Thursday, December 15, 2011

Deductions versus Credits, Part III

Personal deductions are based on two concepts - one that you should not pay taxes on taxes, and two, as incentives to do certain things.

3.  Personal Deductions

Personal deductions are an odd thing.  Your personal life is not a business - that is to say, your consumption of goods and services does not generate a profit and it is not intended to.  You just spend money on stuff (and hopefully invest some of it) and that's that.

So why would there be deductions for personal income?  Two reasons:  First, you should not have to pay taxes on taxes, and second, to give you incentives to do things like buy electric cars or caulk your windows.

The first one is pretty straightforward, or so it would seem.  It is not fair to make you pay taxes on money you paid to pay taxes.  So State and local taxes are deductible.  Property taxes are deductible.  Personal property taxes are deductible.  Even sales taxes are deductible, although most people don't have the patience to add up the total sales taxes they paid in one year and deduct them.  And for that reason, we have the "standard deduction" which sort of covers that sort of thing - roughly.  Again, taxes are not an exact science, although maybe in the future with computers and smart phones, we could track all this stuff down to the penny.

And if you don't feel like adding up your mortgage interest and stuff, you could take the "standard deduction" which again, is an approximation of the stuff you should get a deduction for.  If you own a home and are paying a mortgage, the itemized deduction works out better - but we are getting ahead of ourselves here.

So you should not have to pay Federal tax on money you used to pay State or other taxes.  Seems like a simple concept, and that is why you deduct from your income, your State taxes, and why you add back in your refunds the next year.

But what about those other deductions?

The interest deduction was started originally, I think, to encourage consumption.  And also, it seemed unfair to pay tax on interest.  And at one time, all interest was deductible - including credit card interest.  Again, this is not to say that racking up credit card debt would make you rich - you cannot deduct your way to wealth!

But about 30 years ago, they decided that only home mortgage interest should be deductible - to encourage home ownership.  It worked - too well.  Remember what I said about government incentives having unintended consequences?  People borrowed against their homes in a rising market, so they could deduct the interest (and pay off credit cards and car loans, whose interest was not deductible, and also at a higher rate).  Then the market went down and suddenly, people who had been living in their homes for 10 or 20 years were 'under water'.  Great intentions, unintended consequences.

And it is hard to change laws like this, without bankrupting lots of people.  You buy a house, counting on an interest deduction, then they change the law and you can't afford the house anymore!  Sounds silly?  Well, recently, student loan interest was made tax deductible.  That really helped me out, as the last two years of my student loans, I could deduct the tiny amount of interest.  But the first 8 years?  I was screwed.

And that illustrates why tax laws should not be changed at a whim - when you create complex series of incentives, you can really mess with people's lives when you arbitrarily change them, such as through a "flat tax" scheme.

There are other incentives as well.  Children, for example, give you a small deduction.  Not enough to justify having children, of course.  And now we can deduct medical insurance premiums - the idea that we should be encouraged to buy health insurance.  And if you get really, really sick, you can deduct the cost of medical bills, above a certain percentage of your income (I was only able to do this ONCE in my life!).

For the most part, these types of deductions are designed to eliminate taxation on items of your life that are not really enjoyable, but necessary.  Health care is not something you enjoy spending money on, and it isn't fair that some have to spend more than others (generally).

The 401(k) is a big deduction as well - and a tax-deferral scheme.  The idea, again, is to encourage you to save for retirement rather than go on welfare.  So your contributions to your 401(k) or IRA, or Thrift Savings Plan, or Simple IRA, SEP IRA or other "tax deferred plan" are not taxable - at the time you make the contribution.  Once again, using deductions as a carrot, to get you to do things you might not otherwise be inclined to do.

So, personal deductions are a different beast than business deductions - although in both cases, Congress has tried to right some sort of wrong, level the playing field, or encourage people or companies to do certain things.

What about tax credits?  Well, if deductions are marijuana, tax credits are pure cocaine.  Instead of merely incentivizing you to do things, they are paying you to do things.

Next:  Tax Credits