Haig-Simons Definition of Income
When you hear the word income, what do you think of? Do you think of the money that you earn from your job? Most people do. In fact, most people simply think of income as money you earn, which is largely correct. But, for those in the financial field, there are other ways of describing income. For example, there's what's called the Haig-Simons definition of income, which states that your income is made up of your consumption plus any increase in your wealth stock. Here's the formula for figuring this definition out:
- (income) = (consumption) + (change in wealth stock)
- I = C + delta W
However, this definition isn't the definition of income that the IRS uses to tax you each year. The consumption part isn't strictly your wages under the Haig-Simons definition. Rather, it includes anything that benefits you financially whether or not you get financial compensation for it. For example, your wages are part of your consumption, as is company paid health insurance. The health insurance is added to your consumption because you're financially benefiting from it.
The idea behind the Haig-Simons definition is that it's a way to keep track of the income that counts for people. It avoids the difference in income between someone who earned say $100,000 from a job and another who earned only $60,000 from a job, but who also earned another $40,000 from his or her stocks. Using the Haig-Simons definition, both of these people have earned the same amount. Also, under the Haig-Simons definition, charitable donations aren't deductible because if a person had the money to donate in the first place, it means that person had earned that money already.
Under a different definition of income, such as that used by the IRS when you're filing your annual taxes, any charitable donations you make are actually tax-deductible. Being tax-deductible, they lower the amount of your income in the eyes of the IRS. You can see how someone can say they have less taxable income just because they donated more. Well, under the Haig-Simons definition, it wouldn't matter how much you donated; your donation wouldn't change the amount of money you earned.
Settlements Income
In addition to the Haig-Simons definition of income, there are other types of income, too. These are types that are legally recognized, and the IRS uses these types when it comes to figuring out your taxable income for the year. First off, you have your settlements income. This is income that you receive from lawsuit settlements that you won. These lawsuits can be for personal injuries or something else. The payment you receive may be allocated for certain things such as back pay, attorney's fees, pain and suffering and so forth.
Another type of income that you can receive that's similar to settlement income is when you receive a lump-sum payment from a retirement plan. There are certain conditions that need to be met before you can take a lump-sum payment, such as reaching the age of 59. Also, when your marital status changes, such as in a divorce, you may have agreed to split your assets in a certain way. Whatever financial gains you receive through a marital status change is considered income.
Transactional Income
Yet, another type of income comes from those monies involved in large transactions, such as when you sell real estate. For example, say you're selling your house for $650,000. You have a mortgage balance of $150,000. After successfully selling your encumbered house for $650,000, you would end up with an income of $650,000 - $150,000 = $500,000. In this case, encumbered means any real estate where someone else has a financial claim on it, such as the bank that has given you the mortgage. Also, if you have a loan or other debt that ends up being forgiven or canceled, the amount that you were forgiven is now considered your income. In IRS terms, this is called cancellation of debt income.
Wealth Planning
Other forms of income also come into play when you plan for your retirement. If you have an IRA that invests in the stock market, your income consists of the earnings you receive from the growth of your stocks. For example, your 401(k) may have earned you $4,500 in one year. Another type of income is when you receive the property or other assets from a deceased family member. For example, your grandpa may have passed away and left you and your family the house that he used to live in. These are all different kinds of income. Whether these are taxable or not is dependent on the IRS and the conditions the IRS has set for various types of income.
Lesson Summary
Let's review. Income is money you earn. The Haig-Simons definition of income states that your income is made up of your consumption plus any increase in your wealth stock. The different types of income that are legally recognized by the IRS include settlements income, such as lawsuit winnings, lump-sum retirement payments and marital status change payments; transactional income, such as real estate sales and canceled debt; and wealth planning income, such as stock market earnings and any inheritances from deceased family members.
