Simplified handling of deductions under the individual income tax.
(January 13, 1944)
"Deductions" under the federal income tax are one of the chief sources of complication. In general they call for more detailed records than do the major items of receipts; the instructions on the return are harder to follow; the taxpayer has more apparent choices as to how much to report; there is more scope for taxpayers to take advantage of unusual ability in construing the statute and Internal Revenue regulations, or to take advantage of being able to obtain legal advice. Consequently, deductions deserve close scrutiny whenever efforts are being made to simplify the individual income tax.
PURPOSES OF ALLOWING DEDUCTIONS
The first step in studying deductions is of course to ask what use they are. They serve two major sorts of purposes:
A. EQUALIZATION Putting taxes more nearly on the basis
The first type of purpose is served by deductions which take out elements of income of which the taxpayer does not get the benefit -- for example, what he pays in state income taxes; what he loses (uninsured) through damage to his property, bad debts, etc.; what he has to pay out in unusual medical expenses on account of a run of illness or on account of some disability. The effect of such deductions is to make more nearly equal the taxes of people of like family status who have the same amount actually available for consumption and for building up their estates.
The second type of purpose is served by the refusal to permit deduction of gambling losses (beyond the amount of gambling gains), and by the allowance of deductions for home mortgage interest and for taxes on owner-occupied homes. The first represents an incentive to avoid gambling, the second an incentive to own a home rather than rent. The allowance of deductions for contributions serves both an incentive purpose and an equalization purpose. It gives stimulus to gifts to charitable, educational and religious institutions; and at the same time it allows for income of which the taxpayer deprives himself to make such gifts, and of which he personally does not get the benefit.
It should be pointed out that from the equalization standpoint the existing deduction system is very imperfect, since it is far from allowing for all the major elements of income of which individual taxpayers fail to get the benefit. The most important shortcoming from this standpoint is the lack of recognition of the extra costs of acquiring an income which fall upon a family in which all the adult members work and none are at home to take care of housework, etc., -- the "working wife problem". The financial advantage of having a competent unpaid housekeeper can scarcely be estimated at less than $500 a year /1/, against which the present law offers no tax advantage except the benefit of one additional $624 exemption under the Victory tax (giving a tax reduction of about $20). Another very serious inequality for which the tax system offers no offsets is the difference in living costs between metropolitan centers and congested "boom towns" on the one hand and smaller places less affected by war activity on the other.
Further inequalities are generated by some of the incentive deductions. While some incentives deductions also help toward equalization -- the deduction for contributions, cited above, is a case in point -- some work in the opposite direction. The most important case is that of the home-owner deductions for mortgage interest and property taxes. Interest and taxes are not dead-weight burdens on the taxpayer like (say) state income taxes. On the contrary, they enable him to occupy a house without paying rent. Consequently, to permit deduction of these expenses is to give an advantage to the home-owner who pays them as against the renter, who must be regarded as paying the same charges indirectly, through his rent, without benefit of tax deductions. On the other hand, to disallow them would create an inequality as between home-owners with mortgage debts and home-owners who are debt-free or who can render themselves debt-free by selling securities and other income-yielding assets to raise funds to lift the mortgage. In short, either allowing or disallowing home-owner deductions involves a particular type of inequality. Equalization of burdens could be achieved only by following the British example and treating the gross rental value of owner-occupied homes as receipts, but simultaneously allowing the owners as business deductions the same amounts allowed to landlords - - including not only interest and taxes but also insurance and depreciation. NET rental value would then be included in gross personal income.
BASIC SIMPLIFICATION METHODS
There are obviously many ways to simplify deductions. The chief ones are:
Some combination of these methods seems to be called for. This memorandum will not attempt to make final recommendations, but will sketch the possibilities under each heading.
TAXING GROSS INCOME -- THE EXTREME CASE OF SHORTENING THE DEDUCTION LIST
Carried to its extreme, the method of shortening the list of allowable deductions leads to a Gordian know solution of the whole deductions problem -- abolishing deductions and basing taxation on "gross income", less personal exemptions and credit for dependents. This solution has been recommended in various quarters as offering the maximum of simplification.
Under the present definition of gross income, however, taxation on this basis would discriminate most unfairly against business men; roughly speaking, the tax base for the proprietor of a business (or a partner) would be his gross PERSONAL income less exemption, etc., plus all his business expenses except "cost of goods sold". /1/ All other business expenses are now provided for by deductions under Form 1040. These business deductions could not well be swept away; if no "deductions" were to be permitted, they would have to be taken care of as "exclusions" from gross income, which would require a new and careful statutory definition of gross income. As will be seen presently, such a redefinition would help greatly toward simplification even if a less drastic solution than abolishing personal deductions were adopted. /2/
Basing taxation on gross income would mean giving up both the equalizing and the incentive effects of personal deductions. The revenue effects (at unchanged rates) might be fairly substantial. In 1941, taxable returns on Form 1040 showed $35.3 billion of net income, of which $16.1 billion was absorbed by exemptions and credits for dependents, leaving a tax base (surtax net income) of $19.2 billion. Total deductions claimed on taxable 1040's were $4.5 billion. Of this amount various types of losses (which would count as business deductions) made up $0.9 billion. Items composed of a mixture of business and personal deductions were interest ($0.8 billion), taxes paid ($1.4 billion), and "other deductions" ($0.5 billion), totalling $2.7 billion. On the purely personal side, contributions were $0.9 billion. Personal deductions on taxable returns filed on Form 1040 thus amounted to some $2.5 billion (supposing rather over half of the mixed group to be personal). Allowing for the fact that Form 1040A allowed for presumptive exemptions of about 6 percent ($0.6 billion) and for the fact that eliminating personal deductions would shift some returns from the non-taxable to the taxable column, the total addition to the tax base would have been toward $4 billion, or about one-fifth of the existing tax base. Since this addition would go into the highest surtax bracket for each return, the addition to revenue would have been more than one-fifth -- perhaps even more than one-fourth.
On the other hand, insofar as deductions are spread uniformly over the field, eliminating deductions and maintaining tax rates unchanged would be substantially equivalent to cutting exemptions slightly and raising rates. Thus, the revenue effects could be obtained in other ways and it is the equalization and incentive effects on which attention should be concentrated. These are covered in the next section, where the different personal deductions are considered separately.
SHORTENING THE LIST OF ALLOWABLE DEDUCTIONS
If some personal deductions are to be allowed and some disallowed, what different does it make which are retained? Since the considerations underlying different types of incentive deductions are more or less incomparable with each other, this question is best approached by listing deductions in the general order of their equalizing effects.
This list pretty well covers all quantitatively important PERSONAL deductions (losses, etc., being regarded as BUSINESS deductions).
In terms of complication, a restricted list extending only through the first four items would present few difficulties. Item 1 could be taken care of as a lump sum. For items 2 and 4, records are almost automatically available. For item 3, since the deduction is restricted to the excess over 5 percent of income, only the small minority who are heavily burdened by medical expenses need be inconvenienced with extra record-keeping, etc. For item 4, record- keeping is very simple. Of the remaining items, 8 (and in some cases 7) can be handled from records the individual in question will normally have on hand; but there is often some room for discussion between the taxpayer and the tax collector as to the interpretation of those records. Items 5 and 6 can be estimated accurately only from rather full records. In general, the deductions which contribute least to equalization contribute most to complication.
In terms of incentive effects, items 5 and 8 are most important. It must be questioned, however, whether item 5 (contributions) does not do more to further CLAIMING THE DEDUCTION of contributions than actually MAKING contributions, at least below the income levels where revenue agents customarily ask to see the records. Item 8 -- home- owner deductions -- may well be highly effective in swapping people who are considering buying the houses they live in. /1/ but in a strictly economic view, it is very doubtful that this advantage is worth the drawbacks of making tax burdens more unequal and of tempting home-buyers to over-extend themselves.