Kleinwachter's conundrum refers to a hypothetical posed by Friedrich Kleinwächter which illustrates how difficult it would be to construct an income tax that could equitably tax gains from consumption, given that employees have different working conditions and personal preferences.
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The Conundrum
Kleinwachter's conundrum imagines two equally salaried employees: an ordinary military officer and a flugeladjutant (a regimental aide-de-camp) to the sovereign. First, imagine that the flugeladjutant "receives quarters in the palace, food at the royal table, servants, and horses for sport. He accompanies the prince to theatre and opera, and, in general, lives royally at no expense to himself and is able to save generously from his salary." To complicate this problem, suppose further that the flugeladjutant detests opera and hunting. How, Kleinwachter asks, can they be equitably taxed?
Revived by Henry Simons
The conundrum was popularized by Henry Simons, who mentioned it in his tax treatise, Personal Income Taxation. In illustrating this point, Simons referred to this one of several hypotheticals posed by Kleinwachter.
Consequences for tax policy
Simons laments that the problem this example poses to equitable taxation "is clearly hopeless": To omit all compensation in kind is clearly inappropriate. On the other hand, to include the perquisites implies that all income should be measured with regard for the subjective relative pleasureableness of diverse activities—the negation of measurement.
Because it is difficult to measure actual utility from personal consumption (which includes in-kind benefits consumed by employees, but also leisure time, and the imputed income from self-performed services and ownership of consumer durables) policy seeks to sensibly and fairly delimit the concept of income in the context of the taxation of in-kinds benefits by developing guidelines that balance equity, neutrality, and administrability.