The Economic Case Against Tax Deductions

Happy April 15th. As every American knows all too well, income tax returns and the payments associated with them are due today. There will be harried efforts to find long-forgotten receipts, frantic attempts to reconcile irreconcilable data - and long lines at the post office. 

The biggest source of all this drama are tax deductions. Or perhaps more accurately, the strenuous and often vain endeavor to qualify for deductions. As the following article explains, must of the exertion expended on behalf of the tax code is generated by the desire to lower tax burdens by playing the deduction game.

The game starts in Congress where varied interests vie for influence in getting their supporters' needs and desires written into the code. Once that happens, others ask, not unreasonably why they should not receive something similar by way of the authorities' largesse and forbearance.

The question that all of this frenzy raises is whether the outcome is worth the activity. From a resource allocation standpoint, it often appears that the US spends as time trying to navigate the tax code as it does actually creating wealth from innovation and enterprise. 1.2 million Americans earn their living as tax preparers. Whether that is a productive investment of education, time and money is an important issue. What if all those people were tasked, instead, to invent a product or service that would generate income and jobs or alleviate poverty?

We'll probably never know. Because we like the feeling that we're getting a bargain. That we've outsmarted the authorities. It's a game and we like playing it. But if we are really serious about getting value for cost, we have to ask ourselves why we can not find more efficient and beneficial uses for our resources. JL

Charles Kenny comments in Business Week:

Current U.S. tax law features 72,000 pages, which is a big reason why the country has  1.2 million professional tax preparers. What makes the tax system complicated isn’t marginal rates—as flat taxers claim—but all the deductions and exemptions
As millions of exhausted Americans scramble to the mailbox with bulging envelopes or click send on multimegabyte files of scanned pages, many will curse a system that seems designed to drive the honest taxpayer to despair. As it does every year, the experience will inevitably boost calls for a flat tax, with its promise of a pain-free April 15—involving one simple calculation and done. A survey by Rasmussen soon after tax day in 2012 suggested that a majority supports a system in which “everyone pays the same percentage of their income in taxes.”
The tax code asks taxpayers to distinguish between farm vs. non-farm income, our earnings as a minister on Sunday as opposed to what we make reading tarot cards during the week, our conservation reserve payments vs. what we spent on mining and intangible drilling costs. Each can be taxed differently or, if we’re lucky, deducted altogether. Yet there’s little economic rationale for any of them.
Take one particular set of calculations—Schedule A itemized deductions. Most appear designed largely to lower the effective marginal rate on the rich, subsidize McMansion construction, and support gifts to Harvard. In 2010, the IRS reports (PDF) that itemized deductions totaled $1.2 trillion dollars—compared with total nationwide adjusted gross incomes of $8.1 trillion. The two biggest sources of deductions were taxes (mostly state, local, and real estate) totaling $445 billion and interest (nearly all on home mortgages) totaling $414 billion. Third on the list were charitable contributions, at $170 billion worth of deductions.
What is the rationale for these deductions? Many analysts suggest that if the charitable deduction were removed, people would give less to charity—perhaps even by as much as their tax bills would rise (PDF). Whether you think this would be a bad thing for the economy and society depends on your relative faith in government and nonprofit organizations to deliver public services. It also depends on how much of that charitable giving is going toward “public services.” After all, charities that “help people in need” account for only about 10 percent (PDF) of total charitable contributions. Health and education combined account for another 10 percent.
The charitable-giving deduction also favors the causes of the stingy rich over the generous poor. Households with incomes between $20,000 and 40,000 give 5 percent of their income to charity, but most get no tax deduction (and very few indeed will get their name on a building or invitations to a black-tie dinner as a result). Households with incomes of $75,000 and above are far more likely to get a tax break. Yet they give away only about 2 percent to 3 percent of their income. The rich also give differently. According to the Congressional Budget Office, households on less than $100,000 a year give 10 percent of their funds to charities designed to provide basic needs and 1 percent to the arts. Households with incomes of more than $1 million give 4 percent to basic-needs charities and 10 percent to the arts.
As that suggests, many of those who get the biggest tax writeoffs from charitable donations aren’t spending their money in a way that benefits the rest of us all that much. According to data from the Chronicle of Philanthropy in 2012, excluding gifts to foundations, there were 14 individual charitable donations worth $50 million or more. Ten of those gifts went to schools, colleges, and universities. Columbia University got the second-largest single donation, and Oxford University was on the list, too—but community colleges, not so much. The other four biggest gifts were to the Allen Institute for Brain Science, the Metropolitan Museum of Art, the Central Park Conservancy, and the New York City Fieldhouse.
As the names imply, if you want to be a beneficiary of large-scale, taxpayer-supported charitable largess, its best to live in New York City —which attracted 40 percent of the value of all $50-million plus donations in 2012. Best of all, if you live somewhere near the top end of Central Park, you’ll be within a mile of four of the seven biggest recipients of donations in 2012, worth half a billion dollars combined. The denizens of upper Manhattan benefit hugely from tax deductible donations. You live in rural Pennsylvania or New Mexico? Tough luck.

The tax deduction for mortgage interest is also a monument to complexity, mis-targeting, and questionable public benefit. Edward Glaeser and Jessie Shapiro point out that there may be social benefits to homeownership—including better maintenance of the housing stock. But there are also downsides—owners are more likely to resist neighborhood racial integration, for example. Either way, Glaeser and Shapiro find that mortgage-interest tax relief benefits wealthy people who would own houses regardless. Perhaps unsurprisingly, the two researchers can’t find any impact of the deduction on actual levels of homeownership. Research does suggest, however, that people who get the deduction buy houses that are 10 percent to 20 percent bigger (PDF) than they would buy otherwise. And that comes with associated costs of longer commute times and environmental harm for everyone else. The deduction on real estate taxes doubtless has the same effect.
If the evidence linking the big Schedule A deductions with a stronger economy or better society is weak, the evidence linking them to a reduced tax burden on richer Americans is very, very strong. The median adjusted gross income in the U.S. is around $34,000. About half of all home mortgage interest deduction payments go to households earning $100,000 or more (or about three times the median income). And nearly two-thirds of the charitable contribution deductions and three-quarters of the deductions for state, local, and real estate taxes go to households earning more than $100,000.
Just like the major Schedule A deductions, most of the thousands of other tweaks to the tax code reflect the influence of special interests—whether they be rich people, the Metropolitan Museum, or the National Association of Homebuilders—rather than rational economic or social policymaking. And it has created one other group that benefits from a miserable tax day—the army of attorneys, tax preparers, and tax software creators who hunt for deductions and exemptions on our behalf. These people create a strong lobby against efforts to simplify the tax code and the tax filing system—including the idea of the IRS preparing a draft return that you could simply accept or amend as necessary.
Remove all the deductions and exemptions, and you’d be able to reduce top tax rates, reverse the impact of the sequester, or draw down the deficit—all at once. You’d also considerably reduce the angst of tax day for millions of Americans and even allow for a downsizing of the IRS and the tax industry itself. On April 15, surely that should be an idea with immense political appeal.