclude receipts from gifts, inheritances, bequests, lottery, or gambling from the definition of income for the purpose of income tax. These receipts cannot be considered as consideration since receivers do not pay any thing for these items. They are not considered economic activities and creation of wealth, but are simply transfer of wealth. They can be subject to a separate tax, but not income tax. Besides, their inclusion in the income creates the problem of doubling counting.

Thus for practical reasons, value of consumption without an exchange transaction is not taxable. For example value of products grown by a person in his garden or imputed rent are not taxable. Only payment for the provisions of labor or capital or combination of both is taxable.

However, sometimes even the payments for the provision of labor are made in kind, not in cash. For example, an employer may provide vehicles, food, clothes, quarters etc. to his employees instead of cash. While it is difficult to determine income for the payment made in kind, there is a practice to levy tax on fringe benefits. There is a common practice to levy tax on all incomes received in money or money's worth. All types of income received are taxable, unless specifically exempt by law.

For practical purpose, income tax laws of various countries define the scope of income for the purpose of income. They generally do not try to create an ideal tax base, but create a workable tax base. In the context, many income tax laws define income as the income generated from specified sources of income. Income to be covered under each source is further elaborated. For example, under the current Nepali income tax act income is defined as cash or in-kind income earned or obtained from (a) agriculture, (b) industry, trade, profession or occupation, (c) remuneration, (d) house and compound rents and (e) other sources. Incomes to be included under each heading are also mentioned in the law.

The draft income tax act 2000 defines income as " a person's income from any employment, business or investment and the total of that income as calculated in accordance with this act." It includes all sorts of income received for the provision of labor or capital or both of whatever form or nature in the taxable income. Exempt from income tax are allowances paid by the government to widows, elder citizens or disabled individuals, gift, bequest, inheritance, and scholarship. Similarly, income of foreign officials, government bodies and non-profit organizations are also exempt. Other types of income fall either one of the three groups of income. The major types of income included under each head are pointed out below: Employment income: All payments or benefits received in respect of employment, including past or future employment, are made taxable. For example, payments relating to the change of terms of employment, fringe benefits, various types of allowances, payments received through third parties all are made taxable.

Investment income: All types of investment income, including dividend, interest natural resource payment, rent, royalty, gain from investment insurance, gain from an unapproved retirement fund interest, or retirement payment made by an approved retirement fund are included in the taxable income. Interests, dividend, royalties all are defined broadly. Capital gains realized on the disposal of fixed assets are also included in the income. Disposal is defined broadly.

Business income: Profits and gains from conducting the business are considered as the business income for the purpose of income tax. This type of income may include, inter alia, service fees, mount derived from the disposal of a trading stock, and net gains from the disposable of business assets or liabilities.

(Dr. Khadka is a noted taxation expert.)