RALEIGH – As many North Carolinians start working on the 2011 income tax returns, and many North Carolina politicians start their 2012 campaigns by talking about tax reform, now is a good time to define a couple of key tax terms: deductions and credits.
Tax deductions and credits may both serve to reduce one’s income-tax liability, but they are not just different words for the same thing. Tax deductions are about defining the tax base. Tax credits are about satisfying one’s financial obligation to government.
When properly used, tax deductions (or exemptions) are tools for ensuring tax neutrality and avoiding government meddling in private decisions. Unfortunately, thanks to special-interest pleading and government incompetence, tax deductions are often improperly used to subvert the tax neutrality they are supposed to ensure.
To understand why, one must first define a few other terms. Gross income is the total amount of money received in exchange for goods or services delivered. Net income is gross income minus the expenses associated with producing those goods and services delivered – expenses such as purchasing raw materials or supplies, renting space, acquiring education or job skills, hiring employees or contractors, and transporting goods.
Once a household or business receives a net income, it can do one of three things with it: 1) give it away without expectation of goods or services in exchange (charity), 2) save it for future reinvestment in producing income, or 3) buy goods and services for consumption (or, in the case of a business, remit the money to its owners or shareholders so they can either give it away, save it, or consume it).
In a properly structured tax system, one that simply seeks to collect money for government without meddling in private decisions, only the third use of net income, household consumption, should be subjected to tax. The argument isn’t that government should favor charity or savings by deducting those amounts from taxable income. The argument is that charity ends up as net income to someone else, not to the original earner, and that money saved and invested today generates a future taxable income – and therefore should not be taxed today, in order to avoid creating a double-taxation bias that favors current consumption over future consumption.
The system I favor, often called a consumed-income tax or unlimited savings allowance (USA) tax, would use deductions merely to limit the tax base to net income that is consumed. There would be a deduction for charitable giving. There would be a deduction for net savings (the amount of money put into savings that year minus the amount taken out of savings). And there would be personal exemptions and deductions to account for education, health care, and other household expenditures on “human capital” – the rearing and training of children who will grow up to earn taxable income.
The logic here is inescapable. If you recognize that it is wrong to tax the principal of a financial investment today as well as its future earnings – because taxing the principal already reduces the return by the same tax rate – then you must avoid the same kind of punitive tax treatment of human-capital investment such as education and training. Financial IRAs ought to have unlimited deductions of money going in and full taxation of money going out. Similarly, IRA deposits used for education and other human-capital formation ought to be deducted from taxable income, as they will generate future taxable income.
So to summarize, tax deductions are about defining the proper income base to which a tax rate will be applied. Tax credits are an entirely different tool. They offer taxpayers the ability to satisfy their financial obligation to government in ways other than sending the government a check.
This isn’t really a new idea. Many early human civilizations, operating without widespread use of currency or banking services, levied taxes in the form of kind – bushels of grain, for example, or animals for food or military use – or forced labor. Resource-poor citizens could satisfy their tax obligation by helping to build roads and public buildings, or serving for a time in the local militia.
I happen to believe that it was better for both governments and individual liberty to move away from in-kind payments or forced labor to taxes paid in cash. Such a system is easier to administer, less likely to be abused, and more likely to result in an efficient allocation of land, labor, and capital. But there may still be cases where it makes sense to allow people to take a credit on their taxes for money they spend or services they render that reduce the cost of government.
In general, however, I prefer the lowest possible marginal tax rate applied to the broadest possible base of consumed income. Such is my deduction from the available evidence.
Hood is president of the John Locke Foundation.