The Misunderstandings of Tax Breaks

Author: Vale

IRS1040There are three major misunderstandings of tax breaks in this country. The first is that that many people think that the "the system is rigged for the wealthy" because "...most federal subsidies aimed at building wealth, such as certain tax deductions,.. credits, and preferential rates, go to the richest taxpayers."

Second, that if all the tax breaks were removed from the system that the government would capture the 'face' value of those breaks. And finally, that all tax breaks are equivalent to the government just handing out checks.

  • Terminology

And is it a tax deduction or a tax expenditure? The framing of the word choice really depends on what message one is trying to convey. The IRS calls them deductions, but those with an agenda call them expenditures. The word expenditure is a complete misnomer because phantom government income is not real spending. The implication is that the government is giving away free money, but in reality, it is more akin to buying a product on sale. Money is still accruing to the government, but less than the "full price." One does not just get a check from the government for nothing (well, many lower income people do, but that is another issue). And sometimes individuals will refer to tax deductions as 'loopholes.' This word choice is purely a dysphemism lending the implication that one is somehow cheating the system, but doing it legally through some sort of convoluted tax dodge structure.

  • The Reality

However, these misunderstandings are inaccurate in a number of ways. The first is that tax deductions are generally not designed to build wealth, but they can help by indirectly saving money on one's tax bill, especially if one would be doing the activity that qualifies for the break regardless of the tax incentives (such as buying a house). But on the contrary, the higher the level of income that one obtains, the fewer the number of deductions one is generally able to claim and the more likely that one is subject to the AMT, which imposes a minimum tax bill. For instance, a deduction for an IRA contribution, qualifying for Pell Grants, and student loan interest deductions are only available to those making less than $60,000 a year and retirement tax savings for a 401(k) are phased out after earning $255,000 per year (and even then, that money is taxed later when taken from the account). The most significant "tax break" that one can claim regardless of income level is the long-term capital gains rate and qualified dividend income that is discussed below (which were both just chopped down slightly in the new Fiscal Cliff Deal for those earning above $400,000 a year).

  • Phantom Value

Articles come out all the time campaigning about how much extra revenue the government could receive if it would just get rid of all the "tax expenditures." One recently put the figure at $1.1 trillion. But a key point these media authors are missing is that some of this economic activity would not take place without the deduction (or preferential rate) available, so it is incorrect as the media often does, to assume that removing the break would capture all of the tax revenue theoretically there. There are interaction effects. By making an activity cheaper, it is increasing economic activity in it. The amount captured would be significantly less than $1.1 trillion if all breaks were removed and removing some long-standing pillars could send shock waves through the economy sending some industries into a tailspin. Doesn't anyone ever ask that if the government really thought it could get the full face value of the breaks, why were they put there in the first place? Keep reading.

  • Why They Exist

The government put tax deductions into the tax code on purpose and one actually has to do the activity that the tax deduction is trying to encourage the populous to do. Tax deductions are written into the tax code for all kinds of activities to encourage behavior through social engineering. If the deduction is being claimed, then the intended policy is working. One should not be chastised for following the incentives that the government placed there in the first place. Furthermore, to claim a tax deduction (unlike tax credits), one has to actually have income and be paying taxes in order to be able to deduct something. Since the size of the break will be proportionate to the investment or activity, which will then be proportionate to wealth and income, it is obvious that wealthier people will be able to use more of a deduction than less wealthy people. They are the ones with the capital to take advantage of all the breaks available to them. But you must understand that this doesn't mean that these wealthier people following the tax code to maximize their deductions aren't paying less taxes than the less wealthy people just because they are getting bigger refunds. Remember that this refund is the taxpayer's own income being paid back to him or her.

  • Comparison

To put the deduction sizing into perspective, let's look at an example: If a wealthy person and an middle class person both mortgage houses at what they can afford, and the less wealthy person spends $150,000, but the wealthier person spends $5,000,000, clearly the wealthier person will be paying more mortgage interest and is going to claim a larger mortgage interest deduction and higher property depreciation than the other person. This should not be a newsflash to anyone. But when the raw numbers are compared side-by-side where the wealthier person was able to deduct $50,000 but the middle class person was able to deduct only $4,000, for example, some people feel that it is unfair that the size of the tax deduction is larger for the wealthier person. But this is just simple math that is being ignored. Usually the end of the story is that income group A was able to deduct X dollars but income group B was only able to deduct Y dollars (with X >> Y). These people suddenly forget about the other side of the coin relating to the higher income group's much greater tax burden. They never juxtapose the $200,000 in total taxes that the wealthier person paid to the $3,000 in total taxes paid by the middle class person.  

  • Rate Wars

Also, many media commentators refer to "preferential rates for the rich," but it is a misleading claim since everyone has access to the same tax breaks. What they are omitting is the long term capital gains rate and dividend rate for investment income that is taxed at a lower rate (for many reasons, see below). It is just that the higher one's income is, the more likely that most of that income is from investment income, not from ordinary income, since there aren't many jobs out there paying millions of dollars a year. The real comparison is not some very successful property developer against an average middle income class American, but instead against CEOs, actors, and athletes, who are making millions of dollars in ordinary income. The dispersion of average tax rates among middle income Americans is high since many people have jobs and many people live off small investment portfolios, but the dispersion is low on the top end since most of that income is obtained through investment income.

  • Purpose

Why does a long term capital gains rate exist (qualified dividend rates exist for similar reasons but with the additional reason of having been taxed at the corporate level)?

  • Risk
  • Inflation
  • Encourages saving and investment
  • Increases liquidity of capital

Most importantly, investments involve an aspect of risk where one can can lose money, which is different from the no risk endeavor of showing up for work and collecting a paycheck. Yes, you can get fired, but on days where you aren't, you are going to get paid and you know up front what that amount will be. When you invest, you don't know if it will even work out, let alone what return you will get. But this risk taking leads to innovation and new products, which improves quality of life for all. Moreover, if one is investing in a business, usually that venture creates jobs for other people, which is an activity that should be encouraged.

Many investments don't pay out for years and inflation will eat away the value of the original principal. The gain is not indexed to the rate of inflation, so the true gain will be substantially less than the 'paper' gain that will have to be reported to the tax authorities. An investment spanning a decade can easily lose a third of its value, so a 50% paper gain, will actually not be a true purchasing power gain at all, but it will be treated as such. The after tax real loss would be 5% versus 10% for the 15% and 30% hypothetical rates, respectively.

Investors have to face the tradeoff of consuming today or saving and having more for consumption later. Encouraging the populous to make the responsible choice to save for their future should be encouraged. As it stands now, one is penalized for saving for the future because they can instead spend all their money today and enjoy it now without penalty*. It shouldn't be a shocker that our country has a low savings rate.

Long-term capital gains rates increase liquidity of capital. Sometimes the gain of an investment can be substantial after holding for decades (such as a house), which means that if the individual sells, they will create a taxable event. With higher tax rates, this individual may not want to sell and put this capital to use somewhere else because the larger tax burden might not make the proposed venture worth it. If the individual never sells because of the cost of selling, fewer additional ventures get funded which could be preventing multiples of that tax money from accruing to the government, and heirs get a stepped up basis on the asset value upon death, so that tax money would be lost forever anyway.

  • Take Away

Instead of arguing for higher long term capital gains rates, why don't people unsatisfied with the current system instead argue for a low flat rate that matches the long term capital gains rate for all types of income? Instead of trying to punish some people, why not reward all people?


*While one usually does pay sales tax on purchases, this is at the state level, not every state has one and every state's sales tax is lower than the the capital gains tax that the federal government and states collect.


# Frov 2013-09-16 13:29
I see this is quite old, but there's a point I'd like to make, and that is that they say that tax deductions or credits are there to inventive certain behavior or purchases, like you also do. However, a great majority of people do not calculate their taxes for the year ahead of time. That being said, they don't decide to purchase a house of X dollars because they'll pay Y interest that will go on Sch A along with the prop taxes and their unreimbursed employee expenses and if they break over 7.5% of AGI for medical expenses (this on is clearly not one to incentivize anything). In fact, loan officers who tell the lie "you can deduct the interest on your mortgage" should be fined or fired for fraud, because that statement is patently false, because they don't do an analysis of your taxes to see if you actually will be able to itemize on Sch A or not. They should say "it MAY be deductable based on a number of factors".

Furthermore, I also don't know anyone who has a child to get the $1k credit (not including the exemption in this because every living person gets an exemption, though it may not always be claimed).

Most people just come in (I'm a tax preparer) and hand me their W2s and wait until I tell them how much they get back. Some even hand it over and ask "how much I get for this?", while others tell me I don't know what I'm doing when they end up owing or get next to nothing back. This is mostly thanks to H&R and their lying signs that say "get your refund here", not everyone gets a refund.

I'm in favor of a flat tax, or even still a much tighter progressive tax, but one where fair is fair. No deductions or credits for buying a house or paying interest or taxes on it, no credits for children (exemption would probably be ok) including Dep Car Exp credit (again, no one ever factors in what their credit will be ahead of time to determine if it's "worth it" to work, their budget, if they have one, determines that), no MFJ (and yes, I'm married with a child). Basically, throw out Sch A and most the credits, ESPECIALLY EITC.
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# Vale 2013-09-22 13:38
Yes, I agree with you that the average American doesn't do any analysis for tax deductions, but I suspect wealthier investors do run the numbers. To your point, only about 25% of tax filers even claim the mortgage interest deduction. Most people don't even qualify unless they are already paying high state and local taxes which brings their total deductions above the standard deduction. With a flat tax, deductions or special rates would not be be necessary because incentives would not be skewed like they are now. The only reason why tax breaks even exist now is because the tax rate structure is so progressive and the government/lobb yists put them in to manipulate behavior.
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# carrytrade 2013-01-14 11:05
I always thought that was silly how some people will say something like "The rich got an average tax break of $5,000, but I only got $100! All the tax breaks go to the rich!" Such a complainer conveniently forgets that the rich paid $100,000 in taxes, while he only paid $2,000. 5% is 5%.
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