How does the tax code influence what we do with our money?
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Listener Dan Sinisi from Chester Springs, Pennsylvania, asks:
What are the different sections of the U.S. tax code designed to incentivize and discourage? There are things which seem obvious, like the home mortgage deduction — or maybe it’s not so obvious.
There are dozens of credits and deductions available for taxpayers that let you reduce either the amount of tax you owe or the amount of income you’re taxed on.
Most American taxpayers are familiar with the standard deduction, which lowers your taxable income based on your filing status.
There are also credits and deductions that can help lower-income people, charitable donors, teachers who pay for school supplies and homeowners who pay mortgage interest, along with many others.
“Tax law is Social Policy 101. Everything that we express in tax law tells us a lot about who and what we value in society, and who we think should be bearing the burdens of the cost of society,” said Hayes Holderness, a professor at the University of Richmond School of Law.
The goals of deductions and credits
Deductions reduce the amount of your income that’s subject to tax. Meanwhile, a credit is a dollar-for-dollar reduction in the amount of tax that you owe.
Holderness said the tax code doesn’t allow you to take deductions for personal items such as food or clothing, so when deductions are offered, it’s important to ask: “Why is that happening?”
Holderness said you can think of deductions as part of buckets. One of these buckets is aimed at incentivizing certain social behavior, and that includes actions like giving money to charity.
“There are plenty of ways that we could justify the charitable contribution deduction. But one is that we just think charitable giving is a good thing, and we want people to do it. So if they get a tax break for doing it, then we’re able to incentivize them to give to charity, where they might have otherwise done something else with their money,” Holderness said.
He pointed out that only those who itemize their tax deductions, instead of taking the standard deduction, can get the charitable contribution benefit. But it still sends the message that “charitable giving is a good thing,” Holderness said.
Another bucket contains deductions that address people’s ability to pay. For example, there are breaks available for medical expenses and interest paid on student loans.
Credits are also directed toward certain types of taxpayers or spending activity, Holderness said.
“You have things like the earned income tax credit and the child tax credit to help support individuals at lower income levels,” he said.
Under the Inflation Reduction Act of 2022, you can get credits and deductions for investing in clean energy, like buying an electric vehicle or purchasing renewable energy for your home.
“Tax credits for electric vehicles or energy-efficient buildings demonstrate some commitment to addressing the effects of climate change, obviously,” he said. “You can really use the tax code in so many ways to express social policy.”
America’s tax rate policies reveal other economic activities that Congress values or wants to incentivize. For example, Congress has assigned a lower tax rate to long-term capital gains, earned through harvesting profits on assets like stocks and bonds, and imposed a higher rate on employment income, said Bruce McGovern, a professor at South Texas College of Law Houston.
This has typically been the case throughout income tax history, although the highest long-term capital gain rate was the same as the highest individual income tax rate from 1988 through 1990, according to the Tax Policy Center.
“One way to think about that is Congress is trying to encourage that sort of investment activity,” McGovern said. “Another perspective on that is: That’s really an inequitable aspect of the federal tax system. Low-income people who don’t have the money to invest are paying tax at a higher rate than higher-income people who are investing.”
The goal of a tax benefit might not be what you assume
The goal of a tax credit or deduction is often pretty apparent, Holderness said. But for some tax breaks, the goal you might think they’re trying to achieve wasn’t what policymakers had in mind.
“The tax code is not written, ostensibly, to incentivize marriage, for example. But there are plenty of times in the tax code where there’s a marriage bonus,” said Pippa Browde of the University of Montana law school. (Plus, she added, tax law also contains marriage penalties.)
And sometimes you’ll need to take a closer look at the fine print. Take the earned income tax credit, for example, which provides a break to workers with low or moderate incomes.
“We might say, ‘Oh, it’s effectively government assistance to needy individuals. Well, that makes a ton of sense. We don’t want people at the bottom of the income scale paying too much in taxes,’” Holderness said. “But it’s tied to work. So now it becomes more of a ‘workfare’ kind of provision that maybe you wouldn’t have expected just on a quick read.”
The EITC was enacted back in the 1970s for several reasons, according to a Congressional Research Service report. It was aimed at incentivizing work, offsetting the “Social Security tax burden” and helping with food and fuel price increases during that inflationary time.
As your earnings go up, so does the size of the credit you receive. “This creates an incentive for people to join the labor force and for low-wage workers to increase their work hours,” according to the Center on Budget and Policy Priorities.
The importance of some deductions has also increased over the decades as the economy changed. The home mortgage interest deduction, which was introduced in 1913, currently allows you to deduct interest on the first $750,000 of your debt.
While it might seem like the goal of this deduction is to incentivize homeownership, another report from the Congressional Research Service explained that this likely wasn’t the original goal.
All interest payments were made deductible during the development of our modern federal income tax code, according to the CRS. The agency explained that the tax code didn’t bother distinguishing between deductions for business or personal expenses. That’s probably because most interest payments were business-related back then, and households had comparatively little debt to pay interest on.
“It really didn’t make a huge difference until the 1950s, when you start having a rise in homeownership and a rise in suburbanization,” explained Sloan Speck, an associate professor at the University of Colorado Law School.
The “American dream of homeownership” originated during this period, Speck said.
“There were a lot more homeowners. They were paying a lot more home mortgage interest,” Speck said. ”You start getting narratives about how this deduction is also tied to that growth in homeownership.”
So its original aim wasn’t to promote homeownership, nor does it necessarily work that way in practice. It might actually be hurting homeownership, Speck said.
Many economists dislike this deduction for a variety of reasons. It encourages larger houses, benefits high-income households, and it can lead to higher home prices, therefore reducing ownership rates, according to the Federal Reserve Bank of St. Louis.
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