Imagine how easy tax returns would be if the IRS ignored deductions and instructed taxpayers to pay a flat percentage of their income, such as “pay 15% of your total income from last year.” A flat tax rate on earnings and investment gains with no deductions (or even a progressive tax with income bands) would turn “tax season” into “tax afternoon”.
Check out this chart above. Despite all the tax code changes over the last 75 years, the revenue received by the IRS has been a surprisingly consistent percentage of our country’s Gross Domestic Product; averaging 17.4% over the more recent 50 years.
The underlying sources of tax revenue have changed over the last 50 years (see chart below). Corporations (the dark blue section) have enjoyed a lower proportionate tax burden while individuals shoulder a higher tax burden through payroll tax and individual tax rates.
So, why are taxes so complicated? One of the main factors that complicate the tax code in the US is the allowance for income tax deductions. Tax deductions exist as a way for the government to incentivize certain behaviors by offering monetary incentives. So, what behaviors is the government incentivizing, you ask?
Get Married: A household income of $100,000 results in a blended tax rate of approximately 17% for unmarried taxpayers, but only around 12% for married couples with the same income level who file taxes jointly in 2024. It’s worth noting, that two single tax-payers making the same income wouldn’t enjoy any tax savings ($200k in household income would still pay the same blended rate as an unmarried tax-payer making $100k). Perhaps the lesson is to marry someone who makes more money than you!
Have Children: Parents of dependent children may qualify for a handful of tax incentives: Child Tax Credit, Dependent Care Credit, Earned Income Tax Credit, and Adoption Credit to name a few. A slew of tax benefits are also available for the education of your child.
Buy a Home: Homeowners' enjoy various tax incentives that don’t apply to renters, including the possible deduction of state and local real estate taxes, and mortgage interest costs. It’s worth noting that student loan interest and mortgage interest are the only two types of interest expense that may be deductible by individual taxpayers. Thus, the government is incentivizing “good debt” and not rewarding forms of “bad debt” such as credit card debt, car loans, personal loans, etc.
Own a business: Tax incentives for business owners range from equipment purchases, hiring workers with disability, and even entertainment expenses with prospective customers. Business owners are also incentivized to spend money to improve their business operations through the use of depreciation, amortization, and write-offs for certain business expenses.
“Business” deductions can encompass quite a range of expenses. In 1988, an exotic dancer, known as “Chesty Love”, claimed the cost of her breast implants as a deduction on her taxes. The IRS initially blocked the deduction, but the U.S. court ruled that the breast implants can be claimed as a business deduction for certain occupations…just in case you were wondering.
Do Good Things for the Environment: Tax incentives exist for electric vehicles and energy-efficient home improvements.
Be Healthy: The tax code considers obesity a disease, so you can include weight loss expenses as medical expenses if prescribed by a physician. This includes membership fees for weight reduction groups and meeting attendance. However, diet food and beverages are not deductible as they replace regular food.
Be Generous: Charitable donations may be eligible for tax deductions (or excluded from your taxable income if given as a qualified charitable donation from your IRA). Did you know that by fostering a pet for a qualified 501(c)(3) pet adoption or rescue organization, you may be able to write off certain unreimbursed expenses like pet food and vet bills? Certain expenses may also be deductible for hosting a foreign exchange student.
Those examples offer pretty clear ideals that the government wants to incentivize to reward certain behaviors. Looking at the tax code through the lens of behavioral incentives offers some lessons on money management as well.
Save for Retirement: Contributions into a qualified retirement account receive various tax incentives (deductibility for some, tax-free growth for others, tax-deferral for all). Sadly, various surveys found that roughly a quarter of older Americans rely solely on Social Security benefits for more than 90% of their retirement income (23% in a Gallop poll, 27% in a poll by Senior Citizens League). Social security shouldn’t be the main income source for retirees. With pensions quickly becoming a thing of the past, retirement savings are extremely important and the government rewards this behavior.
Sell your Losers: Selling an investment at a loss is never fun, but losses (in a non-IRA account) can used to offset gains on profitable investments or even deducted against ordinary income up to a limit. Why would the government incentivize loss-taking? The most likely answer is that the government recognizes that risk-taking is an important element in building one’s net worth… and sometimes losses come with risk-taking.
By allowing losses to be deducted, investors are incentivized to take risks and strive for higher returns. This is also a solid axiom for investment management in general, “sell your losers and let your winners ride.”
Hold your Winners: Holding investments for longer than twelve months results in a lower tax rate (“long-term” capital gains treatment) as compared to selling shorter-term investments at a gain. Again, there is a money-management wisdom here. Investors with a longer-term view are typically rewarded more than investors who engage in frequent stock trading.
The tax code is cumbersome and complicated, but as you complete your taxes this year, remember that this is one of the few areas that the government will actually reward you for clear actionable behavior that they spell out in advance. Thankfully, they are incentivizing the things that matter to society and generally make us more successful people. I’ll stop short of praising the tax code, but I find that a little understanding of the incentives can help us appreciate the complexity.
Any opinions are those of Brady Raanes and not necessarily those of Raymond James. This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.
Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.