Variable life insurance and annuity contracts are susceptible to being marketed and sold to taxpayers for whom such contracts are unsuitable and to being used in wraparound insurance shelters. As a method of addressing these problems, I propose current taxation for the risky returns on these contracts but continued deferral for a deemed, risk-free return amount. The increased transparency resulting from the forced separate tax accounting of contract components should improve consumers' ability to receive adequate suitability evaluations and may also lead to lower fees. Current taxation of risk-related returns removes an apparently key shelter incentive and should make it possible to eliminate costs imposed as a result of the government's response to the wraparound shelter.
This last point requires further elaboration in light of the literature on the taxation of risk (Domar-Musgrave). This literature posits that, given certain preconditions, taxpayers effectively do not pay tax on risky returns under a normative, flat-rate income tax. Because of the problems associated with pinning down the real-world implications of Domar-Musgrave, using it to inform incremental reform proposals remains unusual. Yet, tax shelter reform seems particularly ripe for examination in light of Domar-Musgrave since shelters are generally marketed to the group of taxpayers most likely to be able to satisfy the preconditions necessary for the non-taxation of risk.
The details of my proposal are guided by the view that, to the extent possible, incremental reform should adhere to a normative income tax, which (in theory) would have the further effect of facilitating Domar-Musgrave results. The details of my proposal accommodate, however, a range of views as to the real-world implications of Domar-Musgrave. Thus, if one assumes that risky returns are meaningfully taxed under our current system, my proposal removes a shelter incentive - the promise of a lower tax on risky returns than that which is available outside variable insurance contracts. If, on the other hand, one assumes that risky returns are largely untaxed, my proposal provides a politically feasible way of removing unnecessary anti-shelter provisions while not substantially affecting taxpayers' ability to reach Domar-Musgrave results.
Charlene Luke, Taxing Risk: An Approach to Variable Insurance Reform, 55 Buff. L. Rev. 251 (2007), available at http://scholarship.law.ufl.edu/facultypub/335