We Live In A Capitalist Society, So Where Is The Capital?
Distinguishing Between Capital and Income
What it the difference between capital and income, and what is the relationship between them? This should be Basic Economics 101, but this distinction has become an economic riddle that few seem inclined to solve.
1) Labor creates capital.
2) Invested capital generates income.
3) Riddle solved.
The distinction between capital and income is explained in the 1913 Congressional Record when the income tax was being created. The Senators who revived the income tax after the ratification of the Sixteenth Amendment had to distinguish between capital and income when creating the tax. Therefore, they had to define their terms and the correct distinction between income and principal (capital) is preserved in their debates.
Senator Cummins:
When the people of the country granted to Congress the right to levy a tax on incomes, that right was granted with reference to the legal meaning and interpretation of the word “income” as it was then or as it might thereafter be defined or understood in legal procedure. If we could call anything income that we pleased, we could obliterate all the distinction between income and principal. Whenever this law comes to be tested in the courts of the country, it will be found that the courts will undertake to declare whether the thing upon which we levy the tax is income or whether it is something else.
1913 Congressional Record, Vol L, Part 4 pg. 3843
The reason that the distinction has become a kind of riddle is because this distinction is not an economic distinction. Here we are dealing with “income” and “principal” as defined or understood “in legal procedure.” These are legal distinctions, not economic distinctions. Here we speak of “income” and “principal” as defined by the Supreme Court, not Adam Smith. This legal or constitutional distinction exist because “income” and “principal” are taxed differently. Income and principal are the two categories of money and somewhere this got lost in our economic education. All money must fall into one of these two categories. The Senators make a clear distinction between these terms numerous time during debate:
If it were within the power of Congress to enlarge the meaning of the word “income,” it could, as I suggested a moment ago, obliterate all difference between income and principal, and obviously the people of this country did not intend to give to Congress the power to levy a direct tax upon all the property of this country without apportionment
1913 Congressional Record, Vol L, Part 4 pg. 3844
Income and principal must be legally separate from each other because they are taxed differently since the Sixteenth Amendment applies to the income, not to the principal. Americans did not give to Congress to the power to tax all principal (or property) without apportionment.
Since the word “income” appears in the Constitution, only the courts can define its meaning. Both the Congress and the U.S. Supreme Court have acknowledged this legal fact:
The people have granted us the power to levy a tax on incomes, and it will always be a judicial question as to whether a particular thing is income or whether it is principal.
1913 Congressional Recored, Vol L, Part 4 pg. 3844
[I]t becomes essential to distinguish between what is and what is not “income,” as the term is there used, and to apply the distinction, as cases arise, according to truth and substance, without regard to form. Congress cannot by any definition it may adopt conclude the matter, since it cannot by legislation alter the Constitution.
U.S. Supreme Court, Eisner v. Macomber (1920)
After the 16th Amendment, “income” is in the Constitution, which means Congress cannot define it. The Court also explains that the distinction between capital and income must be maintained:
Whatever difficulty there may be about a precise and scientific definition of “income,” it imports, as used here, something entirely distinct from principal or capital either as a subject of taxation or as a measure of the tax.
U.S. Supreme Court, Doyle v. Mitchell Bros. (1918)
What is the distinction between income and principal? Principal and capital are synonyms and may be used interchangeably, but there is a clear distinction between income and principal. The strict legal distinction between capital and income must be enforced because a tax on income is subject to the authority of the Sixteenth Amendment, but a tax on capital is not. The Constitutional meaning of “income” in the Sixteenth Amendment does not include money that is capital.
What is Capital?
Capital comes from labor, either through employment or business activity; labor creates capital. Employment earnings and business profits are capital. Capital is a category of financial gain that is separate and distinct from income: Some financial gains are capital and other financial gains are income. All financial gains are one or the other.
Capital is a store of wealth and money is capital in its most basic financial form. Capital is a financial gain that comes from one’s own labor and the Senators explain that too:
The earnings of any person from any occupation or profession would, if not spent in like manner, become principal. If by professional effort any person should earn a given sum annually and he spends half of it, he saves the other half. The half so saved in turn becomes principal. That principal is property.
1913 Congressional Record, Vol L, Part 4 pg. 3843
EARNINGS that are saved and not spent become PRINCIPAL. When distinguishing between income and principal, earnings that are saved are principal. Principal is synonymous with money that is property. The amount is irrelevant. If a baseball player earns $20 million a year and spends half and saves the other half, the $10 million saved is the principal. This is the money the player has available to invest if he chooses. This $10 million that is saved is property. This $10 million that is property cannot get confused with money that is taxed as income as the Senators observed during debate:
If we make a mistake and include in our designation of what is “income” something which is not income, but is property, then, of course, the court would come in and settle that controversy
1913 Congressional Recored, Vol L, Part 4 pg 3845
If the baseball player spends all $20 million, then the player can never have any principal to invest. The Senators provide other examples illustrating the distinction between capital and income:
Mr. CRAWFORD. I should like to ask the Senator if he seriously asserts that politicians have an income?
Mr. WILLIAMS. Well, after they get through with the year they have not much left. [Laughter]
Mr. BRANDEGEE. No net income.
Mr. WILLIAMS. But they have at least had a salary and an opportunity to have an income.
1913 Congressional Record, Vol L, Part 4 pg. 3838
This exchange makes little sense today, considering the way these terms are confused. Today, “salary” and “income” have become synonyms, whereas in the exchange above, the salary represents capital, and depending how that capital might be invested, would give a Senator the opportunity to have an income. The salary is not income. This observation from Senator Lodge is similar:
Of course the men of small earnings and small incomes pay taxes to the Government of the United States in the indirect form.
1913 Congressional Record, Vol L, Part 4 pg 3839
Here is another example of how the proper distinction in terms has been obliterated. As in the previous example, “earnings” and “incomes” have also become synonyms although, according to truth and substance, “earnings” are capital, not income. These examples illustrate that a salary and earnings are financial gains that are separate and distinct from an income.
The conversion of capital into money
Life and labor are a person’s most valuable capital assets. The Supreme Court has recognized the distinction between “income” and the conversion of capital into money. In Doyle, the Court observed:
Starting from this point, the learned Solicitor General has submitted an elaborate argument in behalf of the government, based in part upon theoretical definitions of “capital,” “income,” “profits,” etc., and in part upon expressions quoted from our opinions in Flint v. Stone Tracy Co., and Anderson v. Forty-Two Broadway, with the object of showing that a conversion of capital into money always produces income, and that, for the purposes of the present case, the words “gross income” are equivalent to “gross receipts,”
U. S. Supreme Court, Doyle v. Mitchell Bros (1918)
“Gross income” is NOT equivalent to “gross receipts.” The Court reminded the government that:
Income may be defined as the gain derived from capital, from labor, or from both combined.” Understanding the term in this natural and obvious sense, it cannot be said that a conversion of capital assets invariably produces income
U. S. Supreme Court, Doyle v. Mitchell Bros (1918)
When a capital asset is converted into money, the money remains a capital asset:
When the act took effect, Appellant’s timber lands, with whatever value they then possessed, were a part of its capital assets, and a subsequent change of form by conversion into money did not change the essence.
U. S. Supreme Court, Doyle v. Mitchell Bros (1918)
The timber is a capital asset and when it is converted into money the essence isn’t changed and therefore the money is also a capital asset. In Stratton’s Independence v. Howbert (231 U.S. 399, 1913) the Court observed:
The sale outright of a mining property might be fairly described as a mere conversion of the capital from land into money
The conversion of capital into money might produce income if there is a valid gain however, the mere conversion of capital is not income:
Yet it is plain, we think, by the true intent and meaning of the act, the entire proceeds of a mere conversion of capital assets were not to be treated as income
U. S. Supreme Court, Doyle v. Mitchell Bros (1918)
The principles expressed above are applicable to all capital assets, including one’s own labor. When labor is converted into money, the money is likewise capital. Abraham Lincoln, in his First Annual Message to Congress, observed:
Labor is prior to and independent of capital. Capital is only the fruit of labor, and could never have existed if labor had not first existed.
Abraham Lincoln, First Annual Message Dec 2, 1861
References stating that capital is the fruit of one’s labor are being edited out of existence to support the false government narrative that all earnings are “income.” Financial capital is the fruit of one’s labor and usually comes in the form of a paycheck. At the end of a work week, 40 hours of life’s capital has been exhausted and in exchange, one receives 40 hours of financial capital. The paycheck restores capital so at the end of the week, one has the same amount of capital as at the beginning. The capital is merely in a different form and the “change of form by conversion into money did not change the essence”: When life and labor are converted into money, the money remains capital. Employment earnings are the “entire proceeds of a mere conversion of capital” from labor into money and are in no true sense income. In a practical sense, if investment earnings are income and employment earnings are also income, then there is no capital in personal finance, and this would be financially and constitutionally absurd. Describing employment earnings as “earned income” is an attempt to obliterate all the distinction between income and principal.
The Supreme Court affirmed that a person’s labor is property. In Butcher’s Union v. Crescent City Co. (1884), it said:
The property which every man has in his own labor, as it is the original foundation of all other property, so it is the most sacred and inviolable.
Supreme Court, Butcher’s Union v. Crescent City Co. (1884)
Capital is a financial gain that comes from one’s own labor. Any job, any trade any profession or occupation whatsoever is a source of capital. The money a person earns from their own labor, whether that means cutting grass or throwing touchdowns, is always capital.
All money by default is capital. Money in your wallet is capital. Money in your bank account is capital. Money in your employer’s bank account is capital. And, the change rolling around under your car seat is capital. When people pass money around, they pass around capital. While capital has many forms such as land, tools, factories, roads, et al., capital in the form of money is the most basic form of capital used by people everyday.
What is income?
Income is a financial gain that comes from investment. Income is the “gain derived from capital,” it cannot be the capital itself. One must invest capital to receive an income.
The Supreme Court’s oft quoted definition of “income” is:
“Income may be defined as the gain derived from capital, from labor, or from both combined,” provided it be understood to include profit gained through a sale or conversion of capital assets.
U. S. Supreme Court, Eisner v. Macomber (1920)
This definition describes an investment gain:
- The gain derived from capital is an investment gain.
- The gain derived from labor is an investment gain.
- The profit gained through sale or conversion of capital assets is an investment gain.
The Court rebuked the government for trying to expand the meaning of “income” to include any financial “gain:”
The government, although basing its argument upon the definition as quoted, placed chief emphasis upon the word “gain,”which was extended to include a variety of meanings; while the significance of the next three words was either overlooked or misconceived. “Derived from capital”; “the gain derived from capital,” etc. Here, we have the essential matter; not a gain accruing to capital; not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property severed from the capital.
U. S. Supreme Court, Eisner v. Macomber (1920)
Adopting a variety of meanings for “gain” in an attempt to tax capital as if it were income is not new because revenue agents have been in the business of confusing these ideas since at least Eisner. The government does the same thing today as it tries to tax any financial “gain” as income. “The gain derived from capital” is the essential matter when identifying a gain that qualifies as income. This whole definition is describing a gain “in the investment” not a gain from one’s own labor, which is the capital itself. The gain from capital, the gain from labor or the gain from the conversion of an asset is measured against the invested capital. This is how income is derived from capital. Income is not any financial “gain,” income is specifically the “gain derived from capital.” There can be no gain derived from capital, labor or both combined without first investing capital and then severing the gain from the invested capital. Without capital there can be no income. Income is an investment gain.
This explains why the income tax was almost exclusively associated with taxing the rich back in 1913. In those days, only the rich had an income. Only the rich had passive earnings from investments. The working man does not have an income. The working man only has capital: Earnings from his own labor.
A Source of Capital
Income is derived from a source of capital; without capital there can be no income.
The Sixteenth Amendment:
Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
U. S. Constitution, Sixteenth Amendment
Income is derived from a source. The verb “derived” means to obtain from a parent substance. A thing is not derived from itself. Income cannot be derived from income. Section 61(a) of the Internal Revenue Code contains the same language:
General definition: except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:
Based on the sentence structure and meaning of the verb “derived” in the statute, there can be no “source of income” in a legal sense because income is derived from the source. The parent substance, the source, is capital. Thus, there is only a “source of capital.” If “source” meant “source of income” it would render 61(a) logically, grammatically, and economically absurd:
“Gross income means all income from whatever source [of income] derived…”
Income is not derived from income. Income is not derived form a source of income. Income is derived from capital, but the capital may originate from many different sources: Any job, any trade, any occupation, or profession whatsoever is a source of capital. Employment earnings are capital and capital must be invested to derive income. This is how income is derived from capital.
The statute must be read:
“Gross income means all income from whatever source [of capital] derived….”
The Sixteenth Amendment must be read:
Congress shall have power to lay and collect taxes on incomes, from whatever source [of capital] derived, without apportionment among the several States, and without regard to any census or enumeration.
U. S. Constitution, Sixteenth Amendment
“Source” = A source of capital.
Income and principal are two separate and distinct categories of financial gains. Some financial gains are capital and other financial gains are income. Capital is a financial gain that originates with one’s own labor and income is a financial gain that originates from investments (the “gain derived from capital”). The distinction must be strictly enforced because they are taxed differently: Income is subject to the Sixteenth Amendment, but capital is not.
Individual Income And Business Income Are Derived From Invested Capital
Capital is the fruit of labor and is usually received in the form of a paycheck. Once a person has acquired capital, it may be spent, it may be saved, or it may be invested. Invested capital produces income. The gain derived from an individual’s capital is individual income. The person who spends all of their capital and never saves or invests a dime, will NEVER have an income.
Business profits are the business’ organic source of capital. Debt and selling stock is not the only way to raise business capital. Business operations produce profits and those profits are the business’ increased capital. The business may spend that capital, save that capital or invest that capital. Invested capital produces income. The gain derived from business capital is business income. The invested capital belongs to the business and so does the income derived from it.
The Supreme Court reminds us that:
Manifestly this argument must be rejected, since the amendment applies to income only, and what is called the stockholder’s share in the accumulated profits of the company is capital, not income
U. S Supreme Court, Eisner v. Macomber (1920)
Accumulated profits are capital. If all those profits are consumed running the business by making improvements, buying new equipment or providing raises for employees and none of the profits are invested into a separate venture, then the business will NEVER have an income.
From this holding we can conclude: That the Supreme Court distinguishes between two types of money – capital and income; that the Sixteenth Amendment applies to income only; and that accumulated business profits are capital and not income.
Both business and individual income are derived from invested surplus capital.
Chicken or the Egg: Which Comes First, Capital Or Income?
We live in a capitalist economy and nothing happens without capital. Employment earnings are one’s source of capital, which can be spent, saved or invested. It is from invested capital that one derives income. The relationship between them is simple. This should be Basic Economics 101. It only becomes complicated when taxing authorities, through craft and subterfuge, attempt to tax capital as if it were income. There is a deliberate attempt to edit the idea of capital out of our personal finances. Income is the product of invested capital: Without capital there can be no income. If it’s a chicken or the egg argument, the capital must come first.
Using alternate terms to describe money adds confusion. Describing money using terms like: Wages, salaries, tips, commissions, rents, royalties, dividends, etc., obscures the distinction between capital and income. All money, regardless how else it may be described, must fit into one of these two categories. Every dollar that comes into one’s possession is either the “gain derived from capital,” or it is the capital itself. Money cannot be anything else. Don’t get lost in the abstraction: All of these terms describe either capital or income, and in the end they all mean money:
Americans have forgotten the difference between capital and income and the confusion is so extensive that many Americans might be surprised to learn that their personal finances include capital. The idea of capital in personal finance has been almost completely erased from from our collective conscience. And yet, without capital there can be no income.
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Summary
This page focuses on two main ideas: (1) Employment earnings and business profits are capital and (2) that capital must be invested to produce income. This page does not address how these separate financial gains are taxed as that will be discussed later.
- Income and principal are two separate categories of financial gain.
- Principal (or capital) is a financial gain that originates with labor. Earnings that are saved and not spent become principal.
- Capital can be spent, saved or invested.
- Income is a financial gain that comes from investment. Income is the “gain derived from capital,” it cannot be the capital itself.
- Earnings are capital. An individual must invest surplus capital to generate an income.
- Business profits are capital. A business must invest surplus capital to generate an income.
- The Sixteenth Amendment applies to income, it does not apply to capital.
- Income is a luxury. Nobody needs an income, but a person cannot survive without capital.