Thursday, December 15, 2011

Deductions versus Credits, Part IV

Tax Credits are like crack cocaine - and about as addictive!

4.  Tax Credits

Tax Credits are a whole different beast than tax deductions.  While a deduction might deduct an expense from your income - or allow you to not pay tax on an expense - a tax credit pays you directly to do something.

And like deductions, tax credits can go horribly wrong, if the people who create the incentives fail to realize how they will pan out.

In any gaming system, you can set up a set of rules and people can play the game and be score by how well they play.  But a few wily people will look at the rules and realize that you can "game the system" instead of playing the game, and end up making more points. Whether it is tax law, the production quota at the Patent Office, or a coupon discount program at the grocery store, there will always be people who try to "beat the system".

And since tax credits are so lucrative, people look to them first for ways to "win".

For example, until recently, the tax code gave you a $5000 tax credit toward buying an electric car.  And by that, it meant that your tax bill will be reduced by $5000, period.  No deduction, just a pure credit, dollar for dollar.  And if your tax bill was less than $5000?  In many cases, you might get paid back, in cash!

The problem is, people realized the definition of "electric car" was pretty vague.  A so-called "Neighborhood Electric Vehicle" (NEV) could be made from a golf cart, by changing the gearing, adding seat belts and turn signals and putting a horn on it.  Voila!  You've got an "electric car" that costs $5000.

So, not  surprisingly, some clever folks set up websites advertising "free electric cars!" that cost $5000.  You buy one, and you take the tax credit in April, and you knock $5000 off your taxes.  The government has, effectively, bought you a free golf cart.

Of course, they closed that loophole quickly, and today, the tax credit for NEVs is only a percentage of the sales price.  For electric cars, there is still a big tax credit, but those cars (the Nissan Leaf, Chevy Volt) cost $30,000 or more - often far more.  No free cars, just a discount on the price.

And of course, this tax credit means that Uncle Sam does not collect as much money on the flip side.  So our tax revenues go down.  In effect, the government is giving away money to people who build wind turbines, buy electric cars, or whatever cause du jour is popular.

A while back, this included "alternative fuel vehicles" which included diesel cars - which the rest of the world hardly considers "alternative".  A friend of mine in Arizona told me about the deal back then  - you buy a 6,000 lb GVW Suburban Diesel, get  tax credit, expense out the cost on your taxes as a business vehicle, and then get a second tax credit from the State of Arizona.  When it was all said and done, it was like getting a free Suburban.  Needless to say, they closed down this deal, as well.

But it does illustrate the problem with the tax code - and why some automakers, such as BMW are still making gas-hog cars like the BMW X6 - as up to $25,000 of the cost of such vehicles can be expensed out, rather than depreciated under section 179.

So we have cars that are gas hogs, designed to the specifications of the tax code, instead of engineering standards.  Talk about unintended consequences!

Are tax credits right or wrong?  Like so much of this discussion, it depends on your point of view, your politics, and whether you stand to benefit from such deductions or tax credits or not.

And, I'm sorry to say this, I'm not really interested in discussing it, as I know the arguments from all sides - the rational ones, the silly ones, and the self-interested ones.

So if you want to post a comment saying "Corporations are evil and should be taxed to death!" don't bother.  I just posted your comment in the last sentence.

And if you represent the wind industry or BMW and want to defend tax credits or depreciation rules, don't bother.  We all understand self-interest.  We 'get it' that you make money this way.

If you want to point out that these incentives - be they deductions or tax credits - have unintended consequences, well, tell me something I don't already know.

If you want to tell me a flat tax is the answer, all I can say is, if you think we have too many foreclosures now, imagine if we take away the home mortgage interest deduction!  Probably half of America would lose their homes.

The point of these four posts, was to explain in simple terms, how these schemes work.  Draw your own conclusions, be that what they may.

But draw accurate conclusions, based on facts, not fantasy.  Saying that "'writing off a loss" is a good thing is silly.   It is still a loss.  Saying that people will stop hiring if you raise personal income tax rates (or indeed even corporate ones) is also nonsense.  And saying that "getting a deduction" is a good thing and getting an even bigger one is better, is nonsense as well.   You have to spend to get a deduction - you cannot deduct your way to wealth.

There is one other "unintended consequence" of our tortured tax laws, and that is the complexity created necessitates an army of accountants and tax preparers and lawyers to administer all of this.  And this does act as a barrier to entry for small businesses.  In this regard, the flat-taxers have a good idea - to simplify the tax code.

But even with a flat tax, you still have to deduct expenses.  You can't get around Schedule C, if you are a company.  Unless you want to tax gross receipts.  And if you did that, many marginal companies, with profit margins of 10% or less would go under in a hurry.

Our tax system is complex, but the basic concepts are pretty simple.  Unfortunately, most people actively refuse to learn them - just as the old ladies who go to the post office this time of year act mystified (for the 50th year in a row) as to how postal rates work.

Active ignorance is never a good game plan.

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