A periodic blog dedicated to providing commentary and encouraging debate on topics in Economics and Finance.

About Me

Age: 26 Occupation: Private Equity

Tuesday, March 20, 2007

Deductive Reasoning - Tax Time

I had to change my layout to get this to fit! Don't be alarmed!


We'll employ a little reasoning on this post to understand how tax deductions benefit some more than others, and why, aside from business expenses, I believe we should switch to credits.


Our tax system is insanely complex for ordinary people to understand. Large corporations and wealthy individuals may have armies of lawyers and accountants whose sole purpose in life is to find the single combination of deductions and credits out of tens, hundreds or maybe thousands of combinations that results in the lowest tax liability. One estimate claims Americans spend as much as $350 billion each year filing personal and business income taxes. H&R Block alone collected $2.5 billion in tax preparation revenue in its last fiscal year.

The most widely misused and misunderstood creation of the tax code has to be the deduction. An overabundance of deductions is one reason why the code is so complex in the first place.

To be sure, tax deductions are a good thing for taxpayers. They get better and better the more money you make, as a matter of fact. What that means, however, is that the highest earners among us (who usually aren't the demographic that the deduction targets in the first place) benefit the most.

Further, because of the complexities of the tax code, many don't fully understand a deduction's effects, and stop at "it must be a good thing." What's more, slime balls who do understand the implications, and know that you don't, will take advantage the fact and will lead you to believe you're benefits are greater than they are. First, some basic math: a deduction of $1000 yields only $250 in tax benefits to someone in the 25% bracket. To get to the answer, simply multiply the deduction by the tax rate.

Now, we examine America's favorite deduction: Mortgage Interest - We're assuming that these five happy families pay exactly the same amount of mortgage interest each year (For simplicity's sake, I'm leaving out the AMT, but, with only the deductions mentioned, its effect isn't material to the discussion).












Average


Yuppy


Corporate


Big


Corporate


Joes


Puppies


Climbers


Timers


Executives

Family Income (Married):

$55,000.00


$110,000.00


$165,000.00


$220,000.00


$5,000,000.00

Tax Bracket

15.00%


25.00%


28.00%


33.00%


35.00%











Mortgage Interest

$12,000.00


$12,000.00


$12,000.00


$12,000.00


$12,000.00











Tax Savings:

$1,800.00


$3,000.00


$3,360.00


$3,960.00


$4,200.00


Why do the Corporate Execs get more than twice what the Average Joes get on the same amount of itnerest? Answer: Deductions benefit higher earners disproportionately.


Let's take this analysis one step further. In 2007, to be able to deduct mortgage interest, you have to give up the $10,700 standard deduction and itemize.


Average


Yuppy


Corporate


Big


Corporate


Joes


Puppies


Climbers


Timers


Executives

Family Income (Married):

$55,000.00


$110,000.00


$165,000.00


$220,000.00


$5,000,000.00

Tax Bracket

15.00%


25.00%


28.00%


33.00%


35.00%











Standard Deduction Given Up

$10,700.00


$10,700.00


$10,700.00


$10,700.00


$10,700.00











Taxes Savings You Give Up

$1,605.00


$2,675.00


$2,996.00


$3,531.00


$3,745.00











Actual Tax Benefit of Home Ownership

$195.00


$325.00


$364.00


$429.00


$455.00



Fortunately, the homeownership deduction is not as bleak as it looks - By itemizing, you get to deduct state & local taxes and property taxes that you wouldn't otherwise (and maybe a few other things, but those are the biggies for most of us.). Let's assume 5% state & local taxes and $2500 for Property Taxes. (Remember, Benefit = Deduction * Tax Rate).


Average


Yuppy


Corporate


Big


Corporate


Joes


Puppies


Climbers


Timers


Executives

Family Income (Married):

$55,000.00


$110,000.00


$165,000.00


$220,000.00


$5,000,000.00

Tax Bracket

15.00%


25.00%


28.00%


33.00%


35.00%











Actual Tax Benefit of Home Ownership

$195.00


$325.00


$364.00


$429.00


$455.00











Add: State & Local Tax Benefit

$412.50


$1,375.00


$2,310.00


$3,630.00


$87,500.00











Add: Property Tax Benefit

$375.00


$625.00


$700.00


$825.00


$875.00











Total Benefits From Itemization

$982.50


$2,325.00


$3,374.00


$4,884.00


$88,830.00



When it's all said & done, the Average Joes make out with just $1000 in tax savings (or about $80 per month), while the Corporate Execs save almost $90,000, almost twice what Average Joe makes in a year, before tax!. If we switched to CREDITS, which are based on what you spend, eliminated all deductions, which are based on what you make, and eliminated itemization altogether, you get a situation that's much more "on the level." Also, you get one that's much, much simpler, and less open to deception by those who stand to gain from our collective ignorance.


Average


Yuppy


Corporate


Big


Corporate


Joes


Puppies


Climbers


Timers


Executives

Family Income (Married):

$55,000.00


$110,000.00


$165,000.00


$220,000.00


$5,000,000.00











Mortgage Interest

$12,000.00


$12,000.00


$12,000.00


$12,000.00


$12,000.00

Tax Credit

15.00%


15.00%


15.00%


15.00%


15.00%











Total Tax Savings:

$1,800.00


$1,800.00


$1,800.00


$1,800.00


$1,800.00

This way, the Average Joe saves just as much as Bernnie Ebbers and the Enron Execs, we don't have to worry about "giving up" the standard deduction, and we probably spend less preparing our taxes.

Great Idea! Why don't we change it now! One thought to leave you with:

Where do you think the incomes of the folks who write the tax laws fall in our "spectrum" above? Do they have more in common with the Average Joes, or the Corporate Execs? Further, who funds their campaigns?

Hint Below....





To be fair, I can't blame them (the status quo would be just fine for me, too). They won't reform until we demand it, and, besides, what would the tax preparers do?

-eternitus

10 comments:

Lance said...

Eternitus,

Great analysis! You should link it to Bubble Meter. There's a common misconception out there that one "gives up" the standard deduction when the itemize when the truth is that the "standard" deduction is just meant to approximate all the itemized deductions otherwise available when one wouldn't be itemizing (i.e., listing") mortgage and other non-standard deductions anyway. As for your "unfairness" in how deductions benefit people paying taxes at different tax rates, you could do the same analysis to show the unfairness of progressive taxation in general. I.e., Why should those who earn more in total pay so so much more on their dollars earned than those who pay less ... 'cause in the end deductions are nothing more than an exemption from paying taxes otherwise due ... and the reasons some folks get such a higher deduction is because they pay such higher taxes to begin with. Now, an argument could be made for why elected officials should have it in their power to institute prohibitive tax rates in the first place ... and then say "but if you spend it how WE want you to spend it, you'll get some of it back ..." Is that really democratic?

eternitus said...

Lance,
Thanks for your comments... In Economics, there is usually a trade-off between fairness (if we can actually define it correctly... another issue altogether) and efficiency.
The tax law is a great example.

I personally believe that some graduated taxation is fair (I'll remember to post about this)... It has to do with the marginal utility (an econ term) of the dollar... but definitely beyond the scope of this reply.

When it's all said and done, doing a cost-benefit analysis, I believe a flat tax & credit system (vs. the current graduated tax, deduction and some credit system) to be the best balance of fairness and efficiency.

We can save billions each year in tax preparation (not to mention time spent filling out forms)... and auditing. Further, wealthy individuals can't easily "buy" an advantage over the less fortunate with a system that so cut-and-dry.

A problem, though, is that the tax system has turned into an industrial monster in its own right. A massive overhaul of the tax system would obviate thousands of jobs (they'd probably be put to more productive use elsewhere, though)... What's more, many people made fairly large purchases based on expected tax deductions... eliminating these (like the graduated mortgage int. deduction) would be tantamount to a "bait-and-switch..." those folks would get short end of the stick...probably shouldn't do that.

The best bet, in my humble opinion, is to grandfather in any historical purchase-related deductions (Say, giving the current tax treatment to all mortgages originated before 1/1/2008), and offer a simple credit going forward.

This issue isn't going away any time soon... but changes have been occuring slowly (shifting to credits)... I have a feeling more are on the way.

Lance said...
This comment has been removed by the author.
Lance said...

Eternitus,

Your solution does seem to make the tax system fairer all around AND at least in part addresses my concern that politicians have the power to say "okay, we'll impose an onerous tax burden on you ... but if you spend your money in the way we want, then your tax burden will instead be reasonable and in line with your ability to pay AND the marginal utility of those extra dollars you are earning. (That is because your proposal seems to provide more transparency to the whole system of tax collection and added transparency tends to reduce the possibility of coercion that the current system uses.)

Dskillz said...

Great post! Where do you get the time to write this? Hope you're not slacking off at work too much!

eternitus said...

Thanks, Skills. I won't tell your boss about your slacking, either!

Lance,
I'm not a big fan of the government telling us how to spend our money... free markets generally lead to efficient allocation of dollars, all else equal. We all know how applying any sort of tax burden screws things up, and eventually leads to a "deadweight loss" (and how "the law of unintended consequences" seems to take over...)

However, when a credit or deductions leads to a net benefit to society (like increased use of hybrid cars)... sometimes the market distortion is a good thing.

__k said...

That's an interesting idea. I do think that the tax code should be simpler in terms of the number of loopholes and credits/deductions, etc. But I'm not against deductions per se. Deductions do save wealthy people more, but that more comes in the form of a higher percentage of what they would be paying in taxes.

As for mortgage interest, I think that it would probably be best to eliminate the deduction altogether. The mortgage interest deduction rewards those who can afford to buy homes (the more expensive the houses they can afford, the greater the reward) with tax breaks, and that tax burden is shifted onto those who cannot buy homes. Besides, home ownership is already a financial advantage. Even now, at the top of the biggest housing bubble ever, in most parts of the country, buying a house now is still financially better than renting for the rest of one's life.

As for progressive taxation, here's something to consider. Is there a certain amount of income that should be tax-free? I like the idea that the amount of income required to survive be tax-free. Taxes would be paid on income above that level. But once that's done, you already have a progressive tax system -- there's a 0% (tax-free) bracket, and a non-tax-free bracket. Perhaps then, up to a poverty level, taxes would be lower than at higher levels; perhaps not. But by that point, the discussion already is only about how progressive the tax system would be.

Lance said...

Eternitus said:
"However, when a credit or deductions leads to a net benefit to society (like increased use of hybrid cars)... sometimes the market distortion is a good thing."

Well ... yes, and no. It seems that because of the tax benefits being granted to hybrid owners, some manufacturers have started using the technology to boost horsepower and not cut overall consumption. Additionally, I've read somewhere that if the government had NOT mandated lower "fleet" consumption starting in the '70s, supply and demand would have instead guided us to consuming less overall crude. I don't know the details of the argument ... but it's sounded like a credible one. I do agree though that there is no completely divorcing government from the interplay of supply and demand in many areas of the economy. Afterall, for example, it really is good public policy to encourage people to be homeowners vs. renters. Owners' have a greater incentive to (a) take care of where they live and (b) invest their time in their surrounding community ... etc.

MyTwoCents said...

Practically speaking, I think we need to have the government encourage behavior that is benefiscial to society. The government's tool for this encouragement is the tax system.

The government needs to encourage stable communities, and flexible markets. The government also needs to generate enough resources to do the jobs that a free market might not be inclined to do (or to do well at least).

A very convincing argument was put forth to me once before that as you earn more and more money/wealth, you consume increasingly more government resources. This then, supports the notion that a graduated tax system is fair.

For instance, if you're a high flying exec (literally) then you depend on the FAA to run an airline system. You depend on the oversight they provide in the manufacture of the components of that system. You even depend on the FCC regulating transmissions so those planes can safely communicate. Compare this to the local minimum wage laborer who at the most relies on the local transit system only.

Think about all of that wealth tied up in our financial systems. You now depend on SEC to keep those markets working transparently so you don't get ripped off. Versus the local laborer again who might not even use a local bank let alone care about what the SEC does.

The list of examples can go on and on but the point is, the government is needed to "keep the market honest" if not completely free, and a graduated tax burden can still be quite fair.

My $0.02.

max said...

Excellent analysis. One thing you hinted at, but didn't develop is that for most people the deductions are not as valuable as they think they are, or as valuable as the salesman made them out to be. It is a nearly unanimous opinion that the mortgage deduction is a big benefit of buying a house, but unless you have significant other deductions, the mortgage deduction will mostly disappear into the standard deduction, yielding minimum or no benefit. I write about this in my blog at www.personalfinance-guru.blogspot.com

Personal Finance Guru
www.personalfinance-guru.blogspot.com