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Thursday, January 5, 2012

A Simple Discussion on Deductions and Exemptions

As someone who works in the tax policy field, I understand where the frustration comes from when people look at the massive schedules of deductions available to both individual taxpayers and businesses.  As such, since tax code simplification is a popular subject these days, some just throw up their hands and say, "Get rid of them all and tax every dollar of income!".  It's an emotionally appealing argument in times like this, but let's remember some theoretical bases behind why we set up the tax code the way we did.

First, I would like to remind people of how businesses are taxed in this country.  Except in a few states where either gross receipts taxes or some form of value added tax exist, businesses are taxed on their net income.  Net income is a defined term that doesn't correlate with cash flow, except in some cases by accident.  For tax purposes, it is the business' gross receipts - deductions for various expenses or bonus deductions for certain activities.  As a general rule, though, the idea is to impose a tax on what is available to the business after it has paid for all of its normal operations.  Businesses not keeping their heads above water don't play taxes.

The same principal is applied in a different way to individuals.  Individuals do not have a "net income" as we commonly understand it.  Individuals have a great deal of latitude in how to incur expenses and pretty much anyone can expand their expenses to fit any income.  However, there are certain minimums that people can't go below and this is the basis of the baseline deductions and exemptions.  A certain amount of income will not be subject to tax in order to allow individuals to pay for baseline expenses without having to pay taxes.  This is to avoid taxing beyond their ability to actually pay their bills.  The effect is to try to create a parallel to business net income for individuals and in so doing not taxing them beyond their ability to pay.

I would be the first to admit that we have far too many specialized deductions and credits that serve very particular interests or that have outlived their usefulness, but to simply rid the tax code of deductions and exemptions is not the answer.  It doesn't even make good theoretical sense.  The reason that more and more people are falling of the tax rolls is because the indexing of exemptions and deductions continues to push people with stagnant nominal incomes below zero taxable income. What this reflects is that the cost of living is accelerating faster than their ability to pay.  Simply deciding to redefine the boundaries of the tax system to have those people pay more in taxes doesn't seem to make logical sense.

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