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In Case It Isn’t Obvious, A Primer On Tax Deductions Versus Tax Credits…

August 8th, 2016 · 4 Comments
Income Distribution · Policy · Taxes

I’ve been doing my taxes myself for a while now, and, thankfully, I am not old enough to have had to file any complicated returns before the advent of online tax preparation systems. That said, tax calculations are complicated enough that there were a number of things that caught me by surprise. For example, I remember my inner monologue that first time…

H&R Block: Would you like to take the standard deduction, itemize your deductions, or calculate both to see which is better?
Me: Why wouldn’t I want to figure out what is optimal? Duh…
H&R Block: *asks for tax deduction info*
Me: *enters tax deduction info*
H&R Block: Based on what you’ve entered, you should take the standard deduction?
Me: WTF is the standard deduction and why did it make all of my charitable giving (like, all $100 of it, people) irrelevant?

By now, my older and wiser self knows what the deal is…most basically, I now get that the tax system offers a “standard deduction” that you can take so that you don’t have to bother with the hassle of entering all of the tax deductible stuff you did over the course of the year. (Similarly, the standard deduction makes things easier for the IRS since there’s no verification to be done.) That sounds fine on the surface, but wait- isn’t there the unintended consequence that the first $X of my tax deductible stuff doesn’t actually help me in terms of lowering tax liability, where X is the amount of the standard deduction? Yup, since the actual choice isn’t between “itemized deductions” and “no deductions” but instead “itemized deductions” and “standard deduction.”

Obviously my next step was to look up how large the standard deduction is in order to determine how annoyed to be. It was a bit lower at the time, but the standard deduction is currently $6,300 for single filers or married couples filing separately, $9,250 for head-of-household filers, and $12,600 for married couples filing jointly. Wait what? What sort of mythical creature has more than $6,300 in tax deductible stuff? (said my 21-year-old self) More importantly, why wasn’t I aware of this when I gladly signed up for a recurring donation to the Human Rights Campaign on the grounds that the tax deduction would basically make it a wash in terms of disposable income? (yeah, I now know that’s incorrect on multiple levels) Or, perhaps more significantly, why wasn’t I bludgeoned over the head with this information when I signed up for a student loan? (For the record, no one told me about the income limits for student loan interest to be tax deductible either, but that’s for another post.)

The point that I’m trying to make here is twofold. First, making expenditures tax deductible is one of those things that sounds nice in theory (since it sounds like a subsidy or discount of some sort) but that likely doesn’t actually impact the bottom line of many households because of the standard deduction situation. Furthermore, even when they do matter- my mortgage interest, for example (since I’m totally a grownup now)- it’s only the amount above and beyond the standard deduction that affects a household’s bottom line. Second, tax deductions are kind of insidious because people don’t seem to fully think through the standard deduction issue when deciding whether to undertake their tax deductible activities. For example, I remember being presented with some sort of “rent vs. buy” real estate calculator a number of years ago, and it definitely didn’t take the standard deduction consideration into account. As a result, many households are likely underestimating the real cost of the “tax deductible” opportunities they are presented with, which leads to distortions in consumption of these opportunities.

But wait, I’m not done ranting about tax deductions…to see why, let’s take a quick tax deduction quiz:

Q: You just donated $100 to the Human Rights Campaign. This contribution is tax deductible. What is the effective cost to you of this contribution?

A: This is a trick question on multiple levels. First, as noted above, your effective cost is $100 if the contribution doesn’t put the total of your tax deductible expenditures above the standard deduction. So let’s assume for the sake of argument that there is no standard deduction and, for simplicity, that this $100 is your only tax deductible expenditure (you scrooge). You still can’t answer this question without looking at how much money you make! This is because tax deductions reduce the amount of income that is taxable, so your discount is equal the amount of taxes that you would have paid on the $100 you contributed. With a progressive tax system, the amount of taxes you would have paid on the $100 depends on how much money you make overall. So let’s take a look at some marginal tax rates (assuming you’re single, but you can see the complete set of numbers here):

  • 10% for income $0 to $9,275
  • 15% for income $9,275 to $37,650
  • 25% for income $37,650 to $91,150
  • 28% for income $91,150 to $190,150
  • 33% for income $190,150 to $413,350
  • 35% for income $413,350 to $415,050
  • 39.6% for income $415,050+

If you make $50,000 per year, you’re paying a 25% tax rate on your last $100 of income. If this $100 is tax deductible, your taxable income goes down to $49,900 and you avoid $25 of taxes. In this case, your $100 contribution effectively cost you $75.

Now let’s see what happens if you were to make $300,000 per year. (Lucky you! Also, Why didn’t you donate more than $100?) In this scenario, you’re paying a 33% tax rate on your last $100 of income. If this $100 is tax deductible, your taxable income goes down to $299,900 and you avoid $33 of taxes. In this case, your $100 contribution effectively cost you $67.

This simple illustration shows how making expenditures tax deductible provides bigger subsidies to higher-income households than to lower-income households. (Not surprisingly, some expenditures are only tax deductible for households making below a certain amount, which puts the bias in the other direction.) Put this together with the observation that lower-income households are less likely to even clear the standard deduction in the first place and it becomes clear that making expenditures tax deductible disproportionately helps higher-income households. I guess what I’m saying is that I want you to come back and read this every time you hear a politician suggesting making an expenditure tax deductible in order to provide relief to income-strapped households.

So…is there a better way? If by “better” we mean “impacts all households equally,” then yeah, probably, and it’s called a tax credit. Tax credits are importantly different from tax deductions in that they operate to lower taxes directly rather than lowering the amount of taxable income. For example, if a 25% tax credit were given for donations to the Human Rights Campaign, then the $100 donation in the example above would result in a $25 reduction in taxes owed for every household that makes such a contribution.

I get that the details of taxes are boring- I mean, this is basically the stuff that accountant jokes are made of. But it’s so important to get right- tax deductions and tax credits are used not only to provide income relief but also to change incentives, and it’s really hard to respond optimally to incentives when you don’t fully get how the incentives offered affect you and your financial situation. In a more general sense, you want to understand how the policies that politicians propose actually affect households so that you know what you’re voting for.

In related news, for example, here are two proposals for easing the burden of child-care costs. You now have the tools you need to think about where the benefits of the policies go, which is good since I sure don’t trust politicians to provide this information themselves in an unbiased fashion.

Tags: Income Distribution · Policy · Taxes

4 responses so far ↓

  • 1 Zechariah G Munford // Aug 8, 2016 at 5:35 pm

    Thanks. Love reading your articles

  • 2 mike // Aug 8, 2016 at 10:52 pm

    to make even more complicated you have to decide if said tax credit is refundable.. and up to / including what limits. In many cases those who make under 30-40k wouldn’t benefit from child care tax credit unless its refundable due to standard deduction, multiple personal exemptions and the general child tax credit etc.

  • 3 J. Edgar Mihelic // Aug 9, 2016 at 4:08 pm

    Accountants are super interesting.
    For example, we just repainted our living room.
    And instead of going with beige, we went with Desert Sand for the main walls. Don’t tell me we don’t know how to live.

  • 4 Um // Aug 13, 2016 at 11:56 am

    I don’t think politicians necessarily know what they mean by ” tax deduction.” Anyway, it makes sense that deductions for charitable contributions would redound to wealthier people, because they are designed to be redistribution. Why would we want the tax effect of a charitable deduction to “impact all households equally?” Isn’t the more important question whether the distributional effect of charitable deductions targets those who need it the most?

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