Unexpectedly Intriguing!
May 21, 2008

Corner of IRS Form 1040 If you're a politician seeking to get campaign donations from a specific demographic group to give your constituents a break by lowering their income taxes, which method of doing so would you prefer to use: exempting a portion of their income from being taxed through deductions or providing tax credits to either lower taxes they pay or put money directly in their pockets?

Better yet, which method is more transparent?

Of course, if you're a politician, you're unlikely to care much about the issue of transparency in the tax code, because that would likely inconvenience you as you go about delivering those special benefits to those special people who make special contributions to you and perhaps your family members. But when choosing between using tax deductions and tax credits to do so, the answer is clear. It depends upon the incomes of the people to whom you intend to provide the tax break.

To understand why, let's turn to the U.S. Chamber of Commerce, who has considered the issue of whether tax credits or tax deductions are preferable where businesses are concerned:

When they're available, tax credits are generally better for you than deductions would be, because credits are subtracted directly from your tax bill. Deductions, in contrast, are subtracted from the income on which your tax bill is based.

So, a dollar's worth of tax credit reduces your tax bill by a dollar, but a dollar's worth of deductions lowers your tax bill by 35 cents if you're in the 35 percent bracket, by 33 cents if you're in a 33 percent bracket, etc. In cases where you have a choice between claiming a credit or a deduction for a particular expense, you're generally better off claiming the credit.

Going purely by the issue of transparency, tax credits beat tax deductions hands down. First, there's no question as to how they affect how much you'll pay in taxes, as the Chamber of Commerce example makes clear. Better still, if the tax credits reduce the amount of taxes you owe to the government below zero, you get to pocket the difference. There's no question as to how much they might impact how much you might pay in income taxes, and it's very easy to find out what you'll be compelled to pay to the government.

Another advantage is that they favor low income earners who would gain a larger percentage benefit than high income earners would from the same tax credit, which makes tax credits the vehicle of choice for the politician seeking the votes of those with low incomes. For example, for an individual making $25,000, a $2,500 tax credit represents 10% of their income. For an individual making $250,000, that percentage drops to just 1% of their income. Now, just consider how many people there are at each of these income levels, and you can see why a politician might favor tax credits as a means to attract the largest possible number of votes.

By contrast, tax deductions are anything but transparent. And with so many potential tax deductions, it's a miracle if anybody can figure out how much they might pay in income taxes in any given year before they take the time and effort needed to file their income tax returns.

We've provided an example of how the tax deduction racket works using the standard deduction of $5,350 for their 2007 income taxes, assuming an individual filing as either Single or Married filing separately. We'll assume that the amount by which an individual's taxable income is reduced is not enough to lower their income tax rate, which would provide an additional benefit for a very small number of people compared to the total pool of taxpayers:

Amount Income Taxes Are Reduced for 2007 Standard Deduction by Tax Bracket
Your Income Tax Rate [%] Amount Your Income Taxes Are Reduced [$USD]
10% 535.00
15% 802.50
25% 1337.50
28% 1498.00
33% 1765.50
35% 1872.50

This example demonstrates that even though the amount of the tax deduction (or rather, the amount of income exempted from being taxed) is the same, we find that the resulting outcome is somewhat less than transparent. Would you, for instance, have recognized that the same tax deduction would so strongly tilt in favor of those with the high incomes that correspond with the highest income tax rates?

Now, consider all the things for which itemized deductions exist. Things like the mortgage interest deduction. Or deductions for medical and dental expenses. Or moving expenses. Or shipping your car and your pets to your new home. Or any of these really weird deductions. Is it even possible to figure out how much you'll pay in income taxes before you do a mountain of paperwork?

Before you get really upset, let's also consider who's doing most of the income tax paying in the United States. Politicians have long recognized that if they want to keep getting the campaign contributions they require to keep getting elected, they need to keep their biggest donors happy. And that means cutting them special breaks. Why, if you believed the lobbyists for the National Association of Realtors, to cite just one example, special tax breaks are needed for new homeowners because, if they weren't provided, people will just pull up stakes and stop living in houses altogether!

Okay, that last example was a bit sarcastic, but really not that far off the truth. In reality, the only real reason these less-than-transparent tax breaks exist is because they were necessary to get high income earners to keep working hard enough to keep the tax money flowing in at levels that keep politicians in power. The money actually collected by the government is used to fund any number of government programs whose sole real purpose is to deliver the maximum number of votes possible to the politicians who fund them.

Ultimately, we have such high income tax rates on the highest income earners in the U.S. for the dual purpose of allowing politicians to exempt large portions of their special friends' incomes from taxation while making a large number of people dependent upon government-sponsored programs and benefits for their livelihoods feel good by making other people who make more money pay for them.

Wouldn't it just be nice to cut out all the noise?

Update: It does occur to us that there might be a situation in which a tax deduction might be fully transparent to all taxpayers. In the unique circumstance of a single flat rate income tax, a tax deduction exempting a specific amount of income for all taxpayers would qualify as being transparent. Then again, it would be no different from a tax credit equal to the amount of income exempted multiplied by the flat tax rate, so why not just call it that and be honest about it?!

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