THE EXEMPTION OF LIFE INSURANCE FUNDS FROM TAXATION BY BRUCE D. MUDGETT, PH.D., Instructor in Insurance, Wharton School of Finance and Commerce, The discussion preceding the enactment of the federal income tax law in 1913 reopened an issue on which life insurance officials and legislators have disagreed for years. Though insurance companies have contended that life insurance funds do not offer a legitimate field for taxation, they have been called upon yearly to pay larger and larger amounts in taxes to the various states in which they operate. The bill introduced in Congress offered no exemption to an individual who protected his dependent family through life insurance from becoming public charges at his death, or who, by the same agency, provided for his own old age. Nor did it exempt the income of the life insurance company, the funds of which are a standing guarantee against family and old age dependency. The discussions of this bill, like most controversies over the question of taxing life insurance funds, have consisted in dogmatic assertions on both sides unattended by any attempt at scientific analysis that would give a basis for testing the arguments. It is doubtless true that most life insurance men accept without proof the statement that life insurance funds should never be subject to general taxation; it is equally true that legislators, in their search for ways and means, are inclined to choose the method which offers easy collection and has the least injurious effect on party success, regardless of the scientific character of the taxation problem. Any permanent settlement of this controversy in the near future is unlikely. With the extension of government activities there is necessity for increasing revenue, and new laws have a tendency to reach untaxed sources of wealth. These laws are often passed, however, without being submitted to the test of a really adequate theory. Those who oppose the taxation of life insurance. funds, having a perfectly good case to defend, have too often devoted their energies to attacks on particular laws and have not made clear the underlying reasons why life insurance funds should receive special consideration. BASIC REQUIREMENTS OF A TAX SYSTEM The statement of principles on which life insurance taxation shall be based is not a pleasant task. One faces two bitterly opposing camps, either ready to fall upon the first heterodox statement and to cry "traitor." It is a profitable task, however, if agreement is ever to replace the present conflict of opinion. Taxes are general or specific. Taxation of any kind is justified on the ground that administration of government results in benefit to the governed. In a broad sense, the function of government is the care of the health, morals and well-being of its subjects and the funds necessary for the conduct of such activities can be obtained by general taxation. The relationship between work performed and revenues obtained is indirect as, for instance, where a tax levied on property is used for the supervision of public health or for the support of judicial tribunals. In extending the field of government, it has become increasingly necessary to carry on special activities and the revenues for such purposes are collected directly from those benefited and should cover only the cost of service rendered. Thus the federal government conducts the postal service and collects two cent for each letter carried. The feeling that the postage tax should not be greater than the cost of this service is reflected in the demand for penny-postage. The government is likewise called upon from time to time to supervise particular institutions and the cost of such supervision may be charged directly. With government thus functioning as general and specific-for the benefit of all, and for the benefit of special classes of the governed -it is proper to distinguish two correlative types of taxation: general taxation, to pay costs of government activities in the benefits of which the whole people share; and specific taxation, to cover the costs of benefits accruing to a limited group. The justice of any system of taxation may be tested on different grounds in so far as we are dealing with these two fields of government enterprise. It may be accepted as a working principle that the conduct of specific operations such as carrying the mails shall be paid for by those who use the mails, or that specific institutions which receive the benefit of government supervision shall be taxed directly to pay its cost. Little disagreement with this principle will be found. An equitable system of general taxation is much more difficult to formulate. Adam Smith stated its fundamental premise when he said "The subjects of every state ought to contribute to the support of government as nearly as possible in proportion to their respective abilities: that is, in proportion to the revenue which they respectively enjoy under the protection of the state." This principle is accepted by John Stuart Mill, and in his elaboration of it he interprets it to mean that "equal sacrifices ought to be demanded from all."2 General taxation should be levied upon surplus. It is true that much popular misunderstanding results from the attempt to explain these doctrines in current phraseology, and clearness is in no way attained by a study of tax systems in the United States. It is quite certain, however, that if Mill were restating his doctrine at the present time he would do so in terms of the standard of living. He would justify any tax system in accordance with the way in which it might affect individual incomes. A tax falling upon the person whose income is insufficient, or only just sufficient, to maintain physical existence and rear a family would be destructive and therefore socially undesirable. All taxes should fall, in so far as possible, on those who enjoy incomes in excess of this amount. Fortunately, the decision as to what is a minimum standard of living need not enter the present argument. The sociologists may be permitted to establish the limit and we may agree not to tax individuals whose incomes fall below this mark. We may say with certainty that the government is justified in taxing the man whose annual income. is $100,000; but the advisability of taxing a $2.00 per day wage may await the determination of the minimum standard. While the amount necessary to maintain this standard need not be stated for the present argument, the factors which it includes do require statement. It means more than the food, clothing, lodging and recreation supplied by current income. It requires provision for times when income may cease through death, sickness, disability or old age. Recent developments of the idea of family responsibility include the belief that the man whose income may cease with death, disability or superannuation must lay aside certain 1 Wealth of Nations, Book V, Chap. II, Part I. • Principles of Political Economy, Book V, Chap. II, Sec. 3. amounts from his weekly or yearly income for insurance or annuities to provide for family needs, should any of these catastrophies occur. Society benefits if all persons whose incomes fail to satisfy these minimum requirements are exempt from taxation. In Mill's own words, "The principle of equality of taxation, interpreted in its only just sense, equality of sacrifice, requires that a person who has no means of providing for old age, or for those in whom he is interested, except by saving from income, should have the tax remitted on all that part of his income which is really and bona fide applied to that purpose." Indeed, he goes further and says that, were it possible to administer the tax, it should be based on expenditures and all savings should be exempted. But, since this cannot be done without great liability to fraud the next best thing is to exempt those amounts which "different classes of contributors ought to save."4 It is at this point that Mill's theory overreaches itself. Present-day social philosophy interprets his doctrine of "equal sacrifices from all" to mean the exemption of all persons whose incomes will not purchase the present necessities of life and insurance against loss of income in the future, and the taxation of all who enjoy a surplus income beyond these minimum requirements. This is thoroughly consistent with the doctrine originally propounded by Adam Smith, and accepted by Mill, of taxing those who have ability to pay. The taxation of expenditures only opens the way for the transmission of large unearned incomes to heirs. Savings should be encouraged in so far as they are used for the education and equipment of children in order to give them the best possible opportunity to develop their talents and make of them socially useful citizens. But savings intended to furnish children with an unearned income that will support them in leisure and idleness may be taxed with wholesome social effect. Unearned incomes are limited by the imposition of an inheritance tax; and it is proper to limit them also in the process of accumulation by a tax on surplus income. Application of these principles to the taxation of life insurance. The theory of taxation here outlined may be applied to the taxation of life insurance funds in the following manner. Specific taxation to pay the expenses of government supervision of the life insurance Mill: Principles of Political Economy, Book V, Chap. 2, 4. 4 Ibid. companies is fully justified so long as the tax does not exceed the expenses of such supervision. Taxation for general government purposes is justified only in so far as life insurance funds represent something more than a sufficient provision of the necessities for maintaining a proper standard of living and providing minimum savings for dependents and for old age. There are two direct means of taxing life insurance funds: a tax on life insurance corporations and a tax on an individual's provision for life insurance. The corporation may be taxed on its assets, on its premium income, on its investment income, or on its profits or surplus. An individual's provision for life insurance may be taxed while being accumulated or when paid to beneficiaries. It is taxed in the process of accumulation when a law taxing income fails to exempt those portions of income used for the purchase of insurance or old age protection; it is taxed after being accumulated, if the income tax law fails to exempt the proceeds of life insurance contracts when paid to beneficiaries in immediate cash or in installments. Taxation of life insurance companies. Taxes on life insurance corporations are justified in so far as they pay reasonable expenses of government supervision; more than this amount may not, in strict theory, be collected unless life insurance funds comprise something more than necessary savings for dependency and old age provision. The company which operates on the stock plan and each year diverts a portion of its funds for the payment of dividends on stock is to this extent more than an insurance and savings institution and may not object to the imposition of a corporation tax on the part of its funds so diverted. This would be a tax on the "gains or profits of trade," in the words of the English income tax law. A purely mutual insurance company has no such profits of trade and either must not be taxed at all or on a different basis. If we were to accept fully Mill's rule that all savings be exempt from taxation, there would be no basis whatever for taxing the mutual company; but the principle stated on page 126 and the principle that has gained acceptance in English tax laws is to exempt savings only up to a certain minimum and to tax all over this amount. If this rule is accepted as a basis for taxing individual incomes it must be accepted likewise in the case of corporate incomes. The tax authorities are then justified in imposing a tax upon all life insurance corporations |