Think the rich guys get all the tax breaks?
Wrong, deduction denier.
In fact, most of the big tax breaks go to middle-income earners like you and me. We don't call them tax shelters. But that's what they really are.
The tax pros call these shelters "tax expenditures." Because they represent dollars not collected by the government, these darling deductions and credits have the same impact on the federal budget as direct expenditures. And each of these expenditures gives special or selective tax relief to a certain targeted group of taxpayers.
Sounds like a tax shelter -- or at least a loophole -- to me.
These targeted provisions either encourage some desired activity or provide special aid to certain taxpayers. Some of them make a lot of sense. For example, the federal government seeks to encourage certain forms of investment. So Congress has legislated accelerated rather than straight-line depreciation on new plants and equipment. This produces more tax savings upfront, creating additional capital for business to expand.
Tax-advantaged investments help create new businesses and new jobs. These new jobs produce more paychecks, and those additional paychecks produce more taxes. In the long run, if everything works as it should, everyone wins.
Some tax expenditures have been adopted as relief provisions to ease tax hardships or to simplify tax computations. The elderly and the blind receive special financial benefits through a deduction called the "additional amount," which is added to their standard deduction. Other tax benefits for the aged -- the retirement income credit and the potential exclusion of Social Security payments from taxable income -- also fall into this personal or hardship category.
Cost now well over $1 trillion per year
Back in 1980, the Congressional Budget Office identified 92 provisions that qualified as tax expenditures, at a cost of $206 billion. Projected 2009 expenditures are more than $948 billion -- and that's before President Barack Obama's $900 billion stimulus expenditures.The financial benefits offered by these tax expenditures resemble those available on the spending side of the budget. A tax expenditure provision can provide special tax relief in any of the following ways:
- Special exclusions, exemptions and deductions. These reduce taxable income and result in a smaller tax bills. Examples are tax-exempt municipal bond interest, the exclusion of employee discounts from taxable income, and dependent-care assistance programs.
- Preferential rates. These reduce tax bills by applying lower rates to all or part of your income. Congress gave taxpayers a big one in 2003: the special maximum tax rate on long-term capital gains or on qualified dividends. (This year, it's 0% for taxpayers in the 15% bracket or lower, 15% for everyone else.) While the dividend and capital gains breaks are available to all, it is true that higher-income taxpayers will derive more benefit than anyone else.
- Special credits. These are subtracted from your tax bill, rather than from the income on which your taxes are figured. For example, the child tax credit or the foreign tax credit.
- Tax deferrals. Deferrals let you pay later rather than now. These deferrals really constitute interest-free loans from the Internal Revenue Service. The best-known deferrals today are the contributions we make to individual retirement accounts, 401k accounts or similar retirement funds.
Tax-expenditure spending and direct spending are two sides of the same coin. Nearly any tax expenditure can be recast as a spending program. One side reduces the revenues collected. The other side increases the actual cash outflows. The real difference is nothing more than a choice between alternative administrative mechanisms.
At least that's the theory. In fact, just like spending provisions, these tax expenditures are really the result of pressure applied by special-interest groups seeking relief provisions for their own constituencies.
For example, the additional amount added to the standard deduction for the blind isn't available for the deaf. I suspect this may have more to do with the political and lobbying power of the two groups than with any inherent difference between the hardships.
What kind of savings are you getting from your own expenditure tax shelters? A lot, according to a 2008 report by the Joint Committee on Taxation (.pdf file) on tax expenditure estimates for fiscal years 2008-2012. Check out the tax shelter deals you may be getting. (Note: These are ranked by size.)
The biggest tax breaks
And if you're not claiming these tax breaks, investigate to see if you can.- Health-care benefits. You don't pay any tax when your employer pays the premiums for your health insurance and health care. Cost to the government over five years: $534 billion. This total doesn't include the estimated cost for deductible health insurance and long-term care insurance premiums. That's an additional $22.6 billion.
- Contributions to retirement accounts. You don't pay any current tax when you or your employer socks away money in pension and retirement plans. Cost to the government: $706.5 billion.
- Lower rates on dividends and long-term capital gains. Cost to the government: $438.1 billion.
- The mortgage-interest deduction. We all love the deduction for home-mortgage interest. But renters and those who own their homes free and clear get nothing. Cost to the government: $402.7 billion. About 79% of the taxpayers who claimed this deduction on their 2005 returns earned $50,000 or more. About 40% of the total earned between $50,000 and $100,000.
- State and local income/sales taxes and personal property taxes. You get a deduction for state and local income or sales taxes and personal property taxes paid. Cost to the government: $148.5 billion. About 81% of the 44.2 million returns that claimed this deduction had incomes of $50,000 or more. About 43% had incomes between $50,000 and $100,000.
- Charitable contributions. Very noble of you. But the rest of us kick in a part of your cost. Cost to the government: $240 billion. About 83% of the 39.2 million tax returns that claimed this deduction reported earnings of $50,000 or more. About 41% of the total had earnings of between $50,000 and $100,000.
- Children under age 17. The child tax credit puts up to $1,000 per child in your pocket. Cost to the government: $230 billion. About 50% of the 31.6 million tax returns that claimed this deduction reported earnings of $50,000 or more. And 69% of that group earned between $50,000 and $100,000.
- The earned income credit. You qualify for the earned income tax credit, which is targeted at low-income taxpayers. Cost to the government: $218.3 billion. About 92% of the tax returns that claimed this benefit last year had earnings of $40,000 or less.
- Life insurance or annuity contracts. No current tax on the inside investment income. Cost to the government: $147.1 billion.
- You die. The basis for all of your assets (the value at which you start to calculate potential capital gains) is stepped up to fair market value on the date of your demise. That means that the tax on all capital gains you earned up to the date of death is lost. Cost to the government: $290.2 billion.
The total for the 10 above? $3.38 trillion over five years. And I haven't even mentioned that the deduction you get to take for property taxes on your home will cost the feds an estimated $73.8 billion over the next five years. We won't even get to the $500/$1,000 addition to your standard deduction for property taxes on your home.
And the big break you now get on any profits from selling your home: An additional $128.4 billion.
I'm not saying that any of these exclusions, deductions or credits is a bad idea. I'm just shining a light on the fact that all the breaks don't really go to the big guys.
I guess that if the expenditure puts money in my pocket, it represents good, sound tax policy.
On the other hand, if I'm a renter in a state with a high sales tax and no income tax and you own a home in a state that has income tax, your deductions for interest, real estate tax and state income tax are coming out of the taxes I pay. You're the one with a real tax shelter. I'm the one making up the difference.