Friday, June 07, 2013

Double Taxation and the Lottery

This is probably old stuff to tax pros, but I just noticed a curious inconsistency in the way we treat lottery winnings for tax purposes. 

Here's the deal: I'm thinking of Gloria Mackenzie of Zephyrhills, Florida, who rode home on a 175-million-to-one longshot to take what is being described as the largest lottery jackpot ever.  Link.  Like most lottery winners, Ms. Mackenzie had her choice: she could take a lump sum now, or a stream of payments.  The payment stream is billed as $590 million; the lump sum as just $370 million.  No surprise that there is a discount for present payment, but I am surprised to learn how they compute it. I had assumed that lottery officials keep those lump-sum payouts artificially low, so as to discourage winners from taking all the money now.  Apparently no: discount the payment stream in the Mackenzie case and you come up with an internal rate of return of about three percent which is just bout as low a return as you can imagine, and which yields a correspondingly generous present value.

But I want to consider the fax consequences.  Underbelly's crack tax department hits the high points. Apparently Ms. Mackenzie has opted for immediate payout, and will liable for a tax right now.  If she had gone for the payment stream, then (so I am told) she would have been liable for tax on each payment as it came due.

But here's the funny thing.  Suppose she takes the payment now and then decides to reinvest. Who knows why: maybe she thinks she can beat three percent.  Or maybe she wants to manage a trust account for her grandchildren.  In any event, apparently she will have to pay tax on any returns from reinvestment.

This struck me as double taxation.  My friend Bruce, whop knows this stuff far better than I, says I'm just thinking like a Republican.  It's no more unfair (says Bruce) then when they tax your salary and then tax any returns your make on reinvesting your salary.

Maybe so.  But now look back at the payment-stream option.  In the case of the payment stream, she would have to pay tax on the individual payments.  But she would not pay any tax on the present value up front.  This strikes me as at lest inconsistent.  If Bruce's pattern is to hold, shouldn't we also tax her on the present value of the payment stream now?


Larry, The Barefoot Bum said...

I dunno, Buce. Taxes usually apply to the movement of money (or occasionally real goods, like when you win a car in a lottery). They usually don't apply to transfers of non-cash financial transfers, except for estate taxes.

In a fiat-money economy, the purpose of taxation is (a) to give people a reason to use money (because they have to use it to pay taxes) (b) to remove excess money from the economy (which is injected (indirectly) by government spending) to prevent excess inflation and (c) to redistribute (or preserve a distribution of) wealth and income.

As such, the question is not whether taxation is perfectly consistent, but is it pragmatically effective at achieving the three goals.

What is, for example, the present value of a new job? A job is a stream of payments over a period of time, which has a present value. How about a bank loan (from the bank's perspective)? Should they pay taxes on the principal they lend (which is, presumably, the present value of the future loan payments)?

If the gov't taxed the present value of a lottery payment stream, then the recipient would owe the IRS money for the first third or so of the lifetime of the payout, which would seem... impractical. Since the winner will receive more (nominal) money in the long run with a payment stream, the gov't's net taxes come out about the same.

Remember, money is just a social convention; we are free to adjust our institutions and customs to fit our wants.

Anonymous said...

Weirdly versions of this question are litigated every so often. Cf.