by Andrew Beattie
Tax deductions help reduce your tax bill – what could possibly be wrong with that? Unfortunately, the truth is slightly more complicated than it looks. A tax deduction is a reduction in taxes for someone, but not necessarily you. Any reduction in the overall tax revenues in the era of big government means that more taxes will be taken from people who don't get the best mix of deductions. This unfortunate truth has a lot of people questioning some of the deductions and the unintended consequences they may have. In this article, we'll look at some of the most controversial tax deductions. (Knowing the tax deductions you're entitled to can make or break your bank account.)
The Mortgage Interest Deduction
If asked to justify the mortgage interest deduction, most people would tell you that it encourages homeownership. This is suspect because the rate of homeownership in Canada – a country that doesn't allow a mortgage deduction – was actually higher than the U.S. in 2009. What the deduction clearly does is provide a tax break for higher income people who are more likely to buy a home and encourage people to take on larger mortgages than they would without the prospect of a larger tax deduction.
This tax deduction was once considered sacrosanct, but has since been fingered as one of the driving factors behind the homeowner piggybank mentality that added to the scope of the 2008-2010 housing crisis. Homeowners are generally seen as dependable voters, however, so it is difficult to imagine a repeal of the tax becoming politically palatable.
Highest Earners, Lowest Taxes
In 2007, Warren Buffett made headlines by criticizing a tax system where he paid less taxes than his employees. The main difference is that Buffett's wealth comes from investment in assets rather than direct labor and, under U.S. tax code, receives more favorable treatment. The reason is simple. The government wants the wealthy to invest their money in the assets and businesses in the U.S. rather than taking it abroad or squandering it.
Moreover, wealthy people can be more nimble and move assets into any tax deferral opportunity - transfer costs aside. This has been handy for local governments issuing tax-advantaged municipal bonds, so both the state and federal government want to see this source of funding continue. There is, of course, a question of fairness. However, there is also a question of practicality - can we tax the wealthy without limiting investment capital?
And someone should mention to Mr. Buffett that the government will not protest if he voluntarily gives over more of his wealth to help out. (We take a close look at the main principles the 'Oracle of Omaha' uses in assessing a company.)
Investment-Specific Tax Breaks
Walking hand in hand with the low taxes on the wealthy, 401(k)-type plans would not exist if the tax breaks hadn't encouraged people to use them. This is good if it encourages people to save and invest for the future. However, it can also lead to people blindly shoving money into investments they don't understand or overpaying for a mutual fund manager to do what amounts to the same thing.
As previously mentioned, municipal and state bonds also enjoy the benefit of being on the right side of the tax code. Not unlike the mortgage deduction, the muni tax-free status gives states enough money that they often forget to balance budgets and lean towards overspending and refinancing. This puts states, and investor capital, in danger.
Industry-Specific Tax Breaks
Why is a car manufacturer more important than a coal mine? Why is a clean energy project subsidized? Does it make sense that some industries are awarded tax breaks and subsidized while other industries are purposely taxed more? What about the workers within those industries that see higher or lower wages because of the tax treatment?
Industry-specific tax breaks are made or broken through intense lobbying in Washington. Very often they can damage a successful business, prop up a failing one and even endanger world trade. Considering the power these breaks have to do harm, you'd think they'd be wielded with caution. Unfortunately, the U.S. has a highly complex tax system that drives companies to do odd things and inefficient things just for the tax break - opening up offices in multiple states, making non-essential upgrades, etc. This tax game is far harder for purely American firms to play than it is for multinationals. Some globe-spanning companies are able to use tax deductions and tax treaties between nations to create "nowhere" money that is not taxed at all. So again, we have the complexity of the tax code favoring the wealthy at the cost of the middle.
The Bottom Line
When it comes to taxes, nobody leaves happy. Even if all deductions were thrown out and a flat rate tax with a negative income tax for the poor was introduced, there would still be unhappy people. The multiplication of deductions and credits, however, is only succeeding in making reducing your tax burden a more difficult task than ever before. To effectively utilize the gamut of tax minimizing strategies, those who can afford to pay often enlist tax specialists to help them. Those that can't afford it, but would benefit most from paying less tax, often get lost in the shuffle. Unfortunately, politics makes it more attractive to work for a tax deduction for a segment of the population that is likely to remember that party when it comes time to campaign than it is to work to make tax cuts that would benefit us all – so this situation is unlikely to change for the better. (Some countries have begun charging a flat tax rate instead of the gradual tax system of the Western world.)
Andrew Beattie is a managing editor and contributor at Investopedia.com.