The Other Side of Tax Deductions

It's tax time again--those hectic final days before the annual filing deadline when millions of Americans scramble for every exemption, deduction and credit they are entitled to and perhaps a few that they aren't.

When the federal income tax was introduced in 1913, the rates ranged from a low of one percent to a high of seven percent. Most Americans didn't even earn enough to pay anything and those who did found the tax quick and simple to compute. Today's federal income tax, however, is a tangled web of rules and forms that taxes not only income but one's sanity as well.

One of the many reasons for this trend toward incomprehensible complexity is the practice of writing various "deductions" into the law. When a deduction is granted because it is a widely-recognized and necessary cost of doing business, few disputes arise. But over the years, as Congress raised rates from those 1913 lows, it began offering deductions for another reason: to reward or punish individual behavior.

At this very moment, Congress is exploring a host of new income tax deduction proposals--for college tuition, medical expenses, retirement savings, etc. Even those of us who champion limited government and self-reliance find ourselves attracted at times to the idea, particularly for things like charitable donations, individual retirement accounts, and medical savings accounts. Tax deductions on the surface seem to further the laudable objective of shrinking government's take, but all of us need to think about the darker side: to some degree, loading up the tax system with these "special exceptions" can actually increase government power at the expense of personal freedom.

As government produces deductions, it often increases its own power to direct wealth created and owned by others. It tells us that we may keep money for this purpose, but not for that purpose. Generally speaking, the arbitrariness of today's tax law encourages spending and discourages savings because of what you can and cannot deduct. You get a bigger tax break if you buy a home than if you rent because Congress has decided home ownership is better for you. Entire industries have grown up around tax deductions that influence individual choices in the marketplace.

In a truly free society of responsible individuals, government's role would not involve the use of its taxing power to shape and mold behavior. Government would raise the minimal revenue it needs to provide the basic, constitutional services it is charged with. It would accomplish that in the most direct and obvious fashion, leaving individuals free to save or not to save, donate or not donate, buy a home or rent an apartment, provide or not provide for their retirement, and endure the full consequences of their own personal decisions. Perhaps we should regard the supposed "need" for deductions to encourage worthy things as a sad commentary: do we really want to rely on politicians to tell us what we ought to do with our own resources?

Economic life is politicized to the extent that what you get to keep of your earnings is decided in Washington or Lansing. The proliferation of deductions in the tax code--at both the federal and state levels of government--has given rise to an endless list of special interests who lobby to keep and enhance the deduction that benefits them and their industries. Tax rates are far higher than necessary, in part because so many exceptions are written into the law, not only in the form of deductions but also by way of credits and exemptions. A huge and intrusive bureaucracy called the Internal Revenue Service is required to police the system.

Ironically, tax deductions make it harder to get rid of the income tax, or even reform it. For example, many economists believe that if we have an income tax at all, the form that would do the least harm to job creation and economic growth would be a flat rate with no deductions. Even though that would mean lower rates for most people, the very thought of eliminating deductions frightens people into supporting the onerous status quo.

Unfortunately, public policy decisions are not made in a world of perfect alternatives. Would tax deductions for retirement savings be better than a government monopoly that would take charge of your retirement for you? Of course. Would tax deductions for medical savings accounts be better than a national health care scheme centralized in Washington? Certainly. Deductions for many things are not without many positive arguments.

As members of Congress or state legislatures debate the merits of various tax deductions, they should pause and reflect on these larger questions implied but often ignored in such discussions. There is indeed another side to every deduction.