Most perverse things about the U.S. tax code?

It would be interesting to gather reader perspectives on the most perverse things about the U.S. tax code. Here is my personal list of things that stick out either because they affect a lot of people or have big dollar signs attached.

That child care expenses are not fully deductible from income. Suppose that a parent works to earn $40,000 per year and pays a nanny $40,000 per year to stay home with the children. As the family is no better off financially than when the parent stayed home personally, why is the family paying more in taxes? Maybe the argument is that the family gets a huge emotional and personal benefit from having a child around and therefore the nanny costs are personal rather than work-related? But if that is true, why are children treated as an economic burden with no emotional or personal value when it comes time to award child support to the parent victorious in a custody lawsuit?

That a person who collects $100,000 per year in child support, more than 20X what a typical married couple spends on a child (see previous posting regarding on UCLA research), can claim that child as a financial “dependent.”

That child support, which in many states functions by design in the same way as alimony, is treated differently from a tax perspective (tax-free to the plaintiff, not taxable to the defendant). Once child support exceeds the USDA-estimated cost of rearing a child, why wouldn’t the IRS treat the excess as alimony-in-fact? (Separately, why hasn’t the IRS addressed the apparent discrepancy between the 567,887 Americans who report paying alimony and the roughly 300,000 who report receiving it, with the result that taxpayers who were not divorce litigants must pay a larger share of their income in tax to make up the shortfall? (treasury.gov report).)

That health care costs, which are nearly 20 percent of the GDP, are deductible or not depending on a huge array of factors, e.g., whether the employer or the employee pays or whether or not one is self-employed. For such a huge sector of the economy one would expect that there would be agreement on whether these should be pre-tax or post-tax expenses. (Personally I think it is madness to pour gasoline on the health care bonfire of cash by making the dollars spent mostly pre-tax. If an industry is consuming an outsized portion of GDP why encourage Americans to keep pouring more money into it? It is also a big hit to the tax base. The government is very careful to limit charitable deductions as a percentage of income but is allowing 20-30 percent of income, for a lot of workers, to be swept off the taxable table.)

Allowing some money managers to claim their fees as capital gains rather than ordinary income. (The “carried interest” stuff that is periodically debated by politicians.) If the point of having a long-term capital gains rate is to ameliorate the fact that inflation-driven pseudo-gains are taxed (see below) and to encourage people to invest in businesses, why give the rate to people who did not put up personal funds and who did not hold an asset long enough for inflation to be an important factor?

That capital gains are not adjusted for inflation (so we pay the same tax on an asset that doubled in nominal value over the past year and on an asset that doubled in nominal value over the past 50 years (i.e., actually lost value because of 50 years of inflation)). This will lead to some crazy behavior if we ever get back to Jimmy Carter-era levels of inflation.

That successful people who lead short lives have a much larger percentage of their income taxed away compared to people who enjoy a long life. This is because the estate tax is a second income tax, taking a cut of money that was already taxed as it was earned. (See Mankiw for how these add up.) Someone who dies during his or her working years is much more likely to pay estate tax than someone who dies following a long retirement in which savings accumulated during working years were spent. [Financially unsuccessful Americans don’t pay any estate tax, of course, because the threshold is pretty high.]

After we (permanently?) melted down our economy with a housing bubble and while we continue to melt the planet by heating and air conditioning double the number of square feet per person that we lived in during the middle of the 20th Century, we continue to subsidize expenditures on housing with the mortgage interest deduction.

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8 Comments

  1. Johnny Caustic

    February 10, 2015 @ 5:22 pm

    1

    But if that is true, why are children treated as an economic burden with no emotional or personal value when it comes time to award child support to the parent victorious in a custody lawsuit?

    Phil, I appreciate your work uprooting the evils of the divorce courts, and I look forward to your book on the topic. But I very frequently see you fall into this hyper-logical style of argumentation where you rely heavily on asking questions about the contradictions in the system. Unfortunately, this is pretty much the least effective tack you can take if you want to change anything.

    If there were anybody honest to answer you, they’d say “Because the real goal of the system is to rationalize giving our female clients whatever they want. If some guy gets screwed, that’s a bonus and we dance an extra jig. Sure, the system is full of logical and moral contradictions; we don’t care and will never give a single moment’s thought to them however much you whine.”

    If you want to have any shot at improving the dysfunctional system, you’ll have to largely ignore the stated rationalizations in favor of exposing and attacking the real motives, which the opponent will never actually state nor admit. Taking potshots at the official rationalizations, as you tend to focus on, is like trying to wage a war by bombing all the enemy’s swampland. It’s just a sink for your energy and ammunition.

  2. philg

    February 10, 2015 @ 6:56 pm

    2

    Johnny: We’re not “uprooting the evils of the divorce courts” (I don’t think it is fair to call them evil in any case since they are only following the statutes given to them by state legislatures) with our book. Our book tells consumers how to use the system, not how to fight it. People who want to make money by having children, for example, can move to Massachusetts or Wisconsin (or at least spend one night in either of those states!). People who want to minimize their chance of becoming a custody lawsuit defendant can move to Arizona or Delaware, where 50/50 custody guidelines prevail. A person who wants to sue his or her spouse and receive alimony can move out of Indiana (no alimony) and into Florida (“permanent” alimony).

    [And note that even if an individual state chooses to have a policy in which people can obtain $1 million/year in child support, nothing stops the IRS from having a policy that treats similar cash flows between plaintiffs and defendants in different states the same, even if one state calls the cash flow “alimony” while the other calls it “child support.”]

  3. Robert

    February 10, 2015 @ 10:32 pm

    3

    I never understood how the government can tax capital gains but limit capital loss carryover to a mere $3000 per year. It’s very much a heads I win, tails you lose type of setup. As far as I understand, in the corporate tax world, losses can be fully carried over to offset future profits.

    My favorite is if a person moves to a U.S. territory. She must demonstrate to IRS that she has closer connection to the territory than the 50 States. One of the criteria for this test is she must not donate to any U.S. based charities such as Harvard or MIT. (See IRS Publication 570)

  4. ICH

    February 11, 2015 @ 11:58 am

    4

    @Robert,

    Haven’t you ever noticed that when it comes to the IRS, it is always a “heads I win, tails you lose situation?” Have you ever heard of someone getting audited and the IRS finding a bunch of extra money they should’ve gotten back? I haven’t, and I suspect that is because the IRS wouldn’t bother to audit those who overpay.

    @Phil,

  5. Dave D

    February 11, 2015 @ 12:32 pm

    5

    These oddities come to mind:

    When an artist donates an original work to a non-profit, only the direct cost of the materials (like canvas and paint) are deductible. If anyone else donates that same artwork, the fair market value is deductible.

    The “Section 1031 exchange” where capital gains taxes on the sale of certain business-related real estate properties can be deferred as long as the proceeds are reinvested in another similar property. Investments like stocks are excluded so if you sell your Coke stock and buy Pepsi, taxes are due.

    Individual health insurance premiums can subtracted from self-employed earnings but not from passive earnings.

    The double taxation of dividends.

    The ability to have both a refund and a late-payment penalty when filing your tax return.

  6. Izzie L.

    February 11, 2015 @ 1:13 pm

    6

    The tax code is such a hodgepodge that it would take volumes to list all the perverse incentives that it creates. The solution is really to get rid of all of it and switch to some sort of flat tax. But the current system has numerous beneficiaries – the housing and finance industry, charities, healthcare, etc. who would fight tooth and nail against simplifications that would get rid of their subsidies.

  7. Andrew

    February 11, 2015 @ 10:25 pm

    7

    Barlett and Steele did a long-term investigation of the tax code for the Philadelphia Inquirer. I think they put it together into a book, but here’s a good introduction:

    http://www.barlettandsteele.com/journalism/inq_tax_1.php

  8. Mark Lutton

    February 17, 2015 @ 11:14 am

    8

    I knew someone who was audited several times and always got extra money back. He started looking forward to those audits.

    He had a very complicated tax situation and was conservative about taking deductions. But in the audit, he could usually persuade the auditor that a potential questionable deduction he had not taken actually was relevant and should have been taken.

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